June 2016 - SL-Advisors

Hearts Outvote Heads in Brexit

June 26, 2016/1 Comment/in Global Issues/by Simon Lack

It’s been 34 years since I left the UK and moved to the U.S., and 25 years since I became a U.S. citizen. I long ago lost the right to vote in UK elections, having by now spent two thirds of my life in the New World. But I shall never lose my pride at growing up English nor my intense interest in what’s happening there.

So I have followed the Brexit vote avidly. It has been described as a struggle between the head, which rationally questions how the UK’s economic prospects can be better with the uncertainty of leaving, and the heart, which laments the loss of sovereignty which EU membership demands. Had I voted, my head would have won and I would have checked the “Remain” box, but I have friends on both sides of this highly divisive issue and I can appreciate the frustrations of the majority. Meanwhile, the EU faces another existential crisis.

U.S. citizens are often aghast to learn of the rules agreed to by successive UK governments in order to be an EU member. The British tabloid press routinely shouts about un-elected bureaucrats in Brussels imposing ridiculous standards of conformity, apparently to promote a more competitive EU-wide market, Many are untrue and some apocryphal, but bananas and cucumbers (to cite just one example) are subject to EU standards on size and curvature. One struggles to comprehend the mindset behind these or the motivation of those who toil to make such rules. I recently heard that EU horseshoes have certain size requirements, which causes at least one UK blacksmith to painstakingly heat and reshape the ones he buys before they’ll fit local horses. Although I couldn’t independently confirm this story, there have been enough similar instances to cause millions of Britons to roll their eyes.

But the major issue was immigration, and an enlarging EU burdened with permanently slow growth because of its catastrophic embrace of the Euro has seen increasing numbers of its citizens migrate north-west to the UK’s more vibrant economy and job market. EU membership requires free movement of EU citizens within EU borders, and an island nation that has repelled European invaders for many centuries was never going to sit comfortably with this. When I was growing up, a vacation in Italy was described as “going to Europe” or to “the Continent”. “Fog in English Channel — Continent Cut Off” is thought to be a newspaper headline from my grandparents’ time. Whether it actually existed or not, the sentiments it represents did, and in some cases perhaps remain today.

If George Soros and other speculators had not demonstrated so spectacularly in 1992 that the British Pound could not stay linked to the Deutsche Mark, the UK might have subsequently joined the Euro, and by now be suffering similarly slow growth with the rest of the Eurozone. It would at least have deterred some immigration. But Britain has always been more ambivalent about the EU than its founding members. The welcoming of over one million refugees into Germany last year, while a huge and selfless act by Germans, rendered UK PM David Cameron’s promises to limit immigration both more vital and less credible.

When a country eschews tangible economic results such as GDP growth and job creation in favor of intangibles like a feeling of greater sovereignty, investors must acknowledge that the pursuit of corporate profits is not everyone’s priority. While it’s foolish to infer anything about the U.S. election, free trade isn’t as important to as many people as establishment politicians might hope. Populism is a force in other countries including the U.S. The benefits of open markets are broad but not uniformly distributed, and the less economically fortunate are finding their voice.

The vote split sharply along regional lines, with London, Scotland and Northern Ireland voting to Remain while most of the rest of England chose Leave. Now a second Scottish independence referendum is likely and it may see the union of 1707 dissolved, while Northern Ireland may be reunited with the Irish Republic. A diminished Britain reduced to England and Wales may seek to deepen its economic ties with the U.S.; London to New York is 3,500 miles, 1,000 miles more than Los Angeles to Hawaii. Or the UK may have second thoughts about Brexit, since the economic pain is likely to occur far sooner than freedom from EU rules. A second EU member could also leave — the Netherlands may hold their own referendum. There are many possibilities and few certainties. Nobody can really be sure how events will unfold.

There was also a generational divide, with younger voters less bothered by immigration and enamored of their EU-wide mobility while older voters reflected nostalgia for the Greater, more ethnically Anglo-Saxon, Britain of old. Because of the propensity of seniors to choose Brexit, a meaningful portion of the 3.8% margin of victory will have passed on before the UK finally negotiates its exit. Consider this quote from one young voter: “Freedom of movement was taken away by our parents, uncles, and grandparents in a parting blow to a generation that was already drowning in the debts of our predecessors.” U.S. baby-boomers are also leaving an unwelcome legacy of debts to cover their un-financed retirement healthcare (Medicare). Different generations are steadily finding theirs interests no longer aligned.

Brexit’s economic impact will affect the UK economy substantially with some forecasting an immediate recession because of the uncertainty. Any long term investment decision confronts acutely difficult assumptions. But if it’s bad for the UK it must be worse for the Eurozone. At least the UK knows where it’s going if not exactly how it’ll get there. Many other EU countries know neither, which is why Eurozone stock markets fell substantially more than the UK’s FTSE. Brexit is far from being just a UK problem. The Euro really didn’t need this.

Nonetheless, life will go on. Consumers will buy what they need and energy will be produced and used. Low volatility stocks will remain that way, relative to the S&P 500 at any rate, and U.S. energy infrastructure is, thankfully, over here rather than over there. Not immune to the turmoil voters have unleashed, but only tangentially impacted.

UK voters have finally tired of an EU that delivers edicts and fiscal austerity. While I wouldn’t have voted to Leave, I am deeply proud of this small but highly consequential nation that has the self confidence to abandon the certainty of a dysfunctional club so as to take back control of its future, uncertain though it may be.

Why Oil Could Be Higher for Longer

June 19, 2016/1 Comment/in Midstream Energy Infrastructure/by Simon Lack

Last week Wood Mackenzie released a report estimating that oil and gas companies will spend $1TN less on finding and developing new reserves through 2020 than was expected to be the case before the 2014-16 oil price collapse. 2016 reductions in capex have been estimated at $300-400BN, but this is the first credible figure we’ve seen over a longer period of time. It’s likely to be followed by substantial changes in the crude oil market that will benefit U.S. shale producers.

To see why this is the case, consider how the risk profile of a conventional new crude oil project has shifted. Whether it’s offshore, or Canadian tar sands, these plays require substantial upfront capital investment with a payoff over many years. If it’ll take you five years or more to extract and sell enough crude oil to earn an acceptable IRR, you are simply long crude oil. Exploration and production companies (E&P) routinely hedge only for a couple of years out, because that’s all that the liquidity of the futures market will reasonably allow. For example, Pioneer Natural Resources (PXD) shows 85% of this year’s crude production hedged but only 55% of next year’s. This is fairly typical.

The price collapse of last year, combined with the growth in U.S. shale extraction and enormous cut in capex, reveals the following calculus: evaluating a new conventional project requires assessing some probability of another price collapse to $30/BBL or lower during the life of the project. Prior large drops in oil, such as in 2007-8 or 2000 coincided with a recession and were the result of a drop in economic activity. While softening global growth bore some responsibility for the most recent drop, it was largely caused by supply increasing faster than demand.

So now imagine the difference in risk assessment facing an E&P company contemplating an investment in a new shale project versus a conventional one. Shale extraction is characterized by large numbers of individual wells completed relatively quickly with high and sharply declining production. Data from the Energy Information Agency shows that the cost of drilling a single well in any of the five most prolific U.S. shale regions has fallen to $6-7MM. Much has been written about declining production costs, which is why U.S. crude oil production only dropped from 9.5MMBD to around 8.5MMBD even while the rig count fell by 75% 2015-16. That increased efficiency includes better use of drilling rigs, so they’re not needed for as long to drill a well. The corresponding fall in costs has also shortened the time to break-even for shale drilling.

By contrast, in Canada the enormous upfront investment required in a tar sands project meant that production has continued to ramp up seemingly impervious to the price of oil. Steam-Assisted Gravity Drainage (SAGD) involves sinking pipes into the bitumen to heat it up for extraction. Shutting down production risks the pipes freezing, causing potential damage to the facility. So Canadian operators have continued production even at prices that fail to cover their operating costs because of the risk to their huge capital investment.

The consequence of a price collapse in the future looks entirely different to these two operators. The U.S. shale operator is nimble and can rely on hedging production because high initial production rates mean more oil is produced sooner. But the shale operator also knows he can respond to lower crude prices by stopping drilling. He has a short response time.

The tar sands operator has to make a long term forecast on crude oil that cannot be hedged. He has no way to mitigate his exposure to prices years out, and his scenario analysis now has to incorporate some possibility of a repeat of 2014-16. Moreover, the existence of shale oil production raises the risk of a future temporary collapse, precisely because the E&P companies whose collective activity might cause it can so easily respond and protect themselves.

The swing producer is not the lowest cost producer, but rather the producer whose time to break-even is shortest. The risk of a future big drop in oil is why $1TN in capex has been cut. The market has changed, and it favors the nimble producer who can exploit temporarily high prices and then drop back when prices do. We may have a permanently higher crude oil price over the long run, precisely because the risk of ruin dissuades the big projects whose supply would lower prices. Canada may never see another new tar sands project. The outlook for U.S. shale, with its constantly improving technology, falling break-evens and short time required to recover capital invested, looks very bright indeed.

Vote No on the Energy Transfer-Williams Merger

June 12, 2016/0 Comments/in Midstream Energy Infrastructure/by Simon Lack

The Energy Transfer-Williams merger continues to be a bizarre spectacle. While the Williams (WMB) Board in an SEC filing noted that a majority was in favor of the merger, their body language says otherwise. They are speaking in code. The filing notes that anticipated synergies from the transaction are virtually zero and that the new ETC stock for which WMB holders will exchange their shares will not pay a dividend for two years. On top of this, three former CEOs of WMB published a letter noting the move by Energy Transfer Equity (ETE) CEO Kelcy Warren to dishonestly enrich himself at the expense of other unitholders (see Is Energy Transfer Quietly Fleecing Its Investors?). They emphatically recommended against the merger. WMB has complied with the merger agreement by recommending a YES vote, but that’s a technicality, required to avoid a $1.48BN break-up fee. Neither company wants to do the deal, but both want to avoid triggering penalties or legal liability for failing to close. WMB even disclosed in a subsequent SEC filing that a dividend cut was likely if they remain independent, so for WMB holders it appears that in either case payouts will be smaller. The stock barely retreated on this news – perhaps the 12% free cashflow yield already provides sufficient support.

We read between the lines and voted NO. We’re comfortable with our modest exposure to Kelcy Warren, but don’t wish to increase it by trading in our WMB stock. We are invested in ETE and WMB.

The chart below is a helpful visual that puts recent moves in the Alerian Index into perspective. The 2015 MLP Crash (which looks like it ended on February 11, 2016) looks similar to the 2007-08 Financial Crisis, at least in terms of the price moves. For much of 2015 MLPs endured their own personal market disaster while other sectors of the equity market outside of energy paid little heed. At 58.2% it was the biggest drop in the Alerian Index’s history, going back to 1997. For those who find such comparisons useful, big drops in the sector have been followed by proportionately big recoveries. So for example, the 52.3% drop in 2007-08 was followed by a 139% recovery over the following two and a half years. As the chart shows, if past is prologue there’s still a long way to go. As we are frequently reminded though, past performance is not indicative of future results. Therefore, our constructive outlook on the sector is predicated on fundamental supports such as valuations and the positive long-term outlook for U.S. hydrocarbon output as we head towards energy independence.

MLPA Conference Attendees Cautiously Assess the Future

June 5, 2016/0 Comments/in Midstream Energy Infrastructure/by Simon Lack

Last week was the annual Master Limited Partnership Association (MLPA) Conference, held in Orlando, Florida. Conferences held in the Sunshine State in June undoubtedly receive a discounted rate compared with January – perhaps some frugality was appropriate given last year’s sector performance. Many were happy simply to have survived the 2015 Crash with their businesses still intact. The Hyatt Regency is a vast facility, although within such a cavernous venue the 10-20% drop in attendance meant it was never crowded, reflective of MLPs remaining an out of favor sector. While there were certainly no signs of a bubble, I can personally attest to the high quality hors d’oeuvres and how they helped promote warm feelings among attendees at the end of each day.

Although events revolve around the formal presentations made by MLP executives, far more useful is the opportunity for more intimate meetings with key individuals running our portfolio companies as well as comparing views with other industry professionals. While most MLPs were represented, a notable absence were Energy Transfer and Williams Companies (WMB). They no doubt concluded that questions would revolve around their contentious merger which has generated multiple lawsuits, and since there’s probably little they can say on the matter there was no point in being there. They were a subject in countless conversations though.

Energy Transfer CEO Kelcy Warren has drawn widespread opprobrium for the recent convertible preferred issue that dishonestly transfers wealth from Energy Transfer Equity (ETE) investors to management (see Is Energy Transfer Quietly Fleecing Its Investors?). WMB has already filed suit on the matter, although their interest in its resolution will drop once the bigger question of the proposed merger is concluded. But conference participants widely derided ETE’s newly granted securities as self-dealing, even fraudulent. It would seem likely that others will sue ETE over this issue if it’s not resolved by WMB. ETE’s ability to credibly engage other managements on possible combinations in the future has been damaged, perhaps irreparably. The question for Kelcy Warren is whether his legacy will include amassing great wealth in part by defrauding his investors. We monitor developments with interest.

One participant noted that there were more bankers in attendance than actual investors, no doubt reflective of the sharp drop in capital markets activity in recent months. M&A deals haven’t occurred in sufficient quantity to fill the gap in bankers’ fee income, as the common refrain about overly wide bid/asks on possible transactions was widely blamed. The same search for transactions attracted an abundance of lawyers, including fifteen from one firm.

In recent years the midstream sector responded to the Shale Revolution with sharply increased growth plans. Much of this was a logical reaction to the huge increase in domestic hydrocarbon production. However, several management teams noted that this put pressure on cashflows since projects must be financed before they generate any return. They attributed the 2015 collapse to this as well as a tendency to “just-in-time” finance, in that equity capital is raised only when actually needed rather than at the inception of a project. The downturn exposed balance sheets in a way that won’t soon be forgotten, and a more conservative approach to funding projects is likely to be the industry norm.

A panel discussion titled “Is the MLP Model Broken” predictably concluded it wasn’t, but a slide from Kevin McCarthy at Kayne Anderson (reproduced below) showed how far from home some underwriters had strayed, with 40% of IPOs since 2008 being non-midstream. Midstream is all we invest in, and most of the 40% non-midstream issues should never have been offered in the MLP structure. Their subsequent performance was a whopping 37% worse than midstream IPOs – examples include recently bankrupt Linn Energy (see Why Linn Energy Was the Wrong Kind of MLP).

The overall atmosphere was cautiously positive, in the same way that surviving a near-death experience makes one appreciate even the mundane. Churchill once noted there was nothing more exhilarating than to be shot at and missed. Such might accurately reflect the emotions of MLP investors following last year’s crash. Just being at an MLP conference provides welcome proof of one’s continued financial existence.

As mentioned, the smaller meetings with senior management of companies in which we’re invested were far more useful than the formal presentations in the enormous ballroom. EnLink Midstream (ENLC), Western Gas Equity Partners (WGP), Plains GP Holdings (PAGP), Crestwood Equity Partners (CEQP) and SemGroup (SEMG) were among those who provided helpful additional information as well as confirmation of their appropriateness in our investment portfolios. Although such interactions are governed by “Reg FD” to ensure all relevant information is fully disclosed to all investors at the same time, it’s still possible to draw insights about strategy with well-crafted, open-ended questions. Asking a CFO what element of their business is least appreciated by most investors can produce useful insights.

Over the past several months increasing concern has been voiced about the enforceability of gathering contracts by midstream MLPs on oil and gas drillers facing bankruptcy. On this question anecdotal feedback overwhelmingly supported the conclusion that hydrocarbon production not dispatched through its contracted gathering and processing infrastructure has few good options. No bankrupt E&P company will induce a new G&P provider to build new infrastructure following a contract dispute with its existing G&P firm. The midstream MLP in such cases holds the stronger negotiating hand. One banker reported to me that he had an MLP borrower with two E&P customers in bankruptcy and he wasn’t worried; even in bankruptcy they’d still need cashflow, and continuing production was the only plausible way to generate it.

The cautiously optimistic tone from a crowd largely chastened by last year’s crash reflected little complacency and a conviction to avoid some of the overly ambitious growth that occurred in the recent past. This should provide a solid foundation for returns in the future.

We are invested in CEQP, ENLC, ETE, PAGP, SEMG and WGP

Archive for month: June, 2016