The diminishing number of MLPs has started to draw attention from sell-side analysts. Morgan Stanley’s Robert Kad wrote in his Midstream Weekly that consolidation was likely to, “impact active manager mandates that have been dedicated to the sector.” The shrinking pool of MLPs and its impact on MLP-dedicated funds has been a developing problem for years. The changed business model during the height of the shale revolution favored growth over distribution stability. The subsequent downturn saw cuts in payouts that soured the traditional investor base of wealthy individuals (see The Disappearing MLP Buyer from March 2020).

Many MLPs responded by rolling up into their c-corp GP parent, sometimes with adverse tax consequences for their holders. This began in 2015 (see Kinder Shows The MLP Model is Changing). The Oneok combination with Magellan Midstream is similarly imposing an unwelcome tax bill on long-time unitholders of the latter.

Robert Kad goes on to suggest that MLP-dedicated funds may adopt broader mandates, perhaps to broad infrastructure or the energy transition, although attractive opportunities in wind and solar are rare in our opinion. Windpower mandates are being renegotiated because the suppliers are losing money (see Why Aren’t Renewables Stocks Soaring?).

Kad notes that diversifying away from MLPs will create selling pressure. Keeping MLP exposure below 25% avoids the tax liability faced by MLP funds such as the Alerian MLP ETF (AMLP). It’s a binary rule – 26% exposure to MLPs still renders the entire fund liable for corporate taxes.

As we’ve noted before, investors in MLP-dedicated funds should worry about whether and how their funds modify their portfolios (see Why MLP Fund Investors Should Care When They Change from October 2020).

Slowly switching into c-corps would impose triple taxation on those holdings because the fund would remain taxable until MLPs fell below 25%. A gradual switch could lessen the market impact at the expense of additional taxes. There’s an advantage to being a first mover, so the managers of the Invesco Steelpath family of MLP-dedicated funds and AMLP are probably watching each other warily, wondering what the other will do.

AMLP updates its unrealized tax liability every day. As of August 21 it was $357MM. AMLP is once more a taxpayer, so its NAV will only appreciate by around 79% of its index (1 minus the corporate tax rate). It’s a terribly inefficient structure. Earlier this year Vettafi, publisher of AMLP’s benchmark, sought stakeholder input on potential changes to the index.

The pressure for change is growing. Investors in MLP-dedicated funds, many of whom have tax-deductible losses, have little upside in staying invested during the process.

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Midstream energy infrastructure has been quietly outperforming the market recently. So far in August the American Energy Independence Index (AEITR) is ahead by 3.5%. The extreme low of Covid in March 2020 provides a flattering point of comparison. But even over the past three years the AEITR is ahead by 15% pa.

Strong performance in 2021-22 inevitably ran out of steam, and this year a small number of stocks with an AI angle have made diversification look pedestrian. But every trend ends, and the release of 2Q earnings has coincided with energy infrastructure gaining momentum.

It helps that earnings were generally good. Results +/- 5% of consensus were the norm, apart from Cheniere which seems to reliably “beat, raise and repeat” to quote JPMorgan’s Jeremy Tonet. The broader pattern has been in evidence for several quarters. The positives are well known to investors – reduced growth capex is supporting growing free cash flow which is leading to improved dividend coverage (1.7X in 2022) and falling leverage (<3.5X Debt:EBITDA by YE 2023).

This is supporting dividend increases and stock buybacks.

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The energy transition and climate change put two competing visions at conflict; rich world countries want lower emissions, while developing countries want higher living standards, which require using more energy.

G7 countries have generally reduced energy consumption over the past decade, and their citizens’ living standards have stayed flat. The US is a notable exception in that energy consumption has grown, aided by the shale revolution and its corresponding increase in domestic supply. Nonetheless our emissions have fallen, mainly because the mix has shifted from coal to natural gas. Renewables have also contributed modestly to this.

By contrast with the rest of the G7, Americans have enjoyed rising living standards during this time (see Celebrating The 4th of July). The reasons are complex and not solely due to our energy policies. But a decade reflects the policy choices each country has made. I’m not sure why the combination of energy consumption, emissions reduction and per capita GDP growth achieved by any of the other six members of the G7 would be preferable to what we’ve achieved in America. No US president should ever feel the need to apologize for American exceptionalism. The world could use more of what we have here.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Energy Transfer’s (ET) acquisition of Crestwood (CEQP) highlights the shortcomings of the proposed merger of Oneok (OKE) with Magellan Midstream (MMP). Because ET and CEQP are both MLPs, combining the two entities doesn’t constitute a taxable event for unitholders. This contrasts with OKE/MMP where MMP unitholders will face the recapture of deferred income tax on prior distributions. The synergies in ET/CEQP are modest and achievable – likely understated given ET’s strong operating history. Projected OKE/MMP synergies were never very convincing because they handle different commodities.  

The market-derived odds of the OKE/MMP deal closing have risen recently, and it looks likely to receive shareholder approval although not ours. We calculate the odds at close to 80%, sharply higher over the past couple of weeks. Both management teams have clearly been actively making the case to institutional investors. MMP investors and their financial advisors should be ready for an unwelcome 2023 tax bill. 

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As we noted last week (see AMLP Fails Its Investors Again), the Alerian MLP ETF (AMLP) will suffer another loss of its rapidly depleting constituents when MMP ceases to exist as a stand-alone entity. ET’s acquisition of CEQP will remove yet another, reducing the total to twelve. 

MMP is 12.44% of AMLP’s portfolio and CEQP another 5.24%. They’ll have to reallocate 17.68% of the portfolio, further concentrating their positions.   

There are no good options for AMLP, but that doesn’t mean its advisor Alps won’t try something. Converting AMLP to a RIC-compliant fund by limiting MLPs to 25% of its portfolio would allow for more diversified holdings. However, this would signal to the market the sale by AMLP of three quarters of its portfolio, depressing the prices of the MLPs it owns and causing its holders great offense.  

Existing investors in AMLP and any other non RIC compliant funds such as the Invesco Steelpath family are all exposed to any of their peer group funds making such a change. AMLP investors must assess the odds of Invesco moving first, and vice versa. It’s a percolating problem and at some point, a resolution will create an overhang of MLPs for sale. The smaller MLPs, favored by AMLP because there are so few to choose from, are especially vulnerable because their only other buyers are the K1 tolerant US taxable individuals that historically owned MLPs for the tax deferred distributions.  

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Last week the Energy Information Administration released data showing that US pipeline exports of natural gas to Mexico hit another record. Living standards in our southern neighbor are rising, which means energy consumption is too. This trend is clear across most of the developing world. Much of the world and especially poorer countries aspire to American lifestyles. Per capita energy consumption and GDP are closely linked. This is what’s driving growth in global energy consumption. Rich world OECD countries want lower emissions, and generally energy consumption isn’t rising among this group. In Germany it’s been falling, a consequence of their disastrous energy policies which are making it a less attractive location for any industry that needs reliable, reasonably priced energy.  

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Our southern neighbor exhibits many of these trends. Mexico’s population has more than tripled since 1960. The UN expects further population growth through 2050. More people with rising living standards mean more energy consumption. As with most countries, improving efficiency has kept consumption below these twin trends. 

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Mexico’s energy consumption grew at a 0.8% Compounded Annual Growth Rate (CAGR) over the past decade. This was behind Asia which averaged 2.6% but well ahead of Europe which saw –0.9%. At 0.6% the US stands out among G7 nations as the only one with growing energy consumption – cheap domestic natural gas has spurred investments in industry.  

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Mexican electricity generation is also growing, following a sharp drop in 2020 due to the pandemic. The CAGR for the past decade is 1.4%, a third of Asia (4.6%) but well ahead of the US at 0.5%.  

Good news for US natural gas exporters is that this remains Mexico’s biggest source of power generation at 56% last year. From 2020-22 solar and wind combined went from a 10.9% share to 11.7%. Renewables are gaining, but slowly.  

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US natural gas will increasingly supply global buyers as our LNG export capacity grows and consumers in developing countries enjoy rising living standards supported by increased energy consumption. The energy transition and efforts to reduce global greenhouse gas emissions will need to align with this reality.  

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Government regulations play a big role in energy markets. Although concern about climate change is part of the political discourse in every democracy, consumers and businesses aren’t going to reduce their emissions without tax credits, incentives and rules to modify behavior.

Sometimes policies can have unintended consequences. Take ships, which mostly use heavy, bunker fuel to provide power. In 2020 new rules written by the International Maritime Organization (IMO) came into effect sharply limiting the sulphur content of ships’ fuel to 0.5%, versus 3.5% previously. Airborne sulphur is a pollutant that can harm people with cardiovascular problems living near ports. Sulphur dioxide is a greenhouse gas. The new IMO regulations were intended to improve air quality and to reduce the maritime industry’s carbon footprint.

It sounded very sensible. But some scientists now think this is increasing global warming, and may even be responsible for the exceptionally warm Atlantic waters off the US east coast and on Ireland’s west coast.

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“Ship tracks” are formed when ships move across the ocean. The sulphate particles ships emit seed clouds, creating a trail of reflective, cloud-like vapor behind them. These clouds reduce the amount of sunlight reaching the earth’s surface. The reduced sulphur content of bunker fuel required by the IMO means fewer ship tracks and has inadvertently allowed more sunlight through. In some areas it could have added as much as 50% of the warming impact of human-generated CO2.

If one day our descendants decide the planet is too hot, they may resort to geoengineering which could include seeding clouds on a vast scale to try and reflect more of the sun’s heat back out to space. The IMO regulations have unwittingly created a geoengineering experiment with the opposite effect. There have even been suggestions that ships should emit salt droplets as they move, to seed more ship tracks and undo the possible damage caused by their lower emissions.

Sometimes you just can’t make this stuff up.

Canada has been frustrated for years in its efforts to transport the heavy crude produced in Alberta to global markets. The Keystone XL was intended to be a solution until President Biden canceled it on his first day in office. Kinder Morgan wisely sold the TransMountain expansion (see Canada Looks North to Export its Oil) to the Canadian federal government in 2018. British Columbia didn’t want Albertan oil passing through its province, and the protracted political dispute eventually persuaded Kinder Morgan to give up on the project.   Once the Canadian government took over vast cost increases took the project’s cost up by more than 4X. It is expected to go into service next year transporting crude from Alberta to the Westridge export terminal on British Columbia’s Pacific coast.

RBN Energy publishes a terrific blog for readers keen for a more technical explanation of markets, midstream logistics and the physics of this sector. In a fascinating post (unfortunately behind a paywall), RBN explains the challenges with getting the crude oil from Westridge into the wide blue ocean. The challenges are many. Ships must traverse a narrow channel to reach the Pacific. It’s constrained by depth and also height (because of two bridges). Bigger ships are more cost effective, but the 245 meter Aframax class is the largest ship allowed in Vancouver harbor. The biggest class of oil tanker, an Ultra Large Crude Carriers (ULCC), is 415 meters long and has over four times the carrying capacity of the Aframax.

Alberta’s heavy crude is, well, heavy. The 42 foot depth of the Burrard Inlet, through which the ships must pass, is less than the 49 foot draft of a fully laden Aframax, so they’ll have to operate at less than full capacity. Once outside the harbor some may even move their cargo of oil onto a bigger ship like a ULCC (called reverse lightering) for more cost-effective transport to their Asian buyers.

The complexity and cost of moving the world’s energy are largely hidden from view. Canada’s fractured politics have significantly boosted the cost of getting their oil exports to market.

Finally, Britain’s Conservative government seems to be quietly backing away from some of the more extreme commitments made in the past regarding emissions. The UK is ahead of many other countries, having phased out coal. Offshore windpower is at times its biggest source of electricity. The North Sea is a blustery place.

Britain has a system of carbon credits, and before Brexit their price tracked the EU equivalent quite closely. Now free of oversight from bureaucrats in Brussels, a weakening of regulations has caused UK carbon credits to drop to around half the EU price. This signals less urgency by British CO2 emitters to buy credits. UK PM Sunak may be quietly pursuing more pragmatic policies to try and boost GDP growth which has lagged peers for a decade (see UK government cuts cost of polluting in latest anti-green move). Nothing official has been said. But there’s a clear pattern around the world of voters pushing back once extreme green policies start to have an excessive economic impact.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Last week the Alerian MLP ETF (AMLP) announced a reduced quarterly distribution. Regular readers know that AMLP has been a rich source of material for this blog. Launched in 2010 when MLPs were synonymous with pipelines, it was designed to offer exposure to midstream energy infrastructure without the K1s that so many investors and their accountants dislike.  

Today MLPs represent about a third of the sector’s market cap. The narrow base of potential buyers has persuaded many former MLPs to convert to conventional c-corps, so as to be attractive to a much wider investor base. It also didn’t help that MLPs cut their dividends in half from 2015-20 – not the way to treat the traditional holders who were high net worth US taxpayers seeking stable income.  

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AMLP’s recent 3.5% distribution cut is especially odd because it’s against the prevailing trend. Dividend hikes are becoming the norm, including at: Magellan Midstream (1%), Oneok (2.1%), Enterprise Products Partners (5.3%), Williams Companies (5.4%), Cheniere (19.7%), Targa Resources (42.9%) and Energy Transfer (54%). 

Since its 2010 launch through the end of June, AMLP has returned 2.61% versus its benchmark of 5.02%, a big underperformance for a passive ETF. Taxes are a big reason why. Alps, the fund’s advisor, has had to make two downward revisions to its NAV in the past year, both the result of recalculating the fund’s tax liability. AMLP is a corporate taxpayer, at least when it has unrealized gains on its portfolio. This unusual concession is necessary to jam MLPs into a ‘40 Act fund, which makes it a non-RIC compliant ETF.  

Because MLPs represent a declining share of the pipeline sector, AMLP’s number of holdings has been shrinking. They’re down to 14, and if Oneok’s acquisition of Magellan Midstream goes through that’ll knock them down to 13. They have an overweight to petroleum products – crude oil pipeline operator Plains All American is their biggest holding. They are underweight natural gas names, because most of them converted to c-corps. We prefer natural gas exposure over crude oil because it has a more robust growth outlook. Oil is primarily used in transportation.  

AMLP is also overweight smaller names, because there are so few MLPs to choose from. Crestwood (CEQP) is a 5.3% position, whereas it’s only 0.42% of the market as defined by the American Energy Independence Index. AMLP, ostensibly a passive ETF, has a 12X market weight position in CEQP because it has so few choices. 

Although global crude oil demand recently touched a record 103 million barrels per day, it is in the crosshairs of governments around the world adopting policies to reduce CO2 emissions. Natural gas is America’s biggest source of electricity generation at almost 40% and is used in many areas that solar and wind can’t serve, such as petrochemicals and fertilizer production. AMLP holders are unwittingly concentrating their exposure in the riskier part of the sector, because that’s where MLPs are.   

AMLP investors don’t just endure the drag of corporate taxes on the fund’s NAV versus its benchmark; they also face the uncertainty that those taxes have been calculated correctly. Last November (see AMLP Trips Up On Tax Complexity) and then again three months ago (see AMLP Has Yet More Tax Problems), Alps suffered the ignominy of disclosing a reduced NAV because of tax complexity. The two adjustments taken together wiped out the last three quarterly distributions.  

It’s unclear why AMLP’s distribution has dropped. Perhaps they have discovered yet more errors in their tax calculations. It remains the biggest ETF in the sector at $6.7BN, evidence that lethargy outweighs critical analysis among its holders. The characterization of its distributions as largely a return of capital used to appeal – this is common among MLPs because the tax code allows them to depreciate their assets even though their ability to generate earnings is growing. In effect MLP investors pay taxes on their distributions when they sell, at which point there’s a deferred income tax recapture. AMLP has in the past incorporated this appealing feature. 

However, this year its distributions have all been classified as income, meaning that taxable accounts have a tax liability this year. The changed nature of AMLP’s distributions coincides with the two NAV restatements, so it’s possible the tax analysis Alps has carried out is responsible. So AMLP now offers declining distributions wrapped in a vehicle that is taxed as a corporation, has restated its NAV twice in a year and no longer offers tax deferred distributions. If your financial advisor still holds AMLP in your account, you might want to see how much of this he really understands.  

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Midstream earnings are in, and generally met expectations as has been the case for the past several quarters. Williams Companies (WMB) enjoyed record natural gas gathering volumes of 18 Billion Cubic Feet per Day (BCF/D). This drove 2Q23 adjusted EBITDA of $1,611MM, versus analyst expectations of $1,568MM.

Liquefied Natural Gas (LNG) exporter Cheniere continued a run of positive surprises with a 13% beat of sell-side expectations and once more raised full year EBITDA guidance. Their success contrasts poignantly with the declining fortunes of founder and former CEO Charif Souki, forced out by activist Carl Icahn in 2015. The following year Cheniere began shipping LNG, and today their 6 BCF/D in volumes represents around half of US LNG exports.

Souki went on to found Tellurian (TELL), best described as a “Cheniere wannabe”. Tellurian has been trying for years to sign up customers and raise the capital required to build Driftwood LNG, an export terminal along Louisiana’s Calcasieu River. Souki is either a visionary who was early to recognize the export potential of US natural gas, or an entrepreneur with excessive risk tolerance always looking to enrich himself first. He’s probably a bit of both. When you invest with Souki, you know he’ll make money; you just don’t know if you will. Some have speculated that TELL would have more success raising capital with a new CEO.

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We noted Souki’s proclivity for excessive upfront compensation early this year when he negotiated $20 million in annual compensation even though Tellurian is years away from shipping any LNG (see Tellurian Pays For Performance in Advance). Developing Driftwood still looks like a long shot.

Souki routinely borrows against his own stock holdings. In early 2020 when TELL was plunging along with the rest of the energy sector, a margin call forced him to dump shares he owned. More recently, weakness in TELL led UBS to seize Souki’s 30-meter carbon fiber hull yacht Tango, pledged as security.

Every midstream company has something to say about their energy transition opportunities. Last year’s Inflation Reduction Act (IRA) increased the tax credits available for Carbon Capture and Sequestration (CCS). At its most generous, the Federal government will pay $180 per metric tonne for CO2 that is extracted out of the ambient air and permanently buried underground.

Even though a generation of young people is growing up mortally afraid that rising CO2 levels represent an existential threat, at around 412 parts per million (0.04%) it’s thinly dispersed in the air around us, and therefore expensive to extract. Nonetheless, Occidental (OXY) is building the world’s biggest CCS facility in Texas. In a few years expect to read that IRA tax credits are offsetting OXY’s tax liability on its conventional oil and gas business.

Sometimes the right geologic formation to permanently hold CO2 is the same one from which natural gas (CH4) was originally extracted. There’s an appealing symmetry in sending the carbon atoms back home after they’ve been separated from the four hydrogen atoms they arrived with while generating a useful chemical reaction that’s left them bonded with two oxygen atoms instead.

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EnLink (ENLC) is better positioned than most to do this, since they provide natural gas to a number of petrochemical facilities along the Mississippi River corridor. The emissions from these facilities have far higher concentrations of CO2. 50% or more isn’t uncommon. ENLC is exploring opportunities to capture some of this CO2 and send it in dedicated CO2 pipelines back towards the region that provided the natural gas whose combustion created it. They estimate that they can earn an EBITDA return of around 20% on invested capital. Midstream energy infrastructure long since stopped being threatened by the energy transition and is instead becoming vital to it.

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Magellan Midstream (MMP) and Oneok (OKE) reported good earnings as investors in both companies vote on their proposed merger. MMP’s adjusted EBITDA was 8% ahead of expectations and they raised their standalone EBITDA guidance for this year by 2%. OKE 2Q EBITDA beat expectations by just under 4%, and matched MMP’s full year increase in EBITDA guidance of 2%. One might ask why they need to combine when business seems to be going so well.

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Votes on the merger are being counted this week, and the market-implied odds of its passage remain finely balanced. We estimate that $3.1BN in value has been destroyed since the announcement in May. Both companies have scheduled a special meeting of shareholders for September 21, at which point the result will be announced. It looks like being a nailbiter.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Midstream earnings have been reported for the most part and generally came in at or close to expectations. Cheniere once again surprised to the upside, with 2Q EBITDA of $1.86BN versus market expectations of $1.62BN. They modestly increased full year guidance, carried out planned maintenance on their Sabine Pass facility on schedule and for the first time spent more cash repurchasing stock than on retiring debt.  

Magellan Midstream reported better than expected earnings and raised full year guidance at the same time as proxies were distributed to MMP and Oneok (OKE) investors to vote on the proposed merger. We estimate the market assigns “more likely than not” odds of shareholder approval. But it’s only a little over 50%, well short of the ringing endorsement both management teams would have liked.  

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We’re unhappy about the tax liability which should have been deferred at the investor’s option but will now become due this year if the deal closes (see Oneok Does A Deal Nobody Needs). We voted no twice – once for each company since we own both. We estimate that $3BN in equity value has been destroyed since the merger announcement. That’s derived from the aggregate market cap underperformance of both stocks versus the American Energy Independence Index (AEITR).  

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Canadian pipeline companies have long enjoyed a reputation for being conservatively run – at times reflecting poorly on their American peers. This was especially true five years ago when it seemed that the only management teams not pursuing growth at any price were north of the border (see Send in the Canadians! and Canadians Reward Their Energy Investors).  

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This year all three big Canadian firms (Enbridge, TC Energy and Pembina) have significantly lagged the sector. TC Energy (TRP) decided to unlock unrecognized value in their liquids business by announcing its spin-off. This announcement came a couple of days after they sold a minority interest in their Columbia Gas pipeline network to Global Infrastructure Partners at a lower multiple than many analysts had assumed it was worth. The expected 5X Debt:EBITDA leverage on the stand-alone liquids business raised eyebrows, and the market has even started to question the security of TRP’s dividend.  

A yield approaching 8% reflects skepticism that TRP will manage its substantial growth capex program and execute needed asset sales flawlessly. We’ve maintained an underweight exposure for the last couple of years, and we’re not yet increasing.  

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A chart from the US Energy Information Administration’s (EIA) recent Short Term Energy Outlook (STEO) prompted us to examine capacity utilization by power source more carefully. Over the past decade the increase in electricity generation from natural gas power plants is greater than the additional output from solar and wind, although you’ll see few headlines on the topic.  

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Increases in solar and wind capacity draw attention. But because they’re weather-dependent and it’s not always sunny or windy, they generate power less frequently and unpredictably.  

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Among carbon-free sources of power, nuclear operates at by far the highest capacity utilization. It’s always on and represents important baseload where it’s used. Hydropower is seasonal, generally best in the spring when snowmelt swells our rivers. Solar is barely over 20%. Offshore windpower tends to be more productive than onshore, but is more expensive too. 

With dispatchable power, coal and natural gas are moving in opposite directions. Coal plants run less efficiently when their output is stopped and then restarted. Power generation from natural gas plants can be ramped up and down more easily. A decade ago coal provided 28% of our electricity compared with 15% today. Coal capacity hasn’t fallen as quickly, hence its reduced capacity utilization.   

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By contrast, the utilization of natural gas power plants has increased, in part because of their greater flexibility in altering their output up and down – either because extreme hot or cold weather raises demand, but also because increased renewables penetration has made flexible, on call power more valuable. Natural gas power plants are a natural complement to renewables, because they provide responsiveness and reliability, qualities not found in solar or wind.  

When you look across the entire US power grid, capacity utilization has fallen from 41% to 36% over the past decade. This is because we’re using more solar and wind. Poorly informed advocates for renewables promote their apparently low cost per unit of power capacity. Sometimes they implausibly criticize utilities for willfully avoiding the cheapest source of power generation. But as our falling capacity utilization shows, this is a flawed measure of the true cost. The cost of dispatchable power or battery back-up needs to be included. Power prices in America are going up as unreliable energy sources gain market share. This shouldn’t surprise anyone, and yet we’re far better off than Germany and some other EU members with their dysfunctional energy policies (see Germany Pays Dearly For Failed Energy Policy).  

China emits the most greenhouse gases and these emissions continue to grow every year. So our climate will be set in Beijing, not Washington DC.  

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

It doesn’t look like a bull market, but July was crude’s best month in more than a year with the Brent benchmark closing up almost $11 per barrel at over $84. After peaking in spring of last year following Russia’s invasion of Ukraine, crude oil has been sliding irregularly lower. Russia has found ways to get its product to market, to the quiet relief of western Europe’s governments whose application of sanctions has been constrained by a desire to avoid causing a price spike. China’s long Covid lockdown further depressed demand.

OPEC wants stable, high prices and regularly tweaks output to that end. Traders now expect Saudi Arabia to extend their voluntary production cuts of one Million Barrels per day (MMB/D) into September. The US is also replenishing the Strategic Petroleum Reserve following the Administration’s blatantly political release of reserves in the run up to last year’s mid-term elections.

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Recession fears are also receding, helped by last week’s US 2Q GDP report. Goldman Sachs recently increased their forecast for global oil demand but stuck to their one year forecast of $93 for Brent. For now, the Fed has confounded the skeptics who believed monetary tightening would cause a recession (see Jay Powell’s Victory Lap)

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Peak oil is still out there somewhere, but for now demand keeps growing. The US Energy Information Administration (EIA) calculates that the second quarter saw record global liquids consumption of 100.96 MMB/D, marginally above the prior record of 3Q18 (100.91 MMB/D). For 2024 the EIA is forecasting 102.80 MMB/D, up from 101.15 MMB/D this year.

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The hot weather we’ve recently experienced in the US has boosted energy demand. But above average temperatures haven’t been the norm throughout the northern hemisphere. In any case, your blogger finds 90+ degrees less distressing than most following a childhood in the UK where the climate is euphemistically referred to as “temperate”, thanks to the moderating effect of the gulf stream. Damp and cool might be more accurate, as the current forecast shows. Britain’s efforts at lowering CO2 emissions are especially selfless, because they could surely benefit from an extra couple of degrees.

Record natural gas consumption for power generation has helped keep Americans cool over the past few days, with an estimated 52.9 Billion Cubic Feet (BCF) burned last Friday. That compares with an average daily consumption forecast for this year by the EIA of 34.5 BCF, which is up 1.3 BCF/Day from 2022.

Union Pacific expects railroad shipments of coal to receive a warm weather boost, as coal-burning power plants ramp out consumption to meet increased demand for air conditioning. However, coal is rapidly losing its share of power generation at 15%, down from 28% five years ago. Natural gas remains America’s favorite source of power at 41% this year, up from 39% last year. Solar is at 4% and wind 11%, both flat year-on-year.

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TC Energy (TRP) announced they’d be splitting the company into two last week on Thursday, 27th. Usually such announcements boost a company’s stock because it’s assumed each new entity will benefit from more focused management attention. Oddly, TRP sank on the news.

Three days earlier TRP had announced the sale of 40% of their Columbia pipeline system to Global Infrastructure Partners. The 10.5X EBITDA multiple was below what some analysts had valued the business at in their sum-of-the-parts analysis. This was followed by the spin-off announcement, and the relatively high projected 5.0X Debt:EBITDA leverage of the new stand-alone liquids business is high relative to peers.

After the price drop, TRP now yields over 8%. Canadian pipeline companies have a more robust history of maintaining dividends than their southern counterparts. A sustainable dividend at this level is likely to find value-oriented buyers.

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Finally, the Vogtle nuclear power plant in Georgia began commercial operations recently. It’s the first new nuclear power plant in the US since 2016 and only the second since 1996. The long hiatus since the early 1990s reflects public skepticism about nuclear safety along with the successful use of legal challenges by opponents to impede development. Nuclear power is expensive because our broken permitting process allows opponents to use the courts to insert unpredictable delays. This boosts the cost, thereby depressing the IRR. The same techniques have been used to delay needed pipeline infrastructure.

The Mountain Valley pipeline is an example – even though Congress recently fast-tracked its approval under the Fiscal Responsibility Act that headed off a debt ceiling crisis, a DC court still saw fit to impose a stay on resumed construction. It took an emergency ruling from the US Supreme Court (a “stay of the stay”) to allow construction to begin again. Long distance high power transmission lines and the related infrastructure in support of solar and wind will face similar headwinds. Reform of infrastructure permitting is an issue that both ends of the political divide should agree is well overdue.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Criticizing the Fed is a self-indulgence afforded the rest of us unburdened with the need to actually set monetary policy. The FOMC usually provides a target-rich environment. The last couple of years have offered a sumptuous feast of mis-steps. 

Start with synchronization of accommodative monetary policy with Biden’s uber-stimulus following his inauguration in early 2021. Quantitative Easing (QE) was promoted from a one-off solution to the 2008 great financial crisis to just another part of the Fed’s toolkit. Over the past fifteen years their balance sheet has taken a series of steps higher, from $1TN to $8TN, with only brief episodes of contraction. They don’t seem to know how to shrink it, so the partial monetization of our debt continues. 

Monetary policy has adopted its own vocabulary, repurposing words such as hawk and dove. Transitory has become a pejorative word since it more accurately described the seeming permanence of high inflation. One imagines a freshman Economics class at Harvard where a self-appointed member of the monetary policy cognoscenti derides a fellow student’s poor grades as transitory.  

Your blogger has taken regular shots at the Fed with irrational exuberance (see Time For Powell To Go). It’s just so easy. 

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So Fed chair Jay Powell might have permitted himself a small victory lap in the green room last Wednesday out of sight of the cameras following his press conference. He’d just announced another hike in the Fed Funds target range, to 5.25-5.5%. As recently as May SOFR futures had been priced for a summer’s end rate of 4.7% with imminent easing. Since then, the June ‘24 futures yield has risen almost 2%, conceding to the Fed. Powell said it’s unlikely they’ll cut rates this year. 

Inflation has been falling – not yet to the Fed’s 2% target but heading that way. JPMorgan is forecasting CPI inflation of 2.4% by next spring. The FOMC is projecting their preferred inflation measure using the Personal Consumption Expenditures (PCE) deflator to average 2.5% next year. PCE tends to be 0.2-0.4% below CPI because its weights adjust dynamically (CPI weights are updated biennially). So the FOMC inflation forecast is more conservative than JPMorgan’s. They expect PCE inflation to reach 2.1% by 2025.  

For months economists have been warning of a recession. JPMorgan projects that 4Q23 and 1Q24 GDP will each be –0.5%, meeting the technical definition of a recession which is two consecutive quarters of GDP contraction. But the day after the Fed raised rates second quarter GDP came in at 2.4%, ahead of expectations as consumption remained strong. Powell has maintained for months that a recession could be avoided, and he reiterated that view at his Wednesday press conference.  

One way to think about the Fed’s dual mandate of seeking maximum employment consistent with stable prices is that they focus on whichever of these two metrics is most off target. Hence in 2020 with inflation stubbornly low they said they’d tolerate higher inflation than in the past in order to achieve higher employment. That reinterpretation of their goals was as transitory as the higher inflation that followed.  

Older readers will remember Ronald Reagan citing the “Misery Index” (Inflation + Unemployment Rate) under President Jimmy Carter as reason to vote him out. If FOMC policymakers ran for office rather than being political appointees, Powell would be running ads proclaiming the Utopian Index (think of it as the Misery Index when it’s low) was looking as good as ever on his watch.  

Full employment is probably still somewhere above 4%, since the time it’s been below 4% has coincided with inflationary wage growth. Both JPMorgan and the FOMC are projecting unemployment next year of around 4.5% and inflation of around 2.5%. If things turn out that way, it will represent a deft monetary policy navigation that seemed implausible just a few months ago.  

Even hyper-active Jim Cramer, ever sensitive to the market’s zeitgeist, asserted on Thursday morning that he had always been a supporter of Fed chair Powell. He proclaimed himself a “Jay fan” — and even a “Jay Hawk.” 

Therefore, we must be at Peak Powell. The Fed’s critics have been relentlessly disarmed by empirical data that suited the Fed’s narrative more than theirs. Recession fears are receding. Inflation has not resisted downward pressure too stubbornly. Partial debt monetization via QE has not led to a collapse of the dollar or hyperinflation. The stock market has remained buoyant, unbowed by the improving returns offered by fixed income. Events have hewed more closely to what Powell told us to expect than the naysayers.  

Jay Powell should gratefully accept whatever accolades come his way. Popularity for a Fed chair is ephemeral. The economy is a fickle mistress. He is, for now, on top.  

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

The market currently assigns barely 50/50 odds of the Oneok-Magellan (OKE-MMP) merger receiving shareholder approval from both companies. When the deal was announced in May approval was judged to be highly likely, but it soon receded as analysts offered only lukewarm approval. We offered our view (see Oneok Does A Deal Nobody Needs) within a few days. In mid-June Jim Murchie of Energy Income Partners (EIP) wrote an open letter criticizing the transaction as not good for MMP unitholders, especially long-term investors whose recapture on deferred taxes will exceed the $25 per MMP unit being offered in the transaction.

EIP released a second open letter on July 17 which reinforced their reasons for remaining opposed to the merger. They contrast MMP’s current fear that electric vehicle adoption will threaten their refined products pipeline volumes with recent previously expressed confidence in their outlook. They calculate that the deal premium is inadequate to compensate MMP unitholders for the tax payments they’ll have to make. EIP correctly argues that while MMP unitholders already had the deferred tax liability that will come due if the deal closes, they currently have some control over when to realize that liability. The OKE-MMP transaction will make those deferred taxes due now. Control over the timing of one’s tax bill has value, which this transaction fails to acknowledge.

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The deal’s odds of success bottomed out in mid-June with EIP’s first letter. They subsequently recovered but have dipped again over the past week with the second letter. The market has already offered its opinion on the transaction, and it is value-destroying.

The 22% premium promised with the initial press release quickly evaporated as OKE stock sank, reducing its value as partial payment for MMP units. From the day preceding the deal announcement, MMP is today up 9% compared with its sector, defined as the American Energy Independence Index (AEITR).  OKE has lagged the AEITR by 4%. Because OKE’s market cap is around 2.3X MMP’s, an investor holding a market weight position in both companies is worse off than if she had simply held the AEITR. In aggregate, OKE and MMP investors together are $2.5BN worse off than if they had been invested in diversified midstream energy infrastructure. It’s therefore fair to say that even the modest likelihood of the deal’s approval has already destroyed $2.5BN in value. If the deal closes, investor losses will be even greater.

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We remain unconvinced of the deal’s merits and solidly opposed, eagerly awaiting the opportunity to vote NO twice – once on our OKE holding and again on our MMP holding.

Sometimes the most profitable capital allocation decisions are to divest assets rather than acquire them. This is the case with Kinder Morgan (KMI) and their sale of the Transmountain Pipeline expansion project (TMX) to Canada’s federal government in 2018. KMI had found themselves caught in the middle of a political dispute between oil-producing Alberta who wanted the added capacity to transport its crude to the Pacific coast, and liberal British Columbia who opposed it. Canada’s PM Justin Trudeau led the Canadian government’s acquisition of TMX for C$4.5BN, arguing its completion was in the national interest.

Five years later TMX is less than a year from completion and the cost looks like C$30.9BN, around 4X what KMI estimated when they began the project in 2016. As recently as February 2020 the Canadian government, which was by then the owner, estimated C$12.6BN. Then Covid forced a suspension of activity. Ongoing legal challenges from environmentalists and flooding added delays. Other drivers of higher costs cited include: “general construction industry and materials cost inflation, supply chain challenges, labor shortages, preservation of indigenous archaeological discoveries along the pipeline’s route, and low contractor productivity.”

Because the Canadian government wants to recoup its investment, the ballooning cost of TMX will be reflected in higher tariffs for shippers using the pipeline. Precise charges depend on the amount of capacity a shipper has committed to use and the term of the agreement. But RBN Energy, who recently published a detailed analysis of TMX, estimates that some customers could wind up paying more than C$10 per barrel.

To illustrate how expensive this is, Enbridge’s Canadian Mainline pipeline, which runs from Edmonton to the US midwest where it connects to pipelines to the US gulf coast, offers similar pricing. So Canadian Mainline will be competitive with TMX for access to crude oil export terminals even though it covers almost 3X the distance.

The outcome vindicates KMI’s decision to sell TMX. At the time the company said they would shut down the project if they couldn’t sell it. Had KMI retained TMX and continued construction throughout its tumultuous last five years, the spiraling cost would have weighed significantly on its stock price. Asset sales don’t come with a post-disposition IRR, but this might be the best capital allocation decision KMI has made in a very long time.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Exxon Mobil (XOM) is not typically associated with Liquefied Natural Gas (LNG) but they are planning to double the volumes they handle by 2030, to 40 million tonnes pa. This would be equivalent to around 5.3 Billion Cubic Feet per Day (BCF/D). The US currently exports around 12 BCF/D although that will grow as new LNG export capacity is developed. XOM is a JV partner in the Golden Pass LNG Terminal in Sabine Pass, LA along with Qatar Energy. They have ownership stakes in LNG infrastructure around the world including in Qatar, Papua New Guinea and Wales. They plan to partner with Qatar Energy to build liquefaction facilities in Texas and Qatar.

From natural gas production to liquefaction, marketing and regassification, XOM is planning to play a role throughout the value chain. Like us, they expect strong long term demand growth. Asia has historically been the leading destination for LNG trade, but Russia’s invasion has created new demand from Europe.

XOM sponsors a cool interactive map that shows where all the world’s LNG infrastructure is located and provides information about ownership, volumes etc.

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The US is largely an LNG exporter. The red stars on the US map are operating liquefaction terminals. Yellow and orange are at various stages of planning or construction. The US does import LNG, most famously in Boston (see two adjacent green stars) to compensate for the impediments they’ve imposed on natural gas pipelines (see Why Liberal States Pay Up For Energy).

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The map of China and Japan shows an extensive network of regassification facilities (green stars). The red stars and other colors in this chart are, confusingly, import terminals under construction not LNG export terminals as on the US map. If you examine the maps very closely you’ll see that five-pointed stars denote LNG export and a Star of David denotes import, regassification. But the overall picture is that Japan can import LNG at many points along its coast. China has well over a dozen import terminals under construction. China is likely to displace Japan this year as the world’s biggest LNG importer.

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The map of Europe shows that most of the LNG import terminals are in southern Europe. Germany wasn’t able to rely on these to replace Russian imports because Europe hasn’t invested in pipelines to move natural gas north. France has long opposed building a pipeline across the Pyrenees. European energy policy was never concerned with energy security and always assumed natural gas demand would drop. Germany quickly set about building regassification facilities on its north coast and has several more planned. European gas demand has been falling, but that’s partly because manufacturing businesses are transferring production to countries that can provide energy that’s reliable and cheap. Dutch fertilizer company OCI is investing $1BN in a Texas ammonia plant that will access cheap local natural gas, and then earn Inflation Reduction Act tax credits by sequestering the CO2 by-product underground (see Sending More Carbon Back Underground).

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America’s per capita GDP has steadily pulled away from Germany’s and other advanced countries, most notably over the past decade or so (see Celebrating The 4th of July). We can all find much to criticize about our politicians, but at least government gets in the way less here than in other countries.

Cheniere exports around half of America’s LNG. They’re considering adding a new pipeline in Louisiana to add supply flexibility to their export terminal. Natural gas is a cleaner substitute for coal, and China’s growing LNG imports offer the hope that they will at some point reduce their industrial use of coal. Ship owners are also investing substantial sums to use LNG. In most cases this is replacing bunker fuel which is highly pollutive and is being phased out via global environmental regulations.

New windpower continues to face spiraling costs. The UK has made good use of the blustery North Sea, but Sweden’s Vattenfall recent halted work on a project intended to power 1.5 million UK homes because the cost has risen 40%. “What we see today, it simply doesn’t make sense to continue this project,” said Vattenfall chief executive Anna Borg.

Vattenfall took an impairment charge of $537MM. Evidently the UK government declined to adjust the terms of the contract to allow work to continue. By contrast, NJ governor Phil Murphy when faced with a similar problem recently redirected Federal tax credits worth up to $1BN to Danish firm Orsted so they can continue to build wind turbines along the NJ coastline (see Environmentalists Opposed To Windpower).

When contemplating the prospects of LNG versus windmills, we always take the former.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund