Williams Companies Stands Alone at the Altar

The Energy Transfer-Williams deal continues to be a rich source of intrigue and fascinating machinations. Sometimes a target company will try and get out of an agreement to sell itself so as to join with a more eager suitor. But it’s not often that an acquirer has second thoughts, and reading through a recent SEC filing by Energy Transfer reveals a blow-by-blow account of the frequent discussions of the William board as they considered their options.

As long ago as February 2014, Energy Transfer Equity (ETE) CEO Kelcy Warren had reached out to Williams Companies (WMB) CEO Alan Armstrong to discuss a combination. Armstrong was initially lukewarm and from the looks of it never became enthusiastic, even voting against the combination when it was finally considered by the WMB board in September 2015.

The “Background to the Merger” is in a section of a filing made, ironically, by Energy Transfer Corp (ETC), an entity created specifically to acquire WMB shares at closing but which for now is doing little more than posting SEC filings. Although ETC is currently controlled by ETE, its filing includes a methodical recital of the WMB board’s consideration of ETE’s offer as well as other competing proposals. Indeed, as the negotiations reached a conclusion WMB insisted on severely limiting ETE’s ability to walk away from the transaction. WMB sought to tighten the “material adverse effect” language that is commonly used and which allows a party to cancel a proposed transaction for no penalty in the event that a major surprise upsets the original economics. Kelcy Warren had pursued WMB for almost two years, and having finally succumbed to their eager paramour the WMB board was intent on making the deal stick.

Buyer’s remorse followed with indecent haste (see The Energy Transfer-Williams Poker Game). Within months ETE’s CFO Jamie Welch was reported to be privately lobbying WMB shareholders to press for modified deal terms, since the $6BN cash payment agreed to by ETE was weighing on the stock price. In fact, the performance of both stocks has been disastrous since the deal was announced, since the new ETC stock with which WMB investors would be paid was to be linked to collapsing ETE, thereby diminishing the value of the sale. It became obvious why ETE wanted out – less clear why WMB insisted on completing a transaction whose value had disintegrated. In May of 2015 ETE’s proposal to WMB had valued the stock at $64. By March of 2016 the prospect of the deal closing had dragged WMB down to $15. By then, Kelcy Warren had fired his CFO (who has sued) and gone nuclear in his efforts to get the deal changed or cancelled; ETE made a possibly illegal and certainly unethical move when they issued preferred equity only to insiders on preferential terms (thus devaluing the currency WMB investors would receive in the transaction, and drawing a WMB lawsuit). In case ETE’s distaste for the transaction wasn’t already clear, they subsequently posted an SEC filing slashing the originally expected $2BN in annual commercial synergies to only $170MM. For good measure they added that the combined company’s presence at WMB’s current headquarters in Tulsa, OK would be substantially reduced.

At this stage both stocks are attractively valued if they remain separate. So it’s interesting to learn how comparatively easy it is for the deal to be broken if the acquirer doesn’t wish to proceed. The merger-arb funds and the journalists who bet on a closing missed this. The New York Times reported on March 4^th that, “…the company’s options appear to be severely limited.” With respect to breaking the deal, last week’s S-4 from Energy Transfer Corp noted that their tax counsel might not be able to deliver a needed tax opinion in time, a necessary condition for closing. One can imagine that if the acquirer doesn’t want to proceed, and an affirmative tax opinion is required from its legal counsel, it shouldn’t be difficult to delay or even fail to obtain such an opinion. Originally WMB didn’t want to be bought and ETE gave chase. Having finally been caught, WMB desires consummation while ETE claims its earlier passion has gone. WMB is at the altar while ETE nurses the mother of all hangovers in a hotel. Did they find each other on Match.com? In this upside-down world of love professed, only to be returned unrequited, it must be difficult for WMB to press a damages claim. Since the abovementioned filing cast further doubt on the deal WMB’s stock has risen. In any event, on June 28^th either party can simply walk away. For Kelcy Warren that date probably can’t come quickly enough. The next target of his affections may run a little faster.

Crestwood Delevers and Soars

On Thursday Crestwood Equity Partners (CEQP) announced a joint venture with Con Edison which placed a 13X EBITDA multiple on the part of CEQP that was rolled into the JV and allowed them to use cash proceeds from the deal to reduce leverage. It was another example of public market equity prices underpricing the value that other energy sector investors assess to be present. Although CEQP jumped over 50%, we believe it’s still attractively priced with a 14% yield following a distribution cut, 1.6X distribution coverage and leverage dropping to <4X by year end. We noted the potential value in CEQP in February (see The Math of a Distribution-Financed Buyback)

Sell-Side Shockers

Meanwhile, MLPs have since February kicked off the casket lid and leapt up, showing vigorous signs of life. Many formerly wealthy MLP investors who hung on are no doubt relieved to be restored from potential mobile home dwellers to at least the category of mass-affluent. Sell-side coverage of the sector is becoming more cautiously constructive, buoyed by the Alerian Index finally reaching positive territory year-to-date. We came across one amusing recommendation from a clearly overworked analyst whose bosses evidently decided to issue an emergency research piece initiating coverage on MLPs. The hapless analyst breathlessly rates Columbia Pipeline (CPGX) “Market Perform”, failing to consider  TransCanada’s (TRP) recently agreed acquisition of CPGX for $25.50 in an all cash deal. So regardless of how the market performs CPGX is going to $25.50. The same analyst thinks WMB investors will suffer a 50% dividend cut if the merger with Energy Transfer goes through, overlooking the 1.5274X ETE exchange ratio they’ll receive for their WMB shares. Who says sell-side research isn’t worth reading?

We are long CEQP, ETE and WMB in our mutual fund and separately managed accounts.

Chart source: Yahoo Finance

The U.S. Energy Information Agency (EIA) is a powerful resource for those interested in the topic. They recently noted that in 2016, natural gas-fired power generation would exceed coal for the first time in history. 18.7 gigawatts (GW) of new gas-fired capacity is due to come online between now and 2018 replacing dirtier coal plants as they are gradually phased out. Moreover, much of this new capacity is located near its source of energy, so Pennsylvania, West Virginia and Ohio (Marcellus and Utica shales) as well as Texas and Louisiana (Eagle Ford and Haynesville shales) have seen much of this added capacity. The travails of the coal industry are well known, with the bankruptcy filing last week of the world’s biggest coalminer Peabody Coal (BTU) highlighting the economic challenges of producing the dirtiest fossil fuel. Cheap natural gas has long been on course to supplant coal for power generation in the U.S. The EIA’s Annual Energy Outlook 2015 forecasts natural gas to move from 27% to 31% of electricity generation by 2040. Only renewables will also enjoy an increased share, with Nuclear and Coal both slipping in importance.

What’s taking place is a fairly dramatic transformation of the ways in which the U.S. uses energy compared with as recently as five years ago. The unlocking of vast amounts of natural gas has provided very competitively priced power for industry, cheap ethane feedstock for use in the production of plastics and by displacing coal has allowed the U.S. to curb its production of greenhouse gases. This last point is especially ironic since the U.S. never signed up to the Kyoto Protocol, whose goal was to limit emissions of carbon and other pollutants.

Sometimes when chatting with clients about energy consumption and fossil fuels I’m asked why we don’t worry about electric cars and solar power upending the sourcing and consumption of electricity. Electric cars sound clean, but it depends on how the electricity they use is generated. The good news here is that it’s increasingly from relatively clean natural gas although it does vary across the United States. A friend of mine is planning to buy a Tesla, and her environmentally-sensitive decision is supported by the virtual absence of coal-fired electricity production in New York and New Jersey where she’ll be driving. Wyoming may offer spectacular scenery and an environment worth saving, but with 89% of its power coming from coal a Tesla won’t much help the environment there. West Virginia and Kentucky are similar.

Renewables are expected to gain in importance, going from 13% of our electricity generation to 18% by 2040 according to the EIA as the first chart shows. Solar energy will grow at a fast rate but from a very low base, as is shown in the second chart. It looks to me as if my grandchildren will reach retirement before they inhabit a world in which solar is the dominant source of energy. Although we invest for the long term, that’s too far out even for us to incorporate into our thinking.

Low prices for crude oil and natural gas have also created challenges across many industries beyond their own. For example, the economics of renewables, including solar, have suffered from cheaper competing fossil fuels. SunEdison (SUNE) is close to bankruptcy as it grapples with this problem. Banking hasn’t been immune —  JPMorgan, Wells Fargo and Bank of America all reported higher loan loss reserves against their energy portfolios last week. And last October, somewhat improbably, United Airlines blamed a disappointing quarter on fewer corporate executives flying to visit oil fields; most would think cheaper fuel is good for airlines.

Although last week saw the bankruptcy of the biggest miner of “old” fuel in Peabody and the pending demise of a champion of new energy in SunEdison, Tallgrass Energy (TEP) had a good week. This Master Limited Partnership (MLP) provides natural gas transportation and storage services in the Rockies and Midwest through their Tallgrass and Trailblazer systems. TEP has a publicly traded General Partner (GP) called Tallgrass Energy GP (TEGP), which runs TEP. As is invariably the case, management is invested in TEGP rather than TEP. If you want to invest alongside management in an MLP it usually pays to own the GP instead. In the case of TEGP and TEP, management insiders have around $1.9BN invested in the GP and only 18MM in TEP itself, a difference of 101X. They obviously have an opinion about the relative merits of these two securities. Last week, TEGP raised its quarterly distribution by 21.4% compared to the previous quarter. Not every part of the energy sector is struggling.

We are invested in TEGP

Drilling Efficiencies

A week or so ago the Energy Information Agency (EIA) released the results of a survey showing the average cost to drill and complete a well in four of the major producing regions in the U.S. As the EIA chart shows, costs were rising going into 2012, but thereafter started to fall and maintained that trajectory as exploration and production companies aggressively sought improved efficiency from their technology and their service providers.

Although this drop in well costs has obviously been good news for the E&P industry (albeit less so for their service providers) it has been complemented by greater output per well. Using data from the EIA’s Drilling Production Report we have created the four subsequent charts, showing, respectively, output per rig for crude oil and natural gas, and total production of crude oil and natural gas, for each of the four regions highlighted by the EIA.  Reduced costs to complete a well might accommodate lower average production per well, but in fact the reverse has generally been happening which has allowed IRRs (Internal Rates of Return) to remain substantially more attractive than would otherwise have been the case.

Natural gas production efficiency has improved dramatically in the Marcellus, which has caused the north east U.S. to switch from being a natural gas importer to an exporter and has begun to displace supplies from eastern Canada.

This is why crude oil and natural gas production have only fallen appreciably in the Eagle Ford, where higher initial production rates of new wells (due to higher pressure) are more than offset by faster decline rates than in other regions.

Natural gas output has soared in the Marcellus, aided by falling costs and a more than five-fold increase in output per rig since 2010. And meanwhile the rig count has come down sharply, as the table shows (Source:EIA).

This all represents a fantastic example of American technological innovation rapidly responding to the collapse in crude oil, probably faster than most observers had any reason to expect. Who would want to bet against continued American advances and improvements in this sphere?

Crestwood

A couple of months ago we wrote about Crestwood Equity Partners (CEQP), in The Math of a Distribution-Financed Buyback. Quicksilver is a bankrupt E&P company that had asked the bankruptcy court to reject Crestwood’s contract to provide gathering and processing services. There isn’t much case history of courts resolving contractual disputes between MLPs and their customers, but the travails of many domesric drillers has certainly drawn attention to this aspect of the MLP business model.

On Wednesday, Crestwood announced they had signed a ten year agreement to provide such services to BlueStone Natural Resources, the acquirer of Quicksilver’s Barnett Shale acreage. Previously shut-in wells will be re-opened and the contract, which consists of both fixed-fee and percent of proceeds terms, commits BlueStone to refrain from constraining production for economic reasons through the end of 2018.

It’s just one contract out of tens of thousands across the industry, but its constructive resolution highlights the symbiotic relationship between E&P companies and their infrastructure providers.

Energy Transfer and Williams

Last week we wrote about the Energy Transfer-Williams Poker Game  and further twists in the plot took place since then as Williams (WMB) sued Energy Transfer (ETE) and CEO Kelcy Warren for violating the merger agreement when they issued convertible securities only to ETE management. There are no sympathetic characters here, but one can already hear the WMB lawyer explaining in court that WMB initially rejected ETE’s overtures, then finally agreed and is simply seeking to close the transaction on the agreed upon terms. Or, ETE pursued WMB in spite of being rejected, finally got the deal they wanted and have now changed their minds.

I guess Kelcy Warren has  earned the right to blunder; while it’s impossible to forecast a resolution, it’s becoming a little hard to envisage a happy combination of these two companies under present circumstances. The uncertainty represents a substantial pall over both stock prices; a grudging break-up payment from ETE to WMB might well be the outcome that lets both managements focus on their operating businesses and brings this sorry, absorbing episode to a conclusion.

One solution that distribution loving MLP investors will find almost unbearable to even ponder is for ETE to scrap the preferred offering, close the deal per the original agreement and suspend the distribution. With $4BN a year in cash flow at the pro-forma parent the $6BN cash payout would be retired in a year and a half with investors looking at a combined company trading at 3x cash flow with conservative leverage.

We are long CEQP, ETE and WMB.

The managements of Energy Transfer Equity (ETE) and Williams Companies (WMB) are engaged in a high stakes poker game. It’s an absorbing spectacle. Last May WMB announced plans to buy in its MLP Williams Partners (WPZ). As with Kinder Morgan, they felt their size as well as the drag from Incentive Distribution Rights (IDR) from WPZ to WMB was making it hard to identify accretive growth projects. Kelcy Warren, ETE’s CEO, made an unsolicited offer for WMB and after fending him off for several months WMB eventually agreed, grudgingly, to be acquired in September. They dropped their earlier plan to merge with their MLP.

Almost immediately ETE was struck with buyer’s remorse. The deal terms included an $8.10 cash payment from ETE for each WMB share, and as MLPs sank this $6BN payout represented an increasing percentage of the deal as well as an unneeded strain on ETE’s balance sheet. ETE had crafted a complex transaction. They were keen to maintain the GP/MLP structure, since Kelcy Warren clearly recognizes the value in an MLP GP (see Energy Transfer’s Kelcy Warren Thinks Like a Hedge Fund Manager). However, ETE couldn’t simply issue new units to exchange for WMB shares to satisfy the non-cash component, because ETE is a partnership that generates a K-1 and WMB shareholders wouldn’t want to exchange their shares in a corporation generating a 1099 for LP units. So ETE agreed to exchange 1.5274 shares in the newly formed Energy Transfer Corp (ETC) for each WMB share.

ETC is supposed to track ETE for two years following the transaction close through a mechanism designed for the purpose, but it’s a novel approach and it’s unclear how they’ll both trade after that. The complexity shows how keen Kelcy Waren was to buy WMB and so retain their MLP as a stand-alone vehicle still generating IDRs for its GP. But as ETE, WMB and MLPs generally fell, ETE’s CFO Jamie Welch apparently began looking for modifications or even a way out of the deal without having to pay a break-up fee. In fact, Jamie was visible in telling WMB shareholders they should reject the transaction, and last month he was fired.

Whether Jamie was fired because he crafted a poor deal or because he was using the wrong strategy to change it, Kelcy Warren soon went on the offensive. In quick succession ETE announced two transactions designed to make ETE and its doppelganger ETC less valuable by enriching senior management at the expense of other ETE/ETC shareholders including, should the transaction close, WMB shareholders.

On March 10^th Energy Transfer announced a limited offering of convertible units available only to insiders and on preferential terms. They followed this up with a substantial grant of new shares by way of compensation to ETE management to take effect after the closing of the WMB transaction. Both moves served to make ETE/ETC a less valuable currency to WMB shareholders, but the collateral damage was to all the existing non-insider owners of ETE. The clear message to WMB’s board is, sit down with us and renegotiate this deal or we’ll make it progressively less attractive to you.

What was unsaid publicly was no doubt communicated clearly in private; these terms stink and if you disagree we’ll make them worse. If WMB walks away they have to pay ETE a 1.5BN break-up fee, unless it’s voted down by WMB shareholders. If both companies agree to break up, ETE has to pay WMB $410MM, the same fee WMB had to pay WPZ when that deal was cancelled. There is no provision for ETE to walk away, so they’d likely face  a lawsuit for substantial damages if they did. Considering the deal originally valued WMB at $43.50 compared to its Friday close of $15.52, you’d think pursuing such a lawsuit would be challenging. More recently, to confirm what a bad idea the merger was, ETE took its earlier forecast of $2BN in annual synergies down to roughly zero.

Apparently the WMB board never was that enthusiastic about the deal in the first place, with CEO Alan Armstrong opposed while activist hedge fund manager Keith Meister was in favor.

Kelcy Warren has become a billionaire through the Energy Transfer family of businesses which he founded in 1995. The deal’s proponents on WMB’s board, including Keith Meister of Corvex, are struggling to show that their earlier advocacy was astute given the subsequent collapse in both stock prices. These billionaires now rather resemble elephants dancing in a cramped tea room; the question for investors is how to avoid being the crushed china set in the process, for both men hew to their fiduciary obligations only as long as more important considerations don’t intervene.

Two years ago Keith Meister showed his true colors with alarm company ADT, when in April 2014 he relied upon a stock buyback for which he’d advocated to sell his big ADT position back to the company. ADT’s stock price subsequently sank 30%. ADT’s CEO Nareen Gursahaney was shown to be inept (see ADT and the Ham Sandwich Test) while Keith Meister created further obstacles for those who believe all hedge fund managers are misunderstood altruists.

So ETE’s strategy is one of devaluing its acquisition currency to the point that it’s unattractive, while WMB’s is one of holding out presumably in the hope of a big break-up fee. And yet, since what’s good for ETE must be good for WMB, it’s obvious that there’s a shared interest in reducing the cash portion of the deal in exchange for more equity. The outline of an agreement is clear to everybody, but so far a WMB board that was split and an ETE management that has completely changed its mind cannot put their egos aside and find common ground. It’s mostly about the capital structure of the combined entity. If they get that right both sides will win. But it also shows that there’s more than one way to handle the funds of public shareholders. Few players in this story are showing themselves to be responsible stewards of client capital. In years to come, situations like this will beg the question: how would Buffett have handled it. Whatever the answer, it won’t be like this.

We are invested in ETE and WMB.

Last week I was in Las Vegas for 48 hours attending a conference. Dear reader, before you smile at this lame attempt to disguise play as work, you should know that I don’t gamble, drink only moderately and do not enjoy loud rock music. Therefore, the sight of yours truly staying at the Hard Rock Hotel and Casino might strike you as incongruous to say the least; I can report that the thumping rock music is as inescapable as the screens of Big Brother in George Orwell’s book 1984. Elevators and bathrooms offered no escape.  Fortunately, I was with many friends from Catalyst Funds, our mutual fund partner, and their company made it a thoroughly worthwhile and enjoyable visit. However, as my wife noted, if you’re planning a weekend of alcohol-infused debauchery and gambling, I might not be your best choice of travel companion.

Las Vegas stands for many things; as I walked through the hotel casino full of hopeful slot machine fanatics and blackjack buffs it reminded me that the entire city stands as a testament to a glaring failure of classical economics. In the theoretical world where individuals make rational decisions to maximize their utility, Nevada’s gaming tables with their negative expected outcomes should have no place. The cheerful acknowledgment of punters that the odds favor the house further illustrates how poor are the economist’s tools for explaining the world. One can only square the circle by allowing that the irrational hope of winning big provides positive utility to those relieved of their cash. State-run lotteries work on the same principle, and we non-lottery buyers theoretically pay slightly lower taxes as a result (although that’s hard to believe in New Jersey). The surest way to win is to be a free-rider; the Hard Rock Hotel’s $43 nightly room charge dramatically underprices the facility, because they rely on guests contributing substantially more in the casino. As a stalwart non-participant, I thank my fellow guests for subsidizing my stay. Meanwhile, consider the tormented soul whose $150 “safe” bet on Michigan State to beat Middle Tennessee in the NCAA tournament was lost but would in any case have only paid out $2.15. Let’s at least hope he derived some modest pleasure from temporarily anticipating his winnings. This is someone with a gambling problem.

There have been moments as an MLP investor in recent months when selling out and placing everything on black might have felt more rational and maybe even offered better results. The constant search for good odds in financial markets renders casinos uninteresting, even while MLPs for a while seemed like a faster way to lose money. Fund flows have certainly been an important driver of near term performance, as noted in last week’s post (Up Is The New Black). Figures on MLP fund flows provided recently by JPMorgan were striking, showing that in February $570MM of net inflows came into the sector. This is a substantial show of confidence by retail investors; it more than offset the net outflows ($543MM) that occurred during the entire second half of 2015, during which MLPs sank by 24%. The -0.5% February loss in the Alerian Index masks the substantial intra-month collapse and rebound that the $570MM of inflows helped fuel.

The appetite of retail investors to buy, and then sell, and now buy again MLPs has been a significant factor driving performance. As noted in The 2015 MLP Crash; Why and What’s Next, for a time such investors bridged the gap between MLPs’ need for growth finance and the limited desire of traditional investors to meet it. Direct investors in MLPs who receive K-1s are the quintessential long term investor, not least because time steadily worsens the tax consequences of selling. Retail investors through mutual funds and ETFs are not always so tax-sensitive, and therefore more reactive to recent performance. February’s substantial inflows reflect this shift to more positive sentiment.

Watching the Valeant (VRX) disaster unfold has, for those who are bystanders like us, resembled viewing an express train hurtling off an unfinished bridge into the ravine below, taking with it the reputations of some highly regarded investors. You’ll find no criticism here – professional humility has always been part of our DNA but if it wasn’t, enduring the 58.2% collapse in Master Limited Partnerships (MLPs) from August 31st, 2014 to February 11th, 2016 assured an additional helping (those dates and figures are imprinted in my memory). Watching someone else’s catastrophe is an awe-inspiring distraction, in the same way that one feels sorrow for the victims of a foreign earthquake while assuring oneself of the sensible choice to not live on a fault-line. We’ll resist the self-satisfied observation that Valeant’s fall eclipsed even the most hated energy infrastructure MLP. During a stunningly brief period of a few months from August 5th, 2015 through last Friday, down for VRX investors was a long way – a staggering 89.7%.

We have no opinion on VRX and certainly wouldn’t suggest that its collapse was obvious. But it’s often the case that fund flows develop their own momentum. While Pershing Square and ValueAct, two large hedge fund investors in VRX, can manage their exposure to this calamity with little regard to fund withdrawals given their long lock-ups, the asset base of Sequoia’s mutual fund (SEQUX) is at the daily whim of its investors. Having similarly peaked with VRX on August 5th, SEQUX is down 33.5% and redemptions are likely causing unwilling selling of VRX by its managers. Morningstar’s placing of its rating under review can’t have helped their fund marketers.

Whatever the true value of VRX, in the short term Ben Graham said the market’s a voting machine, and investing in public equities forces you to endure the popularity (or loss thereof) of your holdings. MLPs certainly found that even as their security prices offered ever greater discounts to value, the marginal investor was nonetheless more often a seller rather than a buyer.

It’s worth revisiting the above chart, originally shown in early January (see The 2015 MLP Crash; Why and What’s Next), which remains our best explanation for the substantial dislocation we endured. Although MLP distributions (in red) used to comfortably exceed new capital raised (in blue), the Shale Revolution gradually reversed this relationship by creating an ongoing need for new infrastructure which required financing. The increasing shortfall between cash paid to investors via distributions and cash taken back via IPOs and secondaries was, for a time, met with new money from mutual funds and ETFs (in green) until falling prices induced these more recent investors to curtail inflows and eventually switch to outflows. Ultimately, institutional flows from non-traditional MLP investors were attracted (see Real Money Moves Into Real Assets). Although operating performance of midstream MLPs wasn’t immune to the collapse in oil, their stock prices often fell by  many multiples of their drop in EBITDA. We continue to believe that what happened exposed the financing model of MLPs far more than their operating results, and that the flow of funds explanation is the most likely cause.

One pre-requisite for buyers to overwhelm sellers is excessive pessimism, and VRX is at least approaching that zip code. 21 of 23 analysts following the stock were bullish prior to last Tuesday’s earnings call, following which there was an undignified rush for the relative anonymity of a target price close to the current market. One firm slashed its target price from $200 to $70 (on Friday VRX closed at under $27). MLPs saw something similar over the past several weeks (see Pity the Equity Analyst) as sell-side analysts reacted as humans to the relentless criticism their bullish forecasts received from investors apportioning blame for their losses. On recent trends, MLPs should soon be positive for the year. The last time that could be said was May 8, 2015. Over the following seven and a half months the sector turned in its worst year ever. Whether or not February 11th, 58.2% below the August 2014 high, was the low for MLPs, it couldn’t be so without sufficient Wall Street analysts giving up. Industry mutual fund flows were heavily negative into the end of 2015, and there’s evidence more recently that flows are turning.  We’re still 43% below the market peak. It is at least no longer unfashionable to expect rising MLP prices.

On Thursday, TransCanada (TRP) announced that they had agreed to acquire Columbia Pipeline Group (CPGX) for $10.2BN in cash (of which $4BN was funded with the proceeds of a TRP secondary offering of equity). The Wall Street Journal had reported on the negotiations several days earlier. TRP of course is behind the Keystone XL pipeline project which was eventually blocked by the Administration, further challenging Canada’s E&P companies as they seek ways to ship crude oil from Alberta to foreign markets.

CPGX is the General Partner that controls 15,000 miles of natural gas pipelines, mostly at the GP level although their MLP Columbia Pipeline Partners (CPPL) holds some of the assets. TRP saw no need to acquire CPPL, since their acquisition of CPGX already gives them control of CPPL and thereby retains the ability to continue dropdowns into the MLP where assets can be more cheaply financed although crucially this financing option isn’t currently available. The deal is the classic use of the MLP/GP structure. CPGX as the GP is analogous to a hedge fund manager, and CPPL is the hedge fund. Owning CPGX provides control of CPPL. CPGX, or now TRP, can eventually move assets into CPPL and continue to earn Incentive Distribution Rights on them, similar to a hedge fund manager earning a fee on assets in his hedge fund.

Although the acquisition valued CPGX at 19X 2016 estimated EV/EBITDA compared with TRP’s 12.75X, TRP expects the transaction to be accretive from 2017 as some of the CPPL backlog drops into production. TRP expects to finance $8BN of projects at CPGX over the next four years, earning $5.5BN in EBITDA over that time and exiting 2020 at a $1.7BN run-rate. The cancellation of Keystone and delay in another big project (Energy East) has left room in TRP’s budget, in addition to which TRP’s size leaves it better placed to finance this kind of backlog. Prior to the deal, CPGX was yielding 2.25%. Moreover, CPGX and CPPL moved sharply in opposite directions following the announcement (Chart Source: Yahoo Finance), as the market reflected the control premium paid for CPGX that wasn’t necessary for CPPL. This illustrates why owning MLP GPs is better than owning MLPs.

We were invested in CPGX until Friday and remain invested in TRP

On Wednesday,,March 23rd at 7pm, I’ll be giving a presentation on my new book, Wall Street Potholes,  at the Westfield Memorial Library, Westfield, NJ. Attendance is free.

For those who follow MLPs closely, one of the enduring mysteries must be the mindset of investors in the Alerian MLP ETF (AMLP). Investors who desire MLP exposure but don’t want K-1s have been attracted to AMLP and a whole host of other inefficient ETFs and mutual funds. As we’ve written before (see, for example, The Enormous Misunderstanding About MLP Funds and Taxes), funds such as these convert the K-1s they receive into the 1099s desired by their investors by paying corporate income tax on their returns. The result is that an investor in a C-corp MLP fund such as this earns substantially less than the index – somewhere close to 35% less since that’s the portion ultimately paid to the U.S. Treasury.

It’s all disclosed in the prospectus, and credit Ron Rowland for first pointing out this pretty fundamental weakness back in 2010. But it turns out few investors or their financial advisors make it to page 5 of the document where the paragraph on “Tax Status” explains that AMLP is a corporate tax payer.

The result, as would have been clear to anyone who carefully examined the fund’s structure and is shown in the first chart, was that AMLP lagged the Alerian Infrastructure Index (AMZIX) from its launch until the market peak in August 2014. Then as the market turned down, AMLP fell less quickly, since it had an accumulated Deferred Tax Liability (DTL) on which to draw. It provided, in an odd sort of way, less volatile exposure to MLPs because the taxes acted to dampen movements both up and down.

The second chart shows monthly returns for AMLP alongside AMZIX since its launch in 2010. Visually, you can see that the moves in AMLP both up and down are generally less than the index against which it is benchmarked.

In August 2015, a year into the MLP bear market, this relationship changed in a way that was disadvantageous to the AMLP investor, in that AMLP began matching the moves in its index rather than moving less than the market. The reason is that AMLP had exhausted its DTL. Taxes are owed on unrealized gains, and the market had fallen far enough to wipe them out completely. As those gains became losses due to further drops in MLPs, AMLP was unable to carry a Deferred Tax Asset (DTA) because of its status as an open-ended investment company. While an operating company can offset losses against future taxable gains, AMLP and its peers cannot.

The third chart focuses in on the monthly swings in AMLP and AMZIX since August 2015 to show that they are much more closely matched.

This is an extremely poor bargain for AMLP investors, because since then they have continued to absorb 100% of the losses in the market but on a recovery, as soon as AMLP gets back to having unrealized gains on its portfolio the taxes will kick back in and investors will once more only receive 65% of the upside. It’s like betting $100 on red at Roulette knowing you’ll only get paid $65. In July 2015 we forecast that this would happen if prices continued to fall (see The Sky High Expenses of MLP Funds). It’s likely that all taxable MLP funds face the same return asymmetry, since MLPs fell far enough to wipe out unrealized gains across the board.

The tax drag shows up in the expense ratio, which for AMLP is currently an eye-popping 5.43%, of which 4.58% is taxes. Virtually no-one I’ve spoken to who’s invested in AMLP is aware of this, as I know from numerous conversations on the topic. The discovery is invariably met with a combination of horror and embarrassment.

The yield on AMLP doesn’t reflect the tax drag, because the taxes come out of the NAV. So while Morningstar lists the yield as 11.81%, a discerning investor would deduct the 4.58% tax drag from this figure to arrive at 7.23%, substantially below the yield on AMZIX.

The defense of the fund’s structure is that it provides MLP exposure without the K-1s, and it does that after a fashion. But in my experience few investors truly comprehend the substantial loss of performance they suffer because of this. It’ll be no surprise to its designers, but AMLP has underperformed its benchmark over every time period since inception other than last year when the tax drag temporarily reduced its downside.

In fact, AMLP’s structure made it the perfect shorting vehicle for hedge funds seeking to bet against MLPs last year, and there is ample anecdotal evidence that this was going on. The asymmetry of its returns (up 65% of the market/down 100% of the market) clearly works to the benefit of the short. In addition, while shorting a security renders you liable for the dividends paid to investors, AMLP’s expense ratio was a substantial mitigant because the tax drag reduces the NAV. In this way, the tax costs incurred by the investors act to reduce the financing costs for shorts, so AMLP investors by owning the security were aiding the very market participants whose objective was to drive down prices and force them out of their investment with losses. Given how MLPs performed last year, hedge funds shorting AMLP evidently enjoyed some success.

The Mainstay Cushing MLP Fund (CSHAX) is similarly structured and invariably underperforms its benchmark. Portfolio Manager Jerry Swank was asked by Barron’s in June 2012 why the fund had lagged its benchmark since inception in 2010 and he replied, “As a corporation, what a mutual fund gives up is a tax drag on the net asset value, as much as a 38% tax drag on NAV.” CSHAX has an expense ratio of 9.42%, of which 7.94% is taxes.

The questioner should have asked, ‘Can you really claim to put investors’ interests first if you design a vehicle like this?’ Instead she moved on, but really; who seriously expects a mutual fund to pay away almost 8% of its clients’ capital in taxes? Funds such as these rely on the cursory examination most retail buyers give to the terms of their investment. They trust finance professionals to recommend thoughtfully designed securities, and that trust is not always well placed.

These securities and others like them (we calculate there are around $20BN outstanding) are deeply flawed. They exploit the unfortunate proclivity of many investors towards superficial research and while their shortcomings are disclosed in documents they’re certainly not understood by their investors.

If you own AMLP, CSHAX or any of the other highly-taxed MLP funds (the clue is a high expense ratio), all is not lost. While their purchase was an error, you can sell now and take the tax loss, maintaining your exposure to a deeply undervalued sector with a RIC-compliant MLP fund properly structured so as to not be a corporate taxpayer. And if your financial advisor has invested your money in a taxable MLP fund, call and ask him if he knows what the expense ratio is that’s eating away at your investment. He’ll probably pay closer attention to fund structure in the future.

It’ll be a while before Master Limited Partnerships (MLPs) will fairly be described as no longer in a bear market. So far the low point was on February 11^th, at which point the Alerian Index was 58.2% below its all-time high of August 2014. The following day, SEC filings revealed institutional purchases by Berkshire Hathaway (BRK), hedge fund Appaloosa and the Oklahoma Teachers Retirement System (see Real Money Moves Into Real Assets), and this seems to have been the catalyst for a modest improvement in investor sentiment. Rising crude didn’t hurt either, and the result has been that the 30.2% three week bounce in MLPs since that February 11^th low is the largest rally since making their August 2014 high.

A technically driven rally is nice, but it’s also interesting to see the level of insider buying in recent months. Just among eight stocks that we follow, we’ve calculated almost half a billion dollars of insider purchases over the past twelve months. Enterprise Products Partners (EPD) is the biggest at $185MM, funded in part by the constant reinvestment of distributions by management. Other purchases of note include $108MM at Energy Transfer Equity (ETE). Crestwood Equity Partners (CEQP), a speculative and therefore appropriately small investment of ours, saw insiders purchase a startling 9.4% of the public float during 4Q15. Tallgrass Energy GP (TEGP) also saw insiders buy 1.7% of the float. It’s worth remembering that these purchases and others are generally funded by distributions paid out to those very same investors. MLPs are highly cash generative businesses.

There have been other informed buyers beyond the institutions and insiders mentioned above. Plains All America (PAA) issued $1.6BN in convertible preferred units to a group of private equity investors that were already invested in Plains and therefore know the business well. They included EnCap Investments, First Reserve and Stonepeak Infrastructure Partners. Targa Resources (TRGP) issued $500MM in similar securities to Stonepeak.

I was chatting with a friend who is a financial advisor the other day, and I asked him what sector of the equity market (apart from MLPs) offers the best opportunity right now. He felt that low volatility, dividend paying stocks could provide a return of better than 10% over the next four quarters. We like that sector too, and we have run a Low Vol Strategy for many years that regularly generates attractive returns (see Why the Tortoise Beats the Hare). It’s a great place to be invested. And yet, there are MLPs yielding well over 10%.

As we noted in last week’s blog (MLP Managements Talk Business), any equity security which confounds the skeptics by paying its dividend for a year will, assuming this draws in additional buyers that drive its yield down by 2%, deliver a 30%+ total return to those who invested a year earlier. Many MLPs still offer this possibility. Given the collapse in MLPs since August 2014, they ought to offer this kind of potential return. In early February after only 9 business days, MLPs were down 19%. Today’s MLP investors have endured some torrid days. But if you invest where you assess a high probability of continued distributions, it’s hard to think of another asset class or sector that comes close. There’s increasing evidence that insiders and institutional investors are acting on that belief.

By way of example of the high yields in the sector, Williams Companies (WMB) on Friday declared a $0.64 dividend. At $19.15, where it closed on Friday, this would be a respectable 3.3% yield if the $0.64 was an annual dividend. But it’s actually a quarterly dividend, so WMB yields 13.37%. Some investors were probably not expecting another WMB dividend so it was a welcome surprise. If the merger with Energy Transfer Equity (ETE) goes through on current terms, when it closes WMB investors will receive dividends of $1.74 annually from the 1.5274 shares of Energy Transfer Corp (ETC) they’ll swap for their WMB shares. But they’ll also receive a one-time $8 cash payment plus a $0.10 special dividend,  so $1.74 on an $11.05 stock price ($19.15 less the $8.10 payments) is 15.75%. The Presidential election is not the only thing that can make your jaw drop.

We are invested in BRK, CEQP, EPD, EQGP, ETE, KMI, NSH, PAGP, TEGP and WMB

Wall Street Potholes — Insights From Top Money Managers on Avoiding Dangerous Products

On Monday, March 14^th at 6:15pm, at the Hilton Hasbrouck Heights, Hasbrouck Heights, NJ, I’ll be giving a presentation on my new book, Wall Street Potholes,  to the American Association of Independent Investors, Northern New Jersey Chapter. There is a modest entry fee. I’ll also be giving a similar presentation on Wednesday, March 23^rd at 7pm at the Westfield Memorial Library, Westfield, NJ. Attendance is free.

MLP managements have been verbose in the last couple of weeks. This is mostly due to the fact that it’s earnings season and conference calls provide an opportunity for investors to obtain additional color from senior executives. It’s the topic of our March newsletter which will be published on Tuesday, but there are many more interesting statements than the newsletter can accommodate.

The elephant in the MLP room is whether distributions will be maintained. Some of the yields are almost willfully defiant, in that they challenge the analyst to hold an opinion. For example, Energy Transfer Equity (ETE) yields 16.7% as of Friday’s close. This is almost certainly a temporary yield; bears will argue it is unsustainable and the distribution will be cut, while bulls will maintain that it is secure. A year from now ETE will probably have moved sharply in one direction or another depending on which view prevails. It is hard to be ambivalent about a 16.7% yield. This is a market that demands strong opinions. Some simple Math shows that if you buy a security yielding 16.7% and over the following year its yield drops by 2% due to price appreciation (reliably paying that 16.7% yield for a year will likely draw in new buyers), your total return is 30%. MLPs should offer this type of possible return, because recent weeks have shown that a 16.7% yield can be offset by a few bad days. But considering the paucity of return potential across other asset classes, it’s hard to see how any serious investor can evaluate her choices without thinking pretty hard about this sector. You may reject a possible 30% one year return as not worth the risk or unattainable, but a failure to consider it is lazy. A 16.7% yield challenges the observer to investigate further.

ETE’s CEO Kelcy Warren naturally maintains that the payout is secure, allowing himself virtually no wiggle room. While asserting that no distribution cuts were contemplated across the Energy Transfer complex, he said, “Our distribution cuts are not required at ETE. And we take our obligation to our unitholders very, very seriously. We have a duty to maintain our distributions. But everybody knows, obviously, that’s an option to the extent of that we need access to distributions to maintain our financial health at ETE; would we reach in to that bucket, it would be the last one we’d reach to, but it’s certainly possible.” Of course, no CEO highlights the likelihood of a cut until it’s done, at which time it appears inevitable. We’ve made our bet, because managements at ETE and other businesses are reducing capex, eliminating their need for new equity and paying close attention to the ability of cashflows to service debt and continue distributions. They are generally doing the right thing. So we side with Kelcy. But it’s also true that while a distribution cut represents a betrayal of your investors, if the cash is used to fund accretive growth projects so as to avoid the dilution from issuing additional equity, as Kinder Morgan (KMI) argued, there’s nothing theoretically destructive to value. On December 8, the day KMI announced its dividend cut, the stock closed at $15.72 and is now at $17.76. Berkshire Hathaway (BRK) doesn’t need stocks that pay high dividends; their challenge is finding good places to invest their cash, and KMI’s subsequent reliance on internally generated cash to finance growth probably made them more attractive in Omaha.

Cheniere’s LNG export facility in Sabine Pass, LA exported its first batch of natural gas last week. The Wall Street Journal published an insightful article highlighting the attractiveness of the U.S. as a supplier to countries such as Lithuania, who are tiring of Gazprom’s hard-line negotiations that typically start on New Year’s Eve when the threat of a mid-winter supply disruption hangs over the price discussions.

The photo is a satellite shot of the U.S. at night, and while most of the lights are in population areas the white box highlights North Dakota where there are few people but lots of gas flaring. Oneok’s CEO Terry Spencer commented this week, “So flared gas, let me just tell you, it’s not an exact science. And it’s quite possible we could have more flared gas than we actually believe we have, because every time we turn on a compressor station it seems like the wells behind that particular compressor station outperform our expectations. Time and time again, more gas is showing up than what we thought.” Since flaring is both bad for the environment as well as commercially destructive, those in favor of additional infrastructure to capture this lost output must include environmentalists, involved E&P companies and indirectly the Lithuanian electricity consumer. The U.S. is on its way to becoming a significant exporter of hydrocarbons, and its reliability will compare favorably with many of the competing exporters. If you choose not to buy from unstable regions or unpredictable kleptocracies, your choices of supply can be limited.  The shifting geopolitics is the long game, but is hardly reflected in today’s asset prices.

We are invested in BRK, ETE, KMI and OKE

It was a busy week of news in Master Limited Partnerships (MLPs). Although there were several earnings announcements, perhaps most notable was the disclosure of new investments by Berkshire Hathaway (BRK), David Tepper’s hedge fund Appaloosa and George Soros in much maligned Kinder Morgan (KMI). Appaloosa also disclosed holdings in KMI warrants, which expire at $40 in May 2017 so represent an exceptionally optimistic view of the company given its current price of $17.37. They also disclosed new holdings in Energy Transfer Partners (ETP) and the Alps ETF (AMLP). These purchases all took place sometime during 4Q15, coincidentally when I added personally to my MLP investments. So these three investment giants shared the disbelief of many at the continued MLP rout. Nonetheless, for those who draw comfort from the decisions of others, it was a good start to the week.

Taxes play an important role for MLP investors. Tax barriers impede many institutional investors from allocating, and most mutual funds and ETFs face a substantial drag from corporate income tax, so it’s worth spending a moment on how these issues likely affected these three investors. First of all, KMI is not an MLP but is instead a C-corp, so there are no impediments to investing in them. In any event BRK is an insurance company, one of the few classes of institutional investor who can easily hold MLPs because they are taxable whereas most institutional equity investors (pension funds, endowments and foundations, sovereign wealth funds) are not.

ETP is a partnership, and Appaloosa doesn’t disclose which of its funds invested. Appaloosa could hold ETP through a domestic partnership since its investors would generally be U.S. taxable. Most hedge fund money is offshore though, so holding ETP through, say, a Cayman vehicle is more problematic. When I was at JPMorgan investing offshore capital in hedge funds 10-15 years ago we used total return swaps executed with a prime broker. These provide the economic exposure to the MLP without the tax problems, but tax opinions have fluctuated on these over the years since the swap has no true purpose beyond tax management. Or Appaloosa may have created a blocker corporation to hold ETP on behalf of its offshore fund and paid taxes at that level. We can only guess, but what is clear is that they regard the potential upside as worth the cost of handling the tax issues.

The Oklahoma Teachers Retirement System evidently feels the same way about the return potential, since they recently added $250 million to their MLP exposure. As a tax-exempt U.S. institution, they may face Unrelated Business Income Tax (UBIT) through their MLP investments. Since tax-exempt institutions generally like to avoid paying taxes, UBIT represents an impediment to holding MLPs. However, they are not prohibited from making such investments, and Oklahoma Teachers may have concluded that the returns even after UBIT remain attractive, or their tax analysis may have shown that the ineligible income from MLPs falls below the threshold for a tax liability given their $14BN in funds.

In any event, all of the above shows that institutional investors are beginning to take advantage of the market dislocation in MLPs, and indeed began to do so several months ago. As we wrote in The 2015 MLP Crisis; Why and What’s Next, the comparative rigidity of the traditional investor base was exposed by the rapid exit of retail investors from MLP mutual funds and ETFs. It’s creating an opportunity. MLPs will not reclaim their place as a stable source of income anytime soon, but an asset class with double digit yields offers the potential for 30%+ one year returns assuming (1) distributions keep being paid, and (2) the constant paying of distributions leads to inflows driving yields lower by a couple of percent. Of course, the potential upside comes with the possibility of losing 10% in a week, as we’ve seen. However, it’s hard to identify another asset class that offers that kind of potential return. And it’s worth noting that investors such as Oklahoma see attractive returns even with the hurdle of potential tax expense. For investors  in a RIC-compliant MLP fund that doesn’t pay tax, such as ours, it’s a simpler decision.

We are invested in BRK and KMI