On Monday the Energy Institute (EI) published the 72^nd edition of the Statistical Review of World Energy. BP handed off this responsibility last year. They probably felt that saying anything about energy consumption would inflame climate extremists without commensurate benefit.

The EI launched the publication with a webinar, which predictably was both upbeat on renewables while lamenting their slow penetration. The interesting data in the review mostly concerns fossil fuels, which one panelist complained remain at 82% of primary energy consumption despite renewables being cheaper. Unspoken was that it might be the result of a conspiracy by energy companies to willfully deny themselves the higher profits widespread solar and wind could provide. Or maybe they’re just not cheaper.

Renewables (defined to exclude hydropower and now four fifths solar and wind) nonetheless reached a 7.5% share of the world’s primary energy consumption last year, up almost 1%. China is the biggest consumer of renewables power at 29% of the global total. They’ve grown their consumption at almost 25% pa over the past decade. China provides many energy superlatives.

Some may be surprised to learn that global natural gas consumption fell 3% last year, but this was a demand response to Russia’s invasion of Ukraine. Prices paid by Europeans jumped as much as threefold, and in Japan almost doubled. US prices rose too but remain far below other global benchmarks.

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The result was that natural gas consumption fell in every region of the world except the US, where it rose 5%. The US consumes 22% of global output and is also the biggest producer with a 24% market share.

Regular readers are familiar with the growth in US Liquefied Natural Gas (LNG) exports, up from almost nothing a decade ago to 104 Billion Cubic Meters (BCM) last year. Global trade in LNG used to be dominated by Asia, but last year European LNG imports rose 57%. The global LNG trade reached 542 BCM, up from 516 BCM the prior year with a ten year Compound Annual Growth Rate (CAGR) of 5%. Japan replaced China as the top LNG importer as the Chinese lockdown slowed domestic economic activity. However, China is expected to displace Japan this year or next. Increased LNG typically reduces coal demand, a goal most will find desirable.

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Coal consumption grew slightly, although surprisingly not in Europe in spite of their need to replace Russian natural gas. Energy conservation and slower growth caused overall energy consumption to dip in the EU, while sanctions had a similar effect on Russia. China continued to burn over half the world’s coal, increasing slightly from 54.6% to 54.8% of global consumption. This is 9X the US, where consumption has been declining at a 5.5% CAGR.

The best news on China is its continued growth of nuclear power, which has a 15% CAGR over ten years. The US remains the global leader in nuclear, producing roughly 2X the output of China. But this lead will shrink as China continues to build new power plants.

The climate change debate pits OECD countries with high living standards against developing countries whose desire for western lifestyles requires more energy use. US per capita energy consumption is 2.5X China’s and an astonishing 20X Africa’s. Our figure is flat over the past decade, while for the non-OECD countries the ten year CAGR is 1%. Poorer countries still have a lot of catching up to do.

Our CO2 emissions from energy have a ten year CAGR of –0.5%, compared with 1.6% for China. If CO2 levels eventually reach a point that harms the planet, it’ll be because China’s emissions were the tipping point.

If you care about US natural gas consumption and exports, the review was full of encouraging realism.

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The world’s major energy companies are confirming the long term future of natural gas with their spending decisions. The forecasts of declining global consumption are what’s required to hit increasingly unlikely net-zero emissions targets, such as the IEA Net Zero Outlook in the chart.

China keeps signing long term LNG purchase agreements, including one recently with Qatar. On Monday China’s ENN Natural Gas’s Singapore subsidiary signed a 20+ year deal with Cheniere. Shell’s CEO recently told investors “Liquefied natural gas will play an even bigger role in the energy system of the future than it plays today,”

This all fits well with America’s growing dominance in the global LNG trade.

The US Energy Information Administration (EIA) warned that much of the country is at risk of energy shortfalls this summer. US power generation has grown at 0.5% pa over the past decade, so the problem isn’t caused by soaring demand. But solar and wind edged up to 15% of electricity generation last year, from 14% in 2021. Their intermittency is increasing our risk of power outages. The eastern part of the country is assessed as low risk, so living in NJ has its good points. But if your air conditioning doesn’t work when you need it in July, blame the climate extremists.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

We’re getting used to 4-5% inflation. Using the Fed’s preferred measure, core Personal Consumption Expenditures (PCE), it’s been above 3% since April 2021. People are quietly mentioning the unmentionable – what if the Fed raises its inflation target? 

The Economist recently published a briefing warning that “failure to quell it quickly will transform financial markets”. Whether the Fed suppresses the economy enough to get inflation back to 2% or not, it’s already too late for it to be quick.  

Richard Clarida was vice chair at the Fed until he resigned in January 2022 amid controversy over well-timed personal stock trades just prior to a barrage of pandemic-related rescue programs. He returned to PIMCO. Clarida told the Economist the Fed, “… will eventually get the inflation rate it wants” adding, “It could be 2.8% or 2.9% when they start to consider rate cuts.” 

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Clarida joins a growing chorus of Wall Street strategists who are asking the same question. There’s nothing magic about 2%. It’s predictability that’s important, although the Economist goes on to argue that higher inflation is damaging precisely because it makes future inflation harder to forecast.  

Don’t expect Fed chair Jay Powell to announce a revised interpretation of their twin mandate (full employment with stable prices). The last time they did that was following their 2020 Jackson Hole symposium. Powell expressed a tolerance for “…inflation moderately above 2 percent for some time.”  Thereafter, “transitory” became overused and then dropped from his lexicon.  

We know this Fed focuses on whichever element of its twin mandate is farthest from target. They do not anticipate events, even though the tools of monetary policy take many months to have an impact. A jump in unemployment could see them pivot away from inflation.   

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As we’ve noted before, some investors are already considering how to respond (see 4% Inflation Is Our Least Bad Option). Aging populations in the rich world mean a shrinking labor force. Globalization, the big driver of disinflation for decades, is reversing as supply chains are modified to match national security needs. Apple is just one company planning to reduce its reliance on China by shifting iphone production to India.  

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Treasury Inflation Protected Securities (TIPS) are expensive, their prices as much distorted by the Fed’s QE purchases as conventional securities. Ten year TIPs at 1.5% are priced for ten-year inflation expectations of 2.2% when subtracted from regular ten year notes yielding 3.7%. This calculation has been below 2.3% all year. It’s a mistake to infer credibility in the Fed’s efforts. The University of Michigan survey shows ten-year inflation expectations have been rising all year, and now sit at a twelve year high of 3.2%, almost 1% above TIPs. This shows the bond market can’t be relied on as a measure of what investors think will happen.  

Stocks are better than bonds in such an environment. Within the equity market, stocks with pricing power should offer protection. The Economist recommends physical assets including infrastructure, because they, “generate income streams, in the form of rents and usage charges, that can often be raised in line with inflation or may even be contractually linked to it.” 

The Economist adds that such assets are hard to access, often “…dominated by private investment managers, who tend to focus on selling to big institutional investors.” 

An important exception is midstream energy infrastructure, the regular topic of this blog. This sector might be the solution to any investor wanting a portfolio designed for a world where 4% is the new 2%.  

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Right on cue, Wells Fargo just published Midstream: Capital Allocation Conundrum—What to Do with All That FCF? They see 10%+ price upside over the next five years from excess free cash flow deployed to either buybacks or dividends. Pipelines have pricing power, in that many tariffs increase automatically with inflation. These are scarce assets, thanks in part to climate extremists who have made new construction unappealing through persistent ruinous court challenges. Mountain Valley Pipeline will soon be finished, but the protracted timeline will serve as a warning that returns on growth capex can be uncertain. Hug a climate protester and drive them to their next protest.  

Dividend yields are around 6%. The Wells Fargo analysis includes baseline 4.3% annual dividend growth and steady capex. The excess cash flow they project is worth around 2% pa. Adding the three together results in a 12.3% pa five year return. That’s not assuming any repricing as investors are drawn towards publicly traded infrastructure, even though returns like this would probably create their own momentum.  

After reading The Economist’s Investors must prepare for sustained higher inflation, you’ll be relieved to turn to midstream energy infrastructure which just might be part of the solution.  

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

Energy Mutual Fund

Energy ETF

Inflation Fund

The Equity Risk Premium (ERP) is a measure of the relative attractiveness of stocks versus bonds. It compares the earnings yield on stocks with the interest rate on ten year treasury notes. For much of the past decade it’s shown stocks to be relatively attractive compared to the average relationship going back to 1962 – of no particular significance also my entire lifetime.

Quantitative Easing (QE), first unveiled with acute insight by Fed chair Ben Bernanke during the Great Financial Crisis (GFC) and abused by successive Fed chairs ever since, made bonds unattractive. QE has evolved from a unique solution to a banking crisis into a form of partial Federal debt monetization. The problems facing regional banks trace their roots to many banks mistakenly concluding that if the Fed was loading up on long term bonds that must make it acceptable to do so. This suspension of critical thinking exposed the absence of competent risk management. America’s more than 4,000 banks have a greater need of chief risk officers than the pool of qualified candidates can supply.

Since the founding of your blogger’s firm, SL Advisors, in 2009, stocks have represented the only meaningful source of return. Bonds have had some good years because the Fed has more or less adopted permanent QE, at least judging from their balance sheet. Repeated promises to kick the QE narcotic habit have done little more than impose a brief pause in the inexorable growth of the central bank’s bond holdings.

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The Fed’s eventual zeal to vanquish inflation has over the past year or so improved the relative appeal of bonds. But fixed income investors must still compete with return-insensitive foreign central banks, pension funds with inflexible investment mandates that require bonds, and our own Federal Reserve with its bloated [$8TN] in holdings. Bonds are a long way from cheap. Ten year yields of 3.75% remain inadequate compared with long term inflation unlikely to return to 2% and a Debt:GDP ratio heading relentlessly up. But some might agree that yields on shorter maturities justify the discerning investor in considering modest exposure. Treasury bill yields above 5% almost seems like a fair return, provoking nostalgic recollections of the time value of money and the “float” banks make on the days required in processing checks.

Last year we responded to the lethargy with which Charles Schwab Bank and its peers raise deposit rates by sweeping client cash into two year treasury notes. More recently our Florida homeowners’ association moved its funds in excess of working capital out of a parsimonious 2% bank “savings” account and into the glorious bounty of 5.25% 90-day treasury bills.

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In April when we last examined the ERP, we concluded that stocks were not cheap. Behavioral finance teaches that overconfidence afflicts too many investors. Opinions come with much wider confidence intervals than are usually acknowledged. Humility among investors is acquired while learning this, if fortunate at only modest expense. There are many ways to value the market, some of which probably make it appear cheap. The ERP is not a secret.

Since April, earnings forecasts have stopped falling. This stabilization has offered hope that the recession promised for later this year will be postponed, helping propel stocks higher. The yield curve has similarly responded. At one point during the demise of Silicon Valley Bank, traders were betting on a Fed Funds rate below 3% by the end of next year, suggesting a cut of almost 2%. More recently, Fed chair Powell’s warning of a couple of years before rates come down left many unconvinced. But traders have shown him enough respect that the ignominy of a premature capitulation on inflation has been quietly shelved.

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Stocks have looked beyond the end of declining earnings forecasts and anticipate upward revisions. Expected growth in profits for next year has moved above 10%. However, when stock prices and bond yields rise together, the inevitable casualty is equity valuation. Whatever you thought in April, an S&P500 at 4,400 is less appealing than the 4,100 of two months ago.

We’re not about to eschew stocks to become bond investors. There’s no alternative to equities for investors who wish to preserve their capital’s purchasing power. Tactically switching out of stocks and back in requires two good timing decisions. Taxes on realized gains make it even harder.

At the risk of repeating an admonition frequently offered on this blog, midstream energy infrastructure stocks remain dirt cheap. Ample dividend coverage, continued financial discipline and pipeline tariffs that are often linked to inflation make this a sector whose entry needs no skill at market timing. We’re not selling anything.

But for the investor with cash to invest in the broader market, we’d suggest that the need for action is not urgent. Today’s entry point is likely to be available again, and perhaps better ones too.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Insider trading hasn’t been eliminated, in spite of the SEC’s efforts. In March Terren S Peizer, CEO of Ontrak Inc, was indicted for selling stock in his company when he knew they were losing a key client. He did the trades using Rule 10b5-1 which governs when senior executives can dispose of shares.

Last week provided circumstantial evidence that insiders were selling NextDecade (NEXT). On Monday and Tuesday NEXT dropped $1, from $6.14 to $5.13, on higher than average volume. There was no news out to justify the drop. The company had most recently reaffirmed its intention to reach Final Investment Decision (FID) on its proposed Rio Grande LNG export facility (see Situations We’re Following). We weren’t aware of any revised ratings from analysts on NEXT. The drop was puzzling.

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On Wednesday morning NEXT announced the issuance of the first of three tranches of equity to France’s TotalEnergies, on terms that the company estimates will result in the French energy giant owning 17.5% of NEXT at $4.86 per share.

It seems likely the issuance of NEXT shares at $4.86 was known to some unscrupulous traders. That’s the only plausible explanation for the stock’s precipitous drop in the days prior. Past direct sales of shares by NEXT have similarly been preceded by selling that turned out to be profitable once the announcement was made.

But this time it came with news of a large LNG offtake agreement, also with TotalEnergies. It means capacity for the first three trains is almost completely sold out, making FID highly likely.

This news caught many people by surprise – presumably including the recent aggressive sellers. NEXT stock soared 50% on almost 38 million shares, around 50X its typical volume. There was follow through buying on Thursday, which brought the stock to 62% above its Tuesday afternoon low.

Insider trading is alive and well. NEXT has a problem in maintaining confidentiality around its capital markets activities. Fortunately, this time those seeking free money were relieved of some of theirs.

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Fed chair Jay Powell maintained the Fed’s posture as more hawkish than the market. He suggested that rates may not come down for a couple of years. Interest rate futures adjusted towards this view but traders are still far from convinced.

It was bad news for banks, many of which loaded up on low yielding securities and loans during QE and now face competition from 5%+ yielding treasury bills to retain their deposits. Tier One capital has sunk since the Fed began tightening last year, although it recovered slightly last quarter.

Federal Reserve Governor Christopher Waller feels no responsibility for the squeeze on net interest margins. “I do not support altering the stance of monetary policy over worries of ineffectual management at a few banks,” Waller said in a recent interview.

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Too many bank CEOs have demonstrated weak risk management. Bailing them out is not the Fed’s job – but as their regulator they should face some tough questions on how monetary policy caught out the industry they are apparently overseeing. If the market is correct in forecasting lower rates next year, it’ll be because the squeeze on net interest margins has impeded credit creation. The 1.5% spread between one year treasury bills and ten year notes renders long term fixed rate exposure unattractive.

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The energy transition is providing opportunities for behavior at both ends of the evolutionary spectrum. Sweden’s overly liberal penal code is insufficient to dissuade two morons from defacing a Monet to promote their dystopian vision. Along with their other sad export, Greta, Sweden is developing an unfortunate reputation for producing spoiled, poorly informed young people. If the Swedes can’t discourage such damage to art, perhaps they should send it to another country where it’ll be safe.

More constructive was Williams Companies CEO Alan Armstrong reminding us that increased deployment of intermittent solar and wind will increase the need for natural gas, to provide the reliability that weather-dependent power does not. Williams correctly noted that, “Nobody’s ever going to be comfortable saying: ‘Oh, we’re willing to risk that for five days, we don’t have wind or solar and we’re not going to have a back-up’.”

Our view aligns with Armstrong’s, which is why we believe natural gas and its related infrastructure continue to benefit from increased demand globally. Last week’s sharp move higher in NEXT as their planned LNG export facility moves closer to FID was an example. We expect an announcement from the company by the end of the month, which should include more detail on the mix of financing they intend to pursue. US natural gas is taking another step towards supplying our friends and allies around the world.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

New York and much of the northeast US was shrouded in smoke from Canadian wildfires last week. Westfield, NJ is around 21 miles from lower Manhattan, which is normally visible if you’re at a high enough point. Last Wednesday it was not. Neither was the sun. Millions of Americans experienced air quality more usually associated with New Delhi.

Global warming gets blamed for most unusual weather events. Whenever it’s exceptionally wet/dry/cold/hot/windy it’s because humans are increasing CO2 levels. Regular readers know we are in favor of strategies to lower CO2. Substituting natural gas for coal is a practical solution already responsible for US success in reducing emissions. More nuclear power seems obvious. We’re not excited at the prospect of increased reliance on weather-dependent solar and wind.

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The New York Times duly reported that, “Human-caused climate change is a force behind extremes like these.” It fits the narrative. Except the data doesn’t support it. Over the past four decades the number of fires in Canada has been declining, and the worst years were in the 80s and 90s in terms of area burned. That’s not to say that lowering CO2 emissions isn’t good if pursued without impoverishing us all. Just that the smoke hanging over North America’s population centers isn’t evidence of a CO2 problem.

The world is beginning to tire of the shrill climate extremists intent on imposing economic devastation and austerity on the rest of us. In the UK the Just Stop Oil people have enjoyed extraordinary freedom to disrupt everyone else. Groups of them standing in the road blocking traffic are protected by police. There are several videos of irate drivers being arrested for trying to push the protesters out of the way.

The list of what makes America great is long. The absence of an American version of these protesters is somewhere in the middle of the list. They would be run over or perhaps even shot at. UK public opinion is asking why the wrong people are being arrested. Sometimes it looks like Little Britain.

In Germany, the Greens have long held outsized influence over policy because of their swing vote in the coalitions that typically form government. “Green getting too Brown” is a more severe criticism than it looks, referencing the brown shirts of the Nazi party. “Heizhammer” (heating hammer) is how many refer to plans pushed by the Greens to accelerate the adoption of expensive, energy efficient heat pumps.

Germany is a global leader in spending money on the energy transition, if not in results. Last year their CO2 emissions were unchanged because they increased coal use to replace Russian natural gas. This was in spite of a 4.7% drop in energy consumption, as industry responded to high prices by curtailing production and in some cases relocating to other countries, including America. Germany’s electricity prices are among the world’s highest. There’s little in their energy policies that others should wish to emulate.

German public opinion is shifting. The Greens now rank behind the far right AfD in polls.

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US energy policies at the Federal level rely more on tax credits and other financial incentives. A few liberal states such as New York are making it harder to access reliable energy, by for example banning natural gas hookups to new buildings.

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Nonetheless, domestic production continues to grow. Last year the Permian region in west Texas and New Mexico hit another record at 21 Billion Cubic Feet per Day (BCF/D). It’s second only to the Marcellus/Utica region (collectively Appalachia). The Energy Information Administration (EIA) reported that this past winter power generation from natural gas set a new record at 619 billion kilowatthours. Renewables are growing but America’s electricity still comes from natural gas.

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The focus on renewables overlooks the fact that electricity is around 23% of global final energy consumption. Within US manufacturing for example, electricity use has remained roughly unchanged at under 15% of energy use for decades. Natural gas use is growing and represents almost 3X electricity.

Because the US hasn’t followed extreme energy policies like Germany, reliable cheap energy is drawing manufacturing here. Germany felt good about their ability to reduce energy consumption last year, but in part it represented production facilities relocating because they were losing competitiveness.

China, consumer of half the world’s coal and the biggest determinant of global CO2 emissions, recently said non-fossil fuel energy sources exceed 50% of their total installed electricity generation capacity. The problem is you can’t believe anything the Chinese government says. So it may or may not be true.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

The Mountain Valley Pipeline (MVP) has suffered countless delays because of continued legal challenges from environmental extremists. Permits issued by Federal agencies were on many occasions rescinded by judges. No infrastructure of any kind can be built with such a process. When the recently passed debt ceiling legislation deemed completing MVP “in the national interest” it implicitly acknowledged that the permitting process is broken. This overrode the prior legal judgments. Let’s hope this provides impetus for reform.

Equitrans (ETRN), whose frustrated efforts to complete MVP led to its extraordinary approval by legislation, has gained over 50% as a result. The stock had previously included no value for MVP, priced as if it would never be completed. NextEra, a partner in MVP, wrote its carrying value down to zero last year.

But ETRN remains well short of fully reflecting MVP’s value. Morgan Stanley has estimated a $14 sum-of-the-parts price target for ETRN. RBC has a Base Case of $10 and an Upside Case of $14. It’s currently at $9.50. The threat of further legal challenges remains. The legislation removed the jurisdiction of any court over actions by Federal agencies on this matter. But it allowed any claim against the law’s validity to be heard by the DC District US Court of Appeals. Analysts believe it’s highly unlikely any further legal challenges can disrupt MVP’s completion.

We think ETRN remains attractively priced.

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Another situation we’ve been following is NextDecade (NEXT), whose planned Rio Grande LNG export project will be located on the northern shore of the Brownsville Ship Channel in Texas, with easy access to the Gulf of Mexico. By combining carbon capture with the condensing of natural gas that’s loaded onto LNG tankers, NEXT says it will be the only such US facility offering CO2 emissions reduction of more than 90 percent.

In April FERC re-approved the construction of Rio Grande. The next step is for NEXT to approve a Final Investment Decision (FID) so that construction can move ahead. CEO Matthew Schatzman expects FID to come before the end of this month.

Substantial uncertainty remains over how it will be financed. We estimate that building three trains with 2.3 Billion Cubic feet per Day (BCF/D) will generate $1.8BN in revenues and around $450MM  in income to NEXT annually beginning by 2028. This is an $11-12BN project for a company whose market cap is below $1BN.

NEXT valuation estimates have a wide range. So any estimate of NEXT depends heavily on the mix of debt, preferred and common equity that’s used for financing. The FID announcement should provide enough detail about how Rio Grande LNG will be financed to provide sufficient cash flow visibility that its perceived risk will fall.

We think at current levels it offers an attractive return potential.

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The proposed combination of Oneok (OKE) and Magellan Midstream has dominated our recent blog posts. We won’t relist our reasons for being opposed as we’ve covered them extensively (see Oneok Does A Deal Nobody Needs).

The market-implied probability of the transaction closing has dropped steadily since it was announced on May 15, because the gap between MMP’s current and proposed price is widening. Jim Murchie of Energy Income Partners recently wrote an open letter to MMP where he voiced criticisms similar to ours in objecting to the deal. Investor mood is turning against. Both companies will need to address the market’s cold response to their work.

In recent conversations with investors, several have expressed surprise that the midstream sector isn’t performing better. Equity market leadership is incredibly narrow (see AI And The Pipeline Sector) so unless you own the half dozen or so stocks benefitting from the AI frenzy it’s hard to keep up.

But fund flows into MLP Products, which is a decent proxy for mutual funds and ETFs in midstream energy infrastructure, have been negative every month this year. Last year’s inflow followed four negative years.

1Q23 earnings were good. Capex remains low, helped by opposition to new projects (hug a climate extremist and drive them to their next protest). Dividends are growing by our estimation 2-4%, and buybacks are retiring 2-3% of the sector’s market cap annually. Together with 6%+ yields, this provides the basis for annual returns of 10% or more.

Clearly there’s no irrational exuberance causing investors to throw money at the pipeline sector. Irrational apathy might be more accurate. But the $837MM of net outflows through the first five months of this year is more than offset by the rate at which companies are buying back stock. There’s also the explicit link to inflation in that many pipeline contracts, representing up to half the sector’s EBITDA according to research from Wells Fargo, reprice using either PPI or CPI.

Eventually these persistently strong fundamentals will cause inflows to resume, as they did last year.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

In February, the transcript of the dialogue between Bing’s chatbot and a NYTimes journalist illustrated a weird, unsettling side of Artificial Intelligence (AI). Kevin Roose, the columnist, mischievously led the chatbot through a series of existential questions about feelings which culminated in advice that Roose was in love with Bing, not his earthly companion. It was amusing, except perhaps for the AI programmers at Microsoft who have likely since dialed down Bing’s sentient scale.

Shortly afterwards I started using ChatGPT. I soon found that it can write a blog post. I shall immodestly claim that they are not as informative as my own, at least for now. But I assume their quality will improve, and I’ll have to do the same or risk being an AI unemployment statistic.

The Alerian MLP ETF is a true embodiment of the Moopy-Lacka-Doo syndrome. It’s confusing, risky, and prone to leaving you in a state of bewilderment. So, if you’re considering investing in this ETF, make sure you have a sense of humor and a sturdy pair of financial roller skates. You’re going to need both.

This is the closing paragraph of ChatGPT’s response to “write a funny blog post critical of the alerian mlp etf”. You can read the full piece here.

It’s like a broken seesaw with a weight limit that only exists to crush your hopes and dreams.

It has no substance, and is short of facts compared with, say, our recent missive, AMLP Has Yet More Tax Problems. But it uses more colorful analogies.

It’s like riding a rickety old roller coaster with no safety harness while juggling chainsaws.

ChatGPT is not burdened with having to write in the fair and balanced way SEC regulations require. Our AMLP pieces seem quite tame by comparison. Perhaps this is how a future roboadvisor will persuade clients to dump AMLP for a more properly structured fund, part of fixing portfolios acquired from the underperforming human FA.

I couldn’t resist emulating the NYTimes journalist with Bing, but ChatGPT dryly responded to my overture, “As an AI language model, I don’t have the capability to experience emotions or form personal attachments.” The programmers can learn too.

AI is fast becoming the must-have acronym. Until recently it was ESG. That always looked like a fad to us. ESG Is A Scam and ESG Has No Clothes resonated with our investors and readers. ESG’s relevance doesn’t extend beyond its impact on fund flows.

Advisor-managed client portfolios are mostly lagging the S&P500 this year, because who can run a portfolio with just five stocks (Microsoft, Amazon, Nvidia, Alphabet and Meta)? When the other 495 companies in the S&P feel underappreciated, you know what’s coming next. Those slides in the generic investor presentation dedicated to ESG or the energy transition will soon be amended to demonstrate the company’s AI bona fides.

The energy sector has been using “machine learning” (what AI used to be called) for years. Enbridge promotes it in their management of wind farms. EOG Resources has earned industry respect for its use of analytics to optimize its E&P activities. As far back as 2017 they were extolling their use of real time data to improve operating performance.

Last year Williams Companies partnered with Context Labs to improve their delivery of clean energy using AI.

Exxon Mobil uses “autonomous drilling” relying on AI in Guyana. Chevron,  Occidental and Shell all publicize their use of AI. Before long not using AI will be the exception, the story worth reporting.

And of course, the computers running AI software require energy, so the sector can benefit both by operating more efficiently and from increased demand for its output.

In the late 90s every company needed a dot-com strategy. Remember Pets.com? At the time ordering pet food online seemed as ridiculous as buying books. But not to Jeff Bezos. Just as with the adoption of the internet, even when it became ubiquitous companies still made sure investors knew they were adopting the new technology.

AI is not a fad. But it’s not as new as it looks either. And it can generate some startling images.

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Machine learning existed long before it was rechristened. Genetically modified food seems recent but really goes back millenia. Vaclav Smil has chronicled how the world’s reliance on just a few varieties of grain for nutrition can be traced back to experimentation in the fertile crescent, when early humans were evolving from hunter-gatherers into farmers.

The market has already anointed the big winners from AI. But many more companies have been using machine learning, dynamic data analysis or continuously optimized algorithms for years. Expect to hear more of them boasting about it.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Last November SS&C Alps Advisors, the people who manage the Alerian MLP ETF (AMLP), admitted that they’d screwed up calculating the taxes owed by their fund. Mutual funds and ETFs don’t pay taxes as long as they comply with the rules of the 1940 Investment Company Act for an exemption. AMLP does not comply, because it invests in Master Limited Partnerships (MLPs). Owning more than 25% renders a fund non-RIC compliant and therefore liable for taxes like any other American company. AMLP is 100% MLPs.

We have written tirelessly on the topic (see MLP Funds Made for Uncle Sam). Last December we noted AMLP’s reduced NAV (see AMLP Trips Up On Tax Complexity) which fell 3.9% at their November fiscal year-end. Because of its flawed structure concentrated on MLPs and thereby liable for corporate taxes, AMLP has a five year annual return of 4.97%. The Alerian MLP Index, which it seeks to track, has returned 7.42%. The 2.45% difference is partly AMLP’s 0.85% annual management fee, but mostly the burden of taxes. By contrast, the investible American Energy Independence Index (AEITR) has a five year return of 11.06%.

Nobody would create AMLP today. MLPs are around a third of the sector, and their numbers continue to decline. It is a relic of a decade ago when the MLP structure dominated. That is no longer the case.

Oneok’s (OKE) proposed acquisition of Magellan Midstream (MMP) a couple of weeks ago caused smaller MLPs to briefly catch a bid as traders calculated the rebalancing within a shrinking pool the loss of MMP would cause for AMLP. The OKE-MMP transaction is looking less likely, as explained later in this blog post.

Nonetheless, AMLP is still the sector’s biggest ETF by a considerable margin. That AMLP retains any holders is confirmation that inertia and benign tolerance still inform investment decisions for some.

November’s tax-based NAV correction wasn’t the advisor’s last word on the issue. Last week they provided a tax update that, “modified the estimate of the Fund’s deferred tax liability” by $188 million, an additional 2.27%.

This will push AMLP’s five year underperformance against an index that has itself severely lagged midstream energy infrastructure to close to 3%.

Since November, AMLP’s NAV has been adjusted down by over 6% as Alps hopes it has finally got its arms around the complex tax issues the fund faces. Their lawyers, who will have carefully drafted the latest press release, wisely added, “The Fund’s estimates regarding its deferred tax liability are made in good faith; however, the daily estimate of the Fund’s deferred tax liability used to calculate the Fund’s NAV could vary significantly from the Fund’s actual tax liability.”

In other words, there could be more to come.

There must exist a hardcore group of AMLP investors who resemble the reliable and extreme primary voters of either political party. They accept their flawed choice with no regard for continued evidence of his (her) failings, because to change now would mean conceding an earlier error. There is no helping these investors. They fork over $50 million in management fees annually to an advisor who has now made two tax errors equal to multiples of that.

But there also exists a swathe of financial advisors holding AMLP for clients whose fiduciary fitness can be questioned by having selected such a poorly run, anachronistic fund. You may be one of these advisors, or you may be a client of one. $405 million of tax-related restatements is starting to look like a situation best avoided. Perhaps a class action lawsuit will seek to restore some of those losses out of past management fees.

AMLP now reports a Deferred Tax Liability (DTL) of $373 million (as of June 2, 2023). Market appreciation will create additional unrealized gains and an increased DTL, which will act as a headwind in a rising market.

The case for not owning AMLP could not be clearer. In fact, its best use may be as a short position, as we’ve noted in the past (see Uncle Sam Helps You Short AMLP).

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Investors in OKE and MMP will be encouraged to see a widening spread between MMP’s price and the value of OKE’s proposed acquisition. This means traders are increasingly skeptical that the deal will get done. Since the announcement on May 12, OKE is down 8% and MMP is up only 11%, half the promised premium. The AEITR is +2.5%. It’s one of those rare transactions that is bad for both sides (see Oneok Does A Deal Nobody Needs). OKE gets higher leverage and MMP investors face an unwelcome tax bill.

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Hopefully it’ll get voted down. We calculate the market-implied odds of it going through are now barely above 50/50*.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

*The probability of the deal happening is estimated as follows:

Let:

MMP = current price of MMP

MMPD = price of MMP implied by deal

MMPND – the price MMP would drop to if the deal was canceled, which is assumed to be its pre-deal level adjusted for subsequent move in sector as defined by AEITR.

Deal Probability, or DP = (MMPD-MMP)/(MMP-MMPND)

Therefore, odds of No Deal = 1-DP

Right up until the last minute, environmental extremists continued to use the court system to stymie completion of the Mountain Valley Pipeline (MVP), which will move natural gas from West Virginia to Virginia. Permits have been issued by too many Federal and state agencies to list here. Extremists led by the Sierra Club with their agenda of limiting energy access continued their relentless abuse of the courts seeking the overturn of previously issued permits.

On Friday, the US Court of Appeals for the District of Columbia agreed that the Federal Energy Regulatory Commission (FERC) had “inadequately explained its decision not to prepare a supplemental environmental impact statement.”

This is how infrastructure projects get held up. The US judicial system is ponderous and unpredictable, which can shred IRR estimates. It’s why nuclear power plants don’t get built. And the same technique is already impacting the build out of renewables. Nobody wants transmission cables built near them.

Equitrans, the main owner of MVP, has struggled for years to overcome legal obstacles and complete the remaining few miles of the pipeline so it can be put into service. A 98% completed pipeline doesn’t generate cashflow. Senator Joe Manchin (D-WVa) thought he had an agreement to pass permitting reform that would have ended the legal challenges to MVP when he threw his support behind the Inflation Reduction Act (IRA). But the expected new legislation never came, as support from both parties melted away.

West Virginia is coal country, and Manchin’s support of the IRA, which includes features intended to drive coal consumption down, has made him one of America’s least popular senators. He’s running for re-election next year and has said he’d vote to repeal the IRA if given the opportunity. Manchin’s Republican opponent Governor Jim Justice has a higher approval rating than Manchin in the state even among Democrats.

Improbably, the debt ceiling legislation is being used to help Joe Manchin’s re-election prospects because a policy rider attached to it supercedes existing legal challenges. The draft legislation includes the following language:

Congress (1) ratifies and approves all permits for construction and initial operation at full capacity of MVP through Secretary of the Army, FERC, Secretary of Agriculture and Secretary of Interior (together, the “Federal Agencies”), (2) gives 21 days from enactment for the Secretary of the Army to give permits for MVP to cross waters and operate, (3) provides judicial review whereby no court has jurisdiction to review any action by the Federal Agencies, including any pending lawsuits (importantly removing the overhang from 4th Circuit, which vacated the WV water permit), and (4) directs any claim against the validity of this law to the DC District US Court of Appeals.

In other words, Congress makes completion of MVP a matter of law, greatly reducing although not eliminating the power of the courts to continue blocking it. That a virtually completed pipeline still requires specific congressional legislation to cross the finish line shows how broken is our country’s permitting of new infrastructure. Climate extremists won’t be happy with MVP, but deployment of renewables infrastructure is at least as vulnerable to similar abusive tactics of the court system.

Equitrans (ETRN) stock jumped yesterday on the news. We had felt its prior valuation assumed MVP would never go into service, so it offered a free call option on its completion. NextEra, a partner in the project, wrote their interest down to zero last year (see High-Energy Earnings Boost Pipelines).

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Oneok’s (OKE) proposed acquisition of Magellan Midstream (MMP) is quietly losing support. As we’ve noted (see Oneok Does A Deal Nobody Needs) many MMP investors will face a bill for the recapture of deferred taxes. Advisors who own MMP in separately managed accounts will need to explain this to every client, and since deferral of taxes is often the point of owning MLPs, this isn’t a conversation they’ll approach enthusiastically.

OKE’s stock has sunk 10% since the deal was announced, so their investors are less enamored of the promised $1.5BN tax shield (obtained at the expense of MMP unitholders) than they are dismayed at the jump in leverage to 4.0X to finance the deal.

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There are plenty of stakeholders who could find it in their interests to vote no. We calculate the odds of it going through have slipped noticeably, although still more likely than not. Both management teams face an uphill battle persuading investors to approve the deal. As we’ve mentioned before, as owners of equity in both OKE and MMP we’re going to use both opportunities to vote no. We would have preferred to see MMP combine with another MLP, which could have avoided the deferred tax recapture.

MLPs were also noticeably weaker than c-corps yesterday, unwinding some of the boost the smaller ones had received in anticipation of Alerian having to rebalance its index (see Alerian Still Clinging On). This confirms the market’s revised assessment of the probability of the deal closing.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

Last week the Midstream Energy Infrastructure Conference (MEIC) held its annual event in Palm Beach, FL. SL Advisors partner Henry Hoffman was there and today’s blog post recounts highlights reported by Henry.  

Oneok’s (OKE) proposed acquisition of Magellan Midstream (MMP) was a common topic, especially the unwelcome recapture of deferred taxes facing MMP. When a c-corp, in this case OKE, buys a partnership (MMP), the limited partners in the target get a bad tax outcome. 

For this reason, Crestwood, LP CEO Bob Phillips told us they’d never sell to a c-corp buyer. Since he’s never sold a unit of CEQP, his recapture of deferred taxes would presumably be significant. Williams CEO Alan Armstrong recalled paying a hefty tax bill on his own holdings of Williams Partners, LP when it was acquired by the parent company in 2018. There are few painless exits from an MLP investment. 

One sell-side analyst reported that MMP had decided to sell because they didn’t see an obvious path to growth short of significant capex, and believed their company was undervalued. Overall companies expressed predictable interest in making bolt-on acquisitions but there was little indication of any other large deals in the works.  

Gabe Moreen of Mizuho Securities, Adam Breit, from Truist and Chase Mulvehill from Bank of America generally agreed that strong balance sheets would allow further industry consolidation but were skeptical about any other large deals like OKE-MMP.  

 Natural gas takeaway infrastructure and permitting reform were two themes that recurred in discussions. Lunch speaker Dan Reicher, former Assistant Secretary for Energy (1997-2001), brought attention to the issue of consistent underinvestment in public infrastructure, particularly in areas that don’t provide immediate private returns. He underlined the criticality of bipartisan dialogue and collaboration in addressing the complex challenges of the energy sector.  

A panel discussion covered potential opportunities for private equity deals, the escalating need for gas takeaway capacity, and the evolution of energy project permitting in the light of increasing social justice focus. J.P. Morgan’s financing panel predicted a challenging environment for upstream financing but expressed optimism for the LNG debt sector noting that financing has continued unabated. 

Another lunch speaker, Dr. Amrita Sen from Energy Aspects, highlighted the robust Asian demand for Liquified Natural Gas (LNG) and the global increase in Natural Gas Liquids (NGL) demand. She noted the persistent underinvestment in the supply of both LNG and NGLs. 

Highlights from interactions with individual companies are below: 

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In a fireside chat, Enterprise Products Partners (EPD) Co-CEO, Randy Fowler, shared his perspectives on acquisitions. Fowler emphasized the importance of quality in three main areas: contracts; the producers underpinning those contracts; and the quality of systems in which these contracts operate. Specifically, he cited the Navitas acquisition as an example.  Fowler also reflected on the company’s response to the COVID-19 pandemic. He noted that most staff returned to office work within 2-3 weeks, with the exception of immunocompromised individuals. He made it clear that remote work was not an option for their field workers and office workers should share the same ethos.   

In a separate panel discussion on the topic of ESG, Fowler pointed out that with 30% of the world’s population living in energy poverty, EPD’s export of propane is making a tangible difference in people’s lives. He noted that EPD exports more propane than Saudi Arabia, a statistic that underscores the scale of their operations. He highlighted the fact that more people die annually from unsafe cooking practices than did from COVID-19 during the peak of the pandemic, emphasizing the vital role of liquefied petroleum gas in addressing this issue. He described LPGs from shale as a ‘true miracle.’  

EPD also reiterated their commitment to the Master Limited Partnership structure. 

Energy Transfer’s (ET) CFO, Dylan Bramhall, provided an update on the regulatory challenges the company is facing. He expressed shock at the Department of Energy’s denial of a permit extension for the Lake Charles LNG project. ET is appealing the decision, the results of which are expected within a month. Bramhall cautioned that this development may signal a shift towards more regulatory activism, potentially introducing a new layer of uncertainty and complexity in securing project financing.  

Bramhall revealed plans to share financing responsibilities for Lake Charles with the individual equity partners rather than at the project level, with ET retaining a long-term 25% stake in the project. He highlighted the financial flexibility of the company and pointed out potential upstream synergies of Lake Charles. Bramhall also shared an ambition for more mergers and acquisitions, ideally financed through cash reserves expected to accumulate after a predicted upgrade to their credit rating later this year. 

Jesse Arenivas, CEO of Enlink, concentrated our group session on the company’s Carbon Capture and Sequestration (CCS) initiatives. He projected that this business would represent 25% of the company’s EBITDA by 2030. Arenivas conceded that weather conditions had negatively impacted the company’s Q1 performance but remained optimistic about Enlink’s future prospects. He suggested that the company’s current market undervaluation makes acquisitions unattractive, effectively eliminating any M&A concerns. 

Breck Bash with CapturePoint, a Texas energy distribution company, also reported seeing huge opportunities in CCS especially after the passage of the Inflation Reduction Act which includes substantial tax credits. 

Alan Armstrong, CEO of Williams Companies, stressed that strong demand for the company’s services is challenging their capacity to deliver. With a long list of promising organic projects in the pipeline, Armstrong suggested that the company is not presently interested in pursuing M&A strategies. He drew attention to the Supreme Court hearing on the Chevron Deference case, indicating that its outcome could have considerable implications for the permitting process in the energy sector.  

Nearly 40 years ago, in Chevron v. Natural Resources Defense Council, the US Supreme Court ruled that courts should defer to a federal agency’s interpretation of an ambiguous statute as long as that interpretation is reasonable. The Supreme Court has agreed to reconsider that ruling.  

In a highly engaging conversation, Targa’s CEO, Matthew Meloy detailed his strategic approach to capital allocation. He highlighted his willingness to buy back his stock at a 7X EV/EBITDA multiple while identifying low-risk investment opportunities in contracted projects at a 4X multiple. Meloy offered insights into the potential sale of non-core assets in South Texas and the Badlands, which require minimal capex and yield stable cash flows. Meloy’s ten-year NPV approach to Targa and its assets displayed a keen sense of value. While he currently sees numerous opportunities, he acknowledged a potential surplus of free cash flow versus investment opportunities in the next 3-5 years. Consequently, Meloy expects a substantial increase in dividend payments in the future, although not near-term. 

Lastly, Tellurian is optimistic about their prospects for securing equity partners by the end of July for their LNG project. They estimated that bank debt would be finalized within two months following the equity financing deal. Despite skepticism in the market, they argued that successfully securing equity financing would significantly boost their stock value. We have been critics of Tellurian, because of CEO Souki’s excessive compensation and a business model that until recently retained natural gas price risk in their LNG contracts which has made achieving financing more challenging.  

Overall attendance at the 2023 MEIC was reported as similar to last year. One analyst was surprised it wasn’t greater given the frequent positive conversations he’s having with investors. 

We found that it confirmed our bullish outlook, based on strong balance sheets, continuing capital discipline and continued global demand growth for US gas, NGLs and crude oil.  

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

Energy Mutual Fund

Energy ETF

Inflation Fund