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

Around ten days ago Conoco Phillips (COP) and Magellan Midstream (MMP) both released their 4Q15 earnings, and held conference calls on February 4th to discuss them. This coincidence of reporting is about all they have in common, but it caused us to look a bit more closely at an energy company (COP) that truly has commodity price exposure and what it’s doing about it.

COP announced a two-thirds cut in their dividend, a completely understandable move because they really are financing it with debt. The problem with an Exploration and Production (E&P) company like COP is that they have to keep replacing their assets. Hydrocarbons produced are assets no longer available to generate future revenues, and so they keep investing in new future production. Consequently, COP’s $3.3BN of 2015 EBITDA was dwarfed by $10BN of capex resulting in negative free cashflow (FCF). They lost $3.50 per share. The company closed out the year with half the cash with which it started ($2.4BN versus $5.1BN) and on top of that their proved reserves fell by 19%, from 8.9 BBOE (Billions of Barrels of Oil Equivalent) to 8.2 BBOE. Incidentally, COP’s 2015 Depreciation, Depletion and Amortization (DD&A) was $9BN, pretty close to their capex. Their new investments were approximately equal to the hydrocarbon assets they extracted and sold. In 2016 their DD&A is likely to exceed their capex by $2BN. They are running very hard and not even moving forward. 2015 was a year COP will happily forget – they lost money, used up half their cash and saw their reserves drop. They have nothing to show for it.

It’s hard to know how to value COP, and especially hard to compare them with an MLP (which is where we’re going). Neither their free cashflow yield nor their P/E multiple are meaningful since both are negative. On an Enterprise Value/EBITDA (EV/EBITDA) basis they’re priced at 15.4X based on 2016 guidance, which incorporates a 36% slashing of their capex budget to $6.4BN. This multiple flatters COP and all E&P companies though, because it backs out depletion and depreciation although their future EBITDA is dependent on continuing growth capex to replace what’s gone.

COP’s dividend cut was a belated acknowledgment of the obvious, which is that they don’t generate any cash to pay a dividend so are funding it with debt. In fact, COP operates in the way that many MLP critics assert is prevalent with midstream infrastructure businesses, although there are substantial differences between the assets of an E&P company (hydrocarbon reserves which are used up) and pipelines which last for decades and don’t require perennial replacement (although they do require maintenance).

MMP reported solid earnings and generates Distributable Cash Flow (DCF), a measure somewhat analogous to COP’s FCF (although MLP critics will disagree on this point). MMP’s DCF covers their distribution, whereas COP really has no business paying a dividend. MMP’s EV/EBITDA, in which their EBITDA is more reflective of FCF generation because its assets are not naturally depleting, is 15.3X on 2016 guidance, roughly the same as COP’s.

Now it’s true that COP has tracked the Alerian Index (AMZX) more reliably than MMP, which is to say MLPs have behaved like an enormous cash-consuming owner of depleting assets rather than the cash-generative owner of sustainable assets that they are (chart source: SL Advisors). The few E&P names in the Alerian index have been dumped following distribution cuts (reliable distributions are one of the  the rules for inclusion), so AMZX no longer includes E&P businesses. MMP has outperformed AMZX, and yet its valuation fails to differentiate it from COP. It has been dragged down by its sector.

We continue to think that the ongoing collapse in MLPs is reflective of their financing model and rigidity of the investor base (see The 2015 MLP Crash; Why and What’s Next). Traditional MLP investors are U.S. taxable, high net worth (HNW) individuals. The arrival of smaller retail investors through mutual funds and ETFs for a time met the increased need for growth capex that traditional MLP investors, who like their distributions, didn’t want to finance by reinvesting everything they received. The retail investor was the marginal buyer, for a while. The surprise has been that upon his exit, new sources of financing have required a substantial price discount. MLP proponents have written for years about the institutionalization of the sector. The evidence clearly shows that once you exclude institutional money managers of retail money, the true institutional investors of public equities (pension funds, sovereign wealth funds, endowments and foundations) are not natural MLP investors because of the tax barriers.

Deciding the sector is cheap and then identifying a manager and implementing is a deliberate process, and while we see some evidence that it is under way, the buyer of an MLP today is most likely still the traditional HNW taxable investor. Given the collapse in prices, he’s not very enthusiastic. In this way, the MLP sector is unlike any other sector of the U.S. equity markets where capital can move in more opportunistically. Eventually, institutional investors will commit more meaningful capital, but it takes time. Most of the publicly listed MLP funds are terribly tax-inefficient (see The Sky High Expenses of MLP Funds), although not ours. As well as selecting a manager to oversee an MLP portfolio, a non-tax paying pension fund must decide to file a tax return (as direct holdings of MLPs would require). These are not trivial decisions. Count the cheerleaders for the “institutionalization” of the MLP sector among those whose views were aspirational rather than realistic.

We are invested in MMP.

We’ve been looking for examples of what happens to a pipeline contract when the Exploration & Production (E&P) company is under financial stress or files for bankruptcy. The question of what happens to long term contracts with Master Limited Partnerships (MLPs) in such cases is becoming one of the more notable concerns, both for MLP investors and for those who would otherwise buy MLPs if they could get comfort on this issue.

It’s a pretty fundamental concern. Pipelines are immobile, and as a result they’re not built without a high degree of assurance that they’ll be used and paid for. What happens when this goes wrong?

Past cycles don’t provide much guidance, because disputes have been rare. We noted a couple of weeks ago (see How Do You Break a Pipeline Contract?) the case of Essar Steel Limited, an Indian steel company, which lost in Federal court when trying to void an agreement to take previously contracted natural gas.

This brought us to Crestwood Midstream, a Gathering and Processing (G&P) MLP with a very depressed stock price and at least one E&P customer (Quicksilver Resources) that is in bankruptcy. If the riskiest place in the energy sector is drilling for crude oil or natural gas at a time of abundance, the next riskiest must be providing the G&P facilities that are the first step in moving that output through the nation’s pipeline network. A single pipe to a single well has a single purpose, and if the well owner ceases to pump natural gas or merely threatens to, the G&P MLP that owns the pipe will pay attention.

Interestingly, Quicksilver continues to utilize Crestwood’s G&P services. U.S. bankruptcy law is intended to maximize the going concern value of the enterprise to the benefit of the creditors, and in most cases the assets of a failed E&P company have more value if they’re still producing. As we understand bankruptcy law, contracts that are above market can be rejected or re-priced to be market-competitive, but individual clauses of contracts cannot be selectively altered. Moreover, an MLP providing a service to a bankrupt company cannot be compelled to continue providing that service if payments are not made.

Contracts between MLPs and their customers are not made public. However, there was an interesting conclusion to one between SandRidge Energy (SD) and Occidental Petroleum (OXY). SD is an E&P company that, while not yet bankrupt, recently delisted from the NYSE. They had a contract with OXY to deliver certain volumes of CO2 and had been failing to deliver the committed amount. Under the terms of the contract, SD had racked up non-performance penalties of $113MM that were set to continue accruing. To get out of this commitment, SD gave OXY natural gas E&P assets, cash and associated midstream infrastructure. This was evidently cheaper for SD than seeking to break the contract, and shows both that companies continue to make decisions on the basis that contracts will be upheld in court but also that OXY found sufficient value in the transferred assets to satisfy their claim.

Returning to Crestwood, their prospects will tell us a lot about how such issues get resolved, because they have other G&P assets and potentially other distressed customers. The degree of financial stress they’re facing is a topic of considerable disagreement. 90% of their 2015 EBITDA was from Fixed-Fee or Take-or-Pay contracts, which traditionally involve little risk of non-payment or commodity price exposure. CEQP’s current yield of 43% reflects substantial concern among investors that 2015’s $560MM EBIDTA will drop in the future due to stress among its customers. However, it’s also possible their EBITDA will be higher in 2016. CEQP has a supportive sponsor in First Reserve who is funding an expansion project in the Permian Basin in West Texas via a 50/50 JV, and owns 16% of CEQP’s units. CEQP used to have the typical GP/MLP structure, but last year combined into one entity which eliminated the cash payments under Incentive Distribution Rights thus leaving more of the cashflow for the LP unitholders.

In fact, CEQP might represent a case study of the outcomes when your E&P customers falter, because CEQP does operate close to the wellhead where financial stress is most acute. Management is more confident than the market that their Distributable Cash Flow (DCF) will continue to cover their $5.50 annualized distribution which for the past four quarters was 1.02X. Hence CEQP LP units currently yield 43%, a level unlikely to be available a year from now; either the doubters will be right and the distribution will be cut, or the stock price will move sharply higher.

Raging Capital makes a persuasive case that the stock is cheap, and in December published an open letter with a supporting presentation advocating value-creating steps management could take, beginning with a cut in the distribution. Reasoning that a 43% distribution yield reflects healthy skepticism among investors regarding its continuation as well as the likely absence of risk-averse income-seeking investors, cutting it in half to 20% would still provide an eye-catching yield while freeing up cash to buy back stock. Saving $2.25 in annual distributions on 68.5MM shares would free up $38MM quarterly, enough to repurchase 2.9MM shares a quarter or 5% of the public float while building ~$9M in coverage (i.e by no longer paying distribution on shares repurchased). Within two years they could shrink the public float by 38%, at which point their DCF even if unchanged would be $8.57 per unit. It’s doubtful CEQP could remain anywhere near $14, since that would represent a DCF multiple of less than 2X. Or, to take a more extreme case: suppose CEQP eliminated its distribution. The stock would presumably collapse since MLPs invariably do at such times. If it dropped $5 to $7, within a year the company could have used the redirected cashflow to repurchase 75% of their units, virtually the entire public float. All they would have done is returned the same amount of cash to investors through a buyback instead of distributions. At that point with a greatly reduced public float the DCF/unit would be $21. It illustrates the absurdity of maintaining such a high dividend yield.

A key assumption is that CEQP’s customers keep performing on their contracts, or if not that they are replaced by customers that do. There’s clearly some downside risk on this issue, but CEQP offers some fairly dramatic optionality. It is a small investment of ours.

Nothing herein is intended to be legal advice. For legal advise you should seek your own legal counsel.

Given the collapse in MLP prices over the last six months virtually any explanation is worth considering. Operating results continue to be unremarkable – Kinder Morgan (KMI) reported 4Q15 financials last week. Their full year 2015 results were 4% lower than their budget; two thirds of the miss was in their CO2 business which is sensitive to the price of crude oil. Overall they generated $7.6BN of EBITDA versus a budgeted figure of $7.9BN. Their Distributable Cash Flow of $4.7BN was 7% higher than in 2014. In April KMI was at $44, and closed the year at under $15.

But operating performance has never come close to justifying the performance of MLPs recently, hence we have cast around for other explanations. The rigidity of the investor base is, we think, an important cause (see The 2015 MLP Crash; Why and What’s Next). Another frequently raised concern is that the rates MLPs earn on their pipelines will be reduced, either because loss-making E&P companies will renegotiate terms or because they’ll fail and a bankruptcy court will impose a lower rate. Although there’s very little history of this, the views of the investor who chooses not to buy MLPs can be more useful than those of the MLP seller, and this issue is being raised more frequently.

It sounds plausible that if the company filling a pipeline with hydrocarbons at one end is losing money, the pipeline owner should care. A pipeline’s immobility requires reliable customers. An E&P company that is unwilling or unable to use previously contracted capacity can cause problems for the pipeline owner as well as for the customer at the other end awaiting receipt of the product.

The U.S. has 192,396 miles of liquids pipelines of which roughly a third each move crude oil, Natural Gas Liquids (NGLs) and refined products. There are over 302,000 miles of natural gas pipelines. There are over 240,000 miles of Gathering and Processing (G&P) lines – often single individual pipes to a single well. These are both narrow and numerous. There are nearly 2.2 million miles of natural gas distribution lines from utilities to residential and commercial customers. Historically, their utilization has been remarkably reliable. While Gazprom occasionally uses its power as a supplier to further Russia’s foreign policy objectives, it’s hard to think of an example where a domestic commercial dispute has impeded the flow of product. Once pipelines are built, they are used with a high degree of predictability. The Federal Energy Regulatory Commission (FERC) governs all natural gas pipelines (other than G&P) and all other pipelines that cross state lines. Interestingly, the thrust of regulation has largely been to limit the power of the pipeline operator, since a customer on the receiving end of a pipeline has few plausible choices if he’s suddenly faced with a price hike. Although a single pipe is immobile and obviously creates a symbiotic relationship with its customer, it’s part of a network which makes the product mobile, affording its owner substantially more flexibility on where to send product than the customer has on where to obtain it. Part of FERC’s role is to control the ability of MLPs to exploit this. Security of supply requires predictability of income. Pipeline projects are cancelled before breaking ground if insufficient commitments are in hand to assure its financial viability. In 2013 Kinder Morgan cancelled the $2BN “Freedom” pipeline that was intended to transport crude oil from West Texas to California for just this reason. The Field of Dreams approach is not widely used.

There isn’t a long history of broken pipeline contracts from which to draw examples. Disputes are hard to find, probably because there’s so little legal ambiguity.  Last year an Indian steel company, Essar Steel Limited, lost a case in Minnesota federal court when their acquisition of a local steel company led them to break an agreement with Great Lakes Gas Transmission Limited Partnership to take their supply of natural gas (used in steel production). Essar’s contention that the global economic crisis invalidated the contract was rejected by the court, which awarded $32.9 million to the plaintiff.

FERC has authority over many potential disputes. In 2015 Buckeye Partners reached agreement following a long-running dispute with several airlines over the rates they were charging to deliver jet fuel from New Jersey to three New York area airports. FERC oversaw the agreement and approved its resolution.

It can be useful to think of pipelines as networks of tributaries from individual plays feeding into processing centers and then into large-capacity trunklines on their way to population centers, power stations, refineries, export facilities and other users. Recently, “farther from the wellhead” has guided the investment recommendations of some, and it makes sense that a G&P network supporting a new, high cost crude oil baisin involves a totally different risk than a natural gas pipeline running into New York City to supply a power station’s electricity production.

Pipelines that are “demand pull,” in that they’re paid for by the end-user (such as a refinery or power station) are less risky than “supply-push”. In addition, 75% of hydrocarbon production in the U.S. is done by investment grade companies, so performance risk ought to be limited. Take-or-pay contracts assure the pipeline operator of revenue regardless of whether the E&P company uses the capacity. Like virtually all U.S. commercial contracts, they are enforceable. None of these seem to represent significant risk of changing contract terms. The place to look for problems is close to the wellhead where a bankruptcy judge is overseeing a failed E&P company’s obligations. However, bankruptcy need not impede the flow of product, since the bondholders could continue operations with a reduced cost of capital having shed the equity holders. While it’s conceivable that a struggling E&P company could seek to renegotiate a contract with the threat of shutting in the well, the problem of weak prices is one of excess supply. Other producers would presumably be willing to use capacity albeit not necessarily in the same place.

2015 saw 41 energy companies file for bankruptcy representing $16BN in debt. So far there are few reports of any meaningful consequences for the MLPs that provide their infrastructure, although there are reported instances of contracts being renegotiated. Williams Companies (WMB) and Chesapeake (CHK) have agreed on lower rates for natural gas transportation in Ohio and Louisiana in exchange for higher future volumes, but this is not a typical case: CHK spun out their midstream assets into Access Midstream with unusually lucrative contracts probably because they were more highly valued by Access investors than their cost as reflected in CHK’s valuation. WMB subsequently acquired Access Midstream. In Pennsylvania, leasehold contracts have been challenged by the state on behalf of many landowners who have seen their royalty checks for drilling leases slashed. But it seems so far to be an isolated case. In another interesting case brought to my attention by Ethan Bellamy of RW Baird and also Dick Flex (see comment on right panel), Quicksilver Resources , which is in bankruptcy, continues to send natural gas through Crestwood Midstream’s (CEQP) G&P network, although Quicksilver is seeking to renegotiate their agreement and has used bankruptcy to reject contracts with other G&P firms. Bankruptcy doesn’t have to lead to a cut in production. Kinder Morgan’s recent results did include a $45 million credit charge in their Terminals business due to two failed coal companies. Of course this reflects the shift away from coal towards natural gas, a trend for which MLPs including KMI are well positioned.

Moreover, demand is not the problem. Last year in the U.S., natural gas production of around 80BCF (Billion Cubic Feet Per Day) was 4BCF higher than in 2014. Exports are expected to double this year. Auto sales were a record 17.5 million with gas-guzzling pick-ups and SUVs representing half of this. Cheap hydrocarbons are producing a demand response.

While MLPs have always paid attention to the credit profile of their customers, there is increased focus on this area from investors.  We’ll continue searching for examples of the likely impact on an MLP when its E&P customer fails.

A poorly designed MLP product Crashes

This could almost be the topic of a second blog post: last week UBS announced the mandatory redemption of two exchange-traded notes that were designed to provide MLP exposure leveraged 2:1. The results have been predictable, and the notes (ticker: MLPV and MLPL) duly performed as designed. MLPV fell from $22 last Summer to under $5 at which point the abovementioned mandatory redemption was triggered. The more seasoned MLPL reached $75 at the MLP peak in August 2014 and recently touched $10. Incidentally, the management of vehicles such as these requires selling MLPs when they fall and buying them when they rise to maintain constant leverage, the type of behavior that has exacerbated the sharp moves in the sector recently and causes a permanent loss of capital for the investor. The clients of UBS were poorly served indeed.

We are long BPL, CEQP, KMI and WMB

This week I felt a pang of pity for a sell-side research analyst. Not an obviously sympathetic constituency, you might well retort. There are many other categories of employment more deserving of such consideration – indeed, probably too numerous to list here. But I did, and here’s why.

This particular analyst (he’ll remain nameless because I don’t wish to embarrass him) has been a relentless cheerleader for Master Limited Partnerships and increasingly so as their prices have plummeted. That’s already sufficient reason for me to express my sympathy. You may have spotted that we have something in common.

Explaining why MLPs keep falling in willful defiance of what an evident minority asserts is compelling valuation can be tiring, and some become weary of it before others.

Plains All America (PAA) is the midstream infrastructure MLP most clearly linked with falling crude oil prices. Like most MLPs they rely on issuing equity to fund their growth plans, and PAA has been growing in recent years to accommodate increased domestic oil production. Acknowledging the unwillingness of investors to fund growth as well as the reality of falling domestic production, PAA recently cut their 2016 growth plans from $2.1BN to $1.5BN.

On Tuesday, January 12th PAA announced they had raised $1.5BN through a convertible preferred security yielding 8%, some 5% less than the yield on their equity. It was privately placed with several institutions, and as a result PAA has no need to issue equity through 2017. Moreover, it was pretty cheap capital since it is convertible to equity at the holder’s option in two years or at PAA’s option (under certain circumstances) in three. In any event, it is junior to all their other liabilities and is in reality equity (which is how PAA regards it). Private equity investors, not normally accused of superficial research, saw fit to invest $1.5BN in equity in an MLP.

So you have a piece of news that is unambiguously positive, in that PAA raised capital on surprisingly inexpensive terms from informed investors and is no longer a seller of its own equity. Now let’s return to our sell-side analyst.

Research reports include a history of the Certifying Analyst’s prior recommendations on the stock. PAA had been a Buy (called an “Overweight”) since October 2011, at which time it was trading at $30 with a price target of $34.50. Through 19 subsequent revisions the Buy recommendation remained, with the price target regularly adjusted so as to be always 10-20% higher than the current price. In October 2014, with PAA at $58 the peak price target of $66 was recorded.

To quote a friend of mine, from that point down was a long way and on Monday, January 11th just prior to PAA’s announcement, its stock closed at $20.36, 70% below its target of fifteen months earlier. Now put the numbers aside, and consider what the past fifteen months have been like for the sell-side analyst. He has doggedly articulated the bullish case through the most relentless selling. He has noted the fee-based nature of PAA’s cashflows, the highly regarded management and their history of solid execution. His analysis is widely read and his day must have increasingly been one of verbal jousting with his firm’s salespeople as they relayed client dissatisfaction and most likely anger. When losing money on an investment it’s some small solace to blame one of the unapologetic cheerleaders.

Sell-side analysts can be highly paid (although one suspects that MLP analysts face a supply/demand imbalance similar to crude oil). But even highly paid people have a breaking point, and this week our analyst reached his. We know this because on Wednesday, January 13th following PAA’s $1.5BN capital raise the sequence of 20 consecutive Buy recommendations was finally broken with a switch to Neutral. The unspoken message was clear:

I am tired of this. Let me hide in the obscurity of the current market price. I no longer wish to explain what cannot be explained to my colleagues or my clients. I am out.

This is how it feels to sell after intending to never sell. If you’re planning to panic, it’s best done immediately.

How do I infer this from a research report that doesn’t make such a confession? Because of what it does say. Acknowledging that the capital raise was undoubtedly good, our analyst nonetheless downgrades the stock because of lack of visibility around crude oil. Of course the crude oil price remains both highly visible and unpleasant. Moreover, because all good research must include a Mathematical basis by which the current price target is derived, the discount rate on PAA’s future cashflows was arbitrarily jacked up to 11% and a zero growth rate was assumed on their terminal value beyond ten years. This last point will seem obscure but is important – PAA is highly unlikely to forego forever price increases on its assets in the future. Or put another way, how do you change the spreadsheet inputs so as to get the desired output, which is an innocuous price target close to the current market so I don’t have to talk about PAA anymore.

Also of note was that our analyst didn’t rely on any of the familiar criticisms of industry bears, such as that the MLP model is irretrievably broken, that contracts will suffer widespread renegotiation or abrogation in bankruptcy court, or that MLPs are a Ponzi scheme. This is because he for one can’t find much evidence of that or he would most assuredly have relied on such to justify his about-face following a 70% drop. He’s just had enough.

Meanwhile, on Wednesday PAA yielded 14% on an unchanged dividend newly declared. Its General Partner, Plains GP Holdings (PAGP) which we own yielded 11.5%. The analyst isn’t even forecasting a dividend cut.

The point of this story is not to argue that PAA or PAGP are cheap, but to show why MLPs remain so weak. The people involved are reaching the limits of their tolerance for remaining bullish when the P&L’s of countless MLP holders say very loudly that any MLP proponent must have an IQ lower than room temperature. The facts as reflected in market prices relentlessly say so. One guy’s had enough, and I feel his pain but shan’t follow his lead.

Pioneer Natural Resources (PXD) was dubbed “The MotherFracker” by David Einhorn last May at the Ira Sohn Value Investing Conference. Einhorn is bearish on PXD and other E&P companies that use hydraulic fracturing to release crude oil from shale formations because he calculates that after properly accounting for their capital investment they don’t grow their reserves or generate free cash flow. We have no position in PXD and no view on Einhorn’s bearish call. PXD has lost roughly half its value from its high is the Summer of 2014 and has also fallen sharply since Einhorn’s presentation last May. Like the Alerian Index, PXD has followed crude oil lower.

The other day an investor presentation from PXD caught our attention, in part because PXD executed a $1.4BN secondary offering. We never like it when a company issues new equity following a substantial fall, and I doubt PXD investors were happy about it either. But it shows there is money available to domestic E&P companies in spite of plummeting crude oil.

Part of the reason probably relates to the continued operating efficiencies being squeezed out by companies such as PXD. As the charts from their December presentation show, costs have been falling 18-25% over the past couple of years; time to drill a well has fallen 40%. As a result, they increased production by 12% last year.

Whether or not this is good for the oil market, it can’t be bad for the energy infrastructure companies that gather, process and transport their output. It highlights the resilience of the domestic E&P industry to the collapse in crude.

Not every E&P company looks like Pioneer though, and crude production is falling in North America as U.S. output expected to be lower this year versus 2015 with both the Bakken in North Dakota and Eagle Ford in south Texas contributing to the drop. Canadian producers in Alberta have long struggled with limited options to get their output to market. This is why the Keystone pipeline is such a big deal for them. The limited transport options mean Alberta crude trades at a substantial discount to the benchmarks, and it recently dropped below $20 a barrel which has caused some wells to be shut in rather than fail to cover even their operating costs. Reports indicate a reduction of more than 35,000 barrels a day of output from two producers.

At this point I imagine the discussions over crude oil strategy within the Saudi government must be heated to say the least. The stubborn refusal of large swathes of non-OPEC production to collapse is opening an enormous hole in Saudi Arabia’s budget as well as many other countries. If the Saudis have a strategy, it requires substantial optimism to find examples of its eventual success. What they need is a face-saving way to shift gears; to declare victory and leave the battlefield. They produced 10 million barrels a day in November and around 25% of this is consumed domestically. Assuming they receive $30 a barrel (their grades of crude are typically subject to a few dollar discount) and it costs them $5 a barrel to produce, they clear $188 million a day on the 7.5 million barrels they export. If they claimed that their strategy had been a success and were therefore announcing a one third reduction in exports, the loss of 2.5 million barrels of supply would cause the global oil market quite a jolt. A $12.50 jump in crude would see Saudi oil revenues unchanged. It’s a thought experiment, but with crude this low some odd things become possible.

The 32.6% collapse in MLPs was in many ways worse than the 2008 financial crisis. Although not as bad as 2008 when MLPs lost 36.9%, almost every asset class was down that year so there was little unique about MLP performance. In 2015 MLPs endured their own, private performance disaster. The Energy sector was in the background singing a similar tune, but midstream energy infrastructure with its reliably boring toll model behaved like a group of highly-leveraged, high-cost oil drilling businesses, sucking investor positions seemingly into a black hole. Like most MLP investors, we didn’t see it coming. A forest from the trees problem due to being too close. We’re going to offer our perspective on how we got here and what it means for future returns.

How We Got Here

First, a little bit of history. The Master Limited Partnership (MLP) legal structure was enshrined in the 1986 Tax Reform Act signed by President Reagan. Provisions to this law passed by Congress in 1987 limited the use of the MLP structure to natural resource activities. Through subsequent IRS rulings this has evolved to mean anything to do with oil, natural gas, natural gas liquids and coal all along the value chain from extraction to distribution.

The exemption from corporate income tax represents the main and significant advantage of the MLP for equity owners. The familiar “double taxation” of corporate profits via corporate income tax followed by dividends or capital gains tax to the equity holder is avoided with MLPs, since they are “pass-through” vehicles. Their profits are only taxed once, at the equity holder’s level. Because more of the profits from an asset go to the owner, MLPs are a good legal structure within which to hold eligible assets. However, because the MLP itself doesn’t pay tax, the tax code ensures that the owners of the MLP most assuredly do.

The structure is most suitable for U.S. High Net Worth (HNW) investors. MLP tax reporting, as with limited partnerships in general, uses a K-1 form rather than the simpler 1099. Few people who file their own tax returns without the help of an accountant will tolerate this. Many accountants guide their clients away from K-1s although in my experience it’s because they find them tiresome and disregard the economic benefits to their clients.

Most of the money invested in U.S. public equities that might consider MLP equity securities isn’t subject to U.S. taxes, either because it’s tax-exempt (such as pensions, endowments and foundations) or because it’s non-U.S. (sometimes subject to dividend taxes; specific tax treatment isn’t important for our purposes). U.S. tax-exempt investors who choose to hold MLPs can be liable for UBIT (Unincorporated Business Income Tax) which they usually reject because they don’t wish to file a tax return. Non-U.S. investors can be subject to Effectively Connected Income Tax (ECI), which can reach Draconian levels and effectively eliminates their MLP appetite. Taxable corporations (such as insurance companies) can hold MLPs so the investor base isn’t limited to U.S. HNW investors. However, expanding the universe of MLP investors beyond its traditional base is not easy, and this remains an important consideration as we learned in 2015.

My first involvement in MLPs was back in 2005, when at JPMorgan we seeded Alerian Capital Management’s offshore hedge fund. Gabriel “Gabe” Hammond, Alerian’s founder, launched the Alerian Index with his partner Kenny Feng (now Alerian’s CEO). Because the K-1 tax reporting was unpalatable to millions of smaller U.S. retail investors much effort was expended with tax accountants in search of the holy grail, which was a tax-efficient way to allow MLP investors to receive a 1099. Solving this problem would open up an entirely new investor class to MLPs. The payoff was potentially huge. Many different structures and solutions were considered. It just wasn’t possible.

However, the absence of a tax-efficient way to give MLP investors 1099s didn’t remain a hurdle for long. Within a few years mutual funds and exchange traded funds appeared which were structured as C-corp ’40 Act funds[1].  They invested in MLPs, delivered 1099s to their investors and paid 35% corporate income tax on the returns. There was no tax-efficient way to avoid the K-1, so it was done in a decidedly tax-inefficient way. To this day, most of the mutual funds and ETFs that focus on MLPs are taxed as corporations, although a few are highly tax efficient RIC-compliant structure such as ours that limit their MLP investments to 25% of the fund. Investors are amazingly oblivious to this, in part because it doesn’t reduce the stated yield but rather comes out of the fund’s Net Asset Value. Although the taxes show up in the form of eye-popping expense ratios of as much as 9%, few retail investors or their financial advisors are aware of this. Even worse, those that do have knowledge of this substantial burden operate under the belief that the tax component is somehow not real. Maybe an expense ratio this high looks like a mistake. Who could possibly design such a thing? These funds carefully avoid stating that achieving the return on the Alerian Index is their objective, because it is of course unattainable and their historic returns show this. The sequential thought process through 2013 was (1) MLPs have done well (2) I don’t want K-1s (3) Here’s a vehicle that gives me MLPs without K-1s. Fund inflows boomed.

Many things are clear in hindsight. One of them is that much of the new money entering the MLP sector via very tax-inefficient funds didn’t possess the same understanding of what they were buying as the HNW investor. They hadn’t examined underlying holdings or thought much about future prospects. Recent positive returns were their investment thesis. Consequently, just as rising prices drew them in, falling prices have seen them flee.

The HNW investor was attracted by stable distributions that were largely tax-deferred (another benefit of investing directly in MLPs) with modest growth. Such investors don’t trade their positions, because to do so would undo the tax deferral benefits. As a result, MLPs enjoy far more stable ownership than most public companies, just the sort of long term outlook many commentators despair is absent from today’s capital markets. Midstream businesses are steady, fee-generating sources of income and they attracted appropriate long-term investors not looking for excitement or high growth. As long as MLPs paid their distributions things were fine.

Dividends are an inefficient way for corporations to return money to shareholders because they create a quarterly tax liability, as well as being taxed twice (once via corporate tax and a second time to the investor). Stock buybacks return capital more efficiently because an investor can always manufacture a 3% dividend by selling 3% of her stock while retaining control of the timing. Nonetheless, reliable dividends are valued. MLP distributions are generally not taxable when they’re paid and so their high payout model doesn’t suffer the same tax inefficiency. The MLP model of distributing its free cashflow relies on external financing (i.e. issuing debt and equity) to fund growth. The average corporation pays out a third of its profits and generally uses internally generated cash to fund growth. The MLP model of higher payouts and greater reliance on external funding sources is not inherently bad. Some feel it imposes extra financial discipline on management through making an explicit connection between capital and its intended use. Indeed, the Miller-Modigliani theory holds that investors should be indifferent to how a company sources its capital (debt, equity or reinvested profits); they should only care about how it’s invested. However, count Miller-Modigliani adherents among those MLP investors who were run over in 2015. The HNW investors who are the predominant financiers of MLPs like the high payout MLP model, so it has prevailed.

For many years, MLPs generated $1 of DCF, paid $1 of distributions (what MLPs call dividends) and tapped capital markets for $0.25-$0.50 to finance their growth plans. The shale revolution has challenged this model.

The Shale Revolution

The development of horizontal drilling and hydraulic fracturing unlocked enormous supplies of crude oil, NGLs and natural gas in parts of the U.S. that weren’t established sources of hydrocarbons. Increased output from regions not previously supported with infrastructure added an important growth element to the MLP story. In 2014 the Interstate Natural Gas Association of America estimated that $640BN of new investment in energy infrastructure will be required over the next twenty years, as this table shows.

The high payout MLP model whereby most cashflow is returned to investors via distributions meant much of the new capital to fund this growth would need to be externally financed.

Tapping pools of investor capital beyond the K-1 tolerant, taxable U.S. HNW faces formidable barriers as noted above. The most important new source was from smaller retail investors whose insistence on receiving the simpler 1099 tax reporting form was accommodated via the growing number of 40 Act funds that held MLPs. Falling crude oil challenged the growth element of the MLP story since reduced domestic production diminishes the need for new infrastructure.In spite of the collapse in crude oil, the fee-driven midstream MLP operating model turned out to be fairly robust to commodity prices – not immune, but with limited exposure. 2016 EBITDA forecasts for diversified midstream energy infrastructure names have been revised down by mid-single digit percentages; farther from the wellhead means less commodity sensitivity. Kinder Morgan’s 2015 operating results are coming in 5-6% below budget (and still up 5% on the year). Investors are clearly anticipating far worse.  As fund flows to the sector fell and finally turned negative, HNW investors were unwilling to provide additional capital even while MLP equity issuance fell. In 2015, MLP returns were dictated much more by capital flows than operating performance.

The high payout MLP model has come in for criticism from some who argue that MLP distributions are partially funded by issuing equity. This is untrue, but what is clear is that the growing infrastructure need to support increasing domestic hydrocarbon production has severely strained the available sources of capital. We believe 2015 performance is about the inadequacy of the long-established investor base to meet this growing need and the inability of alternative sources of capital to fill the gap. Operating results at midstream infrastructure businesses remained resilient with only modest exposure to collapsing crude oil prices. The growing conflict between high payouts and increasing growth plans is exemplified by Kinder Morgan.

Kinder Morgan

A simplistic model of how MLPs fund themselves is to examine what portion of the distributions MLPs pay out is then tapped as new capital via IPOs and secondary offerings. New equity raised increased from $5BN in 2008 to around $30BN in 2013. Distributions received by MLP investors grew from $10BN to $25BN. Therefore, new capital went from taking half of MLP distributions to well over 100%. Kinder Morgan Partners (KMP) reflected this trend, as their need for new equity capital rose from 73% of distributions paid out in 2008 to 101% in 2013. KMP investors in aggregate were reinvesting all of their distributions back into the business.

For a while the industry’s need for additional capital came from the growing number of MLP-focused ETFs and mutual funds, whose inflows increased tenfold from 2011 to 2013. This helped bridge the gap between the limited desire of K-1 tolerant MLP investors to reinvest more of their distributions back into the sector and the need of MLPs to finance growth.

Nonetheless, the yield on KMP units remained stubbornly high, consuming much management attention as their ambitious growth plans pushed up against the limits of customary MLP investors to provide financing. In 2014 they embarked on a significant restructuring that eventually resulted in a catastrophic destruction of value and betrayal of their core investor base. Recognizing the limits to external financing as an MLP, they became a conventional corporation (a “C-corp”) instead. Although this now gave them access to virtually any public equity investor, they persisted with the 100% MLP payout model and its reliance on external financing for growth. This variance with the more typical corporate funding model of a one third payout ratio and mostly internal financing eventually drove their cost of equity to where it no longer made sense to raise external funds. KMI had many choices including cutting their growth plans, selling assets and seeking JV partners. However, the 2014 restructuring had been about financing their growth and in 2015 that remained their priority.

For a while the market supported the new structure. KMI shares maintained their uptrend into 2Q15, but as the inflows to ’40 Act funds petered out and switched to outflows in the Summer the increasing selling pressure on MLPs affected KMI too. It was in some ways similar to a bank run; as long as the market believed they could finance growth by issuing equity at a 5% yield, they could. As the market began to question that by pushing the yield higher, their growth prospects became less attractive in a negative spiral.

Original KMP investors suffered enormously; they endured a dividend cut in 2014 as they received lower-yielding shares in Kinder Morgan Inc. (KMI); their exchange of KMP units for KMI was a taxable event; their new KMI units eventually collapsed, and then they suffered a second dividend cut in late 2015. KMI management owns around 18% of the shares, so they have suffered with their investors. It nonetheless shows that alignment of interests doesn’t guarantee good judgment.

KMI’s situation was different because they are bigger, more leveraged and have more ambitious growth plans than other MLPs. But the industry is being forced to reconcile its desired growth with the limited interest of traditional MLP investors to finance it. The shallow commitment of many ’40 Act fund investors became apparent when MLP prices stopped rising. The biggest monthly inflow to such funds of just under $3BN occurred in September 2014, merely a month after the Alerian Index peaked. A group that looks past the 35% tax drag prevalent on most funds and expense ratios as high as 9.4% (see Mainstay Cushing MLP Premier Fund[2]) can’t be expected to have done much research on their holdings. Their proclivity to be momentum investors, providing growth capital on the way up, continued on the way down. The cycle will probably repeat.

Valuation

At the risk of stating the obvious after such a year, valuations are as compelling as they’ve ever been for MLPs. The Alerian Index ended the year yielding 8.5% based on most recent distributions. Our SMA portfolio of GPs yields 7.3% and grew at 13.4% in 2015 (including KMI’s dividend cut). We expect 10% distribution growth over the next two years, and distribution coverage is 1.08X (excluding KMI which now covers its reduced dividend 4.6X).

Operating performance for many midstream infrastructure businesses was barely different in 2015 than expected a year earlier. For example, we went back and found JPMorgan forecasts of 2015 Distributable Cash Flow (DCF) per unit/share as they were in August 2014, when the market was peaking. We compared these forecasts with where 2015 results are coming in for the names in our MLP Strategy that are covered (around two thirds). DCF figures are coming in 1-2% lower than expected in the Summer of 2014, while their equity prices have fallen 40-50%. MLPs fell a long way for good reasons, but 2015 operating results were clearly not the major cause and we find it implausible that investors are looking ahead to far worse results in 2016. This is what prompted us to examine more closely the investor base, and to consider capital flows and the apparent unavailability of crossover buyers to invest at depressed prices.

What Next?

The absence of readily available capital to replace the exiting ’40 Act funds has highlighted the limited investor base. Although some commentators claim to see increasing institutional investment in MLPs, it’s more limited than they suggest. Google “Pension plans and MLPs”, examine SEC filings or look up who are the largest owners of MLPs, and you’ll find little evidence of pension funds, endowments or foundations. Such institutional investors that do exist are managing money on behalf of retail and HNW investors who have chosen the sector. There simply aren’t large pools of professionally managed institutional capital able to opportunistically and quickly increase their exposure to MLPs. The tax barriers substantially reduce the portion of the return they can keep, which drives up their required return (although current valuations may well be sufficient to draw in such capital in the months ahead). The fact that most MLP ’40 Act funds are highly tax-inefficient demonstrates that better alternatives generally don’t exist, unless you focus on MLP C-corps as we do. MLP closed-end funds (CEFs), which at least have permanent capital, nonetheless behaved like open-ended funds because forced deleveraging turned them into sellers too as prices fell. For example, Kayne Anderson (KYN), a large CEF, was down 51%.  Even other, generalist mutual funds which can theoretically hold up to 25% of their assets in publicly traded partnerships (which includes MLPs) are unlikely to shift much of their assets without doing careful research on a new sector, making them relatively slow-moving. As ’40 Act investors have been redeeming, their sales require a K-1 tolerant HNW investor to take the other side, often increasing his MLP exposure in a falling market. Anecdotal reports of macro hedge funds shorting the sector added further pressure.

As a result, the supply of MLP funding has turned out to be quite inelastic. Since crossover investors from other sectors are constrained by taxes, finding a balance between demand for capital and its supply relies mainly on traditional MLP investors shifting more of their portfolios to MLPs, something that has required an unexpectedly substantial drop in valuation.  The transfer from one type of investor to another has been highly disruptive.

Financing growth is the challenge facing the energy infrastructure industry. They have an advantageous tax structure but the investor base isn’t growing as fast as their need for new capital. How MLPs perform in 2016 and beyond will depend on how management teams resolve the conflict between their key investor base’s finite desire to reinvest more of their distributions and the industry’s growth plans. Clearly, new money from HNW investors required substantially higher yields, probably reflecting the fear that other managements will abuse them like Kinder Morgan and reinvest their capital for them by slashing payouts. The good news is that IPOs and secondary offerings fell sharply in 2015, reducing the portion of MLP distributions reinvested to below a third, lower than in 2008. This represents new buying capacity for the sector.

Kinder Morgan spectacularly demonstrated that converting to a corporation is not a solution. Smart management will slow existing growth plans so as to limit their need to access very expensive equity while maintaining payouts and will shift towards more internal financing, JV partners and asset sales. Buckeye Partners (BPL) and Magellan Midstream (MMP) both fund all their growth internally and have ample distribution coverage. All the General Partners we own have have coverage >1X.  Moreover, new projects should have higher required returns since MLPs’ cost of capital has risen. Less reliance on new equity should lead to faster per unit distribution growth in the future.

The MLP General Partner, as we have often written, still looks very much like a hedge fund manager and internally financed asset growth at the MLP can be just as profitable as using external capital. The pursuit of growth as a priority is not a value creating strategy, as Kinder Morgan showed. The shockingly high volatility of MLP prices in 2015 will lead to heightened perception of risk among investors for some time. The price collapse was not anticipated and initially we, like many others, struggled to reconcile it with steady operating results. In recent months our thinking has evolved to examining the investor base more carefully. We’ve concluded that capital flows were a far more important driver of MLP returns than operating results in 2015.

More modest growth plans can, by preserving payouts, attract more capital from long-established investors which will stabilize the sector and restore the trust between the industry and its providers of capital. Too much pursuit of growth will result in significant investor turnover and value destruction. Those MLP managements whose growth plans exceed investor appetite will abandon the MLP structure in favor of a C-corp, foregoing the tax advantages of the MLP structure in search of a bigger pool of clients and turning over their existing investor base in the process. More thoughtful management will tailor their growth to the MLP capital available. New equity issuance dropped sharply in 2015 coincident with fund outflows, and as a result the portion of distributions reinvested fell, potentially freeing up new capital to be invested. Current valuations are such that a demonstrated commitment to maintain payouts is all that’s needed to provide stability and thereafter positive returns. Our investment approach is guided by these views.

We are invested in BPL, KMI, and MMP

[1] Non ‘40 Act Exchange Traded Notes (ETNs) also provided MLP access to non-K-1 tolerant investors

[2] This was the expense ratio for the year ended 2/27/2015 as of 12/19/2015