Last week Linn Energy (LINE) filed for bankruptcy. Over the past year or so we’ve come across quite a few people whose exposure to Master Limited Partnerships (MLPs) regrettably included LINE. They were attracted by the yield, whose steady rise until 2013 belied the unpredictability of their cashflows. LINE was engaged in Exploration and Production (E&P), and so they were always going to be a bet on the price of crude oil. The company bought acreage when crude was at $100, so it was always going to be challenging for them once it collapsed. The stability of their distribution didn’t reflect economic reality.

Back in 2013 there were also questions raised in Barrons about LINE’s accounting treatment for options that were used to hedge their output. The SEC subsequently investigated. We typically avoid E&P companies anyway, but whether the criticisms of non-GAAP treatment were justified or not, LINE wasn’t making it easy for investors to analyze their financial statements. Their website, which now includes information on their restructuring, says, “LINN Energy’s mission is to acquire, develop and maximize cash flow from a growing portfolio of long-life oil and natural gas assets.”

MLP investors were originally seeking stable income, although the 2015 rout has in our opinion created the most deeply undervalued sector in the equity markets. A cute bit of Math is that a 2% drop in yields (through price appreciation) will generate no less than a 30% total return[1] over one year for any equity sector (or individual equity security). Only MLPs offer this kind of potential.

Although E&P companies can and do structure themselves as MLPs, their returns are ill-suited to the traditional MLP investor base. During 2014-15 every single E&P MLP in the Alerian Index cut or eliminated their distribution. This drove the drop in distributions on the index and fueled fears of further distribution cuts across the rest of the sector. The rules under which the index is constructed require that a distribution cut causes the offending name to be ejected from the index, so although there are still E&P MLPs, the leading index has gradually been relieved of their burden.

Because MLPs normally pay out most of their cashflow, an E&P business is particularly ill-suited to this form of organization. If you own an asset (crude oil in the ground) and you distribute the net proceeds from its extraction to your equity investors, your underlying asset base is depleting. You may confuse the issue by investing in new crude oil acreage with new capital raised, but eventually the music will stop. The collapse in crude kicked the CD player off the chair sooner than expected for some, but it’s not a sustainable model.

This contrasts with owning an asset that’s appreciating, such as an installed pipeline whose replication becomes ever more expensive as development goes on around and above it. Many pipelines would cost multiples of their original cost to build today with population centers having grown up, easements harder to obtain and regulatory approvals ever more demanding. This is a business built on sending back the recurring cashflows earned from renting out its capacity.

Both business models, the depleting asset and the recurring cashflow from rented capacity, can legally exist as MLPs. But they’re not to be confused with one another. The market dislocation of last year is cleansing the sector of weaker models, leading to a quality upgrade. LINE was the wrong kind of MLP. Their distributions were the result of using up their reserves in the ground. In effect, they were returning capital to investors rather than profits, although the collapse in crude oil hastened their demise. While it was unpleasant for investors in LINE, they’ll better appreciate the more secure foundation of their other MLP holdings.

[1] For example: a security priced at $6 pays a $0.60 dividend, yielding 10%. Over the next year its price rises to $7.50, causing its yield to drop to 8%. The $1.50 price gain plus the $0.60 distribution equals a $2.10 return on the original $6 investment, or 35%.

Quarterly Earnings

We’re approaching the time of year when report cards proclaiming, “what a joy your child is to have in my class” are dispatched with varying degrees of sincerity. Quarterly MLP earnings are the report cards of the industry, and a time when investors can similarly consider whether they are happy to have included PCD (Promised Cashflows Delivered, LP*) in their portfolios.

A couple of years ago Master Limited Partnerships (MLPs) used to be a reliably boring sector. The influx of new money from ETF and mutual fund investors quickly turned and fled when oil started declining (see The 2015 MLP Crash; Why and What’s Next) which caused MLPs to be exciting in a decidedly distasteful way.

However, operating results for midstream infrastructure businesses weren’t remotely as volatile as their stock prices, which increasingly supports our theory of last year’s collapse; it was a funds flow issue caused by recent investors following (and thereby accentuating) near term momentum. Most firms have released their quarterly operating results, and they were generally decent with some mild positive surprises. MLPs rarely release figures that are substantially off expectations.

TransCanada (TRP) reaffirmed 8-10% growth in its current C$2.26 dividend (yielding 4.4%). Targa Resources (TRGP) experienced some modest softening of margins in their natural gas Gathering and Processing (G&P) segment although volumes were overall as expected. Western Gas (WES) reported EBITDA 15% ahead of expectations due to sharply higher production by Anadarko (APC), their sponsor. This allowed the GP of WES, Western Gas Equity Partners (WGP), to grow its distribution 24% YoY, twice the rate of WES. It’s why the people who run MLPs don’t invest in MLPs, but instead put their money in the GPs that run them. Hedge fund managers make their money from payments they receive from the hedge funds they manage. So it is with MLP managers. As the chart shows, if you add up where MLP insiders invest their own money they prefer GPs by a factor of 22X.

EnLink Midstream Partners (ENLK) was slightly ahead of expectations and provides 1.09X distribution coverage. Its sponsor and biggest customer Devon Energy (DVN) raised its production guidance by 3% having previously announced moves to shore up its balance sheet (asset sales, secondary equity offering and sharply reduced 2016 capex). Credit enhancement moves by DVN are good for its MLP. ENLK’s GP, EnLink Midstream (ENLC) yields 7.3%.

Spectra Energy Partners (SEP) reported EBITDA that was 7% below expectations as mild winter weather reduced natural gas volumes. They are pressing on with Access Northeast which will enhance natural gas distribution and storage in New England if it is implemented. Kinder Morgan (KMI) recently cancelled their North East Direct project due to insufficient demand, so it’ll be interesting to see how Access plays out. SEP increased its distribution 8% YoY. Their GP Spectra Energy Corp (SE) yields 5.3%.

Energy Transfer-Williams

Energy Transfer Equity (ETE) CEO Kelcy Warren has tried everything to extract himself from his ill-advised pursuit of Williams Companies (WMB). His former CFO lobbied WMB shareholders to reject the deal; with dubious legality and no fiduciary compunction ETE issued preferential securities to management, diluting the deal’s value to WMB; they also slashed the anticipated synergies from the original $2BN figure.

Risk arb traders are not a group that normally draws much sympathy. They buy stock in companies that are being acquired and hedge the position by shorting the acquirer. They bet on deals closing as anticipated, which they usually do. Frequent modest profits are occasionally punctuated by expensive surprises. The chart below shows the price of WMB compared with the actual price implied by the terms of the ETE deal. The smaller the spread (or discount to deal terms), the more likely it is to close. The bigger the spread, the less fun risk arb traders are having. You might also think of it as representing the fluctuating stress imposed on involved traders as the odds of the deal closing oscillated. Even Bobby Axelrod (from Billions) would have been challenged to make money. It’s a curious set of circumstances when the suitor experiences such rapid regret (see Williams Stands Alone at the Altar) and that made it harder for some to assess likely outcomes.

Kelcy Warren recently said of the deal, “We can’t close. We don’t have a transaction that can close. So I want to be very clear, we can’t close this transaction.” Since the absence of an affirmative tax opinion is the basis for this conclusion, we can assume that such insight was arrived at only belatedly (after the other forms of avoidance described above had been used). They may still close on altered terms, although since the WMB board was previously divided on the topic it’s hard to imagine them coming together on less favorable terms given recent history. ETE’s tax counsel has certainly earned their fee.

We are invested in ENLC, ETE, KMI, SE, TRP, WGP and WMB.

*PCD is not a real company

 

Williams Companies Stands Alone at the Altar

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

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

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

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

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

Crestwood Delevers and Soars

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

Sell-Side Shockers

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

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

Chart source: Yahoo Finance

Drilling Efficiencies

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

 

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

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

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

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

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

 

Crestwood

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

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

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

 

Energy Transfer and Williams

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

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

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

We are long CEQP, ETE and WMB.

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

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

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

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