Long-time MLP investors need little reminding that the sector is out of favor. The Alerian MLP ETF (AMLP), with its tax-inefficient structure (see MLP Funds Made for Uncle Sam) has been shedding clients for years (see AMLP’s Shrinking Investor Base). Its focus on MLPs while they dwindle in number means it omits most of the biggest pipeline companies, as they’re corporations. AMLP’s distributions are down by a third (see Why Are MLP Payouts So Confusing?).

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AMLP is designed to provide passive exposure to the Alerian MLP Infrastructure Index (AMZIX). It turns out that pipeline companies haven’t done nearly as badly as this index. The focus on MLPs has always excluded corporations – for many years, when MLPs were controlled by a General Partner (GP), Incentive Distribution Rights (IDR) allowed generous payments from the limited partners in AMZIX to the GP’s. Because AMZIX excluded corporations, it left out many of the GPs who were receiving IDRs payments. Although this model has largely disappeared, the exclusion of most GPs meant that AMZIX included the inferior side of the GP-LP equation. And there remain a handful of MLPs that still labor under the burden of making IDR payments to their GP — all unfortunately included in AMZIX. These include MLPs Cheniere Energy Partners (CQP, controlled by Cheinere Energy Corp, LNG) and TC Pipelines (TCP, controlled by TC Energy, TRP). Avoiding MLPs that owe IDR payments to a parent would have helped AMZIX perform better.

The GP-LP relationship has always looked more like the one between a hedge fund manager and its hedge fund. Hedge fund managers and MLP GPs both fared much better than investors in MLPs and hedge fund (see MLPs and Hedge Funds Are More Alike Than You Think).

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Canadian pipeline companies are among the best run in North America. In recent years they have been acquiring MLPs, rolling them up into the corporate parent. For example, Enbridge acquired U.S. pipeline company Spectra Energy, which included Spectra Energy Partners, its MLP, in 2016. Transcanada (TRP) bought Columbia Pipeline Group the same year, and later rolled up their MLP. All these acquisitions led to the assets leaving AMZIX, because they were no longer housed in MLPs. Excluded from AMZIX but still significant was when Pembina (PBA) bought Veresen in 2017 and also acquired Kinder Morgan Canada after it has sold its Trans Mountain Express pipeline expansion to the Canadian Federal government.

In early 2018, the Federal Energy Regulatory Commission (FERC) surprised investors with a tax ruling that prevented MLPs from including investors’ imputed tax liability in setting natural gas pipeline tariffs. Although FERC later walked back this hasty ruling, the damage was done and natural gas pipelines are largely housed in corporations, where FERC’s tax ruling has no effect.

The general shift from MLPs to corporations as the desired corporate form, so as to access a broader set of investors, has taken place throughout this time. The result is that AMZIX doesn’t reflect the North American pipeline industry (see MLPs No Longer Represent Pipelines). It has the last three big pipeline companies that maintain their MLP status, and a bunch of small gathering and processing names that are more risky. It also has an overweight to crude oil and refined products pipelines, with a corresponding underweight to natural gas pipelines.

AMZIX has wound up with a form of adverse selection – seemingly always on the wrong side of the trade. Holding MLPs that paid IDRs to GPs, rather than GPs themselves; gradually becoming more concentrated as MLPs were rolled up into corporations; and drifting away from natural gas pipelines, leaving them with commensurately more crude oil risk at a time when transportation demand faces a lot of uncertainty.

The American Energy Independence Index (AEITR) was always designed to reflect the better side of the historic GP-LP relationship, and to be broadly representative of the North American pipeline industry. MLPs, as defined by AMZIX and its associated investment product AMLP, have had a miserable decade. But the broad North American pipeline industry as defined by AEITR has done substantially better over multiple timeframes, because of the construction advantages noted above. For almost the past decade it’s performed 14% p.a. better

When an investor complains about lousy MLP performance, they’re right, but they’re also revealing that they’ve had too much exposure to the wrong index.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Approximately 80% of our investments in midstream energy infrastructure are corporations – we invest in MLPs selectively. There’s a big difference between investing in pipeline corporations with their wide investor base, and MLPs whose pool of natural buyers is withering.

That’s why eight of the ten biggest names in the American Energy Independence Index (AEITR) are corporations. Last week, Bloomberg published Pipeline Funds Imperiled With Even MLPGuy Seeing Their End. MLP-dedicated funds, and more importantly their investors, face some tough decisions in the months ahead.

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MLPs long ago lost the support of their traditional investor: the older, wealthy American willing to accept the tax complexity of a K-1 in exchange for attractive, tax-deferred yields. The Alerian MLP ETF (AMLP) has cut distributions by a third since 2014, reflecting what MLPs have done (see When Will MLPs Recover?). These investors feel betrayed, and they’re not coming back.

The Alerian MLP Infrastructure Index (AMZI), which is what AMLP tries to track, has a float-adjusted market cap of just $61BN. This is too small to justify a sector-based approach, a point made in the past by CBRE’s Hinds Howard (known as @MLPGuy on Twitter). Regulatory limits cap holdings of big MLPs, causing smaller MLPs to be overweighted. The AEITR is 73% companies rated BBB or better, compared with  just  42% in the AMZI.

Publicly traded funds represent an important part of the MLP investor base. At the end of February, Wells Fargo estimated there was $30BN in such funds, of which Closed End Funds (CEFs) represented over 40%. Showing arrogant recklessness, these CEFs entered March with leverage of up to 40%, and in the subsequent forced deleveraging they blew up.

We’ve often warned about this, most recently in November (see Should Closed End Funds Use Leverage?). Their rapid demise contributed significantly to the overall selling of MLPs in mid-March. These portfolio managers owe everyone else an apology (see The Virus Infecting MLPs). It’s been the worst month in memory for pipelines — the AEITR is -40%. But the Kayne Anderson MLP/Midstream Fund (KYN) is down 65% for the month. The Clearbridge Energy MLP Fund (CEM) is -80%. The Tortoise Energy Infrastructure Fund (TYG) is -82%. This group has destroyed most of their client capital. They have no risk management. MLP CEFs no longer exist as a practical matter. They can’t do much more damage.

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Open-ended MLP-dedicated mutual funds such as those run by Steelpath (now owned by Invesco), Center Coast Brookfield and Mainstay Cushing face a choice. The extreme volatility and diminished pool of names make it unlikely they’ll attract many new clients. Like AMLP, their complex, tax-inefficient structure has always been a burden, because they pay corporate taxes on profits (see MLP Funds Made for Uncle Sam). Invesco recently had to spend $400 million correcting mis-stated NAVs dating back to 2015 – evidently the tax treatment even confused the fund’s accountants. Today, all these funds are a long way from having to pay corporate taxes.

It must make sense for them to broaden their mandate to include pipeline corporations, whose market cap is roughly twice as big as MLPs. Doing so will place further downward pressure on MLPs as these funds diversify their holdings.

Tax-exempt U.S. institutions and non-U.S. investors rarely invest in MLPs, because they face onerous tax liabilities if they do. Valuations are so depressed that some may decide it’s worth the trouble. But they’re likely to stick to the big three of Enterprise Products (EPD), Energy Transfer (ET) and Magellan Midstream (MMP).

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The result is that it’s hard to identify much natural demand for MLPs. By contrast, pipeline corporations can be bought by anyone. This absence of investors has led to even the three biggest MLPs performing worse than the three biggest pipeline corporations in the last month. The broader trend for pipeline corporations to outperform MLPs began early last year. The American Energy Independence Index is 80% corporations, and has beaten the Alerian MLP Index by 14% since then.

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Moreover, compared with pipeline corporations, MLPs are (1) more exposed to crude oil with less natural gas, where demand is more stable, (2) more exposed to gathering and processing, which depends heavily on production from the specific areas served, (3) riskier credits, with more BBB- (one notch above junk) and below than corporations, and 4) less protective of investor rights, with poorer corporate governance and in some cases blatant conflicts of interest. In other words, the MLP-dedicated portfolio has more of what’s most vulnerable (see Today’s Pipelines Leave MLPs Behind).

The smaller MLPs are especially short of natural buyers. Years ago when the MLP industry had its own conference, StonMor (STON) was an incongruous participant as an MLP in the “deathcare” business (funeral homes and cemeteries). They had a complex structure even for an MLP, and they were out of place among energy investors. They’re now a corporation, and following various self-inflicted problems in 2016 are trading at roughly 5% of their value from years back. They didn’t fit in anybody’s portfolio.

MLPs unable to interest institutions will similarly struggle to attract natural buyers.

Investors in MLP-dedicated strategies should ask themselves: who are the likely buyers of what they own? For now, everything is so cheap that they could easily bounce. But over the longer run, we think MLP-dedicated funds will wish to diversify, which could mean selling most of their MLPs and buying pipeline corporations. A conversion of one of the big three would probably force the issue.

This will hurt performance, and nobody wants to be invested in the last fund to make that shift. Diversified exposure to midstream energy infrastructure through corporations, with just a handful of big MLPs, offers plenty of upside once we get past the coronavirus. But CEF investors saw their MLP allocations reduced in a fire sale, thanks to incompetent portfolio management. Having incinerated most of their investors’ capital, MLP CEFs won’t be a source of demand going forward. High net worth investors have been abandoning MLPs for years. ESG funds buy the biggest pipeline corporations (see our video ESG Investors Like Pipelines) but not MLPs because of their weak governance.

Open-ended ETFs and mutual funds that are loaded up with MLPs are likely to diversify. So if a portfolio of MLPs no longer makes sense, their only place is as part of a bigger portfolio. And if an investor owns just a few MLPs, she’s likely to focus on the big ones. A portfolio of MLPs has an uncertain future.

Disclosure: SL Advisors manages investment products designed to incorporate the advantages described above.

Last week Kelcy Warren, CEO of Energy Transfer (ET), defended the MLP structure. He’s definitely correct that MLPs possess a powerful tax advantage over corporations, in that their profits are only taxed at the investor level. Tax-deferred income free of the double-taxation to which corporate profits are subject is very appealing, and for years it drew countless buyers. Unfortunately, Warren is part of the reason that the MLP structure is losing favor. Midstream energy infrastructure and MLPs used to be synonymous, but widespread distribution cuts and investor abuse have left the old, rich Americans who used to be the investor base betrayed.  The names Kelcy Warren and Rich Kinder still elicit strong reactions from longtime MLP investors.

The Alerian MLP ETF, a good proxy for how MLPs have performed, has cut its distribution by 34% since the market peak in 2014. Companies chose to finance growth projects in excess of free cash flow, and ultimately resorted to either outright distribution cuts or “backdoor” distribution cuts by merging with a their lower yielding corporate general partner. Many MLPs abandoned the structure, and income seeking investors in turn have abandoned the remaining ones.

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The result today is that MLPs represent 36.5% of the sector by market capitalization, as defined by the Alerian Midstream Energy Index — AMNA (see MLPs No Longer Represent Pipelines). Kinder Morgan, ONEOK, Enbridge, Targa Resoures and Williams Companies are among those that have fully adopted the corporate structure.

MLP-dedicated mutual funds and ETFs were originally designed to offer sector exposure to retail investors who didn’t want to deal with K-1s. They saddled their investors with a ruinous tax burden, because funds with over 25% of their portfolios in partnerships (which is what MLPs are) have to pay corporate tax. It seems odd to take a tax-efficient vehicle and add taxes to it, but showing how few investors read the fine print, these products took hold. And they’re now focused on just 36.5% of the sector (see Are MLPs Going Away?).

To illustrate how much things have changed, just two names, Energy Transfer and Enterprise Products, represent 43% of the market cap of all MLPs.  Dedicated MLP funds are forced to drastically underweight these two, which leaves them with outsized exposure to the smaller MLPs. They’ve moved a long way from diversified portfolios of large, fully integrated “toll road” pipeline systems that originally attracted investors.

The biggest of them, the Alerian MLP ETF, has since inception delivered less than one third of its index. This is probably the worst performing index ETF in history. Corporate taxes have taken a bite, and when the sector delivers a couple of big years the tax hit will be even more noticeable (see MLP Funds Made for Uncle Sam). The 1.04% since inception annual return is not far from the 0.85% advisory fee, putting AMLP in the company of the hedge fund industry in making profits while the clients don’t.

If you ever meet one of the hapless souls who’s chosen AMLP, you’ll find they’re probably unaware of the tax drag.

The shrinking number of MLPs has rendered MLP-dedicated funds less representative of the sector. Of the ten biggest North American pipeline companies, six are corporations and so excluded from AMLP and its cousins. Every time another pipeline company leaves the publicly-traded MLP universe, these funds are left with fewer names and a preponderance of small ones. The market has shifted since many of these were launched a decade or more ago (see AMLP’s Shrinking Investor Base).

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If any of these funds decides to reduce their MLP exposure below the 25% threshold, so as to be more representative and avoid corporate taxes, it’ll depress MLP prices because many will have to sell three quarters of their holdings. A quarter of the $135BN in public float for all MLPs is held by $34BN in MLP dedicated-funds. It’s a crowded space.

Moreover, AMLP reflects the worst of MLPs – AMNA is 21% Gathering and Processing (G&P), the more risky end of the midstream business because it’s more dependent on production from specific areas. Due to limited choices, AMLP has 26% exposure to G&P. Even worse, natural gas pipelines are a big underweight in AMLP, even though the long term prospects for natural gas are more visibly positive than for crude oil and liquids. Natural gas pipelines represent 46% of AMNA, but only 27% of AMLP. So AMLP investors have an overweight towards crude oil and liquids.

Investors are starting to act on the many flaws of MLP-dedicated funds. Over the past year, $4.1BN has left the sector. The American Energy Independence Index is investible (you cannot invest directly in an index) and has weights that are more reflective of the industry. Its holdings are mostly corporations, which reflects today’s pipeline business. Several names are ESG holdings for Blackrock and other big fund managers, but MLPs don’t pass ESG screens because of poor governance (watch ESG Investors Like Pipelines). The broader investor base and ESG qualities helped pipeline corporations outperform MLPs last year.

Disclosure: our affiliated investment products are structured to reflect the insights listed above.

Our blog has a Search function that allows users to quickly find what they’re looking for. One of our most often read blog posts is MLP Funds Made for Uncle Sam, which is easily found by entering “Sam” in the search box.

SL Advisors is a secular organization, but searching for the word “Christmas” generates a surprising number of results.

Some relate to the seasonal pattern in which November weakness in MLPs is followed by a rally into January. Why MLPs Make a Great Christmas Present, MLPs Lose That Christmas Spirit and MLPs Weak in November, As Usual all reference Christmas in the text.

In Stocks Are the Cheapest Since 2012 a year ago we welcomed Christmas as a respite from relentless selling. Stocks, including midstream energy infrastructure, duly rallied with our American Energy Independence Index gaining 20% since then.

Investor frustration with the sector was high at times during 2019, and few probably expected the year’s returns to finish where they are. Energy infrastructure has joined the festive season in recent weeks.

Although New Jersey is not having a white Christmas, it’s still too cold for golf. This remains one of our favorite cartoons.

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We wish all of our readers a Merry Christmas, Happy Holidays, and much joyful time with family and friends.

Yesterday Blackstone (BX) surprised Tallgrass Equity (TGE) investors by sweetening their offer for the shares they don’t own to match the price they originally paid in March. It marks a victory for Limited Partners in TGE, which retained its partnership structure even though it’s taxed at a corporation so as to avoid issuing K-1s.

The sideletter that provided a floor on the price management received for their LP units was unfair, and caused us to criticize it in September (see Blackstone and Tallgrass Further Discredit the MLP Model) when BX announced their offer to acquire the remainder of the shares. Most sell-side analysts were embarrassingly silent in standing up for their investors, conflicted as they are by the desire to win banking mandates from the protagonists. RW Baird’s Ethan Bellamy is a standout exception, unafraid to raise awkward questions during earnings calls, which renders his research opinions more credible. Other sell-side analysts should take note.

TGE CEO David Dehaemers claimed not to understand (see Tallgrass Responds to Critics, Missing the Point) and with nobody else publicly taking his side, he brought forward his retirement. This ended a disappointing episode in an otherwise successful career.

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Although the degree of sweetening from BX was a surprise, once they’d invested in TGE it always made sense for them to acquire the rest. Having a public equity position in a private equity portfolio adds unwelcome valuation realism. Private equity funds are reporting far better investment returns than public markets (see Private Equity, Private Valuations), even though they occasionally commit some howlers (see Leverage Wipes Out Investor’s Bet on Enlink). GIP’s 44% partial ownership of Enlink (ENLC) can hardly be their desired position – they’ll either buy the rest or exit, realizing a substantial loss. Information on GIP’s intentions has been sparse. PE investments rarely lose value as quickly as this one, and explaining it has been an unwelcome distraction for GIP’s overworked investor relations people.

TGE’s pending disappearance as a public company also represents another step in the shrinking universe available to Alerian’s MLP indices. TGE was a 4.7% weight in the Alerian MLP and Infrastructure Index (AMZI), followed by the tax-burdened ETF AMLP (see MLP Funds Made for Uncle Sam). TGE is far less than 4.7% of North American midstream energy infrastructure, as shown by its 2.4% weight in the American Energy Independence Index. Because AMZI is limited to partnerships, the TGE proceeds will have to be reallocated across a subset of the pipeline sector, further increasing AMLP’s concentration and rendering it even less representative (see AMLP’s Shrinking Investor Base).

Sentiment among energy investors remains poor. The S&P E&P ETF (XOP) is -21% for the year. Energy has sunk to 4% of the S&P500. The Alerian MLP Infrastructure index (AMZIX) is -3% YTD and reached a low of 44% off its August 2014 high last week. This contrasts with the S&P500, which is +26% for the year. MLP tax loss selling has caused further downward pressure, since so many investors have realized gains in other sectors to pair against energy losses.

Although energy has been weak, wide performance divergences exist. Midstream energy infrastructure has done far better than the E&P companies that are its principal customers. Within that, pipeline corporations have done better than MLPs, which continue to suffer from erosion of interest among their traditional income-seeking investor base. Canadian corporations are among the best performers. TC Energy (TRP, formerly Transcanada), is +50% for the year including dividends, even handily beating the S&P500 with its 26% gain.  Few investors in midstream energy infrastructure realize how well TRP has performed, unless they own it. Enbridge (ENB), North America’s biggest midstream energy infrastructure company and also Canadian, is +31%. Pembina (PBA), a less well known Canadian pipeline company, is +27%.

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Like their banks, Canadians pipeline companies tend to be run more conservatively. Over the past five years they’ve also set themselves apart from the rest of the sector. Their U.S. cousins would do well to adopt some of their disciplined capital allocation and prudent management practices. These three companies represent 55% of the 2019 Free Cash Flow (FCF) we project for the industry. Their performance supports the case that growing FCF leads to a higher stock price (see The Coming Pipeline Cash Gusher).

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The Alerian MLP ETF (AMLP) is a rich source of opprobrium on this blog, because of its flawed tax structure (see MLP Funds Made for Uncle Sam). It does retain one useful feature though, in that it’s relatively easy to short. Big pipeline companies are under-represented in the Alerian index, because most of them are not MLPs. So AMZIX is stuffed full of what investors don’t want.  AMLP follows AMZIX, albeit from a distance. Because of its structure, since inception performance of 1.6% is only half its benchmark of 3.2%. AMLP is the worst performing passive index fund in history. This year AMZIX is 15% behind the investable American Energy Independence Index (AEITR), which is 80% corporations, including the abovementioned Canadians.

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Comparing the two indices, one can see the recent sharp divergence in performance, which was probably exacerbated by tax-loss selling of MLPs. Short AMLP and long an AEITR-linked security has been a profitable trade. AMLP’s tax drag hurts in a rising market, where its flawed structure impedes its ability to appreciate with its underlying portfolio. But recent weakness has been led by the MLPs that predominate in AMLP, highlighting the importance of being in the right kinds of companies in this sector. Investors are favoring well-run Canadian pipeline corporations and shunning MLPs.

The Canadian pipelines offer powerful evidence that it’s possible to generate steady returns in this business. Those U.S. companies that perform well over the next couple of years will do so by adopting more of their culture from north of the border. Assuming FCF grows as we expect across the sector, performance of the Canadian stocks suggests positive returns should follow.

We are invested in ENB, PBA and TRP. We are short AMLP

We manage an ETF which tracks the American Energy Independence Index

Closed end funds (CEFs) are an obscure sector of the market with a small but fiercely passionate following. Because they have a fixed share count, they can trade at a premium or discount to the value of their holdings, which are usually public equities or debt.  This creates appealing opportunities to buy at a discount to intrinsic value. Closed End Fund Advisors provides a lot of useful information on the sector.

Liquidity is always a problem, so the investors tend to be retail with a small handful of institutions. It can sometimes take several days to get into or out of positions. We occasionally run across financial advisors who invest in CEFs for their clients.

In theory, CEFs should generally trade at a discount to Net Asset Value (NAV), because of their relative illiquidity compared to the basket of underlying shares. MLP CEFS have an especially interesting history. We often note the terrible tax structure of the Alerian MLP ETF, AMLP (see MLP Funds Made for Uncle Sam). But MLP CEFS pre-date AMLP and provided some justification for its launch.

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This is because for many years MLP CEFs consistently traded at a premium to NAV. The Kayne Anderson MLP/Midstream Investment Company (KYN) illustrates this point. For most of its history, KYN shares have traded at least 5% higher than NAV and at times over 30%. MLP CEFs possess the same tax inefficiencies as AMLP, in that they are liable for corporate taxes because they are more than 25% invested in MLPs.

The benefit of the tax drag is that KYN investors get exposure to MLPs without the tax hassle of K-1s for tax reporting. A decade ago, investors clearly placed a high value on this simplified tax reporting, as evidenced by the substantial premium to NAV at which KYN traded. AMLP’s 2010 launch took place against this backdrop of strong demand for the tax-burdened, 1099 structure.

Where KYN and other MLP CEFs differ from AMLP is in their use of leverage. This is common in CEFs and supports higher yields in exchange for increased NAV volatility. In addition, the interest expense lowers taxable income, which can lower the inherent inefficiency of an MLP CEF with its corporate tax obligation.

For the past year, KYN has traded at a discount to NAV averaging almost 10%. It’s another symptom of declining retail interest in the sector. The sharp 2014-16 drop with heightened volatility caused some damage.

It’s worth revisiting the use of leverage by MLP CEFs. To continue with KYN, in reviewing their past financials, they seek to stay close to “400% debt coverage”, meaning that their desired portfolio consists of $400 in investments funded with $100MM in debt and $300MM in equity. So $1 invested in KYN controls $1.33 in MLPs. The 400% debt coverage rises and falls with the market. Rebalancing back to their target requires selling after a market drop, and buying following a rally (i.e. buy high, sell low). KYN tends to move a little more than the market as a result.

The question is, whether such leverage continues to make sense. MLP balance sheets have come under a great deal of scrutiny in recent years. The industry has moved towards self-funding growth projects with less reliance on external financing; higher distribution coverage; less leverage. Investment grade companies now target around 4X Debt:EBITDA.

A portfolio of MLPs is pretty concentrated. An investor in KYN or other MLP CEF, by accepting leverage at the CEF level, is implicitly rejecting the industry’s 4X Debt:EBITDA target as needlessly conservative. Is this a smart decision? It might make sense to add leverage to a diversified portfolio, because the low correlations across pairs of individual names will keep the portfolio’s volatility below that of its average holding. But if you’re invested in a single sector, the average volatility of the holdings will come close to your portfolio’s volatility. Adding leverage to that portfolio increasingly looks like adding more debt to each individual holding. The practical result is that the investor is adding more risk than the company and credit rating agencies deem appropriate.

We don’t use leverage in our business. The sector has been volatile enough in recent years, and the periodic rebalancings that are required tend to force you to buy high/sell low.

In KYN’s most recent quarterly financials (August 31), they noted 401% debt coverage versus their target of 400%. Since August, the Alerian MLP index (AMZX) has dropped 10%, implying KYN’s coverage ratio has sunk to 360%. Restoring their 400% target coverage will have required selling over $110MM in securities, adding to the market’s recent selling pressure. Last year’s 4Q saw a 17% drop in AMZX which was almost certainly exacerbated by MLP CEFs delevering. The rebound earlier in the year would have seen MLP CEFs similarly increasing leverage back up.

MLP CEFs are constantly chasing the market to restore their desired leverage. Higher volatility increases the cost of such frequent portfolio rebalancings. We think it’s time their investors reassessed whether accessing the sector with leverage makes sense.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Inflation Fund

Our blog topics are often informed by the subjects that come up in conversations with clients. October was a wrenching month, with the Alerian MLP index slumping to -6% versus +2% for the S&P500. MLPs have lagged equities by an astonishing 22% YTD. Over the last couple of weeks we have been busier than usual fielding calls from investors. By far the most common question in various forms is, when will MLPs recover?

So, for the benefit of those with whom we haven’t recently chatted but are wondering the same thing, below we summarize our thoughts:

• Energy sector sentiment. This remains terrible. Investors would still prefer more disciplined capital allocation. Management teams too often seek dilutive growth, often because their compensation isn’t aligned with per-share metrics. .avia-image-container.av-mtzcdl-3aae4a3889715264767f4ea672ed74a6 img.avia_image{ box-shadow:none; } .avia-image-container.av-mtzcdl-3aae4a3889715264767f4ea672ed74a6 .av-image-caption-overlay-center{ color:#ffffff; }
  
  Midstream energy infrastructure has handily outperformed the E&P sector this year, and capital discipline is improving. But many of the people we talk to are weary, looking for reasons to remain invested and searching for confirmation in their original investment thesis that increasing production should benefit pipelines with their toll-like model. However, there are positive signs here, in that Free Cash Flow for midstream energy infrastructure is set to soar over the next couple of years (see The Coming Pipeline Cash Gusher). Growth capex peaked last year, and existing assets are generating more cash. These are both driving FCF to almost $10BN this year, $27BN next year and $43BN or so in 2021. Recent quarterly earnings generally provided confirmation of this positive trend. For example, Targa Resources (TRGP), one of the worst offenders, has 2020 investment spending plans of $1.2BN, half of this year’s. Former CEO Joe Bob Perkins flippantly talked about new projects as “capital blessings”. Investors won’t miss his self-serving arrogance.
• Retail investors are selling. Approximately $3.6BN, roughly 7% of the total, has left MLP mutual funds, ETFs and related products in the past twelve months, which creates constant downward pressure on prices. Although our own products have seen net inflows this year, this is not the norm.
• The MLP business model is probably dead. Pre-2012, pipeline companies organized as MLPs and paid out 90% or more of their cashflow. Back then, America obtained its oil and gas from roughly the same places in the same amounts year after year. Few new pipeline projects were needed, so with little need to retain cash MLPs offered high yields. These attracted income-seeking investors who, because of the K-1s that MLPs issue, tended to be wealthy. In other words, old, rich Americans. The Shale Revolution offered up oil and gas in places not traditionally served by infrastructure – for example, the Bakken in North Dakota and the Marcellus in Pennsylvania. The Permian in west Texas, although long a producing region, saw significant increases in volume. MLPs decided to invest in new pipelines, pressuring balance sheets and ultimately sacrificing distributions. Kinder Morgan was the first to slash its payout, before ultimately simplifying its structure as Kinder Morgan Inc (KMI) absorbed the assets of its MLP, Kinder Morgan Partners (KMP). The rationale for becoming a corporation was to access capital from the world’s institutional equity investors rather than just the old, rich Americans who buy MLPs (see Kinder Morgan: Still Paying for Broken Promises). Most institutions avoid publicly traded partnerships because of complex tax considerations. In the process, original KMP investors, who had invested for stable tax-deferred income, suffered two distribution cuts and a taxable transaction when their units were swapped for shares in KMI. Many thousands remain bitter to this day.  Rich Kinder’s promise of ever rising distributions fueled higher payouts back to his general partner via Incentive Distribution Rights (IDRs).
• Prior to 2014, many investors viewed the distribution as sacred and assumed that Rich would honor his promise to continue paying them.  After realizing they’d been duped into essentially transferring their money to Rich Kinder through this IDR mechanism based on broken promises, they’ve understandably become disillusioned.  If you run into a former KMP investor, ask about their betrayal by Rich Kinder. It’ll be a colorful story.  Other MLPs followed KMI’s lead. MLPs shed their income seeking investor base in their desire to fund growth projects. More distribution cuts and unwelcome tax bills followed. This transition to institutional, total return investors has been far harder than they assumed. The legacy of betrayal continues to hang over the sector. KMI had a slide titled “Promises Made, Promises Kept”, boasting about their 13 years of distribution growth. .avia-image-container.av-vndiyx-dbdd505165c8dbee016b589c9b032359 img.avia_image{ box-shadow:none; } .avia-image-container.av-vndiyx-dbdd505165c8dbee016b589c9b032359 .av-image-caption-overlay-center{ color:#ffffff; }
  
  The Alerian MLP ETF has cut its distributions by a third, reflecting similar cuts by its underlying components. This is the only time we’re aware of in which companies slashed distributions even while operating performance was fine, as shown by the growing EBITDA on the slide below. .avia-image-container.av-u096ll-9a9441580c35e1fb276b2961f175edf7 img.avia_image{ box-shadow:none; } .avia-image-container.av-u096ll-9a9441580c35e1fb276b2961f175edf7 .av-image-caption-overlay-center{ color:#ffffff; }
  
  But if you’ve invested for the income and it’s cut, you’re let down and no mitigating circumstances will compensate. It’s why MLPs have shrunk to well under half the midstream energy infrastructure sector, with conventional corporations (“c-corps”) now dominant. .avia-image-container.av-10ksp8p-06b0e8b82337747bbd140b5320b32f0b img.avia_image{ box-shadow:none; } .avia-image-container.av-10ksp8p-06b0e8b82337747bbd140b5320b32f0b .av-image-caption-overlay-center{ color:#ffffff; }
  
  Investors in MLP funds or MLP-only portfolios can select from a couple of big MLPs and many very small ones while overlooking six of the ten biggest pipeline companies, since they’re corporations. AMLP, with its 100% MLP construction and disastrous tax structure, would never be created in today’s form. It is a slowly shrinking legacy to the past (see MLP Funds Made for Uncle Sam).

• Election year concerns. A Warren victory is perceived as the most negative, due to her proposed ban on fracking. If applied to federal lands this would have some very modest impact on production. Most drilling takes place on private lands and is regulated by the states. An outright ban on fracking would require an act of Congress which, barring a complete Democrat sweep to include control of the senate, we believe is highly unlikely.
• Tax loss selling. This seems to happen every year, but energy’s chronic underperformance has created opportunities for investors to pair gains elsewhere with losses in this sector.
• Climate Change. It’s hard to assess the impact of investors who might otherwise invest in energy declining to do so, either for ESG reasons or because they fear public policy will impose harsh limits on use of fossil fuels. ESG funds are notable investors in some of the biggest pipeline corporations but not in MLPs because governance (the “G” in ESG) provides weaker investor protections. Tallgrass recently demonstrated this (see Blackstone and Tallgrass Further Discredit the MLP Model). The result has been that the MLP-dominated Alerian MLP index has increasingly lagged our own American Energy Independence Index, which is 80% corporations. .avia-image-container.av-kqhkvd-78a38b90feaddf1f065c513f8571ced4 img.avia_image{ box-shadow:none; } .avia-image-container.av-kqhkvd-78a38b90feaddf1f065c513f8571ced4 .av-image-caption-overlay-center{ color:#ffffff; }
  

Our best bet is that tax loss selling will soon abate, and continuing evidence of capital discipline will draw generalist investors to invest. There’s certainly plenty of interest from other buyers (see Private Equity Sees Value in Unloved Pipelines). But the history of distribution cuts, some poor capital allocation decisions and episodes of investor abuse because of weak MLP governance have depressed sentiment for some time.

For many years November was the best time to buy, with the predominantly retail investor base making the January effect more pronounced than in the broader equity market. The effect has become more muted as companies have switched from MLP to corporation, but still remains a factor (see Give Your Loved One an MLP This Holiday Season) 

We are invested in KMI and TGE

As recently as five years ago, the terms “MLPs” and “pipelines” were interchangeable. If you wanted to invest in pipelines for their steady growth and attractive tax-deferred yields, you had little choice but to be a K-1 tolerant, MLP investor. MLP-dedicated funds were developed to provide retail exposure to the sector, but the corporate tax burden has contributed to their disappointing performance (see MLP Funds Made for Uncle Sam).

A far bigger contributor to poor performance has been years of distribution cuts to fund growth (see It’s the Distributions, Stupid). Income generating businesses became growth-seeking, as the Shale Revolution drove the industry to reinvest more of its cash in infrastructure. America’s energy renaissance broke the MLP model.

This has led to a steady diminution of the importance of MLPs to the midstream energy infrastructure sector, since many of the biggest have converted to be corporations (“c-corps”). This makes them available to a far wider pool of investors than MLPs, which still generally struggle to attract significant institutional support.

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One consequence is that the Alerian MLP Index (AMZX) is becoming steadily less representative of midstream. This is why two years ago we created the American Energy Independence Index (AEITR), recognizing that MLPs are only part of the story. AEITR limits partnerships to 20%, reflecting their diminshing importance and allowing investment products linked to it to be fully RIC-compliant with no corporate tax burden. AEITR also excludes MLPs that are controlled by a General Partner (GP), because of the weak rights such MLP investors have as well as the dilutive payments (called incentive distribution rights) from the MLP to the GP.

The shift to corporate form for the industry has left AMZX including only four of the ten biggest names in the sector in its index – because most of the giants are corporations. It’s also led to it being more concentrated – 70% of the index is in only ten names (versus 60% for AEITR) and 49% is in only five (versus 37%). And the market cap of the underlying names in AMZX is $257BN, only slightly more than half the AEITR’s $490BN.

Investors are increasingly shifting to broader exposure, which is why corporations have been outperforming MLPs. This is illustrated by the AEITR (80% corporations) leading the AMZX (100% partnerships) by 7% over the past twelve months.

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Partnerships provide weaker protections to investors, especially on issues of governance. It’s why Energy Transfer (ET) was able to award preferential securities to management three years ago (see Will Energy Transfer Act with Integrity, written when misplaced hope remained that they might). More recently, Tallgrass (TGE) showed that it’s not above self-dealing either, when it became apparent that Blackstone’s bid to acquire the 56% it doesn’t yet own would trigger a sale of management’s TGE units at a far higher price via a sideletter (see Blackstone and Tallgrass Further Discredit the MLP Model). Asset managers observe far higher ethical standards than some public companies.

Weak governance is why many institutions avoid partnerships. A research report from JPMorgan recently noted that, “…given the proliferation of corporate governance problems in the MLP space, many generalist investors will not entertain the notion of discussing MLPs in our investor conversations.”

In 2018 there were no MLP IPOs, compared with 20 in 2013 and 18 in 2014. This year Diamondback floated a minority interest in their midstream business as Rattler Midstream (RTLR), but that company elected to be taxed as a corporation, seeking to broaden its appeal by providing a 1099. However RTLR has a partnership governance structure, which means fewer rights for RTLR investors.

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Over $50BN is invested in vehicles that track MLP indices, much of it in tax-burdened funds. JPMorgan reports $2.5BN in outflows over the past year. The shrinking pool of MLPs is making them less representative, and poor performance has led to outflows, which in turn weighs on pricing.

Changing to a more representative index would require these funds to dump MLPs, which would further depress MLP valuations. As a result, Alerian continues to talk up the MLP structure with blogs such as the sycophantic TGE: Take-Private Bid Highlights Continued Private Equity Interest in Midstream. There’s no mention of the controversial sideletter noted above.

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There continue to be some good MLPs, such as Enterprise Products Partners (EPD), Magellan Midstream Partners (MMP) and Crestwood Equity Partners (CEQP). Some that are closely held see little value to incurring a corporate tax burden (see Pipeline Billionaires Cling to Partnership Model Others Shun).  ET is well run but undervalued, reflecting the perceived risk to investors of more questionable dealings by management. MLPs with a history of fair dealing receive a higher valuation than others. But poor governance remains a headwind to greater investor interest.

Surprisingly, ESG funds own several large midstream corporations including Kinder Morgan (KMI), Oneok (OKE) and Williams Companies (WMB) (see Improving disclosures is key to ESG investment in midstream, analysts say). Partnerships are not among the names held by ESG funds, because on “G” (Governance), they come up short.

Pipelines are no longer synonymous with MLPs, even though many funds behave as if they are. Fund flows and relative performance show investors are taking notice.

We are invested in CEQP, EPD, ET, KMI, MMP OKE, TGE and WMB

The Alerian MLP ETF (AMLP) remains the largest ETF in the sector, in spite of its ruinous tax drag (see MLP Funds Made for Uncle Sam) and long term returns that are less than half of its index. It’s been a commercial success for its promoters but unfortunately, a disastrous investment for many holders.

However, there are signs that AMLP’s fan base is slipping. Its share count’s steady growth abruptly stopped last summer. Since then, shares outstanding are down over 8%. Half of that drop has come this year.

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Midstream energy infrastructure has been a frustrating sector to be sure, and to some degree AMLP flows reflect broader investor sentiment. Through 2014 assets grew, and even during the 2014-16 energy collapse AMLP’s share count increased.

But since last summer, there’s increasing evidence of lost market share. Figures from JPMorgan show AMLP experienced 2H18 outflows of $942MM, a disproportionate share of the sector’s $2.9BN outflows during that period.

Market direction doesn’t seem to make much difference. Last year’s outflows coincided with sector weakness, but outflows have continued this year even though midstream energy infrastructure has been a leading market performer. AMLP’s 2019 outflows have roughly cancelled out inflows to other funds.

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Back in 2010 when AMLP was launched, there was clearly investor demand for MLP exposure that avoided K-1s. The corporate tax drag meant AMLP, an index fund, could never come close to matching its index. Buyers overlooked or were unaware of this weakness.

Much has changed over the years. MLPs used to be synonymous with pipelines, but the limited investor base has led many large companies to convert to corporations. Today, North American midstream energy infrastructure is two thirds corporations by market cap (see Pipelines’ New Look).

The MLP structure remains tax-efficient, but its income-seeking investor base has proven to be a fickle source of equity capital. So those MLPs that remain, such as Enterprise Products Partners (EPD), do so because they don’t need to issue equity. There were no MLP IPOs in 2018. Blackstone recently announced plans to convert from a partnership to a corporation, concluding that the K-1s were not worth the trouble.

The shrinking pool of MLPs reflects this change (see Are MLPs Going Away?). AMLP’s 100% MLP exposure omits many of the biggest pipeline corporations.

AMLP also holds an ignominious position on the Top Ten “Money Burned” ETFs posted on Twitter recently. The sector’s poor performance has a lot to do with this, but the corporate tax drag on top of poor results was enough to gain AMLP entry to the list.

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The steady erosion of AMLP’s investor base suggests that investors are starting to acknowledge the ruinous tax drag and the switch away from MLPs to corporations.

Since AMLP holders are deciding to exit, it suggests that MLP prices will continue to experience downward pressure relative to corporations, a trend that has been well established this year. The sector is cheap, but broad energy infrastructure exposure that includes corporations will continue to deliver better results than a narrow, MLP-only approach. AMLP owners should sell, probably taking a tax loss, and move into a more diversified product.

Regular readers will be familiar with our blog posts on the topic, and so now are many investors.

We are invested in EPD and short AMLP.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).