More on the Changing MLP Investor

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Last week’s blog post, The Changing MLP Investor, received more interest than usual.  There’s no shortage of research explaining why MLPs are cheap, but it seems few stop to consider the mindset of those who decline to act on this opportunity. Sometimes it’s more helpful to understand the non-buyers.

Following the collapse two years ago (see The 2015 MLP Crash; Why and What’s Next) the sector staged a strong recovery in 2016. However, over the last six months prices have sagged. Oil weakness earlier in the year was blamed, but in June crude began to recover and the previously high correlation with MLPs inconveniently fell. Prices for oil and MLPs are linked when sentiment dictates, but are economically not that close. Consequently, the relationship can weaken with little warning, revealing their transitory affinity for one another.

Continuing the theme from last week’s blog that focused more on investors, for a time the Shale Revolution led MLPs to substantially increase their annual capital needs. Subsequently, some lost access to equity financing. The result was that acquisitions, new projects and expansions led to increased use of internally generated cash, leaving less for distributions. In some cases there were distribution cuts. But there are indications that we are over the hump – a higher cost of equity for those firms needing more of it has imposed discipline, and projects are increasingly financed without tapping the capital markets. Annual capital needs are down for the third successive year and are running at about half the pace of 2014.

Nonetheless, investors continue to punish those firms that are growing their asset base. The table below highlights four transactions in the past year that have all led to stock price underperformance. The message is that traditional MLP investors prefer income over growth. The choice of many management teams to favor asset growth has led to investor turnover and today’s attractive valuations.

Interestingly, Blackstone recently acquired Harvest Fund Advisors, an MLP investment manager, reflecting their recognition that long-lived energy infrastructure assets offer attractive returns.

The Changing MLP Investor

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Why aren’t MLPs performing better given the fundamentals? On valuation, they should be compelling. Using EV/EBITDA (Enterprise Value /Earnings Before Interest, Taxes, Depreciation and Amortization), they are virtually on top of utilities, a point not reached either in 2008 or 2016.

Typically, MLPs are valued at a higher multiple. Although like utilities, they depreciate their assets, unlike power plants, pipelines buried underground typically appreciate, since their cashflows grow. They also have more flexibility in their customer base, since a pipeline can move hydrocarbons from anywhere that’s connected by the network. The customer base of a utility is geographically fixed. And EBITDA generated by a utility is subject to taxes, whereas MLPs don’t pay tax. For all of these reasons, EV/EBITDA multiples for MLPs are usually higher. Consequently, when relative valuations approached one another as they have twice briefly in the past decade, a sharp recovery in MLPs followed.

The yield on the Alerian MLP Index is currently 7.8%, 5.6% above the ten year treasury and substantially wider than the 15 year average of 3.5%. Moreover, MLP debt is performing far better than their equities, suggesting no particular financial distress.

2Q17 earnings were largely uneventful, with the dramatic exception of Plains All American (PAGP) which warned of a likely distribution cut (see MLP Investors Learn About Logistics). Management teams report that business is fine, cashflows growing and product moving. At some point in the next year we’re likely to see U.S. crude oil production exceed 10 Million Barrels per Day, a record last seen in November 1970. Yet MLPs fall when crude prices are weak and seem indifferent when they rise. What is going on?

MLP investors originally signed up for high, stable distributions with modest growth and not much excitement. The widely-hated K-1s provide a useful tax deferral for those willing to hand them off to an accountant. The tax benefit accumulates over time, creating a powerful incentive to delay selling which would make the tax bill come due. Some MLP investors really do hold forever, or at least their lifetimes, leaving their heirs to benefit from a stepped-up cost basis that wipes the tax slate clean. In a world of trigger-happy equity analysis with a relentless focus on the next few days or hours, MLP investors are what every company says they want: in for the long term.

There is increasing evidence that this stable investor base has been turning over. The Shale Revolution created the need for more infrastructure to support America’s drive to energy independence. It’s a truly exciting story that exemplifies much that is great about the U.S. (see Why the Shale Revolution Could Only Happen in America). But quite a few managements in their drive to seize the ensuing growth opportunities have imposed an unwelcome financial model on their loyal investor base. Stable distributions with low growth were put at risk with increased leverage seeking faster growth. The result, as Kinder Morgan showed, was that the MLP structure doesn’t work if you’re big and need to fund large capital projects.

The consequence for Kinder Morgan Partners (KMP) investors was an unwelcome tax bill as their units were absorbed by Kinder Morgan Inc. (KMI), and ultimately two dividend cuts. KMI recently announced they’ll be raising their dividend next year, since their backlog of new projects is a fraction of what it was three years ago and so they have more cash available to resume higher payouts (see What Kinder Morgan Tells Us About MLPs). But the psychological damage to KMP investors has been done. Every financial advisor I talk to has some clients who owned KMP and were effectively betrayed. They never signed up for higher leverage in search of faster growth, but the stewards of their capital decided for them. The experience has made many long-time MLP investors wary of being seduced by valuations into committing new capital.

KMI was only the first. Other companies, including Targa Resources (TRGP), Plains All American (PAGP), Oneok (OKE), Williams Companies (WMB) and Energy Transfer (ETP) have undertaken various types of structural simplification. In every case, it was a result of growth that strained balance sheets and it ultimately led to a cut (sometimes two) in distributions to MLP investors, an unwelcome tax bill or both. PAGP warned of an impending second distribution cut earlier in the month. The most loyal investors in the public equity markets have had their trust abused by management teams whose choices ultimately risked the stable payouts their clients had always sought. Although no reliable figures exist on this topic, several MLP executives have admitted to substantial turnover in their investor base in recent years. Income seeking investors did not sign up for this. The 58.2% drop in the Alerian Index from August 2014 to February 2016 remains a recent, highly unpleasant memory. When combined with multiple cases of broken distribution promises, many long-time MLP holders feel abandoned. The investor base is changing.

That is what is creating the current valuation opportunity. Today’s investors in energy infrastructure like the yields but are also fine with cash being reinvested back in the business, something MLPs did on a much smaller scale in the old days. Recent buyers recognize the opportunities to grow cashflows through enhancing existing assets and building new ones at attractive IRRs. The Shale Revolution is a tremendous opportunity for energy infrastructure businesses to generate stable and growing cashflows for many years ahead. But financially, getting there has been highly disruptive for an investor base originally not much concerned with growth. This transition from one type of investor to another isn’t happening smoothly, but it’s happening.  Valuation discrepancies such as the EV/EBITDA comparison with Utilities won’t last forever.

We are invested in Energy Transfer Equity (General Partner of ETP), KMI, OKE, PAGP, TRGP and WMB

 

 

Same Assets, Different Payout

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We regularly get questions from investors about why the dividend yield on MLPs is often higher than for energy infrastructure C-corps that are in the same business. In recent years several MLPs have transferred their assets into their C-corp parent. Examples are Kinder Morgan (KMI), Targa Resources (TRGP) and Oneok (OKE). The merger of an MLP with its C-corp parent has typically been accompanied by a dividend cut for the MLP investors, who wind up with C-corp shares through a swap.

The assets don’t perform any differently just because they’ve been moved to another entity. But it highlights the differences between C-corps and MLPs from both a taxation and a financing perspective.

The two diagrams below show this. In each case, assume the underlying assets and the need for growth capital are the same; the only difference is the type of entity (MLP or C-corp) owning the assets.

Traditionally, MLPs pay out >90% of their Distributable Cash Flow (DCF) in distributions. DCF is defined as cash generated from operations less the cost of maintenance expenditure on existing assets. Note that generally companies (i.e. C-corps) pay out substantially less than this. Across the S&P500 the average payout ratio is currently 42%. This is largely because of the “double taxation” of dividends, in that corporate profits are taxed first at the corporate level (via corporate income tax), and then again at the investor levels (via personal taxes on dividends and capital gains).

Since paying dividends is a very tax-inefficient way for corporations to return value to shareholders, high pay-out ratios would be exceptionally inefficient. The recent trend is for companies to return profits via buying back their stock. S&P500 companies are currently spending 28% more buying back stock than paying dividends. This also reduces their share count, boosting per share growth.

MLPs don’t face the same tax inefficiency, hence the higher payouts. Consequently, they pay out most of their DCF and then issue equity to finance growth. Their number of units outstanding therefore grows, diluting per unit DCF.

When assets formerly held by an MLP are moved into a C-corp, their cashflows are treated differently. Because C-corps have lower payout ratios, less of the Free Cash Flow (roughly analogous to the MLP’s DCF) is paid out in dividends. This has two results:

  • Assets held in an MLP will pay a higher yield to investors than those same assets held in a C-corp.
  • The C-corp’s lower payout leaves more cash to finance growth, which in our example eliminates the need to issue equity. Not issuing equity means no dilution for shareholders, which in turn means faster per share dividend growth.

Across the energy infrastructure investments we hold, dividends are covered approximately 1.5X by free cashflow. An extreme example is Kinder Morgan (KMI) which has a FCF yield of 10% but a dividend yield of 2.5% (they have announced they’ll be raising it next year). KMI is reinvesting most of its FCF in growth, thereby not issuing any dilutive equity and so driving FCF higher. In addition, since FCF is generally growing, the total return on these investments should exceed the FCF yield itself.

Some will note that the point of MLPs is to hold eligible assets without having to pay corporate tax on the returns, and argue that use of the C-corp subjects those returns to taxes needlessly. In practice, energy infrastructure C-corps that have acquired assets from an MLP have employed tax strategies to minimize or eliminate any corporate tax liability, so this concern is moot (see The Tax Story Behind Kinder Morgan’s Big Transaction).

In summary, C-corps pay less of each dollar earned and reinvest more, compared with an MLP holding the same assets. Lower payouts lead to faster growth, since cash not paid out is reinvested in the business. The dividend yield on a portfolio of equities is an unreasonably low estimate of total return. For example, the S&P500 yields 2%, whereas most observers would assign a higher long term return target to stocks (unless they’re very bearish), because dividends grow over time which contributes to an investors overall return. C-corps that own energy infrastructure exhibit similar characteristics, albeit with higher yields and growth prospects.

We are invested in KMI, OKE and TRGP

MLP Investors Learn About Logistics

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We hear so often how energy infrastructure is all about pipelines and storage assets with fee-based contracts that when another part of the business pops up it can cause quite a stir. So it was that Plains All American (PAGP), one of the biggest crude oil pipeline operators in the U.S., provided an unwelcome example of the uncertainty surrounding one aspect of their business. Accelerating changes in the marketplace adversely affected their Supply and Logistics segment, such that PAGP thought it worthwhile holding their Wednesday morning earnings call on Tuesday evening, immediately following their earnings release.

Supply and Logistics involves taking temporary ownership of crude oil, Natural Gas Liquids (NGLs) and natural gas with the objective of unloading it elsewhere for a profit. The idea is not to make money from price moves, but rather to generate a profit from known inefficiencies in the transportation network. If you can buy crude oil at point A for $45 a barrel and sell it at point B for $48 while spending less than $3 on storage, transportation and overhead, it can be a profitable business. It has been so in the past; in 2013 PAGP generated $893MM in EBITDA from this activity, although its profits have been declining since. It is in effect a profit from inefficiency of the domestic transport network. If crude is worth $3 more at point B compared with point A, the cost of transport should be around $3, or crude will flow until the arbitrage is eliminated.

The problem, as PAGP belatedly discovered, is that the market is becoming more efficient. Three years ago Congress lifted the ban on crude exports, which removed one significant inefficiency. Patches of excess pipeline capacity further challenged arbitrage opportunities by providing shippers with more choices. More recently, a flattening of the crude oil futures curve along with lower volatility reduced opportunities, as did more competition. Several other firms have de-emphasized or exited the business over the past couple of years.

The deep disappointment no doubt felt by PAGP CEO Greg Armstrong and those who know him is that they didn’t see this coming. Plains is better positioned than most to see first-hand changes in the supply and logistics of hydrocarbons. They pride themselves on a very sophisticated view of shifts in the marketplace. Three months ago a weak first quarter in this segment was partly blamed on warm winter weather. Propane held in inventory anticipating stronger prices had to be sold on weakness.

The outlook for profits in Supply and Logistics is so uncertain that PAGP says they’ll likely exclude it from their calculations of Distributable Cash Flow (DCF), the metric underpinning their distribution. They’re currently forecasting only $75MM this year. Although a strategic review is underway and will likely take a couple of months, the Facilities and Transportation businesses can only support a payout of around $1.80 per share (albeit with 1.1X coverage), down from $2.20 currently. Plains cut their distribution last year when combining their MLP and GP, so this likely represents a second cut in two years. Another management team’s reputation is shredded. Greg Armstrong will not care to be compared with Rich Kinder who also oversaw two dividend cuts in as many years at Kinder Morgan, but many investors will see little between them. In both cases a seasoned CEO has been shown to poorly anticipate changes in a business in which he’s spent his entire career. If Greg Armstrong didn’t see it coming, it’s hardly surprising that PAGP investors didn’t either.

We are invested in PAGP

Shale Drillers Find Efficiency Isn't Rewarded

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Master Limited Partnerships (MLPs) have been reporting earnings over the past couple of weeks. For the most part they have come in as expected, with few surprises in either direction. Crestwood (CEQP) and Tallgrass (TEGP) both reported system volumes slightly higher than expected; generally though, they were unremarkable, which is the sort of boring stability MLP investors like. Although most CEOs are pretty sure their stock is undervalued, TEGP CEO David Dehaemers  is positively convinced this is the case. And since TEGP sports a 5.25% yield forecast to grow by 40% (not a misprint) in 2018, his case appears compelling to us.

The real story of the past week is not MLPs but their customers, who we also follow closely. MLP investors may feel that their patience is being tested, as the sector gyrates with crude oil while persistently refusing to appreciate as its high yields imply it should. At least MLP investors are being rewarded to wait, with attractive quarterly distributions being paid in many cases during August. Even so, the trailing one year return on the Alerian Index of 2% seems paltry compared with the S&P500, whose one year return is 16%. MLP investors might feel unloved. In the classic British sitcom Fawlty Towers, manic hotel owner John Cleese is told not to worry, that there’s always someone else worse off. To which he replies, “Is there really. Well I’d like to meet him, I could do with a laugh.” You can see the clip here at the 18 minute mark.

Therefore, the recent performance of U.S. shale drillers is worth considering, albeit with less shadenfreude than John Cleese. They are the customers of MLPs, and the regularly demonstrated efficiencies with which they extract hydrocarbons are not, of late, rewarding their investors. Over the past year, the six most active independent shale drillers have returned -21%. 2Q17 earnings reports over the past couple of weeks have hastened this slide, as future production growth has been guided down. The announced capex reductions across the exploration and production sector (see Financial Discipline Among MLP Customers) have helped boost crude prices by around $6 a barrel since June 21. However, lower guidance from the six names highlighted is in most cases due to specific technical challenges they’re encountering and resolving. They’re not reporting that margins are too tight. Nonetheless, in such a market investors want every name in the group except the ones they hold to produce less.

Weakness in the stock prices of shale drillers may be weighing on MLPs. Energy infrastructure inevitably trades with the sector it supports. Kinder Morgan (KMI) is in XLE, the energy sector ETF. Swings in sentiment inevitably move its price regardless of its fundamentals.

A piece of good news that didn’t receive much attention was Senate approval of two new commissioners to the Federal Energy Regulatory Commission (FERC). This will restore their quorum, and should allow a substantial backlog (estimated by RW Baird at $14BN) of infrastructure projects to receive approvals and proceed. Their completion will add incrementally to the cashflows of their owners and ultimately augment payouts to investors.

We are invested in CEQP, KMI ad TEGP

 

 

The Age of Oil

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The Prize: The Epic Quest for Oil, Money and Power was first published 27 years ago, although Daniel Yergin added an Epilogue in 2008. It is nothing less than an economic and political history of crude oil. At 910 pages of text and footnotes it’s an epic read, but you can select sections of interest and jump around, leaving and returning to it later. The very beginnings of the U.S. oil business were about producing kerosene from “rock oil” to replace whale oil or turpentine used for light. Its illuminative qualities were deemed far superior to the alternatives and production took off in the early 1860s. The Civil War boosted demand and the oil business had begun. John D. Rockefeller became the richest man in America by selling kerosene.

During the early 1900s the internal combustion engine created a new market for gasoline, promoting oil in importance over coal as a source of primary energy and leading Daniel Yergin to dub the 20th Century “The Age of Oil”.

The 1973 Oil Shock is a distant memory for those of us old enough to have any first hand recollection. It’s therefore quite sobering to re-familiarize oneself with its history as recounted by Yergin in 1990 when its ramifications remained fresh. Iconic photos of cars lined up outside gas stations were a vivid reminder of modern society’s dependence on oil; they also exposed the western world’s sudden vulnerability to an adverse clash of politics and economics in a volatile region.

Reading about events some 44 years later, the ability of Arab oil producers to turn a spigot so as to influence U.S. policy decisions was outrageous, an affront. The history of how OPEC came to wield such power is well recounted by Yergin. From 1948-72, 70% of newly discovered proved oil reserves were located in the Middle East. This concentration of oil resources combined with western governments’ inattention to their increasing reliance on monarchs with whom their interests were not aligned created the conditions under which the Arab Oil Embargo was so effective.

Countries were placed on one of three lists (Friendly, Neutral or Unfriendly) depending on how closely their public policy statements pleased Arab oil suppliers, with deliveries modified commensurately. Europe produced very little oil and Japan virtually none. By contrast, U.S. production reached 9.5 Million Barrels per day (MMB/D) in 1973, coincidentally, a record we will soon eclipse.

Although America wasn’t self-sufficient, it wasn’t as reliant on OPEC as others. However, strong domestic demand had caused imports to almost triple over the prior six years, to 6 MMB/D, so energy independence was not a realistic objective. Over the prior quarter century the U.S. share of world production had fallen from 64% to 22% as Middle East nations ramped up their output from 1.1 MMB/D to 18.2 MMB/D.

The 1973 Arab Oil Embargo was a political and economic shock, and ever since the U.S. has paid close attention to the region. The 1990-91 Gulf War fought to eject Iran from Kuwait was arguably all about oil reserves, and the U.S. continues to maintain a large military presence in the area. Yergin’s book had the good fortune to be published in December 1990, just a month before the U.S. and its allies launched Desert Storm. There is an eight episode documentary accompanying Yergin’s book that can be found on Youtube. It was shown on PBS in 1992-93, a couple of years after the book’s publication, and provides interviews with many of the oil executives and government officials involved at that time. One U.S. oil CEO had expected public opinion to demand less reliance on imported energy following 1973, and the second oil shock in 1979 after the Iranian revolution. But diversity of supply lessened OPEC’s power, and the Gulf War showed that Middle Eastern oil reserves couldn’t be seized by an unfriendly power.

Nonetheless, I found that reliving those events through Yergin’s book and documentary provoked feelings of outrage, and a wish that we never again find ourselves so vulnerable to others.

And guess what? American Energy Independence, for generations no more than an aspirational state, is clearly now in America’s future. It has multiple definitions – the Energy Information Agency (EIA) defines this as BTU independent, which means that we are a net exporter of energy in all its forms once they’re converted to their energy-equivalent, BTU content. The EIA’s Annual Energy Outlook 2017 projects that we shall achieve BTU-independence within the next decade. We recently achieved Natural Gas independence, as exports began exceeding imports over the past twelve months. Shipments of Liquified Natural Gas are set to rise substantially in coming years as new liquefaction plants become operational. We’ve long been a net exporter of coal.

Although BTU-independence is the most complete measure of our reliance on others for energy, most casual observers think simply in terms of oil independence, especially given the contemporary history recounted by Daniel Yergin. Photos of drivers sitting in gas lines remain an emotive image. The EIA makes a Reference Case forecast (its Base Case) but includes other less likely but still plausible scenarios. Their central expectation is for the U.S. to remain a net importer of petroleum products (defined as crude oil, refined products and natural gas liquids), albeit at a steadily diminishing rate, falling by two thirds within a decade.

But if crude prices rise higher than they expect, or improvements in the technology driving shale oil and gas output surprise to the upside, the U.S. could become a substantial net exporter.  OPEC long ago lost its ability to call the shots and in recent years their inability to set prices has been amply demonstrated. This is the enormity of the Shale Revolution. Its impact is far more than simply economic, although in that respect it’s already substantial. Its geopolitical effects will continue to reverberate through different countries’ needs for energy security. U.S. policy in the Middle East will reflect a reduced reliance on the region’s major export, something Americans will overwhelmingly welcome.

In a recent interview on the Shale Revolution, Yergin cited the sanctions imposed on Iran as an example of shifting energy power. He asserted that without the growth in U.S. oil production, the removal of Iranian oil supplies from the market would have been unworkable. Yergin has found that in discussions with foreign decision makers across Europe and Asia, there is a recognition that America’s role in the world is changing, in part because of improved security around energy supplies.

Today we’re seeing an alignment of resources, technology and public policy that together are bringing a seemingly Utopian vision closer to reality. Energy infrastructure is growing as it adapts to increased production that is supplying new markets. It may have taken half a century, but the dynamism of American capitalism is denying the ability of foreign despots or hostile governments to inflict substantial economic harm through manipulating energy exports.

 

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