Energy Transfer Shows Who's the Boss

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Ten days ago, investors in Energy Transfer Partners (ETP) were content with a high distribution yield of 11%, albeit with little growth and (if they were honest with themselves) some risk of a cut in the future. Investors in Sunoco Logistics (SXL) had similarly come to terms with a 7.6% yield bolstered by the prospect of high single digit growth. The buyers of each security had self-segregated to the combination of current income and growth prospects that suited them.

Once again, Energy Transfer Equity (ETE) CEO Kelcy Warren has surprised, creating sharp price movements and fresh blog material in the process. As General Partner (GP) of ETP and SXL, ETE controls them both, and that control was on full display. So it is that SXL is acquiring ETP, upsetting the basis on which investors in both securities had made their decisions. ETP investors currently receive a $4.22 annual distribution. In exchange for their ETP units they’ll receive 1.5 SXL units. SXL pays a $2.04 distribution, so the new $3.06 distribution (i.e. $2.04 X 1.5) represents a 27.5% cut for ETP investors. They weren’t happy.

Meanwhile, SXL’s high single digit distribution growth prospects may now be challenged following its combination with the slower-growing ETP assets, although the $200MM in annual operating synergies will help. In short, ETP and SXL investors will both shortly own something different than they bought. If ETP investors had favored growth over income they would have already held SXL. It was a demonstration that Limited Partners (LPs) in MLPs are limited in more ways than one.

Both ETP and SXL were down sharply once the deal was announced. It’s not an obviously bad transaction, and Kelcy Warren made a good case for the combination on a conference call later the day of the announcement. It just imposes a different return profile on current investors than they sought. So there will probably be some turnover as the unhappy sell their holdings to the optimistic.

The winners include ETP bondholders, since less cash paid to equity holders in the form of distributions means improved debt coverage. The other winner is ETE, which shouldn’t be surprising because that’s where Kelcy Warren invests his money. Although near term Distributable Cash Flow (DCF) to ETE will be lower than before, since distributions to the former ETP investors will be lower, it makes the Incentive Distribution Rights (IDR) forgiveness that ETE has extended likely to lapse within a couple of years rather than possibly continuing on. The new SXL will be larger and more diversified, which should in time lead to a lower cost of capital.

We’re invested in ETE, alongside management because that’s what we do. Even that close alignment doesn’t always guarantee success; earlier this year we noted how Kelcy Warren issued new convertible preferreds to himself and the management team that gave them the ability to reinvest dividends at a fixed, low price of ETE (see Is Energy Transfer Quietly Fleecing its Investors?). As a result, Kelcy is regularly buying new ETE units at $6.56 each, the level they hit earlier this year because of his ill-advised pursuit of Williams Companies (WMB), even though the collapse of that transaction and subsequent rebound in the sector has taken ETE back as high as $18.

Investors in ETE are there rather than ETP or SXL precisely because we understand the favorable asymmetry that benefits the GP. The dilution of ETE investors that these convertible preferreds causes was therefore a bitter pill for the non-management ETE investors to swallow. A class action lawsuit followed (Energy Transfer Equity LP Unitholder Litigation), in which the plaintiffs alleged these securities unfairly transferred wealth from them to management. Based on reviewing the transcript of oral arguments earlier this month, the memorably named Judge Glasscock appears to be sympathetic to this claim although allowed that he needs to study the relevant documents before ruling. If the offending securities are cancelled as they should be, a future transfer of well over $1BN in ETE interests to management will not take place.

Faced with the prospect of investing in someone who so easily abandons his fiduciary obligation to his investors, we were tempted to give up on ETE. However, they’re a smart management team and fortunately we allowed our commercial instincts to trump our principles. It’s what Kelcy would have done.

The Bond Market Loses Its Friends

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In 2013, my book Bonds Are Not Forever; The Crisis Facing Fixed Income Investors presented a populist framework for evaluating interest rates. The prospects for the bond market can only be evaluated by considering the U.S. fiscal situation, which is steadily deteriorating along with that of many states. I was dismayed to read the other day of an analysis that places New Jersey (where I live) dead last behind even Illinois in its funding of public sector pensions. We have, at almost every level of government and household, too much debt.

The solution has, since the 2008 Financial Crisis been low rates. If you owe a lot of money low rates are better than high ones. Financial repression in the form of returns that fail to beat inflation after taxes is a stealth means of transferring wealth from savers (lenders) to borrowers. Count the central banks of China and Japan with their >$1TN in U.S. treasury holdings among those on the wrong side of this trade, along with many other foreign governments and sovereign wealth funds.

Some have argued that low rates only help the wealthy (through driving up asset prices); they impede lending (because lending rates aren’t high enough to induce banks to take risk); they force savers to save more (thereby consuming less) than they otherwise would, because returns are so low; and they communicate central bank concern about future economic prospects. Low mortgage rates help homeowners and drive up home values which helps McMansion owners but not first-time buyers. Low rates may be good for the wealthy, and by lessening the burden of the government’s debt they may indirectly help everyone. But to someone with little or no savings, the tangible benefits are not obvious even if they are real (through higher employment, for example).

Nonetheless, we are likely at the early stages of watching this benign process swing into reverse. The conventional result of lower taxes combined with higher spending should be a wider deficit, rising inflation and therefore higher interest rates. The bond market is already beginning to price this in through higher yields, well before any discussions of next year’s budget (or even the appointment of a White House Budget Director).

Part of the problem is that bonds don’t offer much value to begin with. They’ve represented an over-priced asset class for years, and it’ll take more than a 0.50% jump in yields to fix that. From 1928 until 2008 when the Federal Reserve’s Quantitative Easing program began distorting yields, the average annual return over inflation (that is, the real return) on ten year treasuries was 1.7%. This is calculated by comparing the average yield each year with the inflation rate that prevailed over the subsequent decade-long holding period of that security. So investing in a ten year treasury note today at 2% would, if the Fed hits its inflation target of 2% over the next ten years, deliver a 0% real return (worse after taxes).

Given the Federal Reserve’s 2% inflation target, even a 4% ten year treasury (roughly double its current yield) would appear to represent a no better than neutral valuation. The deficit was already set to begin rising again before even considering any Republican-enacted tax cuts and other stimulus (such as infrastructure spending). In fact, borrowing at today’s low rates to invest in projects that will improve productivity makes sense in many cases. But under such circumstances, with the possibility of inflation above 2%, perhaps a yield of 5% or even 6% is the threshold at which ten year treasuries (and by extension other long term U.S. corporate bonds at an appropriate spread higher) could justify an investment.

Holding out for such a yield is fanciful. Millions of investors demand far less, which is why we don’t bother with the bond market. Our valuation requirements render us wholly uncompetitive buyers.

Low rates may be the best policy for America, but it looks as if we’re about to try boosting growth through greater fiscal stimulus. The Federal Reserve will seek to normalize short term rates, perhaps faster than their current practice of annual 0.25% hikes. The twin friends of gridlock-induced fiscal discipline (sort of) and low rates are moving on, leaving fixed income investors to fend for themselves. Bonds are a very long way from representing an attractive investment.

 

Political Change Supports Energy Infrastructure

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We believe energy infrastructure (Master Limited Partnerships, or MLPs) should be one of the clear winners from last week’s election. There are two aspects to this:

Regulation.

Earnings calls with MLP management have increasingly included discussions of what many perceive as a hostile regulatory environment. New York State’s ban on fracking is one example, but more meaningful was the set of decisions in New England that led Kinder Morgan (KMI) to cancel its North East Direct (NED) pipeline project. The northeast U.S. is short of natural gas transmission and storage capacity, with the result that in the winter New Englanders pay very high prices for natural gas. NED was planned with the intention of alleviating this situation, but a Massachusetts Supreme Court ruling prevented utilities from making long term commitments for pipeline capacity. Without such long term commitments KMI determined that the returns from the project were inadequate and uncertain, so it was cancelled.

Another more recent example is the Dakota Access Pipeline (DAPL), currently under construction by Energy Transfer Partners (ETP). Whatever your view on whether the pipeline should be built or not, it seems clear that ETP complied with regulations in how they sought approvals for the pipeline’s route. In spite of the Courts rejecting challenges to the project, the Administration took an interest late in the day and over-ruled the Army Corps of Engineers (the Federal agency responsible for approving the route). The result has been a delay in pipeline completion, with a corresponding delay in its cashflow generation and a rapidly deteriorating return on investment for ETP. The Administration’s unexpected involvement cast uncertainty over any new project relying on Federal approval. It appeared capricious and motivated by the election rather than ETP’s failure to follow the correct process. An extensive examination of the background is here. As a result of the election the project now looks likely to be approved, possibly within days but certainly once Trump is in office.

Perhaps most famously, the application to build the Keystone XL Pipeline was held up for years by the State Department (it fell under their jurisdiction since it crossed the border with Canada) before finally being denied. The extended period of uncertainty added to its costs, which eventually resulted in TransCanada Corp (TRP) writing off C$2.9BN, as well as causing friction with our northern neighbor in their efforts to move crude oil more efficiently and safely. This was also poor policy, justified as an effort to impede Canada’s development of its oil sands resource because of the negative environmental effects. TRP subsequently sued the U.S. for $15BN in foregone value creation. It’s possible the project may be resurrected next year.

Investors often ask us if the Obama Administration’s hostile stance towards fossil fuels is negative for MLPs. Over the past eight years, volumes of crude oil, natural gas liquids and natural gas produced have climbed substantially so the raw numbers don’t reflect an anti-fossil fuel bias. However, the episodes described above do, and regulatory uncertainty has had a growing impact on which projects get done. Developing our energy infrastructure is key to America attaining Energy Independence, a state that is not far away in natural gas and perhaps attainable in crude oil within a decade.

The incoming Republican administration can be expected to adopt a regulatory philosophy that is more supportive and predictable. This can only be good for MLPs.

Trade

We don’t know much detail yet about how U.S. trade policy will shift. However, it’s not a stretch to suppose that a pronounced bias towards domestic production of many things could include crude oil. Although we currently produce around half the crude oil we ultimately consume in the form of refined products, tariffs on crude oil imports would favor additional growth in domestic production and would not obviously be at odds with the type of trade policy articulated by Candidate Trump. Relying more on our own resources has the added benefit of reducing our economic exposure or even interest in regions such as the Middle East. There could be perceived national security benefits from being more self-reliant.

There’s also the possibility that a Trump Administration could withdraw from the nuclear deal  with Iran which might in turn lead to the reimposition of sanctions, curtailing Iranian crude oil exports.

We offer no view on whether such policies are good or bad; we’re only focused on making the most sensible investment choices under existing circumstances. Public policy is clearly moving in a direction that places America’s near term interests first. The election was unequivocally positive for MLPs.

We are invested in ETE, KMI and TRP

Initial Reaction to the Election

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As we all digest the election results, and amid much near term market uncertainty, a few thoughts:

Good businesses in America will for the most part still be good businesses. The shift in political direction will likely include less regulation and in some cases deregulation. Domestic energy infrastructure with its ability to exploit America’s shale resources and limit our dependence on crude oil exports is unlikely to be one of the economy’s losers. While the turmoil in equity markets raises concern of an economic slowdown, the operating performance of midstream Master Limited Partnerships (MLPs) was only modestly affected by last year’s collapse in crude oil prices. Energy consumption in the U.S. is remarkably stable from year to year, and fee-based contracts that limit commodity price risk are widely employed. We think in times of uncertainty, investments in domestic energy infrastructure are one of the more robust choices you can make.

With promises of tax cuts, infrastructure spending and a vow to replace Janet Yellen because of the Fed’s low rate policy, there’s little reason to be constructive on bonds.

Stability with Falling Costs in MLP Earnings

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Last week saw the bulk of our MLPs reporting on quarterly earnings. The drop in crude oil and tightening election probably counted for more as the market was weak. But we felt earnings were generally in line with expectations with few negative surprises. There were plenty of questions on the regulatory environment for new projects. In response to a less certain and more drawn out approvals process, MLPs are revising their assumptions about how long projects take as well as steering away from less friendly areas such as New England. Several noted that pipes already in the ground have greater value as it becomes harder to build new ones.

Plains All American (PAA), reported results that were a little weaker than expected in spite of positive developments in the Permian. The existence of Minimum Volume Commitments (MVCs) makes it harder for them to forecast take-away demand even if they can forecast supply. This is because excess pipeline capacity in a region can cause E&P companies to take decisions that would otherwise seem uncommercial because of an MVC. If you’ve committed to buy pipeline capacity and have to pay for it regardless of whether or not you use it, this can cause you to ship oil or gas as long as the net revenue offsets some of the MVC. This squeezes margins and skews basis differentials.  Since contracts are private, it’s hard to know who’s acting based on an MVC versus more normal economics. PAA CEO Greg Armstrong commented on this issue during their call and noted how even with PAA’s detailed knowledge it makes forecasting demand harder.

We are invested in Plains GP Holdings (PAGP) which will soon merge with PAA. We expect U.S. crude oil production to increase slightly over the next several quarters and significantly over the next several years and PAA/PAGP should see increased cashflows from higher utilization of their pipeline network.

A couple of things stood out to us and are displayed below. Enlink Midstream Partners (ENLK) and its General Partner Enlink Midstream LLC (ENLC) reported solid earnings. In 2015 MLP prices fell far in excess of what was justified by the fundamentals. The slide from ENLK’s recent earnings call shows stability in metrics such as their Leverage Ratio, which ranged from a low of 3.7X to a high of 4.0X over the past seven quarters and is now back to 3.75X. Distribution coverage has stayed virtually unchanged. And yet in February ENLK had lost two thirds of its value from a year earlier. The emergency liquidation by many investors, seemingly without regard for the fundamentals, was responsible.

Another interesting chart was from Anadarko Petroleum (APC), who control Western Gas Equity Partners (WGP) by virtue of their 78% ownership. WGP in turn is the GP of Western Gas Partners (WES). APC’s onshore drilling activity is in the Delaware Basin in West Texas and DJ Basin in Colorado and Wyoming. They’re  WES’s biggest customer, and so APC’s ability to reduce costs over the past couple of years impacts volumes passing through WES’s midstream infrastructure.

APC now reports that their cost to drill a well is below $5MM, and their breakeven to produce an acceptable return on capital is $35 a barrel. Shale drilling is characterized by numerous wells cheaply drilled with fast payback times, by contrast with conventional projects that require high up front investment and long payback times. This is why we believe U.S. producers with access to “tight” oil are becoming the swing producers; more nimble than conventional suppliers, they can respond more easily to price signals. For more on this, see Prospects Continue to Brighten for U.S. Energy Infrastructure and OPEC Blinks.

Regarding OPEC, the strategy embarked on two years ago of seeking market share at the expense of price has been a colossal failure. A recent article by the Petroleum Economist (only available to subscribers) noted that OPEC’s oil revenues had plunged from $0.75TN during  the twelve months ending October  2014 to 338BN over the past year, a drop of 55%. OPEC may fail once again to restrain output among its members, but regardless they have helped usher in a far more efficient era in U.S. shale production (see Why the Shale Revolution Could Only Happen in America). The Petroleum Economist article closes with, “OPEC lost this battle – and it knows it. It is tired of cheap oil.”

We are invested in ENLC, PAGP and WGP

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