The Tumult in MLPs

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If the recent violent sell-off in energy infrastructure stocks has you puzzled, you have plenty of company. That’s why Sunday’s blog is going out early, because we’ve been discussing it with so many people. We enjoy a regular dialogue with many of our investors and last week was the busiest we can recall in responding to clients.

Many wanted to understand why MLPs had followed crude oil lower earlier in the year but failed to mimic its recent recovery. It’s easy to sympathize. A bullish view on oil was almost a prerequisite to committing capital to the sector in the first half of the year. Never mind that linking MLP operating performance to oil is in most cases futile. Their stock prices and oil did move together for months, until that correlation broke down most inconveniently as oil rose.  Investors feel duped.

Many callers were looking for confirmation that they’re not missing something, so absent were compelling explanations. Is it tax reform? Little detail is known, but the Administration has proposed allowing owners of partnerships to pay taxes at newly reduced corporate rates rather than the higher ones on income (see MLPs and Tax Reform). And anyway, the MLPA is well practiced at lobbying against adverse tax changes.

Perhaps investors are looking ahead to declining global crude oil demand? It’s a long way off and in any case US output looks set to exceed it previous high of 10 Million Barrels per Day next year, eclipsing a record set in 1970.

Is shale output peaking? The rig count is growing but more slowly. But looking across a broad selection of exploration and production companies, capex plans for 2018 don’t show much sign of retrenchment.

Tax loss selling was suggested by some — energy stocks offer many of the rather limited opportunities this year to sell at a tax-deductible loss. As MLP investors are painfully aware, the stock market has been registering new all-time highs seemingly every week. Hedge fund selling was certainly cited in some quarters, but there are a lot of hedge funds and they’re always buying and selling.

BP’s IPO of its refining business was probably responsible for some selling as investors created room by liquidating other positions. We didn’t participate and it doesn’t look as if we missed an opportunity since it quickly traded below its initial pricing.

Enterprise Products (EPD) used an announced future buyback to redirect cashflow back into new projects (see Why Don’t MLPs Do Buybacks?). It’s reflective of the shifting financing model. An Energy infrastructure sector with opportunities to reinvest in its business is redirecting cash from payouts to capex. It’s disillusioning to the income-seeking investor but is a sensible move if the returns are attractive. The continuing shift from income-seeking to growth-oriented investors is disruptive (see The Changing MLP Investor and More on the Changing MLP Investor), and is a major theme driving recent returns.

Energy Transfer Partners (ETP) yields over 13%. It’s a safe bet that a year from now its yield will be lower, either because the investor skepticism such a yield demonstrates is proven correct and it’s cut, or because buyers scoop up the stock and drive the yield lower. Yesterday, in an act of willful defiance aimed at the skeptics, Energy Transfer raised the dividend both on the GP, Energy Transfer Equity (ETE), and ETP.

Investing usually involves making a decision with adequate information but not all the knowledge one might like. There’s consequently a certain paranoia that, when things don’t go as expected, it’s because others (usually those selling) had some insight overlooked by the buyer. This can be a valuable self-protective instinct. The trader who concludes he knows all that’s needed to trade profitably is usually an ex-trader before too long. Many clients were explicitly or implicitly worried that this might be the case.

But while a certain amount of paranoia can be useful, it’s not always correct that a mark to market loss proves an analytical oversight. We continue to scour for tangible justifications behind the recent move, so far with limited success. We’ve talked to investors in the last week who are buying, holding and selling. The first two are easy to justify on valuation terms even though it takes a brave soul to risk capital under current circumstances. But the sellers we’ve chatted to know little more than the first two categories. What they do know is that they’ve had enough. They feel aggrieved that a correctly constructive view on oil prices has been destructive. They are tired of their clients asking why, in such a buoyant equity market, they own stocks that are falling. They’re fed up with missing the action. Maybe valuations are compelling but they’re no longer of a mind to wait for other buyers to act on this. They don’t possess more facts than the buyers, they’ve simply run out of patience.

It’s a pity, and will probably look like an emotional decision over the long run. But it sure felt good earlier in the week, and may well look brilliant following another week of selling.

Market timing is rarely easy, and so we remain invested because valuations are more attractive in energy infrastructure than any other sector. Don’t use leverage. Pick companies and sectors with strong balance sheets. This enables waiting out the inevitable swoons that over-managing positions causes.

We are invested in EPD and ETE

Why Don’t MLPs Do Buybacks?

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Ten days ago Enterprise Products (EPD) announced that they may in the future initiate a buyback of units, perhaps in 2019. Bigger news was the moderation in the growth rate of their distribution, so the buyback received less attention. But it highlights an interesting fact about MLPs, which is that they rarely do buybacks.

Part of the reason is taxes. Companies in the S&P500 in aggregate return only 42% of their profits in the form of dividends. From a purely tax-efficiency standpoint they shouldn’t pay dividends at all – profits are subject to corporate tax and then the holder has to pay tax on the dividend income. The distortion caused by taxes means that corporations that pay dividends deprive investors of the benefit of deferring taxes, which they could do if companies fully relied on buybacks to return capital. In this way, investors could choose when to realize a portion of their investment and incur the corresponding tax liability. Don’t expect this to change anytime soon though.

By contrast, distributions paid to MLP investors don’t determine their taxes; Buy and hold MLP investors pay taxes on their proportionate share of the profits of the business, regardless of the distributions received. Because MLPs themselves aren’t taxed, there’s no double taxation of profits to owners. For years the market rewarded steadily rising dividend payments, and so MLPs paid out the substantial majority of their Distributable Cash Flow (approximately equivalent to Free Cash Flow less Maintenance Capex) and raised new equity when they needed capital. Since distributions paid to MLP investors aren’t tax-inefficient, there’s little need for MLPs to use buybacks to return extra cash to investors. Moreover, in the GP/MLP structure in which the GP operates like a hedge fund manager (see MLPs and Hedge Funds Are More Alike Than You Think), buybacks might lower the payments received from Incentive Distribution Rights (IDRs), as IDRs are determined both by the level of dividend paid as well as the number of LP units outstanding. So MLPs don’t do buybacks – they generally pay out most of their cashflow and typically issue new equity for new projects.

Except now, EPD has announced they may initiate buybacks, reflecting another development in the shifting financing model for energy infrastructure. Traditional MLP investors (i.e. the wealthy, taxable Americans who are willing to deal with K-1s) have turned out to be an unreliable source of new capital. They like their distributions but they don’t like reinvesting them through secondary offerings or IPOs. This relative tight-fistedness has exposed the comparative largesse of MLPs in distributing most of their cashflow at a time when the Shale Revolution has created opportunities to put it back into their businesses. This is why many large MLPs have concluded that the structure doesn’t work if you need to raise a lot of money.  Kinder Morgan was the first to pursue “simplification”, which by now is understood to result in reduced payouts, freeing up more cash for investing in new projects and therefore less need to issue equity at high yields.

The point of having a public equity listing is to be able to raise capital. The 7.6% yield on the Alerian Index doesn’t entice investors as much as it should because they suspect further simplifications. But for MLPs, it still represents an unreasonably high cost of financing.

EPD is conservatively run, and a reduced growth rate in their distribution is a modest step to redirect capital internally so as to lessen their need to raise money externally. It’s simplification-lite. Intriguingly though, rather than boost the growth rate back up in a couple of years, they may buy back units. Stable distributions are highly prized and even the best run businesses want to shield investors from variability in profits with highly predictable payouts. EPD is introducing greater capital flexibility, since buybacks are never guaranteed. They’re adopting one feature of a C-corp (lower payout ratios) while retaining the tax-efficient MLP structure.

An interesting debate is whether the large MLPs abandoned the investor (as holders of Kinder Morgan Partners certainly felt) or whether the MLP investors abandoned MLPs (as demonstrated by persistently high yields). Simplification transactions and more minor changes such as EPDs are all a result of MLP investors not wanting to reinvest their cashflows as eagerly as their businesses would like them to.

It’s the best explanation we have to justify continued weakness in the sector, as the investor base migrates (not altogether smoothly) away from the yield-seeking to the growth-oriented buyer.

We are invested in EPD

Downside Risks for MLPs

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The Shale Revolution is a powerful recent example of why America’s system of capitalism is so enduring. We’re not just leaders in shale oil and gas, the U.S. is pretty much the only game in town (see America Is Great!). One day it will probably be the basis for college courses across the country to illustrate the power of the free market. A year ago OPEC abandoned its efforts to bankrupt the U.S. shale industry through ruinously low crude oil prices (see OPEC Blinks). Although it wasn’t well recognized in many other parts of the world, our domestic energy industry was able to harness a long list of advantages:

1) The right geology

2) Existing network of energy infrastructure

3) A highly skilled labor force

4) An entrepreneurial culture

5) Water supplies in the right places

6) Technological excellence

7) Constant drive for productivity improvements

8) Privately owned mineral rights

9) Highly developed capital markets

It’s not the first time the U.S. has used its economic advantages to win a battle. As a result, we are on a path to greater energy security, improved geopolitical flexibility and American Energy Independence.

It’s a great story and recounting it to clients is never boring. But where can it go wrong?

Clients often ask, and it’s a fair question, not least because few investors have forgotten the 58.2% drop in the Alerian Index from August 2014-February 2016. The recent distribution cut at Plains All American (PAA) (see MLP Investors Learn About Logistics) remind that the occasional negative surprise remains possible across a landscape of generally rising cashflows and declining leverage.

The most obvious threat is a recession. Energy infrastructure is about moving, processing and storing volumes of hydrocarbons. If economic activity slows, energy consumption of all kinds slows too. Although many pipeline contracts are underwritten by volume commitments from shippers, overall cashflows for the sector would still suffer from less throughput. During the 2008 Financial Crisis MLPs fell along with everything.

Lower crude prices are an ever-present threat, very real after 2015. Oil affects investor sentiment far more than cashflows, as we often note. However, the industry is also much more invested in the growth of domestic hydrocarbon output than it was ten years ago. The sensitivity of domestic production to pricing broadly affects the utilization of existing and newly built capacity. Energy infrastructure is mostly about volumes, but those volumes are increasingly sensitive to prices. As the U.S. increases its role in export markets, domestic output will be impacted by global prices.

Slower growth and weaker hydrocarbon prices are the obvious threats. Geopolitical risks rarely receive consideration until they’re presenting an imminent threat, but we think about those too.

The Middle East remains an unstable place. The nuclear agreement with Iran is at some risk of being abrogated by the U.S., with unpredictable regional consequences. Substantial crude oil passes through the narrow Straits of Hormuz, between Iran and the United Arab Emirates. The recent vote by Iraqi Kurds for independence risks creating a backlash not just from Iraq’s central government but also from Turkey with its sizeable Kurdish population. Recently, Turkey suspended deliveries of oil from Iraqi Kurdistan passing through a pipeline on its territory.

A disruption of crude oil from the Middle East would drive up prices, and might even stimulate increased U.S. production if sustained. In any event, domestic output would be unlikely to fall.

North Korea represent another potential hotspot, with the very real possibility of the U.S. being involved in armed conflict. While we won’t make any investment forecasts based on a scenario of war on the Korean peninsula, we do note that the physical assets of energy infrastructure businesses are virtually 100% located in North America dispersed across the country. There’s minimal non-U.S. exposure, although swings in commodity prices could still impact significantly.

When considering what can go wrong outside America, investments in Energy Independence would seem to offer more protection than other sectors.

The tax reform proposals lack sufficient clarity to assess their impact. However, a lower U.S. corporate tax rate should boost after-tax profits at most corporations, In addition, allowing investors in pass-through vehicles (which should include MLPs) to pay tax on their passive earnings at the lower, corporate rate rather than at ordinary income tax rates should further boost their attractiveness (see MLPs and Tax Reform).

Former Defense Secretary Donald Rumsfeld’s famous “unknown unknowns” are what planners in many fields worry about. What we’ve highlighted above includes certain known “tail-risk” events (i.e. unlikely but impactful). We consider these regularly, and new ones as they appear on the horizon. Part of defense includes owning solid businesses and avoiding leverage, which is how we invest.

A Futurist's Vision of Energy

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Recently a client drew our attention to a presentation by Stanford University Futurist Tony Seba. He has made a splash with his predictions of imminent, dramatic changes in the transportation industry. In less than a generation he expects a world of self-driving (i.e. autonomous), electric vehicles (EVs) supported by a heavily solar/wind-powered electric grid. In June he gave this presentation which you might find interesting.

Tony Seba is an engaging presenter. Moreover, the future of U.S. energy infrastructure will be impacted both by the increasing use of renewables for electricity generation as well as the growth in EVs (renewables and EVs are separate topics, albeit linked). In discussions with investors both of these topics regularly come up. There’s the near-term impact on the sector of growing production driven by the Shale Revolution. Farther out, the growth in renewables (mainly solar and wind) combined with dramatic improvements in battery technology, could represent an existential threat to segments of the U.S. oil industry.

We read and think about these issues a lot. Behavioral economists teach that humans tend to make overconfident forecasts, whether it’s of equity returns, jellybeans in a jar, or the impact of new technology. Precise forecasts exude confidence and draw attention. A date when EVs will predominate is more eye-catching than a range of dates within which such change is more likely than not. Nonetheless, precision in such matters is usually wrong, and we are not with Tony Seba at the extreme end of predictions; the future is rarely so certain. He makes some specific forecasts, including that crude oil demand will peak in 2020-21, after which it will fall 30% by 2030. He also forecasts that by 2030, 100% of new mass-market vehicles bought in the U.S. will be autonomous EVs.

Exxon Mobil (XOM) recently published Outlook for Energy: Journey to 2040, their regularly updated long-term energy forecast. They have an institutional bias towards fossil fuels so they’re never going to line up with a futurist. Nonetheless, forecasting energy use is critical to their long term survival. Seba includes a reference to Eastman Kodak, a company which invented digital photography and was then destroyed by it. XOM will be aware of that example of disruptive technology.

The Outlook for Energy makes forecasts too, beginning with growth in global GDP and population. They forecast 1.8 billion cars, trucks and SUVs on the roads in 2040 (versus 1 billion today) as rising living standards in developing countries drive demand. While expecting impressive percentage growth rates in wind and solar, they expect oil and natural gas to increase their share of the world’s energy needs. Overall, they see fossil fuels slipping modestly, from above 80% to just under 80%, with both coal and oil losing market share to natural gas. They expect crude oil consumption to be around 17% higher in 2040 than it is today. By 2040 they expect 15% of new car sales globally to be hybrids, and 10% of U.S. car sales to be EVs.

To summarize:

  Seba XOM
Electric Vehicles 100% of U.S. sales by 2030 10% of U.S. sales by 2040
Crude Oil Consumption Down to approx 70MM Barrels per day by 2030 Up to approx 115 MM Barrels per day by 2040

 

One of these will be spectacularly wrong.

Although they’re both point forecasts and so unlikely to be precisely right, we think it’s more likely Seba will miss by a lot. His presentation opens with an old photo of New York’s Fifth Avenue in 1900 full of horse-drawn vehicles, and moves to 1912, same place, with all automobiles. It’s true that some new technologies have been highly disruptive, but it doesn’t follow that they all are. Seba’s analogy to the car is intended to validate his EV/solar forecast, although he wasn’t around in 1900 to predict the former.

Growth rates can quickly lead to exponential change when projected out a decade or more. Yet change more often follows an “S” curve, with a high growth rate during widespread adoption followed by slower growth thereafter. We think it’s unlikely the electric grid could adapt so quickly to transmitting the substantially increased electricity required to run a national EV fleet. We also note Seba’s assuming no new advances in the technology of the internal combustion engine, whereas there are continual improvements here too. And the Shale Revolution itself is a form of disruptive technology. We think natural gas is the most likely winner, as it’s the cleanest fossil fuel and enables increased use of renewables by providing baseload electricity for when it’s not sunny or windy.

The price advantage Seba forecasts for solar assumes that the recent substantial productivity improvements in shale drilling don’t continue at all. In fact, he assumes that all the losers, which includes automakers, utilities, oil and gas producing companies, refineries and all those invested in life today as we know it, will stand by passively while their business models are disrupted by new technology. In fact, they are and will continue to respond, by improving their own technology. Furthermore, until battery storage technology and cost improve substantially, we still need backup power for intermediate solar power.  This provides demand for of fossil fuel baseload capacity, which often comes from natural gas “peaker” plants (i.e that run only during times of high demand). It’s hard to see a widespread transition to renewables without increased natural gas usage..

An 80% drop in car ownership by 2030 (another Seba forecast) implies widespread car-sharing. Using an Uber-type app to summon an autonomous EV when you need it suggests acceptance of a generic car. What if you need a babyseat? Extra room for luggage? A big family? We think car demand will remain more heterogenous than Seba suggests. Other non-technology hurdles include issues of liability — if your autonomous EV causes an accident, who’s at fault? What if a software bug causes multiple, simultaneous collisions? The deep-pocketed corporations developing the technology will need protection from class action lawyers before it is allowed to go mainstream.

Directionally, Seba’s probably right in that we’re eventually moving to EVs. But investing requires timing too. Seba’s most extreme, widely known forecasts could miss and yet still gain plaudits for getting the direction right, in the same way an equity analyst might gain followers with the highest target price for a hot stock even if it never gets there. But as investors, we care about pace of change as well as direction. Vaclav Smil, a thoughtful and prolific writer about many topics including energy, articulated the major impediments confronting widespread, rapid adoption of renewables. This brief essay, albeit nearly four years old, is still relevant.

The left chart in the panel below looks complicated, but it shows the proportion of primary energy delivered by each source going back two centuries, on a semi-log scale. The point is that growth slows sooner than expected, and the notes underneath highlight that fossil fuels in aggregate stopped gaining market share in the 1970s, which is probably not intuitive to most people. The chart is from Energy Transitions: Global and National Perspectives, 2nd edition (2016) by Vaclav Smil. The chart on the right shows sales of hybrids and the sensational early growth that fizzled out. Had Tony Seba been giving his presentation in 2005, he probably would have had a chart projecting a car market dominated by hybrids and leaping from its then current 1.4% market share, whereas a decade later it was at 2.0%.

And yet, it really is an exciting future. Personally I can’t wait for autonomous vehicles. I’m sure I’ll own one myself once the technology is proven (I am known by my friends as a late adopter of new things). Being driven by software so the passenger can read, send a text message or even sleep will surely be a great improvement in safety. When I’m finally in my autonomous EV and not driving I’m sure it’ll be better for those around me. Although  Seba doesn’t highlight this, one of the strongest arguments in favor of autonomous vehicles is that the software will operate them more safely than unpredictable, sometimes impaired humans. Automobiles kill nearly 1.3 million people globally every year and an additional 20-50 million people are injured or disabled. In this arena like so many others, technology will eventually make the world a better place.

We watch these and other developments carefully. We acknowledge the danger of holding any view with excessive confidence, and new information can cause a reassessment.  The further out one goes the harder it is to be certain about oil demand and its price. Growth in wind, solar and other future energy technologies should be taken seriously and must already be a consideration for any big, conventional oil and gas project with a projected return over decades. The optimistic case for renewables highlights the incredible advantage of the Shale Revolution, where development costs are low, production quick, and investments recouped in months. This compares favorably with conventional projects (respectively, high, slow and over many years).  For now, we believe Tony Seba’s vision is farther off than he thinks, but what a fascinating journey we will be taking with American innovation revolutionizing the global energy markets from both sides.

Energy Sector Gathers Momentum

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Last week I was chatting with an investor about the attractive valuations in the MLP sector. 2Q17 earnings were generally in-line, with the notable exception of Plains All American (see MLPs Learn About Logistics). Valuations are compelling, with the yield on the Alerian Index currently sitting at 5.5% above the ten year U.S. treasury, 2% above its 20-year average. On an Enterprise Value to EBITDA basis, energy infrastructure compares favorably with Utilities (see The Changing MLP Investor).

And yet, even though MLPs and crude oil have generally been moving together this year (see Crude and MLPs March Higher Together), in recent weeks MLPs have lagged the bounce in oil. So the natural question is, what is the catalyst that will cause investors to act on these valuation advantages?

CFA charterholders have to pass three fairly rigorous exams that (among other things) demonstrate an ability to analyze financial statements. In an effort to include most forms of equity analysis there is a brief section on Technical Analysis. When I studied that material I could almost feel the apologetic tone from CFA Institute as they reconciled undoubted antipathy towards an area that has wide adherence and works just often enough to warrant inclusion.

Many investors we know rely on fundamental analysis to make decisions but then use technical analysis to refine timing. The merits of an investment change far less often than its price, and technicals can help here. We’ve noted a pick-up in activity from some buyers partly because such analysis is indicating a change in trend.

It’s not just crude oil that has developed a recent uptrend. The broader energy sector has also moved sharply higher, with prices now above the 200-day moving average. In 2015 a tough operating environment for exploration and production companies (i.e. the clients of MLPs) led to substantial weakness in the energy infrastructure sector. Although they are clearly not synchronized, recent strength in crude and energy stocks would seem likely to improve sentiment among MLP investors. Performance between the two sectors is unlikely to diverge for long.

On a different topic, Alerian announced last week that they’d be capping individual constituents at 10% in the Alerian MLP Index (AMZ). This is a sensible move that brings this index into line with the Alerian MLP Infrastructure Index (AMZI). Enterprise Products Partners (EPD) was most impacted because it was previously 20% and was the cause for the change.

EPD’s share has risen in part because their market cap has risen relative to their peers but also because some MLPs have simplified their structure and been dropped from the index. The most recent example was Oneok (OKE), which merged its GP-owning C-corp OKE with its MLP, Oneok Partners (formerly OKS). Many people think of Kinder Morgan (KMI) as an MLP but following their simplification in 2014 which saw the assets of Kinder Morgan Partners absorbed into KMI, they have no longer been part of the AMZ (although still in AMZI). There’s more to energy infrastructure nowadays than MLPs, and C-corps represent an increasingly significant element.

Although Alerian does a good job in managing their indices, they have an odd way of measuring distribution growth. The 6% average annual growth rate they report reflects trailing growth of the current constituents, not the actual growth of the constituents that were in the index at the time. So the recent change in EPD’s weighting, which will similarly boost the weighting of several other names, will alter the historic growth rate. The actual growth rate experienced by investors in the Alerian Index of course won’t change. Running an index is complicated.

Finally, we’re heading into the fourth quarter, a time when seasonal patterns around MLPs become more important. In last year’s blog post on the topic (see Give Your Loved One an MLP This Holiday Season) we explained which months were best for buying purely when considering seasonal patterns. It’s worth rereading if you’re thinking of investing over the next few months.

We are invested in EPD, KMI and OKE

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