On Tuesday morning, Enbridge (ENB) and Spectra (SE) revealed how they’d spent the Labor Day weekend by announcing their merger. After the highly contentious and ultimately unconsummated Energy Transfer/Williams soap opera, it was a welcome surprise to see two large energy companies join their businesses agreeably, without rancor.

Although the financial media excitedly covered the union, investors in the Master Limited Partnerships (MLPs) controlled by ENB and SE might well have wondered what’s in it for them. In another demonstration that the General Partner (GP) is where the action is, their long list of affiliated MLPs enjoyed only muted revaluation at best. The combined ENB/SE will control (among others) Spectra Energy Partners (SEP), Enbridge Energy Partners (EEP) and Midcoast Energy Partners (MEP). Yet since control of the MLP lies with the GP rather than the Limited Partners (LPs), there was no need to acquire the MLPs.

Not only did SEP investors not see a bump in their stock price, but SEP’s price fell as the market reflected its greater use as a source of funding for the $26BN combined capex program scheduled 2017-19. One of the MLPs, EEP, has a cap on its Incentive Distribution Rights (IDRs, the fees paid to the GP) of only half the limit set for SEP. This makes it potentially attractive for EEP to be rolled up into SEP where the more generous SEP IDR structure would apply to its cashflows. GPs always have options.

Suppose two big hedge fund managers merged. To avoid any confusion we’ll use fictitious names of two already successful firms, Masters of the Universe (“Masters”) and Kings of the Cosmos (“Kings”). The owners of Masters and Kings would rightly celebrate, since they anticipate many operating efficiencies as well as synergies by working more closely together. Clients of the hedge funds run by Masters and Kings would gamely cheer the union as well, reasoning that a good financial event for the stewards of their capital surely couldn’t actually be bad for the clients, even if no objective evidence supports such warm feelings. Principals from Masters and Kings would reach out to significant clients and explain their new growth strategy as “win-win”, “good for all concerned” and “driven by partnership philosophy.”  In fact, a good rule as an investor is to recognize that when a money manager refers to his clients as “partners” (think hedge funds and private equity) the fees look less partner-like and more wealth-transfer-like.

Masters and Kings will use their now larger aggregate Assets under Management (AUM) to grow their investment strategies to the limits of their capacity and beyond. They’ll rely on the Large Size = Highly Successful = Defensible Decision thought process of new investors and their consultants. The original clients’ misplaced earlier happiness is rewarded with lower returns.

It’s not a perfect analogy. MLP investors are generally treated far better by MLP GPs than are hedge fund and private equity clients. And hedge fund managers rarely merge, although size and performance reliably follow opposite paths.  But the ENB/SE merger is about synergies, faster cashflow growth and stability from diversification. The affiliated MLPs’ main purpose in life is to provide cheap capital to support the GP’s growth plans. A skillful GP generates MLP returns just sufficiently attractive to keep investors returning, but anything in excess is wasteful. When an MLP yield falls from, say, 7% to 5%, the corresponding strong price performance cheers its investors. However, to the GP the resulting low yield on its MLP creates an imperative to cash in by issuing equity cheaply to fund more growth. A GP who allows the yield on his MLP to fall too far is missing an opportunity to issue equity. Investment bankers rarely fail to point this out.

We like the ENB/SE merger, but that’s because we’re invested in ENB and SE rather than any of the affiliated MLPs. We also note that Williams Companies (WMB) continued the rally that followed its escape from the altar with Energy Transfer. The 11.4X Price/Distributable Cash Flow multiple of WMB looks attractive relative to SE’s 25.3X, more so following ENB’s willingness to merge at that valuation.

We are invested in ENB, SE and WMB

Talk about MLPs nowadays and pretty soon you’ll get to crude oil. Few will quickly forget the collapse in crude from 2014 that led to the collapse in MLPs. To be an MLP investor seemingly requires a view on the price of what moves through their infrastructure (although only 7% of pipelines in the U.S. carry oil; natural gas, natural gas liquids and refined products are more dominant).

Since pictures can be more eloquent, we’ve produced some visual insight to the long term relationship between the two. Going back to 1996 (the start of the Alerian Index) crude and MLPs have sometimes moved together and sometimes not. However, an investor who had the foresight to call oil’s sometimes violent but ultimately limp twenty year move from $19.50 a barrel to $43 today might have been dissuaded from buying MLPs. He would have missed a thirteen fold increase in value.

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However, we’re not trying to forecast the level of one from the other but their respective returns (forgive me, their first derivatives). How will changes in crude oil affect returns to MLP investors? Both have moved up over twenty years, but not always together as the second chart shows.

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And the third chart confirms what we all knew anyway, which is that their returns have become more correlated. In fact, the past couple of years have seen a dramatic shift in the relationship. In June 2014 the correlation was 0.1, which is to say there was effectively no relationship at all. Since then it has tightened to levels last seen in the 2008 financial crisis, when everything apart from government debt was falling.

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Having examined the past, what can we conclude going forward? First, correlations tend to mean-revert, and it’s not a big leap to suggest that MLPs and crude oil will decouple to some extent. The three month correlation of daily returns (not pictured here) is more sensitive than the 12 month correlation we’ve used, and it shows that the relationship has weakened in recent weeks.

Another point to note is that correlations across asset classes in general are moving up. Stocks and bonds have both been registering new highs. As MLPs have recovered from their February low they become more highly correlated with both asset classes (although at still 35% off their old August 2014 high a switch from almost anything into MLPs looks attractive). And in fact, MLPs have demonstrated a more meaningful relationship with stocks both recently and over twenty years. So the more pertinent question for the potential MLP investor is to ask where stocks are going, but perhaps that seems both obvious and unanswerable, so attention shifts back to crude.

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We think the correlation will come down from current levels. But as U.S. hydrocarbon production increases our economy will gradually enjoy less of a consumption boost when crude oil falls. Traditionally, cheaper gasoline has been regarded as a tax cut, but many economists were surprised at the muted boost to consumption that we saw last year.

We also think the long term outlook for crude oil is positive. $1TN of cuts in drilling budgets through 2020 will make it hard to source new supply needed to offset roughly 5MMB/D of depletion and another 1.0—1.5MMB/D of new demand. We wrote about this recently in Why Oil Could Be Higher for Longer.

It’s perfectly natural for investors to mention crude oil and MLPs in the same breath. But we think the strong recent relationship will weaken, and industry fundamentals will dominate again.

Stocks have in recent years been the destination of choice for bond refugees. The guiding strategy behind monetary policy since 2008 has been to drive investors into riskier assets so as to boost economic growth. Amid mounting evidence that this objective was being achieved, the Federal Reserve has contemplated the timing around ending this strategy by normalizing rates. In fact, the Federal Reserve has provided so many false warnings of an impending tightening of monetary policy that it’s barely worth paying attention. I have kept track of their evolving rate forecasts ever since they began providing greater precision back in January 2012. The chart of “blue dots” represents individual FOMC members’ expectations for the Fed Funds rate. Four and a half years ago they kicked off this greater openness with a forecast of a single tightening that year and a 0.75% rate by 2014. It’s fair to say that in early 2012 none of them expected the August 2016 funds rate to be where it is at 0.25%. Ever since they started with the blue dots, they’ve strained to adapt their updated forecasts to their persistent inaction.  It has been an amusing if not especially informative spectacle. You’d think it would be easier to get it right than the record suggests — they are, after all, merely trying to forecast their own actions. However, tactics regularly overwhelm strategy, as a moment of weakness in any sector of the economy is extrapolated into the possibility of a disappointing GDP number. If you look hard enough, there’s always softness somewhere. FOMC members possess many skills, but good forecasters they are not.

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Not everyone has been surprised by the lethargic return to “normal” interest rates. Since it is the political season (i.e. shameless self-promotion is all around us), back in 2013 your blogger noted high levels of public debt and concluded that, “As a society we want low rates, and the Federal Reserve is pursuing a set of policies that are clearly in the public interest.” See Bonds Are Not Forever; The Crisis Facing Fixed Income Investors (Wiley, 2013).

Consequently, interest rates have remained lower for far longer than most investors expected. Every fixed rate mortgage has turned out to be more expensive than going with an adjustable one. Every non-defaulting corporate bond issued was, in hindsight, more costly than relying on floating rate debt. Eventually a borrower somewhere will lock in an all-time low in rates, but it hasn’t happened yet.

It’s not hard to find examples of strong performance in bonds, but even by recent standards I found the chart below from the Financial Times striking. The UK may have voted itself a recession via Brexit, but among the winners are holders of long-dated Sterling denominated corporate bonds whose prices in some cases have reached two times their par value at maturity.

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Because of continued central bank monetary accommodation, the indices touching new highs are many and varied. Stocks, bonds, utilities and REITs are all at or very close to all- time best levels. As a result their yields are all commensurately paltry, as one might expect. By comparison, energy infrastructure, as represented by the Alerian MLP Index, offers both a substantially higher yield and a meaningful discount to its former high. With so many asset classes trading at hitherto unseen levels, it’s increasingly difficult to identify pockets of value. Momentum investors of course have plenty of choices, since so many sectors have strong upward momentum. MLPs have been no recent laggard on this score either, having leapt 60% from their low this past February. But it seems to us that if you like your investments to offer some kind of value cushion for when the momentum inevitably turns, MLPs should hold your attention. The yield spread between MLPs and REITs remains close to the widest levels it reached during the 2008 financial crisis. Switching from REITs or Utilities into MLPs looks like a portfolio upgrade.

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For information on our MLP mutual fund, please click the link below:

Last week’s blog post (Williams Satisfies Two Masters) highlighted the different views of cash payouts by the MLP investors who hold Williams Partners (WPZ) and the C-corp investors who hold Williams Companies (WMB), the General Partner of WPZ. WPZ investors value regular payouts whereas WMB investors are driven by total returns. WMB neatly gave both types of investor what they desired by diverting WMB dividends to buy new WPZ units which provided cash to fund WPZ’s capex program, and thereby eliminated the risk to WPZ’s distribution. One of the powerful features of the GP/MLP structure is that is allows a business to access different classes of investors who can have different objectives. As their appetite to provide capital fluctuates, the GP/MLP can access the more willing investor class.

Continuing this theme, Energy Transfer similarly found a way to make everyone happy with the same set of assets.  CEO Kelcy Warren is masterful at moving cashflows and businesses around to find value. Aligning your interests with Kelcy Warren works most of the time, even if he is occasionally ethically challenged (see Is Energy Transfer Quietly Fleecing Its Investors?).

On their recent earnings call, Energy Transfer Equity (ETE) generously announced that it would waive $720MM of Incentive Distribution Rights (IDRs) due from Energy Transfer Partners (ETP) to ETE over the next 6 quarters.  IDRs are the payments an MLP makes to its GP and are somewhat analogous to the incentive fees a hedge fund manager earns from his hedge fund. ETP traded up following the announcement of this largesse, and ETE traded down.  On the surface this is a straight transfer of value from ETE to ETP, a movement of cashflow from one pocket to the other. It’s a zero-sum transaction.

The ostensible reason is to support ETP’s stock price which will make it easier to sell new units of ETP. On the previous earnings call, Kelcy said: “In order to support ETP with its cost of equity capital in light of ETP’s current common unit price, ETE has recently advised ETP that ETE intends to waive its rights to receive incentive distributions, with respect to ETP’s 2016 issuances of common units… whether pursuant to the ATM or other offerings of common units, through fourth-quarter 2017 distributions. As these potential IDR waivers have not been approved by the ETE board, ETE is not formally bound to these proposed IDR waivers. This reinforces ETE’s commitment to support ETP.”  On the same call, Kelcy noted that, “ETE will do what it needs to do to support ETP”

ETP rose 10% on the day of the announcement.

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Although the conference call made it sound like an altruistic move by ETE, the relevant SEC filing noted that in exchange for these IDR waivers ETP was granting ETE new Class J units which would transfer $1.8BN of ETP’s depreciation, depletion and amortization (“DD&A”) to ETE over a period of three years (2016-18). Both ETP and ETE are partnerships issuing K-1s, so the proportional share of depreciation runs through each investor’s tax return. ETP investors will in aggregate have $1.8BN less in tax-deductible depreciation expense, approximately $3.44 per unit (there are 524MM ETP units outstanding). Assuming a 45% marginal tax rate (K-1 tolerant MLP investors are usually in the top rate) the taxable ETP investor is $1.55 per unit worse off. The IDR waivers work out to be worth $1.37 pre-tax per unit. So it’s at best a wash.

Prior statements from ETE include an assertion that ETE would not suffer any reduction in cashflows from ETP, and on the most recent conference call, Kelcy confirmed that there would not be additional IDR waivers applied to new equity raised at ETP. The IDR forgiveness is not equally spread over six quarters but is modestly back-ended. Therefore, we deduce that ETP will issue additional equity which will pay IDRs to make up for the shortfall from this IDR waiver. The rise in ETP’s stock price that followed this announcement makes it a little easier to issue equity. It also shows that ETP is valued, like other MLPs, on a pre-tax basis.

While MLP investors are drawn to the sector because of the tax-deferral that depreciation charges afford, few calculate their effective after-tax return on each individual security. They just send the K-1s to their accountant, who grumbles while charging a bit more, and the investor winds up with a lower tax bill. Figuring out which MLPs one holds are the most tax-effective is beyond most investors’ interest or ability. After-tax returns are notoriously quixotic and vary based on an individual’s tax situation. ETE management has insightfully spotted this. For this reason, most investment analysis relies on pre-tax returns. And sure enough, Barron’s quoted four analysts who gushed about the IDR waiver while ignoring the loss of tax shield (see Energy Transfer Partners Gets Fee Break from Parent, Shares Rise).

Kelcy has figured out that if investors don’t value something that highly you might as well give it to someone else. ETE investors (of which Kelcy is 18%) value the tax shield more accurately, which is clear since ETP’s stock rose even though the after-tax outcome for ETP investors didn’t add any value. Meanwhile, not only does the swap of tax shield for IDR waivers leave ETE investors better off after tax, but ETP can now issue new equity more easily, which will throw off additional IDRs for ETE indefinitely. The IDR waiver is expected to be $130M in 4Q17 after which it expires.  Starting in 2018 ETE will receive $520M more in IDRs each year for its “support” in which it gave up no cash flows and received $810M of value in DD&A units. Those Energy Transfer people are pretty clever.

We are invested in ETE and WMB

Just so it doesn’t seem as if we only pick on Energy Transfer, here’s a link to a recent TV spot on hedge funds.

Williams Satisfies Two Masters

Master Limited Partnership (MLPs) have been reporting earnings over the past couple of weeks. They were largely as expected with several names providing modest positive surprises. There were also some other interesting announcements – notably the sale by Energy Transfer Partners (ETP) and Sunoco Logistics (SXL) of part of their interest in the Bakken Pipeline Project to Enbridge Energy Partners (EEP) and Marathon Petroleum (MPC).

We calculate that ETP and SXL collectively invested $2BN developing this asset and have received $2BN for a partial interest, leaving them with a significant economic stake for minimal cash outlay. In addition, they removed competitor project Sandpiper by bringing its sponsors into their project and MPC’s refineries will be an important customer which could provide an uplift to volumes.  The value of the assets and backlog of the Energy Transfer Family is why we’re invested for now in ETP and SXL’s General Partner (GP), Energy Transfer Equity (ETE). This is in spite of misgivings about management who remain unapologetic about acting in their own self interest (see Will Energy Transfer Act With Integrity?). On this topic we salute friend Ethan Bellamy, R.W. Baird’s Senior Analyst covering MLPs, for shunning the usual, sycophantic “great quarter guys” posture of most analysts and asking CEO Kelcy Warren a direct question on his crooked converts.

But our focus this week is on Williams Companies (WMB). As they warned before the vote on their ill-fated merger with ETE, a dividend cut was coming and was duly announced this week. In the meantime, a failed effort to fire CEO Alan Armstrong resulted in six of thirteen board members resigning.

Dividend cuts usually reflect strategic mis-steps by management, and although WMB controls a unique asset in Transco (an extensive pipeline network covering much of the eastern U.S.) their stock has lagged the Alerian Index substantially over the past two years. CEO Armstrong might argue that the influence of activists led by Keith Meister (an investor whose long term advice is of dubious value, as we wrote in  The Corvex Discount) forced poor strategic decisions. The pending sale to ETE limited WMB’s ability to make any other moves, such as raising capital, until it was resolved.

But in this case WMB is using the cash saved from its reduced dividend to fund its growth capex, most of which is going to expand its Transco asset at attractive multiples. Although WMB cut its dividend by 70%, its MLP Williams Partners (WPZ) maintained theirs and both securities rose on the news. It was a perfect illustration of  the divergent views of dividends. WMB investors are total-return oriented and cheered the redirection of cash into high-return projects. WPZ investors just want the cash. Both classes of investors are getting what they want.

It reflects a different approach to the Sponsor/MLP model. Traditionally, the sponsor develops the assets and then sells them to its MLP through a “dropdown” transaction. The MLP raises capital through a secondary offering of equity (usually supplemented with debt) and uses the cash raised to pay its sponsor for the asset.

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This model broke down last year as MLP yields rose to levels that made equity financing prohibitive. And yet, many attractive investment opportunities remained. It illustrates that the problem with midstream MLPs last year was not poor operating performance but a need for growth capital in excess of traditional investors’ desire to provide it (see The 2015 MLP Crash; Why and What’s Next).

Prior to the WMB dividend cut, WPZ yielded 9.7%, representing an expensive cost of equity capital. The 70% cut in WMB’s dividend will save $1.3BN annually. WMB expects to invest $1.7BN through the end of 2017 in new WPZ units. WPZ will use this cash to fund its capex, thereby eliminating its need to issue equity to the public and also taking pressure off its distribution.

WMB can in the future sell the WPZ units it will be acquiring through the next five quarters when the market environment is better and yields are lower. It’s an elegant way to provide WMB C-corp investors what they want (invested capital in high return projects) and WPZ investors what they want (stable distributions under any and all circumstances). Because the two classes of investors have different objectives, there are different times to access them for capital. Today the C-corp investor is more receptive, whereas MLP investors are setting a higher price. In time the cycle will shift, and the MLP investor will be a more eager capital provider, at which time WMB may sell its WPZ units. Crucially, the Incentive Distribution Rights (IDRs), under which WMB earns 50% of WPZ’s incremental Distributable Cash Flow (DCF) will remain with WMB even after the WPZ units are sold. It’s like a hedge fund manager investing his own cash in his hedge fund when investors are hard to find but opportunities attractive, and later on replacing his capital at a profit with outside investors’ money which will pay the ubiquitous “2 & 20”.

This is why it’s better to invest in MLP GPs.

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We are invested in ETE and WMB

More on Solar

We received quite a few comments on our August newsletter (see Why Electric Cars Are Good for Fossil Fuels). We see solar-derived electricity generation growing at a high rate, but maintain that electric cars will for the foreseeable future consume electricity that is largely derived by burning natural gas and coal.

There are solar bulls who forecast that the sun will provide a substantial portion of our electricity in less than a generation (see Ray Kurzweil: Here’s Why Solar Will Dominate Energy Within 12 Years). Mr. Kurzweil’s Wikipedia page lists him as a computer scientist, inventor and futurist. He works for Google, so is a seriously smart guy.

So we won’t take on Mr. Kurzweil’s forecast directly; I’m personally a late adopter on most new things and on solar domination well, I’m just not quite there yet. But an important challenge for solar is that U.S. electricity consumption is barely growing, rising at 0.5% annually since 2000 according to the Energy Information Administration’s Annual Energy Outlook 2016. So to be significant quickly, solar will have to gain market share from traditional sources of electricity generation – and it is expected to gain at the expense of coal (as is natural gas). But to become the dominant source of electricity it will have to undercut many power stations that still have years of useful life ahead of them.

Moreover (as my partner Henry so insightfully noted), to do so they’ll need to deliver electricity not simply cheaper than the fully-loaded cost of a power plant but below its marginal cost. A nuclear power plant involves a high up-front cost to construct. Thereafter, its operating costs are the threshold for any new, competing source of electricity. As in micro-economics, once your fixed costs are spent, as long as you cover your variable costs you’ll keep producing widgets (or Megawatts). Power plants last for decades, so the openings for solar even if competitively priced will occur very slowly as less efficient plants are retired.

Furthermore, utilities and municipalities account for two thirds of U.S. gas transport capacity (pipelines) and sign long-dated volume & price commitments, making a quick switch ever more cost-prohibitive.  Replacing retired coal capacity is how natural gas is making inroads into coal (although expensive environmental regulations are hastening the process). For these reasons and a lot of others specific to the intricacies of the electric utility sector (including load balancing and regulations), we think solar will grow and yet fail to be dominant for decades, similar to all past transformative energy technologies.

Earnings season is here, and with it the quarterly ritual of the earnings conference call. Quite a few MLPs have declared their distributions, and of the 32 that we’ve seen so far none have cut while half have announced increases. Those we care about include Western Gas Equity Partners (WGP), which announced a year-on-year increase of 19.2%. Its MLP Western Gas Partners grew at 10.7% year-on-year, illustrating the faster growth enjoyed by General Partners. Similarly, EQT GP Holdings and EQT Midstream, increased their 2Q16 distributions 63% and 22% respectively over 2Q15. Magellan Midstream (MMP) grew at 10.8% year-on-year, while Crestwood Equity Partners (CEQP) was flat after cutting its distribution in April (see Crestwood Delevers and Soars). CEQP still yields over 11%.

Kinder Morgan (KMI), no longer a Master Limited Partnership (MLP) but nonetheless a bellwether of the sector, reported a solid quarter and maintained its dividend (slashed by 75% in December) unchanged. KMI is big enough that their fortunes are somewhat reflective of the overall energy infrastructure industry. Chairman Rich Kinder can scarcely have had a wilder ride than the last three years. In January 2014, frustrated by the weakness in KMI’s stock price in the face of relentless criticism from a small research firm, Kinder famously said, “You sell. I’ll buy. And we see who comes out best in the long run.”

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Kinder no doubt believes the long run is longer than the time since he spoke those words, because KMI is still substantially lower than it was back then. Kinder was still bullish at the top, and his antagonist remained bearish at the bottom. At least they both have conviction. Like other MLPs, Kinder Morgan identified growth opportunities beyond the appetite of traditional MLP equity investors to provide financing. In 2013 MLPs were raising more in equity capital than they were paying out in distributions (see The 2015 MLP Crash; Why and What’s Next). The Shale Revolution had created the need for more infrastructure, but it still strained their traditional financing model almost to breaking point. Kinder of course abandoned the MLP model altogether and became a conventional corporation (a “C-corp”), which made their stock available to any global investor and not just the limited pool of U.S. taxable, K-1 tolerant buyers. For the rest of the MLP sector, new mutual fund and ETF buyers provided an additional source of equity capital for a time, but falling prices caused some of them to exit. Every MLP investor by now knows how 2015 ended. KMI hoped to maintain the MLP distribution payout model of returning approximately 100% of Distributable Cash Flow (DCF) to investors. Finally, with the double-digit yield on their stock communicating a complete absence of gratitude for this largesse, they accepted the inevitable and slashed the dividend so as to delever their balance sheet (see Kinder Shows The MLP Model is Changing).

Which brings us to the most recent earnings call. Successful, big companies don’t shift strategy every quarter, even if sell-side analysts desire more “market-responsive” (i.e. fickle) planning. KMI had long argued that a Debt/EBITDA ratio of 5.5-6.0X was appropriate given their diversified business. The strategy shift triggered by the dividend cut in December was accompanied by a new, relentless focus on bringing this leverage ratio down to 5.0X. The cash saved by reducing the dividend was earmarked for paying down debt and financing growth projects, resulting in a less levered, self-financing KMI.

December 2015 to July 2016 is scarcely the long run by most standards. Nonetheless, analysts on the recent call were heard asking why KMI couldn’t finance some of its backlog of growth projects by issuing debt. Their $13BN backlog has a capex/EBITDA multiple of 6.5X, and is currently financed fully with internally generated cash (i.e. equity). This is down from 7.5X at their Analyst Day earlier this year, the result of “high-grading” their backlog (i.e. dropping the less attractive ones).  With a 15% unlevered after-tax return target on projects and a borrowing costs in the low single digits one can begin to see the appeal of debt financed growth.

Two quarters ago, sell-side analyst questions revolved around the speed at which KMI could reduce its leverage. Today, they’re being asked why they don’t increase leverage. One can hear the sighs of exasperation in the management team as they respond to the shifted goalposts such questions represent. It’s why running a private company can be more attractive – in fact, we often noted last year that if MLPs were unlisted and investors had to rely fully on financial statements in their evaluations, they would have concluded that not a great deal had changed. But this rapid shift in sentiment is what creates the opportunities for those that are able to keep their eye on the ball. Happily, Barron’s is shifting gears rather more slowly, with their first cautiously positive piece on MLPs in recent memory (see MLPs: Is It Safe to Dive Back Into the Pool Yet?). Skepticism is good.

We are invested in CEQP, KMI, MMP and WGP

The expression “like sending coals to Newcastle” can be traced back to the 17^th century, reflecting the insight that whatever else Newcastle needed in those days did not include coal. This windswept port on the North Sea was conveniently located near some of the biggest coalfields of northern England. During its heyday, American trader Timothy Dexter defied common sense and sent a shipment of coal to Newcastle, causing anticipation of a substantial loss. However, perhaps by luck he had the good fortune for his cargo to arrive during a miners strike, thereby profiting from unusual and temporary demand. Coal exports have long since ceased along with local coal production. Today’s Newcastle possesses little of note beyond an English football stadium with capacity well in excess of their local team’s ability (they were just relegated from the Premier League). Meanwhile, Newcastle in the Australian state of New South Wales has become the world’s most prolific coal exporting port.

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LNG to the UAE doesn’t quite roll off the tongue as easily as Coals to Newcastle, but it might be a modern-day equivalent. The Middle East has 2.8 quadrillion cubic feet of proved natural gas reserves, enough to meet current global demand for 23 years. OPEC reports that the United Arab Emirates (UAE) holds around 10% of this. And yet, earlier this year the Energy Atlantic LNG tanker unloaded 3.38 BCF (Billion Cubic Feet) of natural gas at the port of Jebel Ali, near Dubai, following an almost seven week journey from the Sabine Pass LNG terminal in Louisiana.

Somehow the power of economics (see Why the Shale Revolution Could Only Happen in America) has overwhelmed the logic of geographic proximity to make such a delivery commercially reasonable in spite of abundant local resources. To show this was no fluke, more recently the Creole Spirit unloaded a similar amount in Kuwait, also sourced from Sabine Pass. The region hasn’t developed sufficient energy infrastructure to properly exploit its resource domestically.

The story of America’s Shale Revolution was built on the single-minded pursuit of unconventional fracking technology by many independent exploration and production (E&P) companies as well as some extraordinary chutzpah by a few. The Frackers by Greg Zuckerman memorably tells the story of some of them. Cheniere Energy (LNG) under then-President Charif Souki was once intent on importing LNG into the U.S. to take advantage of relatively high domestic prices. Cooling natural gas to a near-liquid state (at -260° F) so it can be moved in a condensed form by ship requires a substantial investment (i.e. US$BNs) to create such a facility, as does the construction of a regasification plant on the receiving end. Souki’s career wasn’t obviously suited to leading Cheniere on this journey, having been primarily focused on raising money for banking clients in his native Lebanon and elsewhere in the Middle East. His past also included a stint as restaurant owner of Mezzaluna, the now infamous Los Angeles eatery where Nicole Simpson ate her last meal on June 12, 1994 before being slain by O.J. Simpson (ahem…allegedly).

Undaunted by the absence of any relevant experience, as President of Cheniere Souki set out to use his former banking ties to finance their new business. The Shale Revolution led to a collapse in domestic natural gas prices and turned the economics upside down, causing Cheniere to turn from prospective LNG importer to exporter.

The facility that can regassify LNG for normal use is not the same one that can liquify it for long distance transport. Converting an LNG import facility to an export one is not the same as reversing a pipeline, and many more $Billions were required for Cheniere to be ready for business. Just as export operations began, Souki was pushed out by its board of directors which included Carl Icahn. The boss’s substantial risk appetite was by now well known, but his latest plan to add a gas trading business was a risk too far for investors who could finally see actual cashflows on the horizon. Souki’s compensation over the years had matched his ego, but recognizing that his risk appetite didn’t match ours we have never invested in Cheniere.

The Sabine Pass facility began exporting late last year and is eventually expected to handle 3.8BCF per day. Some of its supply travels from the Marcellus shale in Pennsylvania along the Transco pipeline network owned by Williams Companies (WMB), in which we are invested. A few weeks ago I had the opportunity to be presenting in Laceyville, Pennsylvania to a group that included landowners receiving royalty checks from the production of natural gas under their property. As we noted last week, few countries assign mineral rights to the owner of the land beneath which they sit.

For just a moment, step away from the prosaic question of the market’s near term direction and consider this: an Egyptian-born Lebanese former restaurant owner raised $Billions to export liquefied natural gas over 11,000 miles to a region of the world whose wealth is totally reliant on hydrocarbons. It couldn’t have happened anywhere else, except America.

We are invested in WMB

A few weeks ago we wrote Why Oil Could Be Higher for Longer, and since then it has elicited quite a few comments back to us from clients and blog subscribers. We won’t repeat it in detail here since readers can simply click on the link above to see it. But our view is that the outlook for U.S. crude production over the intermediate term is very constructive, and certainly better than current consensus. This relates to the superior economics of shale wells compared to conventional drilling, and the associated ability of shale Exploration and Production (E&P) companies to quickly respond to changing prices by adjusting drilling activity faster than their peers.

“Shale wells,” (i.e horizontal wells drilled into source rock and stimulated by fracking) have many competitive advantages over conventional wells that give us confidence American production of Oil, Natural Gas Liquids (NGLs), and Natural Gas will greatly exceed consensus expectations to meet new energy demand and fill the void left by depleting fields.

A recent article in the Financial Times expanded on this theme (U.S. shale is lowest-cost oil prospect). A chart accompanying the article showed the break-evens of twenty potential future projects and the cheapest half-dozen are U.S. shale plays. In fact, shale oil development benefits from many of the advantages that are inherent in the U.S. Most Americans take for granted that property ownership comes with mineral rights for anything found below their property, but around the world this is by far the exception. In most countries mineral rights belong to the government. Getting a farmer to agree to allow drilling on his land is easier if he’s able to negotiate a monthly royalty check as opposed to a central authority simply exercising its control.

Although many of the cheaper sources of new oil are U.S. shale, Wood Mackenzie doesn’t believe there’s enough to satisfy the world’s consumption at current prices. Depletion of existing fields plus new demand create a need for roughly 6MMBD (million barrels a day) of additional supply annually. The market will clear at the marginal cost of the most expensive barrel needed to balance the market – a price that looks a good bit higher than today’s spot price. And for those who think offshore drilling can be attractive, BP just announced the final charge of $5.2BN for the 2010 Deepwater Horizon spill in the Gulf of Mexico. Their total costs for this one incident add up to $61.6BN, a hit only a few global companies could absorb. You can be sure that any offshore drilling in U.S. continental waters has to account for this possibility in its risk analysis.

Critically, low-cost U.S shale wells can be drilled much more quickly and come on with significantly higher initial production (IP) rates with steep decline curves.  In fact, a new shale well can go from planning to full capital payback before most new conventional  projects are even producing.  This fast decline rate also allows shale oil producers to hedge the bulk of their production, which occurs in the first several years, in the futures market which is only liquid for a few years out.  It’s worth noting that the quicker the payback the quicker shale E&Ps can plowback cash into new shale drilling. The chart below from the U.S. Energy Information Agency highlights how IP rates have improved over the past few years (click on image to expand).

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Geographically, the U.S. is blessed with generally sufficient water supplies close enough to the shale plays that they support, since fracking requires a lot of water. Entrepreneurial drive is as strong a force in America as anywhere, and that combined with highly developed capital markets make access to financing and substantial wealth accumulation possible for those who are able to profitably exploit this resource. And continued technological innovation spurred by entrepreneurs is relentlessly driving costs down faster than most expected and faster than conventional plays, further increasing their competitive cost advantages, playing to another American strength.

Even with all the American advantages and helped by the tailwind of high commodity prices it still took a decade for shale drilling to have a meaningful impact on output. Major shale drilling anywhere outside the U.S is a long way off, providing a huge first mover advantage.

In other words, the shale revolution is occurring because of all these inherent strengths in the U.S. On top of which, energy independence which is where we’re heading as a result, is in our national interest and highly likely to remain that way. The entire story is built on U.S. advantages and oriented towards U.S. interests. From a strategic perspective, given what we know today, it seems to us that perhaps the best secular investment theme available is the continuation of this trend, to the obvious benefit of the midstream infrastructure Master Limited Partnerships (MLPs) whose support is critical.

It’s no longer the case that a distribution cut is bad for an MLP. In April, Crestwood Equity Partners (CEQP) cut its distribution at the same time as announcing a JV with Con Edison and steps to reduce its leverage (see Crestwood Delevers and Soars). Last week Plains GP Holdings (PAGP) announced a simplified structure with its MLP Plains All America (PAA) and an 11% distribution cut at PAGP. Both stocks moved sharply higher on a perceived lower cost of capital and therefore improved growth prospects. Williams Companies (WMB) is likely to cut its dividend so as to reduce leverage, but at a 12% yield there can be few who would be surprised by this. A distribution cut in support of a stronger balance sheet seems to attract more buyers than sellers nowadays.

Lastly, we note that Shell Chemicals is investing $6BN in a new ethylene facility in SW Pennsylvania near Pittsburgh (artist’s impression from Shell at left). It’s located there to be close to its supply of ethane in the Marcellus and Utica shale areas, of which it expects to consume 90-100 thousand barrels a day. The facility will in turn produce 1.5 million tonnes per annum (MTPA) of ethylene and 1.6 MTPA of polyethylene, widely used in everything from food packaging to automotive components. This is not a region that has seen a new large industrial project such as this in living memory. It’s another example of the tangible results of the shale revolution.

We are invested in CEQP, PAGP and WMB

The Brexit vote is now two weeks behind us and I still watch developments with jaw agape. Rarely in history has the consequence of a popular vote led so directly to a recession. The IMF has forecast that the UK economy will shrink by 1.5% through 2019 if they agree to a Norway-style EU access (i.e. similar EU budget obligations, lack of immigration controls and submission to EU regulations but with no ability to influence them, not exactly what Brexiteers voted for). Or, if EU access conforms to the World Trade Organization (WTO) tariff framework, the UK economy will shrink by 4.5%. Leading Brexit campaigners such as Boris Johnson and Nigel Farage have exited stage left now that their goals have been achieved. Brexit voters gamely advise that everything will be OK, while decision makers prepare for a recession. Fewer UK jobs will likely reduce immigration anyway, although this is hardly the best means of achieving that goal. And yet, in theory the entire non-UK EU population of almost 450 million people could have relocated to the UK, at which point the country would have resembled a Piccadilly line tube train at 5pm. Free movement of people, a core, inviolable principle of the EU, is absurd.

Nonetheless, Brexit was not a carefully considered response but a visceral reaction with far-reaching and poorly considered consequences. Churchill  once said, “The best argument against democracy is a five-minute conversation with the average voter.” Brexit leaders have led their followers to the cliff and then retired to the pub for a drink while they watch the leaderless deal with the aftermath.

One result is that bond yields globally have fallen to hitherto unimaginable levels. The Barclays Aggregate Index is +6% YTD, beating the S&P500. Regular readers will be familiar with our past illustration of the paltry returns available on bonds whereby we compare a barbell of stocks and cash with the ten year return on bonds. In our April newsletter we wrote about The MLP Risk Premium. With reasonable assumptions about MLP distribution growth rates and prevailing valuations in ten years, you could swap out your bond portfolio for as little as 10% in MLPs with the rest in cash while still achieving a bond-like return. MLP yields have fallen since we wrote that in April, but so have bond yields so the broad set of choices still favors almost anything over bonds but certainly still MLPs.

Federal Open Market Committee (FOMC) minutes released last week confirmed what we’ve long noted, that Janet Yellen will never miss an opportunity to avoid raising rates. Ignore their words and try considering this Fed’s actions as if they’d announced the solution to excessive debt was to keep rates low for a long time. The rhetoric doesn’t reflect such a strategy but their actions most assuredly do. Waiting for rates high enough to justify an investment requires substantial patience, during which time investors are steadily pursuing equity-type risk with its better return prospects.

Tallgrass Energy GP (TEGP) raised its quarterly distribution by 16.7% quarter-on-quarter and 84.2% year-on-year from its pro-forma 2Q15 level. Not every MLP or GP is raising its distribution by any means, but less than six months ago such would have been unthinkable. Meanwhile, the Alerian MLP ETF (AMLP) reached a milestone of sorts, in that the recent recovery in MLPs has finally moved AMLP to where it once again has unrealized gains on its portfolio. As we noted in March (see Are You in the Wrong MLP Fund?) this is the point from which AMLP investors will now earn only 65% of any subsequent upside since the U.S. Treasury will take 35% through corporate tax. Indeed, the tax drag has already had an effect, since AMLP’s YTD performance through June 30 is +10.7% versus the Alerian Infrastructure Index +13.1%. Those AMLP investors who are bullish on the sector (which presumably includes all of them) will, if right, contribute modestly to Federal finances at the expense of their own investment results and reputation for careful analysis. AMLP is the refuge of those who stop at Pg 1 of a prospectus rather than examining Pg 23, Federal Income Taxation of the Fund. This is part of the reason why a more thoughtfully designed, non-taxable, RIC-compliant MLP fund (which we run) has done very well.

We are invested in TEGP.

As regular readers know, the proposed merger between Energy Transfer Equity (ETE) and Williams Companies (WMB) has been a rich source of material. Last week a judge’s ruling enabled ETE to cancel the deal since a needed tax opinion was not forthcoming. WMB found it convenient to say the least that ETE’s tax counsel Latham Watkins, having originally provided informal guidance that no adverse tax outcome was likely, later changed their minds coincident with their client souring on the deal. However, Judge Sam Glasscock III found no coincidence and absent a tax opinion that the deal was tax-free, ETE had its escape hatch.

We didn’t think the deal would get done, but we remain interested in the fate of the convertible preferred securities ETE issued in March. As we wrote before (see Is Energy Transfer Quietly Fleecing Its Investors?), a select group of ETE insiders representing 31% of the common units outstanding was given the opportunity to swap their units for preferred securities with a guaranteed dividend which could be reinvested in more common units at $6.56 per share (ETE closed Friday at $13.80). Ostensibly this was to shore up ETE’s balance sheet given the $6BN cash payout they had agreed to under the merger. But it had the additional result of devaluing ETE units for all the other holders, including WMB investors who would be receiving new securities linked in value to ETE. WMB naturally sued. This looked like a very aggressive, almost scorched earth negotiating strategy by ETE in their efforts to force a renegotiation on WMB. However, as we noted in May, ETE CEO Kelcy Warren indicated that these securities would remain outstanding even if the merger was cancelled.

WMB’s lawsuit of these securities didn’t receive a ruling from Judge Glasscock. He recognized his ruling on the tax opinion was likely to scupper the deal anyway, rendering WMB no longer an injured party. However, the same judge is hearing a lawsuit on this issue from other plaintiffs.

Without doubt, the abovementioned securities represent fraud by ETE’s management. Every ETE investor would welcome the opportunity to swap their common units for the ones Kelcy and his friends own. He has a fiduciary obligation to other ETE investors which this action clearly violates, transferring substantial value (we estimated $1.3BN) from investors in the same class of units to the insiders. Since ETE no longer faces the prospect of finding $6BN, the apparent need for the securities themselves has disappeared and we await their cancellation.

So we’re watching to see if ETE  acts with integrity and voluntarily cancels the convertible preferreds. Or will they seek to retain this wealth transfer with a different justification? It’s going to be hard for ETE to negotiate future deals credibly following the WMB experience, but especially so if they choose wrong on this issue. One can forgive the second thoughts on the merger, because the market moved sharply against MLPs last year. This was an issue of judgment. But a CEO who openly defrauds his public partners has lost his reputation for good. What use to the world is a dishonest billionaire, beyond donating his money to have a couple of buildings named after him? In future dealings with Kelcy and the other insiders, including John McReynolds (President of ETE’s General Partner), Matthew Ramsey (President of Energy Transfer Partners), Marshall McCrea III (Group Chief Operating Officer) and Ray Davis (retired, co-founder), you’d always have to assume that they could once again fail to act in good faith having done so before. Based on the data we analyze about our blog subscribers, we know senior managers at ETE are reading this.

It may surprise, but we remain invested in ETE. We believe Kelcy Warren will cancel these securities. He and his team have built a fantastic business. They are enormously talented. They can avoid any loss of face by simply saying the securities are no longer needed. This is the right thing to do. You won’t find any sell-side analysts asking tough questions on this issue out of fear of causing offense. At SL Advisors we are free to say what many other analysts are merely thinking, because our only interest in ETE is that its value appreciate and its stock price rise. In this way, we are completely aligned with our clients and free to call it as we see it.

Kelcy, do the right thing.

We are invested in ETE and WMB