On Thursday Energy Transfer Partners (ETP) released earnings that beat expectations on just about every measure. Midstream infrastructure businesses generally don’t report results too far from consensus – surprises usually come in other ways (more on this below). ETP’s $1.94BN of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) was more than 10% ahead of Street estimates. NGL/Products, Midstream, Natural Gas and Crude Oil segments all delivered impressive results.

ETP’s yield has remained frustratingly high for investors and management. At 12%, it reflects substantial investor skepticism about the prospects of its continuation. CEO Kelcy Warren might have felt that Thursday’s results would cause a sharp revaluation higher, whereas ETP managed a muted 4% gain. Its yield remains stubbornly high.

Earlier in the week Warren had testified in Delaware at a civil class action suit against ETP’s General Partner, Energy Transfer Equity (ETE). The plaintiffs contend that a 2016 issuance of convertible preferred securities to 31% of unitholders (ETE senior management) represented an impermissible transfer of value away from investors. We have written about this before (see Will Energy Transfer Act With Integrity?) The offending securities were issued at a time of severe weakness in ETP and ETE stock prices due to the ultimately failed effort to merge with Williams Companies (WMB).

In short, the securities allowed management to reinvest their future dividends at the then current low price, but further protected them from future dividend cuts. A rising stock price would see them reinvesting at an historic, lower level, and if the price fell due to a dividend cut their special dividends would be partially protected.

It looked like an aggressive ploy to force WMB to cancel the deal, since the result was to dilute the value of the merger to WMB investors. But even after the deal collapsed for other reasons (a revised tax opinion that conveniently rendered it unworkable), the new securities remained.  Kelcy’s ill-advised pursuit of WMB justified issuing special securities with the stock price at its low, and he wanted to keep them.

Investors sued ETE, quite rightly claiming self-dealing by management. Judge Glasscock will soon decide the legal outcome. However, the market has already offered its opinion. Energy Transfer is a well-run business that will provide management a sweetheart deal given the chance. Strong operating results from attractive assets receive a valuation discount because of sly management. As we said once before, investing with ETE is like sitting at a high-stakes poker table with a strong hand drawn from a deck of marked cards. Energy Transfer’s securities are valued accordingly.

Last week Macquarie Infrastructure Corporation (MIC) showed why investing for the long term requires a management team that shares this vision.

In a move that stunned investors, MIC announced weak operating results, lower guidance and a dividend cut. MIC’s infrastructure businesses are not limited to energy, since they have an aviation division too. But they are included in some energy infrastructure indices as well as held by investors who focus on the sector. They just showed why market sentiment towards such businesses remains so poor.

As recently as November, MIC announced a 10% dividend hike, forecasting 2018 growth in Free Cash Flow (FCF) of 10-15%. Just three months later, they cut the dividend by 31% and lowered their FCF growth forecast. It’s true there had been a change in CEO in the interim, but investors had little reason to expect this type of outcome.

The subsequent conference call showcased why so many investors have lost faith in infrastructure businesses. When asked to justify the dividend cut so soon after raising it, CEO Christopher Frost commented, “Could we have taken a different path?…Yes…But maintaining our dividend policy would likely have meant…forgoing our growth agenda” (emphasis added).

This is exactly what has alienated investors and caused new buyers to pause. MIC invited a set of equity holders that valued growing dividends. They then chose to repurpose those cashflows to invest in new projects, even though they haven’t recently demonstrated much ability to estimate returns on investment. So what type of investor should hold MIC? A fairly fleet-footed one.

A management team that doesn’t have a consistent long term outlook will draw investors who don’t care about the long term view. MIC was understandably down 38% on the day. It’s unclear what anybody should expect from the company.

Too many American energy infrastructure businesses have let investors down. Often they’ve chosen growth over what their existing financiers want, and sometimes they’ve ignored their fiduciary obligation, shredding expectations and losing support. Valuations are attractive in part because of management teams that continue to alienate investors.

It doesn’t have to be so. Canada’s Pembina Pipeline Corporation (PBA) also announced good results last week. They have no history of issuing special management-only securities. They generally do what they tell you. They describe their financial model as based on “guardrails” with metrics oriented towards 8-10% FCF growth while maintaining their investment grade credit rating. On their conference call they said acquisitions were low on their list of priorities, behind operating existing assets more efficiently and building from scratch. Investors rejoiced, driving their dividend yield down to 5.25% as the stock rose. The Canadians seem to be getting it right.

We are invested in ETE and PBA

On Thursday the U.S. Energy Information Administration (EIA) released updated figures on proved reserves as of 2016. In order to count as proved, companies must be reasonably certain that the reserves are recoverable under existing operating and economic conditions. Improvements in technology have increased the amount of recoverable reserves from some shale formations.

The dramatic increase in Permian reserves is driving increased production. As we noted (see Rising Oil Output Is Different This Time), Permian output is set to reach 3 Million Barrels per Day (MMB/D) in March. It’s increasingly looking as if pipeline demand is approaching capacity. JPMorgan recently said they expect pipeline bottlenecks to develop in 2H18 and into 2019, before additional capacity currently under construction is added. But they expect that by 2020 tightness will occur again. Permian production is expected to reach 3.5 MMB/D by the end of this year, and continue rising to 4.1 MMB/D through 2019 and 4.9MMB/D by 2020.

New takeaway capacity will be required by then. In recent years, midstream infrastructure businesses have rarely missed an expansion opportunity even if it led to stretched balance sheets. NuStar (NS) was the most recent firm to acknowledge such over-reach. The collapse of their GP/MLP structure and distribution cut announced ten days ago were caused in part by the failure of their early 2017 Navigator acquisition to ramp up cashflows quickly enough. The industry’s history of providing new capacity too readily has diverted cashflows from distributions to growth and debt repayment, frustrating traditional investors. They’ll be hoping that recent financial discipline sweeping across energy producers similarly afflicts pipeline operators, resulting in higher returns on future projects.

Overall U.S. proved reserves of crude oil and lease condensate were virtually unchanged in 2016 versus 2015 at 35.2 Billion Barrels. Gains in the Lower 48 states were offset by declines in Alaska and offshore. Proved reserves of natural gas rose 5% to 324 Trillion Cubic Feet, as total additions were 150% of production. The U.S. continues to enjoy a substantial cost advantage in natural gas production, with exports of Liquified Natural Gas (LNG) set to reach 10 Billion Cubic Feet per Day (BCF/D) by late 2019, 3% of global consumption.

Commodity prices affect proved reserves as they have to be commercially recoverable. The 2016 oil and gas prices used for these calculations were 15% and 6% lower than in 2015. When the 2017 figures are published they’ll be based on oil and gas prices 20-21% higher. U.S. reserves are likely to keep growing.

The American Energy Independence Index (AEITR) finished the week +2.7%.

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Risk Parity is a portfolio construction technique that seeks to allocate capital so as to maintain similar levels of risk from each asset. Some commentators are blaming it for the recent market turmoil, since superficially its practitioners are expected to reduce risk when it rises. That can often mean selling stocks. AQR is among the asset managers who employ this approach. In 2010 they published a paper explaining the theory, noting that traditional portfolios typically derive a larger proportion of their risk from equities than is implied by simply looking at percentage allocations.

A 60:40 stocks/bonds portfolio will incur more than 60% of its risk from stocks, because they move more than bonds. Risk Parity seeks to compensate for this, and the paper showed improved returns over a passive 60:40 approach. The paper goes on to describe a portfolio with less equity exposure than a traditional 60:40 portfolio and correspondingly less risk. Because it has a higher Sharpe Ratio (i.e. better risk/return) but lower return, leverage is then employed to raise the risk to the same as 60:40, at which point the return should be higher.

Since allocations under a Risk Parity regime target a given level of risk, changes in risk estimates will lead to a shift in allocations, and may also require changes to leverage. One popular measure of risk is volatility. For simplicity, we’ve defined it as the average percentage daily move over the prior ten days. Although Risk Parity is typically applied to asset classes, the concept can also be applied to sectors within an asset class. A strategy of achieving Risk Parity among asset classes can also be designed to achieve Risk Parity across sectors within an asset class.

In response to criticism that funds employing Risk Parity are behind the recent sharp moves, some managers of such funds have responded that such shifts are slow – their models are designed to recalibrate over longer periods than just a few days. It’s impossible to know the extent to which the critics are right — on Friday JPMorgan estimated that most of the “severe” unwind was over. However, we’ve noticed another shift, which is that risk in the energy sector is falling relative to the S&P500. This is partly due to correlations increasing, as they do during market dislocations. Sector differentiation becomes less important than overall market exposure, and sectors move up and down together. For example, the S&P Low Volatility Index is down 6.5% for the month, almost as much as the S&P500 itself (down 7.2%), even though Low Vol should be, well, less volatile.

Nonetheless, Risk Parity strategies that are deployed at the sector level could eventually increase energy exposure at the expense of other sectors whose relative volatility against the S&P500 has increased.

It can seem an arcane topic. But put simply, in a time of heightened volatility, the Energy sector is gyrating with the rest of the market whereas it was previously moving sometimes twice as much. The first chart compares XLE with SPY, where although average daily moves have increased in both cases, SPY moves have jumped by 150% while XLE moves have “only” doubled.

Many reliable trends have abruptly shifted, including persistent low volatility. The spectacular collapse of the Credit Suisse note (XIV) following the spike in volatility was extraordinary. Why would people hold a product that seems destined to eventually blow up?

The difference in volatility is more dramatic when comparing Energy Infrastructure (defined here by the American Energy Independence Index) with the S&P500. Their average daily moves are roughly the same. Until recently, energy infrastructure (including MLPs) was moving twice as much as the broader market. Domestic, midstream assets that support U.S. energy independence have experienced a comparatively modest increase in volatility compared to the overall market. Daily moves in the S&P500 and energy infrastructure are converging. At a time of increased uncertainty, if investors begin to value the more reliable cashflows these companies generate, further buying of the sector will follow.

The American Energy Independence Index (AEITR) finished the week -4.2%, outperforming the S&P500 which was -5.2%.

Tax Freedom Day is that point in the year when you’ve figuratively earned enough to pay all your taxes. For the rest of the year you can feel as if your income is your own. Naturally, it can never come soon enough. Investors in the hopelessly tax-burdened ETF, the Alerian MLP Fund (AMLP) face the contrary prospect: the point at which their investment returns are taxed at the fund level before anything is paid out. If the opposite of freedom is bondage. AMLP investors recently passed Tax Bondage Day.

This comes about because AMLP is not a conventional ETF, but is a tax-paying C-corp. Anecdotally, it’s clear few investors realize this, because most ETF’s are RIC-compliant and therefore not taxable at the fund level. Conventionally, you don’t stop to consider whether the ETF you own is taxed like a corporation. But AMLP is a C-corp, paying taxes on its earnings before paying out what’s left to holders.

The weakness in energy infrastructure last year wiped out unrealized gains for AMLP and many other tax-burdened MLP funds. Since you don’t owe taxes on losses, AMLP’s Deferred Tax Liability (DTL) was eliminated. However, the sector has been recovering since late November, and probably the only negative consequence of the rebound is that AMLP now has unrealized gains once more. Therefore, it has begun to owe corporate taxes again. As of January 16^th it owed $93MM, a cost in addition to and approximately equal to their annual management fee. As the market rises, so will their DTL.

You can find further detail on this issue from past blogs. Hedging MLPs explained how AMLP is useful as short position, because the tax drag will limit its appreciation to 79% of the market’s whereas it can still fall 100% of the market. Some MLP Investors Get Taxed Twice and Are You in the Wrong MLP Fund both examine the implications of a tax-paying C-corp for investors.

The reduced corporate tax rate means the tax drag is less than it used to be – and it’s been substantial. Since inception, AMLP has returned less than half its benchmark, largely because of tax expense. The reduced corporate tax rate will help, but it’ll still represent a serious drag on returns. Many investors are expecting strong performance over the next couple of years. Valuations are attractive, and energy lagged the market substantially in 2017. Seeing your fund hand over 21% of a double digit return before paying distributions will represent a substantial cost, and an unnecessary one because there are correctly structured energy infrastructure ETFs around that aren’t subject to corporate tax. It is possible to invest in the sector via a RIC-compliant vehicle.

On a different topic, the U.S. Energy Information Administration confirmed its forecast of record hydrocarbon production in 2018. Natural gas and natural gas liquids broke records in prior years, but this year crude oil production will also breach a previous high. Moreover, the mix of hydrocarbons should please almost everybody because it’s moving heavily away from coal and towards cleaner-burning natural gas. America’s emissions are moving in a better direction, thanks to the Shale Revolution.

The investable American Energy Independence Index (AEITR) finished the week -1.5%. Since the November 29th low in the sector, the AEITR has rebounded 12.8%.

We are short AMLP