Rich Kinder's Wild Ride

Earnings season is here, and with it the quarterly ritual of the earnings conference call. Quite a few MLPs have declared their distributions, and of the 32 that we’ve seen so far none have cut while half have announced increases. Those we care about include Western Gas Equity Partners (WGP), which announced a year-on-year increase of 19.2%. Its MLP Western Gas Partners grew at 10.7% year-on-year, illustrating the faster growth enjoyed by General Partners. Similarly, EQT GP Holdings and EQT Midstream, increased their 2Q16 distributions 63% and 22% respectively over 2Q15. Magellan Midstream (MMP) grew at 10.8% year-on-year, while Crestwood Equity Partners (CEQP) was flat after cutting its distribution in April (see Crestwood Delevers and Soars). CEQP still yields over 11%.

Kinder Morgan (KMI), no longer a Master Limited Partnership (MLP) but nonetheless a bellwether of the sector, reported a solid quarter and maintained its dividend (slashed by 75% in December) unchanged. KMI is big enough that their fortunes are somewhat reflective of the overall energy infrastructure industry. Chairman Rich Kinder can scarcely have had a wilder ride than the last three years. In January 2014, frustrated by the weakness in KMI’s stock price in the face of relentless criticism from a small research firm, Kinder famously said, “You sell. I’ll buy. And we see who comes out best in the long run.”

Kinder no doubt believes the long run is longer than the time since he spoke those words, because KMI is still substantially lower than it was back then. Kinder was still bullish at the top, and his antagonist remained bearish at the bottom. At least they both have conviction. Like other MLPs, Kinder Morgan identified growth opportunities beyond the appetite of traditional MLP equity investors to provide financing. In 2013 MLPs were raising more in equity capital than they were paying out in distributions (see The 2015 MLP Crash; Why and What’s Next). The Shale Revolution had created the need for more infrastructure, but it still strained their traditional financing model almost to breaking point. Kinder of course abandoned the MLP model altogether and became a conventional corporation (a “C-corp”), which made their stock available to any global investor and not just the limited pool of U.S. taxable, K-1 tolerant buyers. For the rest of the MLP sector, new mutual fund and ETF buyers provided an additional source of equity capital for a time, but falling prices caused some of them to exit. Every MLP investor by now knows how 2015 ended. KMI hoped to maintain the MLP distribution payout model of returning approximately 100% of Distributable Cash Flow (DCF) to investors. Finally, with the double-digit yield on their stock communicating a complete absence of gratitude for this largesse, they accepted the inevitable and slashed the dividend so as to delever their balance sheet (see Kinder Shows The MLP Model is Changing).

Which brings us to the most recent earnings call. Successful, big companies don’t shift strategy every quarter, even if sell-side analysts desire more “market-responsive” (i.e. fickle) planning. KMI had long argued that a Debt/EBITDA ratio of 5.5-6.0X was appropriate given their diversified business. The strategy shift triggered by the dividend cut in December was accompanied by a new, relentless focus on bringing this leverage ratio down to 5.0X. The cash saved by reducing the dividend was earmarked for paying down debt and financing growth projects, resulting in a less levered, self-financing KMI.

December 2015 to July 2016 is scarcely the long run by most standards. Nonetheless, analysts on the recent call were heard asking why KMI couldn’t finance some of its backlog of growth projects by issuing debt. Their $13BN backlog has a capex/EBITDA multiple of 6.5X, and is currently financed fully with internally generated cash (i.e. equity). This is down from 7.5X at their Analyst Day earlier this year, the result of “high-grading” their backlog (i.e. dropping the less attractive ones).  With a 15% unlevered after-tax return target on projects and a borrowing costs in the low single digits one can begin to see the appeal of debt financed growth.

Two quarters ago, sell-side analyst questions revolved around the speed at which KMI could reduce its leverage. Today, they’re being asked why they don’t increase leverage. One can hear the sighs of exasperation in the management team as they respond to the shifted goalposts such questions represent. It’s why running a private company can be more attractive – in fact, we often noted last year that if MLPs were unlisted and investors had to rely fully on financial statements in their evaluations, they would have concluded that not a great deal had changed. But this rapid shift in sentiment is what creates the opportunities for those that are able to keep their eye on the ball. Happily, Barron’s is shifting gears rather more slowly, with their first cautiously positive piece on MLPs in recent memory (see MLPs: Is It Safe to Dive Back Into the Pool Yet?). Skepticism is good.

We are invested in CEQP, KMI, MMP and WGP

 

Coals to Newcastle

The expression “like sending coals to Newcastle” can be traced back to the 17th century, reflecting the insight that whatever else Newcastle needed in those days did not include coal. This windswept port on the North Sea was conveniently located near some of the biggest coalfields of northern England. During its heyday, American trader Timothy Dexter defied common sense and sent a shipment of coal to Newcastle, causing anticipation of a substantial loss. However, perhaps by luck he had the good fortune for his cargo to arrive during a miners strike, thereby profiting from unusual and temporary demand. Coal exports have long since ceased along with local coal production. Today’s Newcastle possesses little of note beyond an English football stadium with capacity well in excess of their local team’s ability (they were just relegated from the Premier League). Meanwhile, Newcastle in the Australian state of New South Wales has become the world’s most prolific coal exporting port.

LNG to the UAE doesn’t quite roll off the tongue as easily as Coals to Newcastle, but it might be a modern-day equivalent. The Middle East has 2.8 quadrillion cubic feet of proved natural gas reserves, enough to meet current global demand for 23 years. OPEC reports that the United Arab Emirates (UAE) holds around 10% of this. And yet, earlier this year the Energy Atlantic LNG tanker unloaded 3.38 BCF (Billion Cubic Feet) of natural gas at the port of Jebel Ali, near Dubai, following an almost seven week journey from the Sabine Pass LNG terminal in Louisiana.

Somehow the power of economics (see Why the Shale Revolution Could Only Happen in America) has overwhelmed the logic of geographic proximity to make such a delivery commercially reasonable in spite of abundant local resources. To show this was no fluke, more recently the Creole Spirit unloaded a similar amount in Kuwait, also sourced from Sabine Pass. The region hasn’t developed sufficient energy infrastructure to properly exploit its resource domestically.

The story of America’s Shale Revolution was built on the single-minded pursuit of unconventional fracking technology by many independent exploration and production (E&P) companies as well as some extraordinary chutzpah by a few. The Frackers by Greg Zuckerman memorably tells the story of some of them. Cheniere Energy (LNG) under then-President Charif Souki was once intent on importing LNG into the U.S. to take advantage of relatively high domestic prices. Cooling natural gas to a near-liquid state (at -260° F) so it can be moved in a condensed form by ship requires a substantial investment (i.e. US$BNs) to create such a facility, as does the construction of a regasification plant on the receiving end. Souki’s career wasn’t obviously suited to leading Cheniere on this journey, having been primarily focused on raising money for banking clients in his native Lebanon and elsewhere in the Middle East. His past also included a stint as restaurant owner of Mezzaluna, the now infamous Los Angeles eatery where Nicole Simpson ate her last meal on June 12, 1994 before being slain by O.J. Simpson (ahem…allegedly).

Undaunted by the absence of any relevant experience, as President of Cheniere Souki set out to use his former banking ties to finance their new business. The Shale Revolution led to a collapse in domestic natural gas prices and turned the economics upside down, causing Cheniere to turn from prospective LNG importer to exporter.

The facility that can regassify LNG for normal use is not the same one that can liquify it for long distance transport. Converting an LNG import facility to an export one is not the same as reversing a pipeline, and many more $Billions were required for Cheniere to be ready for business. Just as export operations began, Souki was pushed out by its board of directors which included Carl Icahn. The boss’s substantial risk appetite was by now well known, but his latest plan to add a gas trading business was a risk too far for investors who could finally see actual cashflows on the horizon. Souki’s compensation over the years had matched his ego, but recognizing that his risk appetite didn’t match ours we have never invested in Cheniere.

The Sabine Pass facility began exporting late last year and is eventually expected to handle 3.8BCF per day. Some of its supply travels from the Marcellus shale in Pennsylvania along the Transco pipeline network owned by Williams Companies (WMB), in which we are invested. A few weeks ago I had the opportunity to be presenting in Laceyville, Pennsylvania to a group that included landowners receiving royalty checks from the production of natural gas under their property. As we noted last week, few countries assign mineral rights to the owner of the land beneath which they sit.

For just a moment, step away from the prosaic question of the market’s near term direction and consider this: an Egyptian-born Lebanese former restaurant owner raised $Billions to export liquefied natural gas over 11,000 miles to a region of the world whose wealth is totally reliant on hydrocarbons. It couldn’t have happened anywhere else, except America.

We are invested in WMB

Why the Shale Revolution Could Only Happen in America

A few weeks ago we wrote Why Oil Could Be Higher for Longer, and since then it has elicited quite a few comments back to us from clients and blog subscribers. We won’t repeat it in detail here since readers can simply click on the link above to see it. But our view is that the outlook for U.S. crude production over the intermediate term is very constructive, and certainly better than current consensus. This relates to the superior economics of shale wells compared to conventional drilling, and the associated ability of shale Exploration and Production (E&P) companies to quickly respond to changing prices by adjusting drilling activity faster than their peers.

“Shale wells,” (i.e horizontal wells drilled into source rock and stimulated by fracking) have many competitive advantages over conventional wells that give us confidence American production of Oil, Natural Gas Liquids (NGLs), and Natural Gas will greatly exceed consensus expectations to meet new energy demand and fill the void left by depleting fields.

A recent article in the Financial Times expanded on this theme (U.S. shale is lowest-cost oil prospect). A chart accompanying the article showed the break-evens of twenty potential future projects and the cheapest half-dozen are U.S. shale plays. In fact, shale oil development benefits from many of the advantages that are inherent in the U.S. Most Americans take for granted that property ownership comes with mineral rights for anything found below their property, but around the world this is by far the exception. In most countries mineral rights belong to the government. Getting a farmer to agree to allow drilling on his land is easier if he’s able to negotiate a monthly royalty check as opposed to a central authority simply exercising its control.

Blog July 17 2016 Image 1

Although many of the cheaper sources of new oil are U.S. shale, Wood Mackenzie doesn’t believe there’s enough to satisfy the world’s consumption at current prices. Depletion of existing fields plus new demand create a need for roughly 6MMBD (million barrels a day) of additional supply annually. The market will clear at the marginal cost of the most expensive barrel needed to balance the market – a price that looks a good bit higher than today’s spot price. And for those who think offshore drilling can be attractive, BP just announced the final charge of $5.2BN for the 2010 Deepwater Horizon spill in the Gulf of Mexico. Their total costs for this one incident add up to $61.6BN, a hit only a few global companies could absorb. You can be sure that any offshore drilling in U.S. continental waters has to account for this possibility in its risk analysis.

Critically, low-cost U.S shale wells can be drilled much more quickly and come on with significantly higher initial production (IP) rates with steep decline curves.  In fact, a new shale well can go from planning to full capital payback before most new conventional  projects are even producing.  This fast decline rate also allows shale oil producers to hedge the bulk of their production, which occurs in the first several years, in the futures market which is only liquid for a few years out.  It’s worth noting that the quicker the payback the quicker shale E&Ps can plowback cash into new shale drilling. The chart below from the U.S. Energy Information Agency highlights how IP rates have improved over the past few years (click on image to expand).

 

Geographically, the U.S. is blessed with generally sufficient water supplies close enough to the shale plays that they support, since fracking requires a lot of water. Entrepreneurial drive is as strong a force in America as anywhere, and that combined with highly developed capital markets make access to financing and substantial wealth accumulation possible for those who are able to profitably exploit this resource. And continued technological innovation spurred by entrepreneurs is relentlessly driving costs down faster than most expected and faster than conventional plays, further increasing their competitive cost advantages, playing to another American strength.

Even with all the American advantages and helped by the tailwind of high commodity prices it still took a decade for shale drilling to have a meaningful impact on output. Major shale drilling anywhere outside the U.S is a long way off, providing a huge first mover advantage.

In other words, the shale revolution is occurring because of all these inherent strengths in the U.S. On top of which, energy independence which is where we’re heading as a result, is in our national interest and highly likely to remain that way. The entire story is built on U.S. advantages and oriented towards U.S. interests. From a strategic perspective, given what we know today, it seems to us that perhaps the best secular investment theme available is the continuation of this trend, to the obvious benefit of the midstream infrastructure Master Limited Partnerships (MLPs) whose support is critical.

It’s no longer the case that a distribution cut is bad for an MLP. In April, Crestwood Equity Partners (CEQP) cut its distribution at the same time as announcing a JV with Con Edison and steps to reduce its leverage (see Crestwood Delevers and Soars). Last week Plains GP Holdings (PAGP) announced a simplified structure with its MLP Plains All America (PAA) and an 11% distribution cut at PAGP. Both stocks moved sharply higher on a perceived lower cost of capital and therefore improved growth prospects. Williams Companies (WMB) is likely to cut its dividend so as to reduce leverage, but at a 12% yield there can be few who would be surprised by this. A distribution cut in support of a stronger balance sheet seems to attract more buyers than sellers nowadays.

Blog July 17 2016 Image 2Lastly, we note that Shell Chemicals is investing $6BN in a new ethylene facility in SW Pennsylvania near Pittsburgh (artist’s impression from Shell at left). It’s located there to be close to its supply of ethane in the Marcellus and Utica shale areas, of which it expects to consume 90-100 thousand barrels a day. The facility will in turn produce 1.5 million tonnes per annum (MTPA) of ethylene and 1.6 MTPA of polyethylene, widely used in everything from food packaging to automotive components. This is not a region that has seen a new large industrial project such as this in living memory. It’s another example of the tangible results of the shale revolution.

We are invested in CEQP, PAGP and WMB

More Thoughts on Brexit; AMLP Reaches a Milestone

The Brexit vote is now two weeks behind us and I still watch developments with jaw agape. Rarely in history has the consequence of a popular vote led so directly to a recession. The IMF has forecast that the UK economy will shrink by 1.5% through 2019 if they agree to a Norway-style EU access (i.e. similar EU budget obligations, lack of immigration controls and submission to EU regulations but with no ability to influence them, not exactly what Brexiteers voted for). Or, if EU access conforms to the World Trade Organization (WTO) tariff framework, the UK economy will shrink by 4.5%. Leading Brexit campaigners such as Boris Johnson and Nigel Farage have exited stage left now that their goals have been achieved. Brexit voters gamely advise that everything will be OK, while decision makers prepare for a recession. Fewer UK jobs will likely reduce immigration anyway, although this is hardly the best means of achieving that goal. And yet, in theory the entire non-UK EU population of almost 450 million people could have relocated to the UK, at which point the country would have resembled a Piccadilly line tube train at 5pm. Free movement of people, a core, inviolable principle of the EU, is absurd.

Nonetheless, Brexit was not a carefully considered response but a visceral reaction with far-reaching and poorly considered consequences. Churchill  once said, “The best argument against democracy is a five-minute conversation with the average voter.” Brexit leaders have led their followers to the cliff and then retired to the pub for a drink while they watch the leaderless deal with the aftermath.

One result is that bond yields globally have fallen to hitherto unimaginable levels. The Barclays Aggregate Index is +6% YTD, beating the S&P500. Regular readers will be familiar with our past illustration of the paltry returns available on bonds whereby we compare a barbell of stocks and cash with the ten year return on bonds. In our April newsletter we wrote about The MLP Risk Premium. With reasonable assumptions about MLP distribution growth rates and prevailing valuations in ten years, you could swap out your bond portfolio for as little as 10% in MLPs with the rest in cash while still achieving a bond-like return. MLP yields have fallen since we wrote that in April, but so have bond yields so the broad set of choices still favors almost anything over bonds but certainly still MLPs.

Federal Open Market Committee (FOMC) minutes released last week confirmed what we’ve long noted, that Janet Yellen will never miss an opportunity to avoid raising rates. Ignore their words and try considering this Fed’s actions as if they’d announced the solution to excessive debt was to keep rates low for a long time. The rhetoric doesn’t reflect such a strategy but their actions most assuredly do. Waiting for rates high enough to justify an investment requires substantial patience, during which time investors are steadily pursuing equity-type risk with its better return prospects.

Tallgrass Energy GP (TEGP) raised its quarterly distribution by 16.7% quarter-on-quarter and 84.2% year-on-year from its pro-forma 2Q15 level. Not every MLP or GP is raising its distribution by any means, but less than six months ago such would have been unthinkable. Meanwhile, the Alerian MLP ETF (AMLP) reached a milestone of sorts, in that the recent recovery in MLPs has finally moved AMLP to where it once again has unrealized gains on its portfolio. As we noted in March (see Are You in the Wrong MLP Fund?) this is the point from which AMLP investors will now earn only 65% of any subsequent upside since the U.S. Treasury will take 35% through corporate tax. Indeed, the tax drag has already had an effect, since AMLP’s YTD performance through June 30 is +10.7% versus the Alerian Infrastructure Index +13.1%. Those AMLP investors who are bullish on the sector (which presumably includes all of them) will, if right, contribute modestly to Federal finances at the expense of their own investment results and reputation for careful analysis. AMLP is the refuge of those who stop at Pg 1 of a prospectus rather than examining Pg 23, Federal Income Taxation of the Fund. This is part of the reason why a more thoughtfully designed, non-taxable, RIC-compliant MLP fund (which we run) has done very well.

We are invested in TEGP.

Will Energy Transfer Act with Integrity?

As regular readers know, the proposed merger between Energy Transfer Equity (ETE) and Williams Companies (WMB) has been a rich source of material. Last week a judge’s ruling enabled ETE to cancel the deal since a needed tax opinion was not forthcoming. WMB found it convenient to say the least that ETE’s tax counsel Latham Watkins, having originally provided informal guidance that no adverse tax outcome was likely, later changed their minds coincident with their client souring on the deal. However, Judge Sam Glasscock III found no coincidence and absent a tax opinion that the deal was tax-free, ETE had its escape hatch.

We didn’t think the deal would get done, but we remain interested in the fate of the convertible preferred securities ETE issued in March. As we wrote before (see Is Energy Transfer Quietly Fleecing Its Investors?), a select group of ETE insiders representing 31% of the common units outstanding was given the opportunity to swap their units for preferred securities with a guaranteed dividend which could be reinvested in more common units at $6.56 per share (ETE closed Friday at $13.80). Ostensibly this was to shore up ETE’s balance sheet given the $6BN cash payout they had agreed to under the merger. But it had the additional result of devaluing ETE units for all the other holders, including WMB investors who would be receiving new securities linked in value to ETE. WMB naturally sued. This looked like a very aggressive, almost scorched earth negotiating strategy by ETE in their efforts to force a renegotiation on WMB. However, as we noted in May, ETE CEO Kelcy Warren indicated that these securities would remain outstanding even if the merger was cancelled.

WMB’s lawsuit of these securities didn’t receive a ruling from Judge Glasscock. He recognized his ruling on the tax opinion was likely to scupper the deal anyway, rendering WMB no longer an injured party. However, the same judge is hearing a lawsuit on this issue from other plaintiffs.

Without doubt, the abovementioned securities represent fraud by ETE’s management. Every ETE investor would welcome the opportunity to swap their common units for the ones Kelcy and his friends own. He has a fiduciary obligation to other ETE investors which this action clearly violates, transferring substantial value (we estimated $1.3BN) from investors in the same class of units to the insiders. Since ETE no longer faces the prospect of finding $6BN, the apparent need for the securities themselves has disappeared and we await their cancellation.

So we’re watching to see if ETE  acts with integrity and voluntarily cancels the convertible preferreds. Or will they seek to retain this wealth transfer with a different justification? It’s going to be hard for ETE to negotiate future deals credibly following the WMB experience, but especially so if they choose wrong on this issue. One can forgive the second thoughts on the merger, because the market moved sharply against MLPs last year. This was an issue of judgment. But a CEO who openly defrauds his public partners has lost his reputation for good. What use to the world is a dishonest billionaire, beyond donating his money to have a couple of buildings named after him? In future dealings with Kelcy and the other insiders, including John McReynolds (President of ETE’s General Partner), Matthew Ramsey (President of Energy Transfer Partners), Marshall McCrea III (Group Chief Operating Officer) and Ray Davis (retired, co-founder), you’d always have to assume that they could once again fail to act in good faith having done so before. Based on the data we analyze about our blog subscribers, we know senior managers at ETE are reading this.

It may surprise, but we remain invested in ETE. We believe Kelcy Warren will cancel these securities. He and his team have built a fantastic business. They are enormously talented. They can avoid any loss of face by simply saying the securities are no longer needed. This is the right thing to do. You won’t find any sell-side analysts asking tough questions on this issue out of fear of causing offense. At SL Advisors we are free to say what many other analysts are merely thinking, because our only interest in ETE is that its value appreciate and its stock price rise. In this way, we are completely aligned with our clients and free to call it as we see it.

Kelcy, do the right thing.

We are invested in ETE and WMB

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