SL Advisors Talks Markets

Energy Transfer’s Distribution Management

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Last week Energy Transfer (ET) raised their quarterly distribution to $0.305, restoring it to a level last paid in July 2020. This cheered a great many people. Among the financial advisors we talk to it is the most widely held individual name. It is perennially cheap. JPMorgan, Morgan Stanley and (according to Refinitiv) 94% of sell side analysts list ET as Overweight.

Following the distribution hike, up 75% year-on-year, ET yields 9.1%. It remains the cheapest big MLP with a 2023 Distributable Cash Flow (DCF) yield of 18%. Under the old MLP standard that prevailed prior to the shale investment bust, 90% of DCF was commonly paid in distributions. Following the hike, their payout ratio is a parsimonious 50%. Like a great performer, ET leaves its audience hoping for more.

Co-CEOs Marshall McCrea and Tom Long retain the deft touch of former CEO (now Executive chairman) Kelcy Warren. ET executes well but always prioritizes management’s interests. Search results on our blog reveal they’re mentioned in 141 separate posts. Enbridge is 54.

In 2016 Energy Transfer Equity (ETE), the entity that ultimately became ET, issued a lucrative class of convertible preferred securities to insiders on the management team (see Is Energy Transfer Quietly Fleecing its Investors?). These securities allowed reinvestment of preferred dividends at $6.56 even if the prevailing unit prices was higher which it always was. This attractive feature was denied to other investors which led to a class action lawsuit. We wondered aloud, Will Energy Transfer Act with Integrity? ET answered by arguing that their maneuver had allowed them to preserve their distribution, winning the case.

ETE was once the General Partner (GP) of MLPs Sunoco Logistics, Energy Transfer Partners and Regency Partners. Through a series of mergers culminating with being absorbed by ETE in 2018, all these LP unitholders endured substantial distribution cuts while ETE’s was preserved (see Energy Transfer: Cutting Your Payout, Not Mine). Management’s investment in Energy Transfer was overwhelmingly in the GP, ETE. We made our investment there to assure the best possible alignment of interests. Notwithstanding the legal case argued in Delaware Chancery by ETE in defense of its indefensible preferreds, many investors in the Energy Transfer family have endured payout cuts.

ET, the surviving entity having absorbed all its MLPs, cut its distribution in late 2020. Investor skepticism about the payout had driven the yield to 18%. Covid-led demand destruction, albeit brief, didn’t help. With no reward in the stock price for such largesse and facing rating agency pressure because of its 5X Debt:EBITDA leverage, the company decided it had better uses for available cash than paying ungrateful unitholders (see Why Energy Transfer Cut Their Distribution). This 50% cut meant long-time investors in Sunoco Logistics, Energy Transfer Partners and Regency Partners had endured cuts of 66%, 72% and 76% respectively since being combined with the parent.

Following last week’s distribution hike ET still trades at a meaningful discount to other large MLPs Enterprise Products Partners (EPD) and Magellan Midstream (MMP). We retain a full position for this reason, but always with a self-protective wariness. ET’s history does not induce the comfort of straight dealing that, say, Jim Teague of EPD provides to their investors.

In 2019 Blackstone acquired the 56% of Tallgrass Energy it didn’t already own via a transaction that paid a substantial premium for management’s units versus the lower one paid to everyone else (see Blackstone and Tallgrass Further Discredit the MLP Model). Perhaps ET’s $41BN market cap makes it too big for such a coup. But you know that if they could do it, they would.

ET’s diverse and well positioned midstream assets, which are largely supported with fee-based contracts offer attractive upside. Their Lake Charles LNG project will add exposure to growing global demand for US natural gas.

LNG import terminals allow for diverse sources. As Germany has learned, if your energy comes via a pipeline you’re locked into a long-term relationship with the supplier. European LNG demand is growing but Asia remains the biggest market. The Philippines expects to increase imports as their Malampaya gas field in the South China Sea winds down. The government just approved construction of a seventh import facility.

The slide in US natural gas prices is due to our mild winter. The Freeport LNG export unit is coming back on line, which will create some additional demand. Cheap US gas will stimulate additional demand for US exports, which will eventually support domestic prices. Curbing US households’ use of gas stoves never looked like a serious proposition, but in any event will not alter the growth in long-term demand.

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

SL Advisors Talks Markets

Will Kinder Morgan Cover Its Cost Of Capital?

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Kinder Morgan (KMI) reported earnings last week and announced that President Kim Dang will be taking over from Steve Kean as CEO. This prompted us to look back over KMI’s history, which reflects some of the best and worst of the MLP sector for the past ten years.

A decade ago the shale revolution drove increased capex for upstream E&P companies as well as the midstream ones that service them. Prior to 2014 KMI operated as the General Partner (GP) to MLPs Kinder Morgan Partners (KMP) and El Paso Partners (EP). The GP-MLP structure always looked to us like the hedge fund manager-hedge fund relationship.

The GP (HF manager) calls the shots and the MLP (HF) does what it’s told with limited rights for the limited partners. The GP could and often did sell assets to its MLP (a “dropdown”), directing the MLP to issue equity and debt to pay for them. Or the GP could direct the MLP to build new infrastructure. The GP had Incentive Distribution Rights (IDRs) which operated like the carried interest taken by HF or private equity managers. It gave them a share of the profits with minimum capital at risk.

Back then we always invested in the GP rather than the MLP because, as with hedge fund managers, that’s where the big money gets made. Rich Kinder exploited his MLPs masterfully and became a billionaire in the process. However, by 2014 the increasing need of MLPs to raise ever more capital to finance infrastructure for the shale revolution was driving up yields, making raising equity capital more expensive.

Kinder was frustrated at KMP’s high cost of capital, so in August 2014 Kinder Morgan announced it was simplifying its structure and rolling its MLPs into KMI to create one single entity. We were moved to write enthusiastically about it (see Valuing Kinder Morgan in its New Structure).

Rich Kinder said at the time, “”We have vastly simplified the structure” and promised “modest cost synergies,” He also promised a $2 annual dividend growing at 10% for the next five years. Less than two years later it was slashed by 75% and still hasn’t recovered.

KMI began a trend to roll MLPs up into their GP parent, which was often a corporation. MLPs had attracted income-seeking, K-1 tolerant investors but the model broke when midstream companies followed their upstream clients into over-investing. Increased leverage led to distribution cuts, alienating the traditional income-seeking investor. The MLP structure has never recovered, and they now represent around a third of the sector. The Alerian MLP ETF remains as an anachronistic vehicle for those who only want MLP exposure and are content with a tax-inefficient structure (see AMLP Trips Up On Tax Complexity).

August 2014 was the peak in the energy sector for that cycle. Since then, KMI has generated a minus 2.9% annual return with dividends, lagging the sector, defined as the American Energy Independence Index (AEITR), which has generated 3.3% pa. KMI’s dividend is $1.11, still a long way from the $2 promised nine years ago.

KMI has a track record of investing in low return projects. Wells Fargo calculates that over the past five years KMI has earned a Cash Return On Investment (CROI) of only 4.4%, the lowest of any big company. Since 1999 they’ve earned 5.6% versus an industry median of 10.7%. KMI’s stock has lagged because they keep investing in projects that earn less than their cost of capital.

Rich Kinder ran the company during most of this period, and he’s misallocated his own capital as well as his investors’ because he’s still the biggest individual owner of KMI shares with around 11% of the company. His personal fortune is from understanding how to exploit the GP/MLP structure that used to exist, but he must think it’s from making good investments.

Which brings us to the new CEO Kim Dang. She became CFO in 2011 and has been part of the management team ever since. The low CROI projects substantially occurred on her watch. Did she internally oppose misdirected capital, or did she misestimate returns as much as Kinder? Neither explanation is good, and KMI’s pliant board of directors doesn’t seem too concerned about the company’s investment track record.

On KMI’s 4Q22 earnings call, Dang commented that, “A large part of my job is going to be about continuity.” Long-time investors may feel a twinge of nervousness at this prospect. An improvement on past performance is needed.

Encouragingly, KMI added $1BN to their buyback program. Given the stock’s poor performance for many years, this might be one of their best uses for excess capital.

We continue to own KMI but at a reduced size relative to its percentage of the sector’s market cap.

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

SL Advisors Talks Markets

US Oil And Gas Production Growing

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The US Energy Information Administration (EIA) published their Short Term Energy Outlook last week. The EIA produces an enormous amount of data and is apolitical. For energy investors it’s really all good news.

US crude production is expected to grow, but slowly. Natural gas production will increase at a faster pace with export growth more than offsetting a modest drop in domestic consumption. US CO2 emissions will continue to fall, accommodating growth in China and other emerging economies where higher living standards are their priority.

The charts tell their own story. You’ll note that Residential and Commercial consumption of natural gas is expected to rise in spite of the musings of the Consumer Product Safety Commission about eliminating gas stoves. And the last four years have shown slightly cooler weather in the US, although not enough to form a trend.

Climate Action Tracker, a website that assesses countries’ commitments to reduce emissions, rates China “Highly Insufficient”. No country is compatible with the UN’s “Zero By 50” goal which requires eliminating CO2 emissions by that date in order to limit global warming to 1.5°C above 1850. Britain and Norway are among those rated “Almost Sufficient”. The US is “Insufficient” while China, India and most of Asia ex-Japan are rated “Highly Insufficient”.

China’s emissions are expected to grow through 2030, at which time the government says they’ll start falling and reach zero by 2060. Western negotiators at the UN who are dominated by liberal politicians too readily accept China’s word. They haven’t been forthcoming about Covid or much else, so it’s unclear why climate change would be different. Rich world countries, where climate concern is greatest, will push ahead with emissions-reducing policies that are more than offset by developing Asia. This gets too little media coverage.

Last week in a significant development, Climeworks announced that they had pulled CO2 from the air and stored it underground at a meaningful scale, verified by an independent third party. Direct Air Capture (DAC) is not easy – there’s around 412 parts per million of CO2 in ambient air, although it has been trending up. Much higher concentrations can be found in the emissions of power plants or petrochemical facilities. Although cheaper to capture at the source, the CO2 then needs to be moved by pipeline to permanent storage underground. Climeworks equipment can be built on or near the porous rock formations appropriate for permanent storage.

This development is another step towards proof of concept. Microsoft, e-commerce company Shopify Inc. and payments firm Stripe Inc have each agreed to pay hundreds of dollars per Metric Tonne (MT) for credits which they can use to offset their own emissions. Because the CO2 is permanently stored and independently verified, this is a more robust and honest way for companies to demonstrate reduced emissions.

The Inflation Reduction Act provides for 45Q tax credits as high as $180 per MT for DAC, a level that is generating interest among several US energy companies. We’ve been following carbon capture developments for some time (see Clean Energy Isn’t Just About Renewables). Occidental is developing the world’s biggest DAC facility driven in part by the 45Q credits (see How Occidental Invests In Lower Taxes).

Concrete maker Lehigh Hanson, plans to capture CO2 from its operations. Start-up CarbonCapture expects to remove 5 million MTs per annum by 2030, and UK-based DRAX 12 million MTs. The 45Q tax credits aren’t capped. The Congressional Budget Office estimated they’ll cost $3BN over the next decade. Credit Suisse thinks $52BN. Forecasts are that around 200 million MTs, representing 4% of US energy-related CO2 emissions, will be captured by 2030.

It’s also possible for carbon atoms to make a virtuous roundtrip. They first leave a natural gas formation as methane (CH4) to be used by a petrochemical facility before being emitted and returned as CO2 for sequestration back in a geological formation similar to the one they left (see Putting Carbon Back In The Ground).

It’s appealing to think that DAC could ultimately solve the problem of climate change. If the technology works, the world only needs to identify enough sites to deploy the Climeworks equipment for permanent CO2 sequestration. It’s much more appealing than relying on vast, intermittent solar and wind farms with requisite battery backup.

But Climeworks understands their market, and their website sensibly positions the company as complimenting other efforts to reduce emissions: “To mitigate climate change, we need all solutions to be working together. One measure alone is not enough.”

When the EIA’s outlook is combined with the positive fundamentals outlined in Wednesday’s blog post (see Bearishness Is Holding Back Energy), there are plenty of reasons for pipeline investors to remain optimistic.

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

SL Advisors Talks Markets

Don’t Bet On A Return To 2% Inflation

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The Fed has a poor forecasting record, something Wall Street never tires of pointing out. The chart below from Barclays shows the FOMC’s constant self-correction on inflation through successive meetings.

Fed chair Powell downplays the blue dots but often refers to them at his press conferences. Usually, the dots move towards the market as the Fed even has trouble forecasting their own policy rate. A recession later this year is the consensus forecast. It’s conventional wisdom that tighter policy will depress growth and induce a pivot. Fed funds futures imply easier policy by year’s end, although with less conviction than a month ago. The minutes released last week showed members expect, “a sustained period of below-trend real GDP growth would be needed.”

Futures modestly bowed towards the blue dots, with rate expectations a year out moving up 0.25% or so since the last FOMC meeting.

Inflation is finally falling and is widely expected to return to 2% within a couple of years. Long-term inflation expectations have remained surprisingly sanguine. Blackrock has a different view. In their 2023 Global Outlook they expect the “politics of recession” to force easier policy on central banks prematurely.

We noted recently that market sentiment measures are as negative as extremes such as the 2008 financial crisis and even turbulent 1980. Inflation was public enemy #1 and there was broad political agreement to vanquish it. Consumer expectations are recession-like and the economy is well beyond full employment.

And yet, there are conflicting measures of the job market. The Establishment survey, which targets businesses, and the Household survey, which targets people, are diverging sharply in estimating job creation. Through December a gap of over 2.3 million jobs opened up between the two in the past year, approximately when the Fed began tightening monetary policy. Friday’s household survey registered an additional 717K workers, so the discrepancy has closed somewhat.

Analysts’ earnings forecasts are trending down and are expected to grow less than 5% this year. As a result, the Equity Risk Premium (S&P500 earnings yield minus the ten-year treasury yield) suggests stocks are at neutral valuation.

This suggests looming economic weakness sufficient to bring inflation back to 2%. But consumer sentiment is already so negative that evidence of a slowdown, such as a couple of weak employment reports, are likely to expose Fed policy to political criticism. Enthusiasm for reducing inflation is unlikely to withstand economic weakness.

This is the point of Blackrock’s view that we’re going to live with higher inflation. They cite three reasons: (1) an aging population (2) geopolitical fragmentation, and (3) the energy transition.

An older population means reduced eligible workers. The participation rate edged up to 62.3% and the unemployment rate fell to an historic low of 3.5%, both consistent with that long-term trend. China’s appeal for manufacturing has weakened with extended covid restrictions. Along with the risk of eventual conflict with Taiwan, companies are bringing production closer to home. The disinflationary effect of globalization is receding.

The energy transition is also inflationary, in two ways. The first is that it drives prices higher. If solar and wind were cheaper they’d be ubiquitous instead of around 14% of power generation which is itself around 19% of US primary energy.

The second inflationary impulse from solar and wind is coming from their consumption of steel, cement, copper and other resources. RBN Energy compares the inputs needed to power a town of 75,000 homes with a single 100 MW combined cycle natural gas plant or 200 MW of windpower. More power output is needed than for the natural gas plant because intermittency requires generating an excess that can be stored for when it’s not windy. They estimate you’d need 200X as much iron ore, 50X as much concrete and 20X as much specialty metals and minerals such as copper, chromium and zinc.

Manufacture of wind turbines is already driving up the prices of inputs. Companies such as Vestas and Siemens Gamesa are renegotiating contracts to try and restore profitability. Avangrid has told Massachusetts that the Commonwealth Wind project, the largest offshore wind farm in the state’s pipeline, “cannot be financed and built” under existing contracts.

None of the three drivers of inflation described above is necessarily deserving of a monetary policy response. Many would regard higher energy prices in support of reduced CO2 emissions as appropriate. Natural gas prices have collapsed in recent days due to unseasonably warm weather and doubts about whether the Freeport LNG export facility will be in operation again by late January as promised by the company. But looking ahead, the energy sector is likely to remain both a source of, and a hedge against, inflation.

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

SL Advisors Talks Markets

Looking Back on 2022

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Readers know not to expect bearish views on energy from this blog. A year ago, we offered ten reasons why we thought the outlook was positive (see The Upside Case For Pipelines – Part 1 and Part 2). We were right about the direction but not all our reasons played out. Below is a report card:

1) Investors become convinced financial discipline will continue Grade: A

Growth capex has remained well contained for the most part. The two big Canadians continue to have outsized investment programs, and together make up almost half of the industry’s total even though they’re just over a quarter by market cap. They both have large business segments within Canada that enjoy highly predictable returns, and as a result both trade at a premium (EV/EBITDA) to the market. Wells Fargo expects growth capex to drop from 41% of free cash flow last year to 35% by 2027. Assuming the trend continues, the market is likely to reward the sector.

2) Pragmatism guides the energy transition Grade: B

California and parts of New England continue to pursue self-destructive policies that in effect accommodate continued emissions growth in Asia ex-Japan while enduring higher costs and less reliability. Most other regions of the US are adopting a more balanced approach. Solar and wind were 12% of US power generation in 2021, and 4.7% of total primary energy consumption. There’s much more to energy than generating electricity. The EIA expects solar and wind to reach 16% of power generation in 2023. Thanks to approaches that vary by state, the US energy transition is less disruptive than the European model.

3) Real yields continue to fall Grade: F

Surprisingly (to us), real yields on ten-year treasury notes have risen by 2.5% this year, from –1% to +1.5%. We had felt negative real yields would drive more investors into income-generating assets, including midstream energy infrastructure. Tightening financial conditions were a headwind for almost all sectors, but not energy. Excessive government indebtedness is likely to limit the economy’s tolerance for high interest rates. Real yields will at some point resume their long-term decline.

4) Inflation surprises to the upside Grade: A

The Fed got this spectacularly wrong. A year ago they expected 2022 inflation, as measured by their favored Personal Consumption Expenditures (PCE) index, to run at 2.6%. They’re now at 5.6%. Private forecasters were also mostly wrong. In April JPMorgan was forecasting 2022 CPI of 5.5%, but now they’re at 7.4%. For 2023 the Fed is forecasting 3.1% (PCE) and JPMorgan 2.8% (CPI). This outcome would represent victory for the Fed. Inflation will fall, but the risk to these forecasts remains to the upside.

5) Republican mid-term gains squash any anti-energy sector legislation Grade: C

Poor candidate selection led to muted Republican gains and failure to regain control of the Senate. Regulatory reform that Joe Manchin thought he’d won in exchange for supporting the Inflation Reduction Act has still not passed. The Mountain Valley Pipeline, built but unused, would be the most tangible beneficiary but renewables advocates should recognize that construction of high voltage power lines will also suffer from the current regulatory uncertainty confronting many types of infrastructure construction. Nonetheless, Democrat policies favor energy investors by discouraging capex, thereby boosting cash flow. Hug your local climate protester and drive them to an event.

6) Sector fund flows turn positive Grade: C

Flows into midstream energy infrastructure funds were negative for the sixth straight year, albeit better than 2021 at $1.1BN through November 2022 vs $1.7BN (same period 2021) according to JPMorgan. Wells Fargo estimates 2022 buybacks at $4.8BN, so sales by retail investors are being easily absorbed by the companies themselves. 2023 buybacks are forecast at $5BN. The sector’s increasing cashflow remains a positive flow of funds story.

7) Cyclical factors that are bullish Grade: A

Goldman’s Jeff Currie believes the ESG movement is distorting the normal capex cycle of the energy sector because high commodity prices are not spurring the type of investment in new production that might otherwise be expected. The result is an extended cyclical upswing, benefiting investors if not consumers.

8) Geopolitical factors that might surprise Grade: A

World events that shock usually hurt equity markets. Energy is different, in that conflict often raises prices and makes energy security more valuable. We had no insight about Russia’s invasion of Ukraine, but US LNG exports are an unsurprising winner. For the first half of 2022 the US was the world’s biggest LNG exporter.

9) Covid loses its ability to disrupt Grade: B

The world finally moved on, except for China where rolling citywide lockdowns reduced growth and demand for oil. China’s recent pivot to dump virtually all restrictions will allow the economy to rebound.

10) Energy transition Grade: A

2022 showed the importance of “dispatchable” energy, meaning energy that’s there when you need it as opposed to when the weather permits. Western Europe didn’t scramble to buy more windmills as Russian natural gas flows petered out. They bought more LNG, especially from the US, and consumed more coal. Policymakers are increasingly accepting that solar panels and windmills aren’t the complete solution. Moreover, traditional energy companies are turning out to be vital to reducing greenhouse gas emissions. The Inflation Reduction Act has boosted investment in carbon capture projects. NextDecade is signing contracts to export LNG for which emissions generated during processing have been captured. The energy transition has gone from threatening the energy sector to providing opportunities.

Midstream energy infrastructure had a great year in spite of a few misses on our report card. Fundamentals that were good a year ago remain so. With free cash flow almost 2X dividends, buybacks increasing, and capex still constrained, 5-6% yields still look appealing.

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