“Oceania was at war with Eurasia; therefore Oceania had always been at war with Eurasia.” 1984, George Orwell.

The hurriedly organized investor call with Plains All American (PAA) a week ago (rushed because of approaching Hurricane Harvey) must have been inspired by the revisionist history propagated by “the Party” in Orwell’s polemic against totalitarianism. PAA’s distribution “reset” (Newspeak for a cut) was larger than previously expected and was directed towards rapidly lowering leverage. Like Orwell’s Ministry of Truth, they explained “…we have assessed the appropriate distribution level to accelerate our deleveraging objectives.”

It’s as if balance sheet strength was always their main objective. There’s no mention of paying stable distributions to their unit holders, which in a different era was the reason for investing in MLPs. If you listened between the lines, you could hear, “We care most about our leverage; therefore, we’ve always cared most about our leverage.”

In January, when PAA acquired a Permian gathering system for $1.2BN they reaffirmed prior 2017 EBITDA guidance of $2.3BN and hinted it might be higher. During their 2Q17 earnings call they cut it to $2BN because of the collapse in their Supply and Logistics (S&L) segment (see MLP Investors Learn About Logistics). Nonetheless, they still forecast 15% growth in 2018, reaching their 2017 target a year late and with a better mix of earnings even more oriented towards traditional, fee-based cashflows since their S&L business has shrunk.

Nonetheless, rating agencies determined that this represented too much risk for an investment grade debt issuer. It’s part of a pattern whereby MLP managements are finding that their goals are not aligned with those of their traditional equity investors. An “It’s not you, it’s me” kind of moment. Although you didn’t ask for this, we went for growth with leverage and risked the distribution. Sorry. Get over it. Ironically, Moody’s still downgraded PAA’s debt to junk in spite of steps that favored debt holders over equity.

Simplification, the euphemism for distribution cuts to fund growth and reduce debt, has been used by several other large MLPs beginning with Kinder Morgan (KMI) in 2014-15 and including Targa Resources (TRGP), Semgroup (SEMG), Williams Companies (WMB) and Oneok (OKE). Current MLP investors are by now a battle-hardened bunch, and the veterans among them are unlikely to sell at this stage because of the recapture of their tax deferral. But it’s hard to see why a yield-driven investor would commit new money to the sector, since the clear message being communicated is that the yield that attracts you today may not be there tomorrow.

The trend is for the resulting entities to look more like conventional corporations, relying less on equity markets for growth capital. The General Partners (GPs) have tended to do better out of the changes, or at least fare less poorly. For example, in its November 2016 Simplification Transaction, Plains GP (PAGP) gave up its Incentive Distribution Rights (IDRs) in PAA in exchange for 246MM units of PAA. At the time this was worth around $7.4BN to PAGP plus assumed debt of $642M. Even today, with the stock 30% lower, it still represents over $5BN of value. And yet, under the newly “reset” distribution just announced by PAGP, the IDRs (if they still existed) would be throwing off less than $12.5MM per quarter. In 2016 PAA paid PAGP $565MM.

PAA investors transferred considerable value to PAGP last year in the forlorn hope of preserving their distribution. It’s probably the worst investment PAA has ever made, and the decision was made for them by PAGP.  Having received almost $8BN to forego IDRs, PAGP then cut the distribution that PAA LPs were receiving. (1) Cancel IDRs for large consideration (2) Cut distribution. It wouldn’t make any sense to reverse the steps, because once the distribution was cut retiring the IDRs would have been worth far less. If not for the Simplification Transaction, PAGP’s stock price would have collapsed following the recent distribution cut at PAA.

Investors have conventionally regarded GPs as providing leveraged exposure to their affiliated MLP, with outsized upside and proportionate downside. But simplification protected PAGP investors from experiencing any worse downside than PAA. Moreover, PAGP even now retains the ability to acquire PAA, transferring its assets to PAGP and revaluing them at market which would create a new source of depreciation charges. In that scenario, PAA investors will get stuck with a tax bill in the same way that Kinder Morgan Partners LPs did when KMI acquired their assets. When PAGP’s current tax benefits expire (in 2016 their effective tax rate was under 11% of net income) they will be incented to do just that. PAGP shares are still worth more than PAA units, which is one more reason why it’s good to be invested with the GP.

KMI, TRGP  and OKE all imposed unpleasant tax outcomes as they acquired assets from their MLP affiliates (see The Tax Story Behind Kinder Morgan’s Big Transaction and Another MLP Simplification Benefits From Favorable Depreciation Rules). Simplification concedes that since MLP investors won’t provide needed growth capital on acceptable terms, it’s time for new investors.  Limited Partner (LPs) investors in MLPs get a tax bill.  GPs get a tax shield!

The only MLPs worth holding have already simplified their structure to eliminate IDRs (such as Enterprise Products, EPD and Magellan Midstream, MMP). They at least have a stable construct. Under the GP/MLP configuration the GP always has the option to waive IDRs so as to preserve LP distributions. However, such moves are rare. The power has always been with the GPs, many of which are C-corps today.

The road to American Energy Independence, driven by the Shale Revolution, is being navigated by regular corporations and GPs rather than MLPs. Valuation metrics that have worked in the past, such as Distribution Yield, are less relevant today given the changes to the financing model. A better measure is  Enterprise Value/EBITDA, which allows comparison with other related sectors such as Utilities (see The Changing MLP Investor). At around 11.2X, this highlights the sector’s cheapness quite effectively.

We are invested in EPD, KMI, MMP, OKE, PAGP and WMB

In the debate over global warming, the environmentalists claim the moral high ground while the “non-believers” deny man-made climate change. The very question of whether you “believe” in global warming suggests religious conviction with little point in debate. This is what makes Alex Epstein’s moral defense of fossil fuels so intriguing.

We have clients across the political spectrum, and it’s a safe bet that they’re with us looking for strong investment results with little care for our views on other topics. However, there are some who concede to a certain moral precariousness in putting their green credentials alongside investments designed to profit from America’s Shale Revolution. For them, Alex Epstein presents an intellectual framework for conscience-free investments in energy infrastructure.

Epstein seizes the moral high ground by correctly defining the metric against which human development should be judged – namely, is it good for humanity? He argues that many environmentalists implicitly value human health and prosperity below other objectives, such as ensuring an unchanged environment. Cheap fossil fuel energy has powered an enormous leap in living standards, life expectancy and population over the past couple of centuries. He argues that humans have been changing their environment throughout history to make it safer and more receptive to human life. These undoubted benefits to the human race need to be balanced against the (oft-debated) environmental results. And while Epstein goes on to question to what degree human activity is warming the planet, the elegance of his insight is that the humanity standard allows one to be a fossil fuel supporting environmentalist. His preferred standard is, “What will promote human flourishing – realizing the full potential of life?” (italics in original).

Since burning fossil fuels supplies 81% of our energy needs, it’s reasonable to assume that government policies which impose constraints will increase the cost of energy through taxes or subsidies that favor renewables. The humanity standard doesn’t preclude this, it simply imposes a rigorous cost-benefit analysis. More highly priced energy may not damage human life in the developed world all that much, but in the developing world cheap, reliable electricity can mean life or death for hospital patients or a community in need of clean water.

Since cavemen lit fires and inhaled smoke while staying warm, humans have balanced energy use with changes to the environment. Still today, 38% of the world’s population uses traditional biomass for cooking, contributing to 3.5 million pre-mature deaths each year caused by household air pollution. Women and children disproportionately bear the cost to their health as well as spending enormous amounts of time gathering wood for fuel. 1950s London was notorious for thick fog caused by coal-burning homes and factories. Coal use was curtailed – Epstein’s standard doesn’t sanction unfettered pollution, it simply sets a standard against which to assess it.

As a society’s wealth increases, the trade-off shifts. When we’re safely housed against the weather, able to access sufficient food, water and medical care, concern for our natural surroundings can increase. But assuming humans are taking existential risks with the planet, a population without reliable electricity or clean water will more readily prioritize these over the environment compared with developed countries. In fact, the morality of fossil fuel use is strongest when applied to the poorest, whose lives are most easily improved. Advocates of the deepest cuts in global energy use must consider parts of the world using energy to reach western living standards. For example, in 2014 Secretary of State John Kerry, in a speech to Indonesians, exhorted them to “Make a transition towards clean energy the only plan you are willing to accept.” Such a call was no doubt well intentioned, but 33 million Indonesians lack access to safe water. Higher energy prices will hardly solve that immediate problem.

Globally, 1.2 billion people do not have access to electricity and have shorter life expectancy as a result, while many more don’t have access to reliable electricity. These people may rightly care about energy availability regardless of how it’s generated. Part of the moral dilemma revolves around sacrifices today to help later wealthier generations. It’s not an easy question, but is one that Epstein challenges his critics to consider more carefully.

The book does not question whether carbon dioxide emissions warm the planet but the degree to which they do, the consequences of such and the cost of cleaner energy on human life and the quality of human life today. This debate will probably continue beyond all our lifetimes and we’ll sidestep offering an opinion. Epstein offers some useful data to illustrate how humans have benefited from harnessing concentrated energy; the average human needs 2,000 calories a day to exist, roughly the same amount of energy required by a 100-watt lightbulb. As we go about our daily lives, we eat food produced and moved by machines; we are transported by machines and we occupy buildings whose construction relied on heavy equipment. Consequently, the average American’s daily machine energy use is 186,000 calories, or around 93 humans. Consider how energy has transformed agriculture, driving enormous increases in productivity and greatly decreasing the percentage of the population working on farms. Freed from a daily search for sustenance, humans have diversified into countless endeavors with time to create all the elements of industrialized societies. Fossil fuels have made modern society possible.

A key advantage of fossil fuels is their concentrated form. A gallon of gasoline contains 31,000 calories, the equivalent of a day’s energy for fifteen humans. By harnessing many multiples of our own physical ability, we have used hydrocarbons to shape our world. From the construction of the most rudimentary forms of shelter, we have adapted our environment to be protected from the elements.

The 2012 debate between Alex Epstein and Bill McKibben (a leading environmentalist), available on Youtube, probably changed few minds but nonetheless provided a useful public airing of views. CO2 emissions have risen along with fossil fuel use. But many measures of human well-being have improved including life expectancy, poverty and access to sanitation. It’s clearly not a coincidence. Every human, regardless of their opinion on climate change, wants a livable planet.

Whatever your views on human-caused global warming, The Moral Case for Fossil Fuels represents a useful step towards greater intellectual rigor on the topic.

Last week’s blog post, The Changing MLP Investor, received more interest than usual.  There’s no shortage of research explaining why MLPs are cheap, but it seems few stop to consider the mindset of those who decline to act on this opportunity. Sometimes it’s more helpful to understand the non-buyers.

Following the collapse two years ago (see The 2015 MLP Crash; Why and What’s Next) the sector staged a strong recovery in 2016. However, over the last six months prices have sagged. Oil weakness earlier in the year was blamed, but in June crude began to recover and the previously high correlation with MLPs inconveniently fell. Prices for oil and MLPs are linked when sentiment dictates, but are economically not that close. Consequently, the relationship can weaken with little warning, revealing their transitory affinity for one another.

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Continuing the theme from last week’s blog that focused more on investors, for a time the Shale Revolution led MLPs to substantially increase their annual capital needs. Subsequently, some lost access to equity financing. The result was that acquisitions, new projects and expansions led to increased use of internally generated cash, leaving less for distributions. In some cases there were distribution cuts. But there are indications that we are over the hump – a higher cost of equity for those firms needing more of it has imposed discipline, and projects are increasingly financed without tapping the capital markets. Annual capital needs are down for the third successive year and are running at about half the pace of 2014.

Nonetheless, investors continue to punish those firms that are growing their asset base. The table below highlights four transactions in the past year that have all led to stock price underperformance. The message is that traditional MLP investors prefer income over growth. The choice of many management teams to favor asset growth has led to investor turnover and today’s attractive valuations.

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Interestingly, Blackstone recently acquired Harvest Fund Advisors, an MLP investment manager, reflecting their recognition that long-lived energy infrastructure assets offer attractive returns.

Why aren’t MLPs performing better given the fundamentals? On valuation, they should be compelling. Using EV/EBITDA (Enterprise Value /Earnings Before Interest, Taxes, Depreciation and Amortization), they are virtually on top of utilities, a point not reached either in 2008 or 2016.

Typically, MLPs are valued at a higher multiple. Although like utilities, they depreciate their assets, unlike power plants, pipelines buried underground typically appreciate, since their cashflows grow. They also have more flexibility in their customer base, since a pipeline can move hydrocarbons from anywhere that’s connected by the network. The customer base of a utility is geographically fixed. And EBITDA generated by a utility is subject to taxes, whereas MLPs don’t pay tax. For all of these reasons, EV/EBITDA multiples for MLPs are usually higher. Consequently, when relative valuations approached one another as they have twice briefly in the past decade, a sharp recovery in MLPs followed.

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The yield on the Alerian MLP Index is currently 7.8%, 5.6% above the ten year treasury and substantially wider than the 15 year average of 3.5%. Moreover, MLP debt is performing far better than their equities, suggesting no particular financial distress.

2Q17 earnings were largely uneventful, with the dramatic exception of Plains All American (PAGP) which warned of a likely distribution cut (see MLP Investors Learn About Logistics). Management teams report that business is fine, cashflows growing and product moving. At some point in the next year we’re likely to see U.S. crude oil production exceed 10 Million Barrels per Day, a record last seen in November 1970. Yet MLPs fall when crude prices are weak and seem indifferent when they rise. What is going on?

MLP investors originally signed up for high, stable distributions with modest growth and not much excitement. The widely-hated K-1s provide a useful tax deferral for those willing to hand them off to an accountant. The tax benefit accumulates over time, creating a powerful incentive to delay selling which would make the tax bill come due. Some MLP investors really do hold forever, or at least their lifetimes, leaving their heirs to benefit from a stepped-up cost basis that wipes the tax slate clean. In a world of trigger-happy equity analysis with a relentless focus on the next few days or hours, MLP investors are what every company says they want: in for the long term.

There is increasing evidence that this stable investor base has been turning over. The Shale Revolution created the need for more infrastructure to support America’s drive to energy independence. It’s a truly exciting story that exemplifies much that is great about the U.S. (see Why the Shale Revolution Could Only Happen in America). But quite a few managements in their drive to seize the ensuing growth opportunities have imposed an unwelcome financial model on their loyal investor base. Stable distributions with low growth were put at risk with increased leverage seeking faster growth. The result, as Kinder Morgan showed, was that the MLP structure doesn’t work if you’re big and need to fund large capital projects.

The consequence for Kinder Morgan Partners (KMP) investors was an unwelcome tax bill as their units were absorbed by Kinder Morgan Inc. (KMI), and ultimately two dividend cuts. KMI recently announced they’ll be raising their dividend next year, since their backlog of new projects is a fraction of what it was three years ago and so they have more cash available to resume higher payouts (see What Kinder Morgan Tells Us About MLPs). But the psychological damage to KMP investors has been done. Every financial advisor I talk to has some clients who owned KMP and were effectively betrayed. They never signed up for higher leverage in search of faster growth, but the stewards of their capital decided for them. The experience has made many long-time MLP investors wary of being seduced by valuations into committing new capital.

KMI was only the first. Other companies, including Targa Resources (TRGP), Plains All American (PAGP), Oneok (OKE), Williams Companies (WMB) and Energy Transfer (ETP) have undertaken various types of structural simplification. In every case, it was a result of growth that strained balance sheets and it ultimately led to a cut (sometimes two) in distributions to MLP investors, an unwelcome tax bill or both. PAGP warned of an impending second distribution cut earlier in the month. The most loyal investors in the public equity markets have had their trust abused by management teams whose choices ultimately risked the stable payouts their clients had always sought. Although no reliable figures exist on this topic, several MLP executives have admitted to substantial turnover in their investor base in recent years. Income seeking investors did not sign up for this. The 58.2% drop in the Alerian Index from August 2014 to February 2016 remains a recent, highly unpleasant memory. When combined with multiple cases of broken distribution promises, many long-time MLP holders feel abandoned. The investor base is changing.

That is what is creating the current valuation opportunity. Today’s investors in energy infrastructure like the yields but are also fine with cash being reinvested back in the business, something MLPs did on a much smaller scale in the old days. Recent buyers recognize the opportunities to grow cashflows through enhancing existing assets and building new ones at attractive IRRs. The Shale Revolution is a tremendous opportunity for energy infrastructure businesses to generate stable and growing cashflows for many years ahead. But financially, getting there has been highly disruptive for an investor base originally not much concerned with growth. This transition from one type of investor to another isn’t happening smoothly, but it’s happening.  Valuation discrepancies such as the EV/EBITDA comparison with Utilities won’t last forever.

We are invested in Energy Transfer Equity (General Partner of ETP), KMI, OKE, PAGP, TRGP and WMB

We regularly get questions from investors about why the dividend yield on MLPs is often higher than for energy infrastructure C-corps that are in the same business. In recent years several MLPs have transferred their assets into their C-corp parent. Examples are Kinder Morgan (KMI), Targa Resources (TRGP) and Oneok (OKE). The merger of an MLP with its C-corp parent has typically been accompanied by a dividend cut for the MLP investors, who wind up with C-corp shares through a swap.

The assets don’t perform any differently just because they’ve been moved to another entity. But it highlights the differences between C-corps and MLPs from both a taxation and a financing perspective.

The two diagrams below show this. In each case, assume the underlying assets and the need for growth capital are the same; the only difference is the type of entity (MLP or C-corp) owning the assets.

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Traditionally, MLPs pay out >90% of their Distributable Cash Flow (DCF) in distributions. DCF is defined as cash generated from operations less the cost of maintenance expenditure on existing assets. Note that generally companies (i.e. C-corps) pay out substantially less than this. Across the S&P500 the average payout ratio is currently 42%. This is largely because of the “double taxation” of dividends, in that corporate profits are taxed first at the corporate level (via corporate income tax), and then again at the investor levels (via personal taxes on dividends and capital gains).

Since paying dividends is a very tax-inefficient way for corporations to return value to shareholders, high pay-out ratios would be exceptionally inefficient. The recent trend is for companies to return profits via buying back their stock. S&P500 companies are currently spending 28% more buying back stock than paying dividends. This also reduces their share count, boosting per share growth.

MLPs don’t face the same tax inefficiency, hence the higher payouts. Consequently, they pay out most of their DCF and then issue equity to finance growth. Their number of units outstanding therefore grows, diluting per unit DCF.

When assets formerly held by an MLP are moved into a C-corp, their cashflows are treated differently. Because C-corps have lower payout ratios, less of the Free Cash Flow (roughly analogous to the MLP’s DCF) is paid out in dividends. This has two results:

• Assets held in an MLP will pay a higher yield to investors than those same assets held in a C-corp.
• The C-corp’s lower payout leaves more cash to finance growth, which in our example eliminates the need to issue equity. Not issuing equity means no dilution for shareholders, which in turn means faster per share dividend growth.
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Across the energy infrastructure investments we hold, dividends are covered approximately 1.5X by free cashflow. An extreme example is Kinder Morgan (KMI) which has a FCF yield of 10% but a dividend yield of 2.5% (they have announced they’ll be raising it next year). KMI is reinvesting most of its FCF in growth, thereby not issuing any dilutive equity and so driving FCF higher. In addition, since FCF is generally growing, the total return on these investments should exceed the FCF yield itself.

Some will note that the point of MLPs is to hold eligible assets without having to pay corporate tax on the returns, and argue that use of the C-corp subjects those returns to taxes needlessly. In practice, energy infrastructure C-corps that have acquired assets from an MLP have employed tax strategies to minimize or eliminate any corporate tax liability, so this concern is moot (see The Tax Story Behind Kinder Morgan’s Big Transaction).

In summary, C-corps pay less of each dollar earned and reinvest more, compared with an MLP holding the same assets. Lower payouts lead to faster growth, since cash not paid out is reinvested in the business. The dividend yield on a portfolio of equities is an unreasonably low estimate of total return. For example, the S&P500 yields 2%, whereas most observers would assign a higher long term return target to stocks (unless they’re very bearish), because dividends grow over time which contributes to an investors overall return. C-corps that own energy infrastructure exhibit similar characteristics, albeit with higher yields and growth prospects.

We are invested in KMI, OKE and TRGP

We hear so often how energy infrastructure is all about pipelines and storage assets with fee-based contracts that when another part of the business pops up it can cause quite a stir. So it was that Plains All American (PAGP), one of the biggest crude oil pipeline operators in the U.S., provided an unwelcome example of the uncertainty surrounding one aspect of their business. Accelerating changes in the marketplace adversely affected their Supply and Logistics segment, such that PAGP thought it worthwhile holding their Wednesday morning earnings call on Tuesday evening, immediately following their earnings release.

Supply and Logistics involves taking temporary ownership of crude oil, Natural Gas Liquids (NGLs) and natural gas with the objective of unloading it elsewhere for a profit. The idea is not to make money from price moves, but rather to generate a profit from known inefficiencies in the transportation network. If you can buy crude oil at point A for $45 a barrel and sell it at point B for $48 while spending less than $3 on storage, transportation and overhead, it can be a profitable business. It has been so in the past; in 2013 PAGP generated $893MM in EBITDA from this activity, although its profits have been declining since. It is in effect a profit from inefficiency of the domestic transport network. If crude is worth $3 more at point B compared with point A, the cost of transport should be around $3, or crude will flow until the arbitrage is eliminated.

The problem, as PAGP belatedly discovered, is that the market is becoming more efficient. Three years ago Congress lifted the ban on crude exports, which removed one significant inefficiency. Patches of excess pipeline capacity further challenged arbitrage opportunities by providing shippers with more choices. More recently, a flattening of the crude oil futures curve along with lower volatility reduced opportunities, as did more competition. Several other firms have de-emphasized or exited the business over the past couple of years.

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The deep disappointment no doubt felt by PAGP CEO Greg Armstrong and those who know him is that they didn’t see this coming. Plains is better positioned than most to see first-hand changes in the supply and logistics of hydrocarbons. They pride themselves on a very sophisticated view of shifts in the marketplace. Three months ago a weak first quarter in this segment was partly blamed on warm winter weather. Propane held in inventory anticipating stronger prices had to be sold on weakness.

The outlook for profits in Supply and Logistics is so uncertain that PAGP says they’ll likely exclude it from their calculations of Distributable Cash Flow (DCF), the metric underpinning their distribution. They’re currently forecasting only $75MM this year. Although a strategic review is underway and will likely take a couple of months, the Facilities and Transportation businesses can only support a payout of around $1.80 per share (albeit with 1.1X coverage), down from $2.20 currently. Plains cut their distribution last year when combining their MLP and GP, so this likely represents a second cut in two years. Another management team’s reputation is shredded. Greg Armstrong will not care to be compared with Rich Kinder who also oversaw two dividend cuts in as many years at Kinder Morgan, but many investors will see little between them. In both cases a seasoned CEO has been shown to poorly anticipate changes in a business in which he’s spent his entire career. If Greg Armstrong didn’t see it coming, it’s hardly surprising that PAGP investors didn’t either.

We are invested in PAGP

Master Limited Partnerships (MLPs) have been reporting earnings over the past couple of weeks. For the most part they have come in as expected, with few surprises in either direction. Crestwood (CEQP) and Tallgrass (TEGP) both reported system volumes slightly higher than expected; generally though, they were unremarkable, which is the sort of boring stability MLP investors like. Although most CEOs are pretty sure their stock is undervalued, TEGP CEO David Dehaemers  is positively convinced this is the case. And since TEGP sports a 5.25% yield forecast to grow by 40% (not a misprint) in 2018, his case appears compelling to us.

The real story of the past week is not MLPs but their customers, who we also follow closely. MLP investors may feel that their patience is being tested, as the sector gyrates with crude oil while persistently refusing to appreciate as its high yields imply it should. At least MLP investors are being rewarded to wait, with attractive quarterly distributions being paid in many cases during August. Even so, the trailing one year return on the Alerian Index of 2% seems paltry compared with the S&P500, whose one year return is 16%. MLP investors might feel unloved. In the classic British sitcom Fawlty Towers, manic hotel owner John Cleese is told not to worry, that there’s always someone else worse off. To which he replies, “Is there really. Well I’d like to meet him, I could do with a laugh.” You can see the clip here at the 18 minute mark.

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Therefore, the recent performance of U.S. shale drillers is worth considering, albeit with less shadenfreude than John Cleese. They are the customers of MLPs, and the regularly demonstrated efficiencies with which they extract hydrocarbons are not, of late, rewarding their investors. Over the past year, the six most active independent shale drillers have returned -21%. 2Q17 earnings reports over the past couple of weeks have hastened this slide, as future production growth has been guided down. The announced capex reductions across the exploration and production sector (see Financial Discipline Among MLP Customers) have helped boost crude prices by around $6 a barrel since June 21. However, lower guidance from the six names highlighted is in most cases due to specific technical challenges they’re encountering and resolving. They’re not reporting that margins are too tight. Nonetheless, in such a market investors want every name in the group except the ones they hold to produce less.

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Weakness in the stock prices of shale drillers may be weighing on MLPs. Energy infrastructure inevitably trades with the sector it supports. Kinder Morgan (KMI) is in XLE, the energy sector ETF. Swings in sentiment inevitably move its price regardless of its fundamentals.

A piece of good news that didn’t receive much attention was Senate approval of two new commissioners to the Federal Energy Regulatory Commission (FERC). This will restore their quorum, and should allow a substantial backlog (estimated by RW Baird at $14BN) of infrastructure projects to receive approvals and proceed. Their completion will add incrementally to the cashflows of their owners and ultimately augment payouts to investors.

We are invested in CEQP, KMI ad TEGP

The Prize: The Epic Quest for Oil, Money and Power was first published 27 years ago, although Daniel Yergin added an Epilogue in 2008. It is nothing less than an economic and political history of crude oil. At 910 pages of text and footnotes it’s an epic read, but you can select sections of interest and jump around, leaving and returning to it later. The very beginnings of the U.S. oil business were about producing kerosene from “rock oil” to replace whale oil or turpentine used for light. Its illuminative qualities were deemed far superior to the alternatives and production took off in the early 1860s. The Civil War boosted demand and the oil business had begun. John D. Rockefeller became the richest man in America by selling kerosene.

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During the early 1900s the internal combustion engine created a new market for gasoline, promoting oil in importance over coal as a source of primary energy and leading Daniel Yergin to dub the 20th Century “The Age of Oil”.

The 1973 Oil Shock is a distant memory for those of us old enough to have any first hand recollection. It’s therefore quite sobering to re-familiarize oneself with its history as recounted by Yergin in 1990 when its ramifications remained fresh. Iconic photos of cars lined up outside gas stations were a vivid reminder of modern society’s dependence on oil; they also exposed the western world’s sudden vulnerability to an adverse clash of politics and economics in a volatile region.

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Reading about events some 44 years later, the ability of Arab oil producers to turn a spigot so as to influence U.S. policy decisions was outrageous, an affront. The history of how OPEC came to wield such power is well recounted by Yergin. From 1948-72, 70% of newly discovered proved oil reserves were located in the Middle East. This concentration of oil resources combined with western governments’ inattention to their increasing reliance on monarchs with whom their interests were not aligned created the conditions under which the Arab Oil Embargo was so effective.

Countries were placed on one of three lists (Friendly, Neutral or Unfriendly) depending on how closely their public policy statements pleased Arab oil suppliers, with deliveries modified commensurately. Europe produced very little oil and Japan virtually none. By contrast, U.S. production reached 9.5 Million Barrels per day (MMB/D) in 1973, coincidentally, a record we will soon eclipse.

Although America wasn’t self-sufficient, it wasn’t as reliant on OPEC as others. However, strong domestic demand had caused imports to almost triple over the prior six years, to 6 MMB/D, so energy independence was not a realistic objective. Over the prior quarter century the U.S. share of world production had fallen from 64% to 22% as Middle East nations ramped up their output from 1.1 MMB/D to 18.2 MMB/D.

The 1973 Arab Oil Embargo was a political and economic shock, and ever since the U.S. has paid close attention to the region. The 1990-91 Gulf War fought to eject Iran from Kuwait was arguably all about oil reserves, and the U.S. continues to maintain a large military presence in the area. Yergin’s book had the good fortune to be published in December 1990, just a month before the U.S. and its allies launched Desert Storm. There is an eight episode documentary accompanying Yergin’s book that can be found on Youtube. It was shown on PBS in 1992-93, a couple of years after the book’s publication, and provides interviews with many of the oil executives and government officials involved at that time. One U.S. oil CEO had expected public opinion to demand less reliance on imported energy following 1973, and the second oil shock in 1979 after the Iranian revolution. But diversity of supply lessened OPEC’s power, and the Gulf War showed that Middle Eastern oil reserves couldn’t be seized by an unfriendly power.

Nonetheless, I found that reliving those events through Yergin’s book and documentary provoked feelings of outrage, and a wish that we never again find ourselves so vulnerable to others.

And guess what? American Energy Independence, for generations no more than an aspirational state, is clearly now in America’s future. It has multiple definitions – the Energy Information Agency (EIA) defines this as BTU independent, which means that we are a net exporter of energy in all its forms once they’re converted to their energy-equivalent, BTU content. The EIA’s Annual Energy Outlook 2017 projects that we shall achieve BTU-independence within the next decade. We recently achieved Natural Gas independence, as exports began exceeding imports over the past twelve months. Shipments of Liquified Natural Gas are set to rise substantially in coming years as new liquefaction plants become operational. We’ve long been a net exporter of coal.

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Although BTU-independence is the most complete measure of our reliance on others for energy, most casual observers think simply in terms of oil independence, especially given the contemporary history recounted by Daniel Yergin. Photos of drivers sitting in gas lines remain an emotive image. The EIA makes a Reference Case forecast (its Base Case) but includes other less likely but still plausible scenarios. Their central expectation is for the U.S. to remain a net importer of petroleum products (defined as crude oil, refined products and natural gas liquids), albeit at a steadily diminishing rate, falling by two thirds within a decade.

But if crude prices rise higher than they expect, or improvements in the technology driving shale oil and gas output surprise to the upside, the U.S. could become a substantial net exporter.  OPEC long ago lost its ability to call the shots and in recent years their inability to set prices has been amply demonstrated. This is the enormity of the Shale Revolution. Its impact is far more than simply economic, although in that respect it’s already substantial. Its geopolitical effects will continue to reverberate through different countries’ needs for energy security. U.S. policy in the Middle East will reflect a reduced reliance on the region’s major export, something Americans will overwhelmingly welcome.

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In a recent interview on the Shale Revolution, Yergin cited the sanctions imposed on Iran as an example of shifting energy power. He asserted that without the growth in U.S. oil production, the removal of Iranian oil supplies from the market would have been unworkable. Yergin has found that in discussions with foreign decision makers across Europe and Asia, there is a recognition that America’s role in the world is changing, in part because of improved security around energy supplies.

Today we’re seeing an alignment of resources, technology and public policy that together are bringing a seemingly Utopian vision closer to reality. Energy infrastructure is growing as it adapts to increased production that is supplying new markets. It may have taken half a century, but the dynamism of American capitalism is denying the ability of foreign despots or hostile governments to inflict substantial economic harm through manipulating energy exports.

Recent earnings reports suggest some moderation in the acceleration of U.S. shale drilling. The CEO of Schlumberger said that equity investors were propagating marginal activity by providing capital based on volumes rather than returns. The retiring Chairman of Halliburton, Dave Lesar, provided some wonderful quotes on his final investor call, including this assessment of the Shale Revolution:

“They are your classic American entrepreneurs, and their success should be recognized. In Silicon Valley, such a success would be greatly celebrated as another industry disruptor. The unconventional disruption is not widely celebrated beyond the energy space, but it should be. The development of US unconventional resources has been as disruptive to the global energy market as Amazon has been to Big Box Retailing or Uber to the taxi business… Made the US more energy independent, caused OPEC to react and changed the fundamental economics of offshore production.”

This is one of the reasons why America is Great.

Anadarko announced a $300MM (7%) reduction in their 2017 capex plan, noting that margins were too volatile to support their previously planned budget (some of this reduction was to non-shale, offshore projects). Halliburton’s Dave Lesar also noted a “tapping the brakes”, which the incoming CEO Jeff Miller clarified as, “going from 80 miles an hour to 70 miles an hour.” Other U.S. drillers including Hess and Sanchez similarly lowered capex. The anecdotal evidence of slower production growth supported crude prices last week, as did OPEC’s meeting in St. Petersburg at which Saudi Arabia pledged to unilaterally limit exports in a further effort to support prices.

The U.S. Energy Information Agency (EIA) publishes a monthly Drilling Productivity Report (DPR). It includes data on output and productivity from the larger shale plays across the country. Many observers including ourselves have commented on the dramatic improvements in productivity that have been taking place. It’s no exaggeration to say that advances in drilling techniques and use of improved technologies have been hugely important drivers behind the rise in U.S. production, in spite of falling prices.

However, part of the productivity improvements have been due to an increased focus on the most productive wells. U.S. producers adopted a defensive posture in 2015-16 as crude prices collapsed, and that included focusing their efforts on their best plays. Although there’s no doubt that actual productivity improved enormously, the figures are likely somewhat flattered by this focus on the best assets.

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One measure of productivity is initial output per well (Initial Production Rate, or IPR), and in some plays (notably including the Permian), this statistic has been declining modestly for about a year. It’s still higher than at any time prior to 2016, and enhancements such as multi-well pad drilling, longer laterals and new fracking techniques have been critical to success. Output continues to grow even while initial production rates are flattening out. It’s a consequence of drillers moving beyond their most productive plays, best rigs and most skilled crews. While they played defense successfully, operating efficiencies were achieved and are being applied more broadly. Although crude oil production from shale plays is likely to keep growing in the current economic environment, the flattening of IPRs is a sign of limits on unconstrained growth. A study from MIT concluded that productivity gains were being overstated by insufficiently considering “sweet-spotting”, the tendency to focus on the best acreage.

Recent earnings reports as well as the IPR data noted above suggest that, while U.S. output will continue to grow, there are visible limits on that growth. Furthermore, after seeing annual declines in breakeven prices of 20% in 2015 and 29% in 2016, Rystad Energy forecasts breakevens are poised to rise 7% in 2017. Nonetheless, productivity remains high enough and costs low enough to gain market share, but perhaps not enough to further depress prices.

Kinder Morgan (KMI) reported earnings last week, including a long expected dividend hike and a pleasantly surprising stock buyback. In many ways the stock performance and corporate finance moves of KMI reflect the Master Limited Partnership (MLP) sector as a whole.

Pre-Shale Revolution, Kinder Morgan Partners (KMP) had rewarded investors with steady distribution growth and modest (for their size) investments in new projects. Their investor presentation included a slide labelled “Promises Made, Promises Kept” with a table showing these consistently higher payouts.

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Not all companies make old investor presentations available on their website – since it allows users to compare statements across years, it can be embarrassing. To KMI’s credit, they do. Consequently, we’re able to delve back several years and recall the world MLPs used to inhabit. This was a time of attractive, stable distributions with modest growth and an occasional need for growth capital. The Shale Revolution was not widely regarded as the energy sector game changer it became. Wealthy U.S. investors tolerant of K-1s liked the mostly tax-deferred distributions. MLPs were an income-generating asset class.

KMP, which was at the time the main operating entity, noted that from 1997 to 2011 it had invested $24BN in new projects and acquisitions. As was the norm, most of that growth had been financed by issuing debt and equity, since KMP paid out most of its Distributable Cash Flow (DCF) in distributions. Over the next two and a half years as infrastructure demand grew, they invested $20BN in growth projects & acquisitions for a total of $44BN over 17 years. The chart below on the left includes $2.3B of organic capex budgeted for 2H14 to total 46.5B by YE2014.

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By mid 2014 KMI had concluded that the MLP investor base was too small to finance its growth. The 2014 presentation heralding the combination of KMI with KMP to create one integrated entity identified $17BN of organic growth projects over the next five years. Since 1997, $20BN of the $44BN had been invested in greenfield & expansion projects, with the balance being acquisitions. So the $17BN five year projected figure was analogous to the $20BN from the prior 17 years, since future acquisitions (the other source of growth) are generally very hard to forecast.

This is how the Shale Revolution manifested itself to big energy infrastructure companies. There was suddenly the need for lots more investment in attractive assets to meet new flows of hydrocarbons. But MLP investors weren’t big enough to provide the capital. KMI concluded this as the yield on their KMP units edged up, driven higher in order to attract the equity capital that their regular secondary offerings demanded. The 2014 KMI/KMP combination was intended to provide cheaper financing.

MLPs exist because of the tax code. Owning pipelines (or MLPs for that matter; see Some MLP Investors Get Taxed Twice) in a C-corp structure makes them taxable at the entity level, whereas MLPs largely don’t pay tax. But the universe of eligible MLP investors is limited to U.S. taxable K-1 tolerant investors, a small segment of all the global institutions who buy U.S. equities. As KMI found, if you need $Billions every year, MLP investors will start charging you more. Although folding KMP’s assets into KMI might have been expected to make them taxable, KMI’s clever advisers structured the deal to not be taxable for many years (see The Tax Story Behind Kinder Morgan’s Big Transaction). KMI could now fund its growth plans from the global equity market, not just MLP investors.

Their big mistake was to continue to think and act like an MLP. So they still planned to pay out most of their free cash flow in dividends, concurrently issuing new equity to get back most of it for growth. But corporations on average pay out a third of their profits in dividends, not 100%. Generating $4.5BN in DCF, paying $4BN in dividends and raising $2-3BN in equity looks a bit odd, albeit attractive to equity underwriters.  So the market priced KMI accordingly, driving up its yield. As it rose above 10% the idea of handing cash earned from existing assets out and getting it back to invest in new assets looked increasingly absurd, so they cut the distribution.

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Notice that all of these issues were corporate finance ones. They all related to the liability side of KMI’s balance sheet. It was all about how best to finance future assets. The collapse in crude oil in 2015 affected KMI only modestly, because their cashflows are overwhelmingly from natural gas. Assets were mostly performing as expected, but their mis-steps were a combination of financing strategy and amount of growth. They certainly had the choice to cut their backlog of expansion projects, which would have lowered their need for new financing. But they chose as they did, and the 75% dividend cut created enough cash to eliminate the need for external funding. Had they opted for less growth they would have been able to maintain their original payout.

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The growth backlog is declining as some projects (notably the $6BN North East Direct project, which was to improve natural gas distribution in New England) were cancelled and others completed. The excess cash is being used to reduce debt and starting in 2018 will be returned through higher dividends and a buyback. Other big MLPs merged their GP and MLP like KMI, reduced growth plans or did both. Leverage rose because new assets are built and financed before they generate EBITDA. As those projects are put into service, leverage is coming down.

Price history will show that KMI and the MLP sector endured a terrible operating environment during the 2015 crash in crude oil. Most investors even today regard the worst bear market in the sector’s history (see The 2015 MLP Crash; Why and What’s Next) as an oil-induced fall in operating results. The reality for KMI was that growth plans driven by the Shale Revolution exceeded the financing capacity of a specialized investor base. This is pretty much the case for midstream in general. It’s not obvious from a price chart, but if you followed developments real time it’s the real story.

We are invested in KMI