Among energy infrastructure companies of note delivering earnings this past week was Spectra Energy (SE) and Spectra Energy Partners (SEP), the Master Limited Partnership (MLP) it controls. The results were good, coming in slightly ahead of estimates. More important was that their backlog of new projects remains robust. Last year SE management produced a soundbite “Drive to 35” forecast, meaning they intended to secure $35BN in new projects by 2020. In their Analyst Day (which came a day after earnings), they reported that almost half of this goal is already in hand. This is important because the bear case for MLPs and U.S. energy infrastructure is that future growth will be cut as E&P names respond to the oil collapse by reducing spending. So far that isn’t panning out among the individual names we follow that have reported recently. There have been modest reductions in planned capex, such as Kinder Morgan (KMI) reducing new investment related to its CO2 business, but the changes have been minor, <5% of planned expenditure.

SE currently pays a $0.37 quarterly dividend, generating a yield of just over 4%. Management is confident they can grow the dividend at $0.14 annually through 2020 over the next couple of years while maintaining coverage above 1X, which is growth of around 9%. Also notable was that the majority of the planned capital expenditure (capex) will take place at their MLP, SEP, where it will be funded. In other words, no new equity issuance for SE which owns the General Partner (GP) and Incentive Distribution Rights (IDRs) for SEP. Asset growth at SEP will increase cashflows to its controlling entity SE — just as asset growth at a hedge fund invariably benefits the hedge fund manager. SE does much more than simply collect cash from SEP, but dividend growth at SE is going to be substantially funded  by other people’s money coming in to SEP.

Plains All American Pipeline (PAA) and its publicly traded GP, Plains GP Holdings (PAGP), both reported earnings. PAA reduced its planned capex for 2015 by 9% compared with 2014 as they reassessed certain projects with today’s lower oil price. They also reduced the midpoint of their EBITDA guidance by 6% compared with figures provided in November. This in turn reduced forecast distribution growth at PAGP to a still robust 21%. Management is well regarded and market reaction to this seemed to conclude that they were being conservative. PAGP currently yields 3%, which while lower than many other energy infrastructure securities is still attractive in our opinion because of the very high growth rate. Their 4Q14 distribution was up 27% over the prior year.

In sum, these two businesses are adapting to lower oil prices but are largely continuing along a similar financial path to last year. We prefer the GPs because of their preferential economics and governance rights (just as hedge fund managers are better investments than hedge funds). Of the names mentioned, we are invested in SE, KMI and PAGP.

The General Partners (GPs) of Master Limited Partnerships (MLPs) have in many cases taken quite a drubbing since the Summer when the sell-off in oil picked up steam. Plains GP Holdings (PAGP) for example has fallen 26% over this time. And yet, midstream MLPs have limited direct exposure to commodity prices. Kinder Morgan (KMI) is now a C-corp following the corporate reorganization that simplified their prior structure which had two MLPs controlled by their C-Corp owned GP. While their corporate structure was altered, their business model wasn’t. So KMI still earns 54% of its pre-depreciation earnings from running natural gas pipelines with fully 82% of its 2014 cashflows fee-based rather than driven by commodity prices.

Last week PAGP announced an increase in their quarterly distribution of 9.8% year-on-year, which caused the price of its securities to rally. Other GPs and C-Corps that own GPs will similarly be announcing earnings over the next several weeks. Their results and guidance will reflect the toll-like model that midstream MLPs operate combined with the advantaged economics enjoyed by those that control them. Over the past twelve months some of them have enjoyed stunningly fast distribution growth: Williams Companies (WMB) yields 5.1% and grew last year at 36%; Oneok (OKE) yields 4.7% and grew at 63%. Given the recent indiscriminate selling of energy-related stocks, the earnings announcements of these and related companies will provide a useful reminder about their business fundamentals. It will be an area well worth watching.

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.

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.