Once again a corporate executive team has demonstrated childlike innocence when dealing with the hard-nosed providers of equity capital. Tetra Technologies (TTI) is the latest firm to combine a good business with a clueless approach to funding it. TTI supports the oil and gas industry, providing a wide array of products and services including fluids, compression equipment, well-testing and decommissioning. They are as much part of the Shale Revolution as the E&P companies that drill for oil and natural gas.

TTI decided they needed some additional equity capital as they were in danger of violating one of their debt covenants. On December 8^th they issued a press release noting that the company was “…considering capital raise alternatives  to strengthen its balance sheet.” They blamed potential weakness in 2017 Gulf of Mexico activity along with the delay of certain projects from 4Q16 into early next year.

The phrase “capital raise alternatives” clearly includes more than one type of capital, and strongly suggests that the simplest form, a public equity offering, was not the most likely outcome. A reasonable guess would have been a private placement of some type of preferred security convertible into common. TTI stock duly fell as investors digested both the slowdown in revenues from certain projects and the likelihood of some additional equity dilution.

On December 9^th, TTI then surprised the market by announcing a generously priced secondary offering of common equity. The 19.4 million shares (expected to be upsized to 21 million) along with 10.5 million warrants represented a substantial 33% increase of the share count, a hefty dilution for existing shareholders.

TTI’s poor handling of the offering weakened their stock price, requiring the issuance of more shares than was otherwise necessary in order to raise the desired amount of capital. To see how this is so, consider the two announcements they made twenty four hours apart.

Their first press release, on December 8^th, was pointless unless they had secured capital in some form. Companies don’t have to disclose that they might raise capital. A company is always interested in raising capital if the terms are attractive. Most likely TTI believed they were sufficiently close on agreeing terms that the desired “capital raise alternatives” were pretty much done. Their stock price fell on the news.

Consequently, the announcement of a public offering the following day communicated that the presumed private capital raise implied in the prior release had fallen through. In fact, it’s highly likely that the potential investors watched TTI stock plummet after the first anouncement, and concluded that they needed more generous terms. The price of TTI now had to reflect that private equity investors had considered an investment and passed.

There was no point in the first press release. All it did was to weaken their negotiating position and eventually force them into a dilutive public offering. CEO Stuart Brightman was paid $2MM last year but only has around $3MM in TTI stock, so the market’s response to his poor handling of the capital raise didn’t cost him very much personally.

Wall Street underwriters (in this case JPMorgan and Wells Fargo) are blessed to have such incompetent clients. It makes their jobs much easier.

 

 

A couple of weeks ago we came across a research note from Wells Fargo titled “Do MLPs Still Make Sense?” Their conclusion was a qualified “Yes”, although it’s not wise to be highly negative when you have a thriving business underwriting their equity offerings.

Last year’s collapse in the sector provoked the question. In our view, this wasn’t so much an issue of operating performance but one of financing growing capital expenditures. As we wrote in The 2015 MLP Crash; Why and What’s Next, the Shale Revolution has led to a substantial increase in the demand for new energy infrastructure, since the new reserves of hydrocarbons are not always well served by the traditional infrastructure configuration (i.e. North Dakota was only recently a significant region for crude oil production; similarly so for Pennsylvania and natural gas).

By 2014 the needed cash to finance this growth exceeded the cash generation capacity of the MLP sector. Since MLPs don’t retain earnings, they mostly tap the capital markets for such finance. The multi-year nature of many projects led to a “just-in-time” philosophy around financing in the same way manufacturing businesses maintain minimal supplies of inventory to limit their need for working capital. A temporary closure of the capital markets as the most recent MLP investors (mostly ETF and mutual fund buyers) fled late last year exposed this model. MLPs have taken many steps in response including greater distribution coverage, less leverage and higher return targets on new projects. They’ve adapted.

It really comes down to whether the Master Limited Partnership structure combined with the General Partner is the best way to finance the assets. Since MLPs are pass-through vehicles with no tax liability, it’s hard to improve on a tax-free structure as the holding vehicle. Any corporation holding eligible assets will be subject to Federal corporate income tax on the profits, which is why a common maneuver is to “drop down” those assets from a C-corp parent into an MLP. The C-corp often retains control through its GP interest in the MLP, and shares in the future economics without providing the capital. The retained connection can be value-enhancing for both entities. An Exploration and Production (E&P) company can finance its E&P assets as a C-corp where capital is cheapest, but still control the infrastructure critical to supplying its customers while using cheaper, MLP capital. Examples include Devon Energy (DVN) with Enlink Midstream Partners (ENLK) and Anadarko Petroleum (APC) with Western Gas Partners (WES). The MLP/GP structure often exists as a symbiotic relationship.

There are many analogous financing structures to be found. As regular readers know, we like the comparison with hedge funds and private equity, where the MLP is the fund and the GP is the hedge fund/private equity manager. The fees paid to the manager clearly take away from the returns earned by the investors – indeed, in the case of hedge funds, spectacularly so as I have often noted (see The Hedge Fund Mirage). However, the size and history of alternatives (hedge funds, private equity and real estate) confirm that a substantial pool of capital is available to finance assets that require active management with payments to the operators. MLP investors are in many ways better off than the investors in these private partnerships; they have the liquidity to sell whenever they want, their investments are subject to all the disclosures of publicly listed companies, and the ten year annual return of 9% is better than REITs, Utilities, the S&P500, Bonds and, most assuredly, hedge funds.

Another analogy is with companies that have two or more classes of equity outstanding. Alphabet (GOOG) and Facebook (FB) both sold shares to the public that allowed the founders to retain substantial control. You’re unlikely to see an activist acquiring a position in these two companies when their performance stumbles, because voting control doesn’t lie with the public shareholders. Clearly, to a substantial number of investors this passive ownership is no barrier. GOOG has returned 12.5% p.a. over the past decade, better even than MLPs.

From time to time investors ask us whether GPs are more volatile than MLPs, and therefore more risky. The history on this topic doesn’t go back that far, because only in recent years has a sufficient number of MLP GPs been publicly available to create a portfolio. Our own Separately Managed Account strategy (which focuses on GPs) has outperformed the Alerian Index by 4.0% p.a. since inception, albeit with modestly higher volatility (20.6% versus 19.8%). Last year certainly saw cases of GPs falling more than MLPs; perhaps most memorable was the 80% collapse in Energy Transfer Equity (ETE) from June 2015 to April 2016. This was mostly due to the ultimately failed effort to merge with Williams Companies (WMB), but nonetheless is now part of the historic performance of MLP GPs.

Financial performance of MLP GPs is highly correlated with the MLPs they control but not obviously more volatile. GPs can exercise substantial control over their cashflows by, for example, directing their MLP to raise capital or divest assets. Moreover, most MLPs today are investing in new infrastructure in support of the Shale Revolution. This increase in their assets will continue to benefit their GPs, similarly to how hedge fund asset growth directly profits the hedge fund manager. If you could buy a hedge fund manager knowing his assets would be growing, how much concern would you really feel over the volatility of his cashflows given that they’ll be increasing?

Finally, MLPs can get too big. Like hedge funds, beyond a certain size it can be hard to generate attractive returns while still growing. There is, in effect, a lifecycle to MLPs. Kinder Morgan (KMI) most obviously demonstrated this. Their solution, to collapse their structure back into a C-corp, was inevitable in hindsight if clumsily executed (see Rich Kinder’s Wild Ride). In 2014 when KMI acquired the assets of Kinder Morgan Partners and El Paso, its two MLPs, the stepped up cost basis created a substantial tax shield for KMI (see The Tax Story Behind Kinder Morgan’s Big Transaction). These two MLPs had depreciated their assets far below their economic value, to the profit up until then of their taxable investors who directly benefited from tax-deductible depreciation not matched by actual economic depreciation in those assets. KMI revalued them, thereby creating a much higher annual depreciation charge on these same assets.

The next logical step will be for KMI to drop down some of these assets into a newly created MLP where the cashflows will not be taxable and the investors in this new MLP can benefit from this higher depreciation. It’s probably too soon for KMI to contemplate such a move, but the tax code creates the possibility of a virtuous cycle whereby assets are first dropped into, and depreciated in, an MLP; subsequently acquired by the C-corp parent with a stepped-up cost basis that resets the depreciation based on current values; and then later dropped again into an MLP. As long as the assets involved have recurruing cashflows, minimal need for maintenance capex and appreciate over time, it’s a legitimate strategy.

The MLP/GP structure contains myriad possibilities. Note also that in November the U.S. was a net exporter of natural gas. Existing in support of an industry that is taking America towards Energy Independence, we think adverse changes to the tax code are highly unlikely and that MLPs have a rich future.

We are invested in ENLC (GP of ENLK), ETE, KMI, WGP (GP of WES), and WMB

We believe energy infrastructure (Master Limited Partnerships, or MLPs) should be one of the clear winners from last week’s election. There are two aspects to this:

Regulation.

Earnings calls with MLP management have increasingly included discussions of what many perceive as a hostile regulatory environment. New York State’s ban on fracking is one example, but more meaningful was the set of decisions in New England that led Kinder Morgan (KMI) to cancel its North East Direct (NED) pipeline project. The northeast U.S. is short of natural gas transmission and storage capacity, with the result that in the winter New Englanders pay very high prices for natural gas. NED was planned with the intention of alleviating this situation, but a Massachusetts Supreme Court ruling prevented utilities from making long term commitments for pipeline capacity. Without such long term commitments KMI determined that the returns from the project were inadequate and uncertain, so it was cancelled.

Another more recent example is the Dakota Access Pipeline (DAPL), currently under construction by Energy Transfer Partners (ETP). Whatever your view on whether the pipeline should be built or not, it seems clear that ETP complied with regulations in how they sought approvals for the pipeline’s route. In spite of the Courts rejecting challenges to the project, the Administration took an interest late in the day and over-ruled the Army Corps of Engineers (the Federal agency responsible for approving the route). The result has been a delay in pipeline completion, with a corresponding delay in its cashflow generation and a rapidly deteriorating return on investment for ETP. The Administration’s unexpected involvement cast uncertainty over any new project relying on Federal approval. It appeared capricious and motivated by the election rather than ETP’s failure to follow the correct process. An extensive examination of the background is here. As a result of the election the project now looks likely to be approved, possibly within days but certainly once Trump is in office.

Perhaps most famously, the application to build the Keystone XL Pipeline was held up for years by the State Department (it fell under their jurisdiction since it crossed the border with Canada) before finally being denied. The extended period of uncertainty added to its costs, which eventually resulted in TransCanada Corp (TRP) writing off C$2.9BN, as well as causing friction with our northern neighbor in their efforts to move crude oil more efficiently and safely. This was also poor policy, justified as an effort to impede Canada’s development of its oil sands resource because of the negative environmental effects. TRP subsequently sued the U.S. for $15BN in foregone value creation. It’s possible the project may be resurrected next year.

Investors often ask us if the Obama Administration’s hostile stance towards fossil fuels is negative for MLPs. Over the past eight years, volumes of crude oil, natural gas liquids and natural gas produced have climbed substantially so the raw numbers don’t reflect an anti-fossil fuel bias. However, the episodes described above do, and regulatory uncertainty has had a growing impact on which projects get done. Developing our energy infrastructure is key to America attaining Energy Independence, a state that is not far away in natural gas and perhaps attainable in crude oil within a decade.

The incoming Republican administration can be expected to adopt a regulatory philosophy that is more supportive and predictable. This can only be good for MLPs.

Trade

We don’t know much detail yet about how U.S. trade policy will shift. However, it’s not a stretch to suppose that a pronounced bias towards domestic production of many things could include crude oil. Although we currently produce around half the crude oil we ultimately consume in the form of refined products, tariffs on crude oil imports would favor additional growth in domestic production and would not obviously be at odds with the type of trade policy articulated by Candidate Trump. Relying more on our own resources has the added benefit of reducing our economic exposure or even interest in regions such as the Middle East. There could be perceived national security benefits from being more self-reliant.

There’s also the possibility that a Trump Administration could withdraw from the nuclear deal  with Iran which might in turn lead to the reimposition of sanctions, curtailing Iranian crude oil exports.

We offer no view on whether such policies are good or bad; we’re only focused on making the most sensible investment choices under existing circumstances. Public policy is clearly moving in a direction that places America’s near term interests first. The election was unequivocally positive for MLPs.

We are invested in ETE, KMI and TRP

Last week saw the bulk of our MLPs reporting on quarterly earnings. The drop in crude oil and tightening election probably counted for more as the market was weak. But we felt earnings were generally in line with expectations with few negative surprises. There were plenty of questions on the regulatory environment for new projects. In response to a less certain and more drawn out approvals process, MLPs are revising their assumptions about how long projects take as well as steering away from less friendly areas such as New England. Several noted that pipes already in the ground have greater value as it becomes harder to build new ones.

Plains All American (PAA), reported results that were a little weaker than expected in spite of positive developments in the Permian. The existence of Minimum Volume Commitments (MVCs) makes it harder for them to forecast take-away demand even if they can forecast supply. This is because excess pipeline capacity in a region can cause E&P companies to take decisions that would otherwise seem uncommercial because of an MVC. If you’ve committed to buy pipeline capacity and have to pay for it regardless of whether or not you use it, this can cause you to ship oil or gas as long as the net revenue offsets some of the MVC. This squeezes margins and skews basis differentials.  Since contracts are private, it’s hard to know who’s acting based on an MVC versus more normal economics. PAA CEO Greg Armstrong commented on this issue during their call and noted how even with PAA’s detailed knowledge it makes forecasting demand harder.

We are invested in Plains GP Holdings (PAGP) which will soon merge with PAA. We expect U.S. crude oil production to increase slightly over the next several quarters and significantly over the next several years and PAA/PAGP should see increased cashflows from higher utilization of their pipeline network.

A couple of things stood out to us and are displayed below. Enlink Midstream Partners (ENLK) and its General Partner Enlink Midstream LLC (ENLC) reported solid earnings. In 2015 MLP prices fell far in excess of what was justified by the fundamentals. The slide from ENLK’s recent earnings call shows stability in metrics such as their Leverage Ratio, which ranged from a low of 3.7X to a high of 4.0X over the past seven quarters and is now back to 3.75X. Distribution coverage has stayed virtually unchanged. And yet in February ENLK had lost two thirds of its value from a year earlier. The emergency liquidation by many investors, seemingly without regard for the fundamentals, was responsible.

Another interesting chart was from Anadarko Petroleum (APC), who control Western Gas Equity Partners (WGP) by virtue of their 78% ownership. WGP in turn is the GP of Western Gas Partners (WES). APC’s onshore drilling activity is in the Delaware Basin in West Texas and DJ Basin in Colorado and Wyoming. They’re  WES’s biggest customer, and so APC’s ability to reduce costs over the past couple of years impacts volumes passing through WES’s midstream infrastructure.

APC now reports that their cost to drill a well is below $5MM, and their breakeven to produce an acceptable return on capital is $35 a barrel. Shale drilling is characterized by numerous wells cheaply drilled with fast payback times, by contrast with conventional projects that require high up front investment and long payback times. This is why we believe U.S. producers with access to “tight” oil are becoming the swing producers; more nimble than conventional suppliers, they can respond more easily to price signals. For more on this, see Prospects Continue to Brighten for U.S. Energy Infrastructure and OPEC Blinks.

Regarding OPEC, the strategy embarked on two years ago of seeking market share at the expense of price has been a colossal failure. A recent article by the Petroleum Economist (only available to subscribers) noted that OPEC’s oil revenues had plunged from $0.75TN during  the twelve months ending October  2014 to 338BN over the past year, a drop of 55%. OPEC may fail once again to restrain output among its members, but regardless they have helped usher in a far more efficient era in U.S. shale production (see Why the Shale Revolution Could Only Happen in America). The Petroleum Economist article closes with, “OPEC lost this battle – and it knows it. It is tired of cheap oil.”

We are invested in ENLC, PAGP and WGP