Another day and another new low for crude oil. Since stocks are moving with oil, trying to figure out the short term direction of the equity market requires being an oil trader. Few of us are any good at this although it’s easy to have an opinion. For our part, we don’t bet on the direction of oil although many of our investments react to it so we’re certainly experiencing the moves.

Master Limited Partnerships (MLPs) as I write this are close to flat on the year (as represented by the Alerian index). Distribution yields have drifted up to 6%. Midstream MLPs care about volumes of product, crude and refined, that they gather and process, store and transport. Lower oil is currently forecast to add 0.5% to US GDP in 2015 as the tax cut that it represents feeds through to higher consumption. Energy demand is unlikely to fall, and obviously should increase at the margin. Americans will drive a little more and worry a little less about conservation. The outlook for MLPs is generally good.

The shale boom may slow, with reductions in capex and therefore at the margin some growth projects that could fuel faster distribution growth may be delayed or cancelled altogether. U.S. oil production may not grow as fast as expected. Of course, it’s not only U.S. production that may slow. Halliburton announced 1,000 job cuts in response to weaker demand for their services across Europe, Russia, Africa and the Middle East. Day rates for offshore drilling are plummeting as reported by Transocean (RIG) and Diamond Offshore (DO). The U.S. is one of the few places where productions costs are falling. Range Resources (RRC) has been reducing its output costs of natural gas from SW Pennsylvania by 7% annually for several years.

Seasonally, MLPs typically rally in December and January as retail investors reallocate cash. So far December is not typical. But 6% yields are attractive with even half the growth you thought MLPs might be generating, and there’s certainly no reason to expect any demand destruction which is what most hurts their businesses. Falling asset prices are never pleasant for the holders of those assets. But an unleveraged investment in MLPs at today’s levels is likely to look prescient a year from now.

Seasonal patterns to the returns of most asset classes rarely seem to last beyond their discovery. “Sell in May and Go Away” has been shown to either work or not work depending on precisely when you close the trade out. Rather than the Summer being a bad time for stocks it’s just that September is poor. Whether that’s for some reason or just random is unclear. As so often in statistics, correlation doesn’t mean causality. One month of the year has to be the worst one during which to be invested in stocks. Since 1960 it’s been September. In 2014 September was poor but January was, unusually, worse. There was no January effect this year. September’s poor record could just be random, absent any compelling explanation.

Master Limited Partnerships (MLPs) have a more pronounced seasonal effect, and it’s likely for good reason (i.e. correlation with causation). It turns out that December and January together have generated 36% of the return on the Alerian MLP Index since 1996 (whereas if monthly returns didn’t vary you’d expect only 17%, or 2/12). The reason is probably that retail investors, who tend to predominate among MLP investors, apply long term consideration to their portfolios around year-end. This can be because year-end bonuses alter their net worth and asset allocation, because it’s the end of the tax year or simply because doing the analysis provides a break from all that family time that comes with the holidays.

In any event, we’re heading into a period of time where the seasonals would suggest that, if you’re considering making an MLP investment over the next six months, committing capital in November may well produce a better result than waiting until February. Naturally, there are always the non-seasonal factors to consider and the volatility in energy-related stocks could understandably give anyone pause. The most recent Saudi news that they’ve cut prices for U.S. buyers so as to protect market share looks like a direct aim at North American unconventional production, and is likely to send another wave of worry through related equities.

Midstream MLP companies that have reported earnings in recent days appear sanguine about current oil prices and their effect on their businesses. If you own a pipeline, storage facilities or a gathering and processing network you care most about volumes rather than the value of the product you’re handling. It’ll take some time to see how that plays out in reported profits for the sector. In the meantime, news reports may continue to pressure everything energy related. If the recent pressure on MLPs turns out to be due to misplaced concern that their profits will suffer along with E&P names who have direct commodity price exposure, then returns over the next few months could be good.

The Kinder Morgan transaction announced Sunday night represents a new paradigm for Master Limited Partnership (MLP) investors. Like any new paradigm, digesting its impact takes some time. Rich Kinder, CEO and largest owner of the eponymous firm that controls Kinder Morgan Partners (KMP) and El Paso (EPB) was one of the early users of the MLP model. He recognized the power of the partial tax shield the structure provides its investors to lower his cost of capital, thereby supporting a growth strategy as this funding advantage allowed the accumulation of additional assets.

MLPs are liked for their steady, tax-deferred yields. The consequent K-1s are generally worth it for investors with $500K or more to allocate. Low turnover is key, because selling an MLP invariably results in the recapture of taxes previously deferred. In our view this directs the investor towards MLPs with stable, predictably growing cashflows. A strategy that involves regular switching out of “rich” names and into “cheaper” ones can create tax consequences that swamp any perceived positive impact on the portfolio. If your money manager is personally invested in the same securities that his clients own, you’ll find he’s acutely sensitive to after-tax returns and as a result is a miserly user of brokers while letting the tax advantages compound over time.

While stable, tax-deferred returns are a well known feature of MLPs, an element that receives far less attention is the weak governance rights and preferential position of the General Partner (GP). Although MLPs are publicly traded, unitholders (as MLP investors are known) have very limited rights compared with traditional investors in corporate equities. Not all MLPs have a GP, but those that do place most of the power with the GP. Read through the prospectus of a typical MLP and you’ll find out just how hard it is to fire a GP. That’s why you don’t see activists buying MLPs. Unitholders don’t get much say in its operation.

Meanwhile, the GP is entitled to a split of the Distributable Cashflow (DCF), basically defined as earnings plus depletion and depreciation less maintenance capex (the cost of keeping existing assets in good working order). The 50% share of DCF that most GPs enjoy represents a significant drag on returns that unitholders get. In the case of KMP, it had long been understood that this limited their ability to grow, and consequently KMP’s distribution yield was around 6.8% prior to this transaction, 1-2% above its peers. Because MLPs don’t retain earnings, they have to raise additional capital by issuing debt and equity for each new capital investment. KMP’s high yield plus the Incentive Distribution Rights (IDR) drag to which its GP KMI was entitled was making it hard to find projects that would cover its cost of capital. KMP was too big to make investments that could cover its funding cost and drive growth. In addition, the 50% GP share continues as cashflows grow while the GP doesn’t have to fund the capital required to grow those cashflows. Just as a hedge fund manager’s 1.5% management fee assures that asset growth is profitable, so it is for the MLP GP.

Rich Kinder complained that the market wasn’t fully valuing KMP’s opportunities, but the price stayed stubbornly low. Given Kinder’s bullish view of M&A activity in the energy infrastructure space, his inability to participate with an expensive currency was frustrating. He concluded that, as good as the MLP structure is, there were limits and the growth of the Kinder enterprise was testing those limits.

Some years ago we began shifting our MLP strategy away from GP-controlled MLPs and into the GPs themselves (as more became publicly available) as well as into MLPs who have no GP (some have bought the GP back in, simplifying their structure and eliminating the drag of IDRs which makes them more competitive acquirers). So although we did once own KMP, we shifted into KMI. We gave up the tax deferral since KMI is a C-corp, paying corporate income tax like any other U.S. corporation and providing investors with a 1099 rather than a K-1. We felt sharing in the 50% IDR split of KMP’s DCF was preferable to having to pay it away as a KMP unitholder. As we’ve written before, it’s analogous to investing in the hedge fund manager (for whom asset growth is always positive) rather than the hedge fund (for whom asset growth may or may not be good). The fact that Rich Kinder concentrated his ownership in KMI rather than KMP was an additional factor we considered.

Now that KMI has simplified its structure, eliminated its IDR and cleverly created $20BN of tax savings, it has a higher dividend with better growth prospects than before. Conventional valuation of KMI compares it with other C-corps that own their GP and have an MLP underneath on which they rely to fund capital investments and funnel cashflows back up to the GP. KMI’s peer group in this regard includes Oneok Inc (OKE), Williams Companies (WMB), Targa Resources Corp (TRGP) and Plains GP Holdings (PAGP). Generally, faster growth prospects (defined here as 5 year estimated Distribution Compounded Annual Growth Rate) dictate a lower yield, and so the chart to the left  illustrates where these securities lie. KMI-Old (i.e. before the announcement) was on a regression line linking its peers, but we liked it because we felt there was the possibility of a transformational transaction such as the one we’ve just seen, KMI-New appears to be a relatively more attractive security because its better growth prospects don’t appear to be fully reflected in its yield. If KMI’s yield dropped down to the regression line its price would be around $50 versus its current level of $39.50 (we’ve assumed they buy back the outstanding warrants at current prices and adjusted their sharecount accordingly). So we still own KMI.

But here’s the point. There’s a good case that KMI should no longer be compared with the other C-corps (technically, PAGP is a partnership but for tax purposes they issue a 1099). What they all have in common is an entity that controls the GP to a publicly traded MLP. This used to apply to KMI but once their simplifying transaction closes later this year that will no longer be the case. KMI will actually look more like a different peer group, consisting of MLPs that no longer have a GP. This peer group includes Buckeye Partners (BPL), Enterprise Products Partners (EPD), Markwest Energy Partners (MWE) and Magellan Midstream Partners (MMP). The revised Yield vs Growth chart comparing KMI with this new peer group is on the right. If KMI was on the new regression line its price would be around $61.

None of these firms is a perfect comparison. BPL’s yield remains high because of challenges to its tarrifs in the NY area as well as its recent mis-step in Merchant Services. EPD has an exceptionally well regarded management team which depresses its yield. Markwest has more cashflow variability because of its gathering and processing business. Nonetheless, the fair value yield for KMI on this basis is even lower than using the more conventional method. We believe it’s warranted due to a now more competitive cost of capital with which to fund acquisitions.

KMI has been a long term holding of ours. We used the weakness caused by Hedgeye’s negative report last year to add. We continue to think it represents an attractive investment, and believe the announced restructuring has made it substantially more attractive than is currently reflected in its market price.

On Sunday evening Rich Kinder, CEO of Kinder Morgan Inc (KMI) announced the transaction that many had been expecting as a response to the persistently low price of Kinder Morgan Partners (KMP) and El Paso (EPB), two MLPs in which KMI owns the General Partner (GP). The problem was that Kinder expects an increasing amount of M&A activity in the energy infrastructure space they inhabit, and his ability to participate has been greatly hampered by the high distribution yields on KMP and EPB. Their high yields (i.e. low prices) make them an expensive source of capital should he wish to acquire any assets by issuing new securities to the seller. He’s long complained that the market didn’t fully recognize the value in the Kinder Morgan complex.

The deal greatly simplifies Kinder’s structure in that four existing public equity securities will be collapsed into one. The drag of Incentive Distribution Rights (IDRs), which direct half of the distributable cashflows to the GP, will be gone and the new KMI will offer a higher dividend and faster growth than the old one. Much has already been written about the transaction. What hasn’t received much attention is the tax issue.

Because KMI is acquiring assets at above their carrying value, they’ll be able to use the new, higher purchase price as their cost basis for taxes. This is quite different than when one corporation buys another. If A buys B for $100 and B’s equity value is $70, A holds $70 of assets and $30 of goodwill. You can’t do much with goodwill. You can’t depreciate it; you can’t write it off against taxes and from time to time you have to test it for impairment. You certainly can’t borrow against it. Many businesses are worth more than their book value equity, which is why goodwill as a concept exists in the course of an acquisition. But the accounting definition of goodwill plays no role in this transaction.

Because Master Limited Partnerships (MLPs) are pass-through vehicles, the LP unitholders own a direct, proportionate share of the underlying assets (rather than shares in a corporation which in turn own the assets). If KMI was acquiring another corporation, they’d wind up with an asset of goodwill equal to the difference between the purchase price and the book value of the acquired company.

Because KMI is buying the underlying energy infrastructure assets directly (since MLPs are pass-through vehicles) the newly acquired assets go on KMI’s balance sheet at the new purchase price. It means they can be depreciated from this new higher value, and depreciation is tax-deductible. KMI used to benefit from depreciation of these assets before the transaction, but only from their lower, original purchase price. And over time the difference between depreciated value and actual value grows, since many pipelines increase in value. For example, Williams Companies (WMB) owns a pipeline network that runs down the east coast from NY to Texas called Transco. On an investor call recently a WMB executive commented that they had once tried to estimate what it would cost to build Transco today if it didn’t already exist, and had come up with a number of $100 billion. To put this in perspective, WMB’s entire enterprise value is $58 billion. It doesn’t mean Transco is worth $100 billion, but it illustrates that easements with perpetual ownership are much harder to replicate in today’s America of 310 million people than they were 30 or 50 years ago.

KMI’s tax savings through the higher depreciation afforded through a higher asset value is worth, they estimate, $20 billion. This is an important source of the higher dividend and the faster, 10% annual dividend growth they now forecast.

Meanwhile, taxes work in a different way for KMP and EPB unitholders. MLP investors pay less tax today on distributions than if the same cash was a dividend, but owe the tax not paid when they eventually sell the MLP. Some investors hold their MLPs for a long time, and maybe even until death (when their heirs are not liable for the taxes). As an MLP investor you’re trying to put off paying taxes as long as possible. The Kinder Morgan transaction is a taxable event for the KMP and EPB unitholders. KMI estimates that the typical KMP unitholder will owe from $13.81 to $18.16 per KMP unit owned, depending on the closing price of the transaction later this year.  That’s more than the cash component of the deal and makes it substantially less attractive for some unitholders (the longer you’ve been an investor the worse off you are). Even if you assume that the taxes would have been paid in 10 years (and assume a 10% return on the money* that would have been invested in KMP but now has to go to the IRS) it still eats up $8.49 to $11.16 of value.

So although the deal was priced at a 12% premium to Friday’s close (in the case of KMP) or a 15.4% premium (in the case of EPB), the impact of having to pay taxes now rather than later gets the typical KMP investor roughly back to where they were with no transaction. KMI though has better prospects, in part due to the tax savings from higher depreciation.

It’s not always appreciated how much control GPs have over their MLPs. Although KMP’s high dividend yield represented a high cost of equity, this never actually precluded them making new acquisitions. The GP, KMI, could have directed KMP to raise capital at a cost above the return on the assets acquired which, while it would have diluted the LP’s returns would still have been good for KMI which would have shared in 50% of the increased DCF without having to put up any extra capital. A GP who so wished could exploit the LPs in his MLP by issuing equity to make acquisitions no matter how bad it was for the LP unitholders because the GP would still get its IDR-based share of the additional cashflows.

So while the transaction may look slightly less attractive to LP unitholders once taxes are considered, they could have received far worse treatment from an unscrupulous GP. Rich Kinder is not like that.

So the lesson here is, to invest alongside the people who run the businesses, which is in the GP. Rich Kinder’s a taxpayer and you can be sure that he gave careful consideration to what his own tax outcome would be. This is why we’ve long been owners of KMI, but had avoided KMP, EPB and indeed most other MLPs where a GP has a claim on the cashflows. If you invest in the GP at least your tax situation will receive more careful consideration from the billionaire alongside whom you’re investing.

*There is a theoretical case for using the investor’s borrowing cost to discount the tax liability. This results in a lower set of numbers and makes the tax analysis less adverse for the KMP unitholder.

Barron’s has one of their by now regular articles on MLPs this weekend as they interview their “MLP Roundtable”. These write-ups are invariably constructive, and the most recent one is no exception. As well as noting the many opportunities offered to build out infrastructure in support of America’s shale boom, General Partners (GPs) received a mention. Roundtable member Douglas Rachlin of Neuberger Berman pointed out that, “GPs are not required to contribute capital to the organic-growth projects or acquisitions their MLPs make; yet they benefit in a disproportionate manner through their ownership of distribution rights.”

Becca Followill of U.S. Capital Advisors added, “Some MLPs don’t have a general partner, which makes them easier to take out and can make a deal more accretive more quickly.”

These are both features of MLPs that we’ve long identified and reflected in our own MLP strategy.

Quite a few names reported quarterly earnings last week. The numbers were generally good and MLPs are overwhelmingly reporting increases in future capital investment which for GPs at a minimum assures continued growth in distributed cashflow received and therefore in dividends paid. But not everything was good. Buckeye Partners (BPL) issued a surprisingly disappointing report which included losses in their Merchant Services division. We’re investors in BPL and have been for years.

The most attractive businesses for MLPs are fee-based whereby they earn recurring income from storage and pipeline assets. BPL largely does this, but like a handful of other MLPs they also have a marketing division which incurs basis risk on its underlying products on behalf of customers, often in exchange for quite narrow margins.

These activities can be quite tricky to manage. MLPs face a principal-agent problem here, in that their desire is to generate a return through using their inside knowledge and control of product to charge more than the cost of the basis risk incurred. However, there is inevitably judgment involved, and while the MLP wants to exploit an additional element of its franchise, if not properly managed the traders involved will seek to make money from the risk taking side of this. In fact, risk-averse basis trading maximizes the firm’s franchise value and minimizes the value added of the trader. The trader’s incentive can therefore be to minimize the apparent value of the franchise so as to maximize the apparent value of his skill-based activities. It can lead to excessive risk-taking, since profits from properly exploiting the MLP’s position in the middle of all kinds of information about supply and demand can appear to value the trader less than trading profits generated through his own skill/judgment.

It’s not only banks that can get themselves into trouble with risk. And in BPL’s case, it appears that a poorly constructed hedging strategy went wrong during the 2Q, causing the Merchant Services unit to swing to an operating loss.

Positions were liquidated, people fired and a more modest business model adopted. But it shows that unwelcome surprises can come from units that appear to offer steady if unspectacular returns, if the principal-agent conflict described isn’t carefully managed.

Yesterday was Williams Companies’ (WMB) Analyst Day. The company gave a strong presentation across each of their divisions. It highlighted the many opportunities to build new infrastructure in response to the shale developments, especially in the Marcellus. WMB’s dividend yield is 3.3% but such is the earning power of the assets they control that management extended their dividend growth forecast of 20% out to 2016 (from 2015) with further strong performance expected beyond that. Much of this is driven by assets held at WMB’s MLP, Williams Partners (WPZ), since WMB owns the General Partner are therefore receives 50% of each additional dollar of distributable cashflow.

WMB controls Transco, a pipeline network that runs from the NE U.S. down to Texas. One of the more memorable pieces of information came when Rory Miller, SVP of the Atlantic-Gulf Operating Area, noted that he’d once asked his team to estimate the cost of rebuilding the Transco system and the figure they came up with was $100 billion (for comparison, WPZ’s enterprise value is $33 billion). This pipeline was first laid 60 years ago, and decades of population growth and development all along the route make the cost of building something similar today prohibitive.

Interestingly, today Goldman upgraded Kinder Morgan (KMI) from Buy to Conviction Buy. Kevin Kaiser of Hedgeye, a small research firm in Connecticut, has been a long-time critic of MLPs and the Kinder complex in particular. KMI owns the GP for Kinder Morgan Partners (KMP) and El Paso (EPB) and while it doesn’t sport the type of growth prospects of WMB we think it’s a similarly attractive security leveraged to the continued development of energy infrastructure in the U.S. Kaiser has long argued that firms such as KMI skimp on maintenance, something not supported by metrics such as operating performance or accident statistics. But the Transco example above suggests that in at least some cases MLPs own assets that are substantially undervalued, at least on a replacement basis.

KMI has been a weak performer over the past year or so, providing at least some vindication for Kaiser (although their business performance has been fine and his negative call on MLPs as a whole has been dead wrong). For our part, we think both companies are very well positioned and are long both WMB and KMI.

Interesting perspective on where the IRS is likely to focus from Robert Willens in Barrons today. He notes, “While the IRS is getting more restrictive on REITs and inversions, they are getting more expansive on MLPs, for some unknown reason. They are allowing a broader class of entity to convert to MLP status.”

Investors in ADT keenly remember the results of Keith Meister’s stewardship of their company, summarized here in our February newsletter. Keith Meister, who runs Corvex Management, LP, invested in ADT, made a forceful case for the stock being undervalued and took a board seat. With the benefit of information garnered in that role he one day exited his position, humiliating ADT’s guileless CEO in the process by persuading him to repurchase Corvex’s stake at a price it has never subsequently seen. Today ADT trades at less than half the price Corvex assessed it to be worth less than two years ago.

Williams Companies (WMB), today welcomes Keith Meister and an affiliated investor Eric Mandelblatt (manager of Soroban Master Fund, LP) on to their board. Corvex had recently disclosed  along with Soroban ownership of around 10%% of WMB (including options). WMB investors (ourselves included, for we have owned WMB since well before Corvex’s announced involvement) are now wondering whether (or perhaps, when) Corvex will “pull an ADT” and use their vantage point on the board to time their exit. For nobody should assume they are long term investors. Striving for long term capital gains tax treatment is not an issue for an offshore hedge fund.

In the ADT movie, achieving a board seat was a step in the elaborate dance between Meister and Gursahaney (ADT’s hapless CEO) that ultimately ended with Corvex’s abrupt loss of love for the company. As a WMB investor, we liked the company before Corvex showed up, and think perhaps we might be better served if he had focused elsewhere. Given Corvex’s history, WMB’s stock today is weaker as investors price in a modest “Corvex Discount”, the price concession necessary to reflect the inclusion on WMB’s board of one who does not accept a fiduciary obligation to all the shareholders of WMB, but only the investors in Corvex.

We think WMB is a good investment. We now have to include an assessment of when Corvex will switch dance partners and whether his moves will ultimately be value destroying (as they were  for ADT when the company vastly overpaid to buy back its stock). Much depends on whether WMB’s CEO Alan Armstrong is a good poker player, for his skills will at some point be on display through the company’s public moves with their new best friend activist investor. We are, for now, partners with Corvex. WMB remains an attractively priced investment. But we are listening carefully for the music to stop and counting the remaining chairs. This is what investing is like when an activist shows up.

On Saturday, Barron’s ran a front cover piece that was negative on Kinder Morgan (“Yield of Dreams”). Andrew Bary has written many thoughtful pieces for Barron’s over the years. In this case he basically reproduced a negative report written by Hedgeye’s Kevin Kaiser from last year. Kinder Morgan Inc (KMI) was down yesterday because evidently some readers of Barron’s haven’t heard of Kevin Kaiser.

The issue Kaiser raises is whether Kinder Morgan Partners (KMP) and El Paso (EPB) skimp on maintenance in order to increase their Distributable Cash Flow (DCF) of which close to 50% goes to the General Partner, KMI. We like KMI for this reason as we’ve noted before. They benefit from increased assets and cashflows at KMP and EPB without having to put up any capital. Rich Kinder does too, since he owns $8BN of the stock.

As for whether they do skimp on maintenance cap ex or not, the evidence would seem to suggest they don’t. Kinder Morgan’s safety record is at least as good as their peers; their return on invested capital has been consistent and above their cost of capital; their leverage ratios have also remained stable.  From these perspectives, we feel comfortable with their management of these assets. As the development of shale oil and gas creates the need for investments in energy infrastructure, Kinder Morgan will be a significant player (they have a current project backlog of $14BN against an enterprise value of about $100BN). KMI should see growth in cashflows from the increased DCF at the MLPs it controls. Its forward dividend yield is 5%, and expected to grow at 8% over the next several years. Kinder Morgan issued a response to the Barron’s article yesterday.

No doubt KMI has performed poorly in recent months, partly because they lowered their forecast dividend growth from 9-10% last year but also due to negative sentiment caused by Hedgeye’s analysis. We continue to think it’s an attractive investment at current levels.

Kinder Morgan Partners (KMP) announced a secondary offering of 6.9 million shares last night at $78.32, raising $540 million. KMP is predictably weaker this morning as is usually the case when an MLP sells stock unexpectedly. For Kinder Morgan Inc., (KMI), the math is somewhat different. KMI owns the General Partner (GP) of KMP, and as such is entitled to 50% of the distributable cashflow generated by KMP. Simplistically, without considering any additional debt that KMP might raise, KMI will  earn the return on 50% of the equity capital KMP has raised. In effect, the value of the assets on which KMI earns a return has gone up by $270 million, without KMI having to put up any money. KMI investors should thank the KMP investors for making this possible.