The Sand Rush

The resilience of the Shale Revolution in in the face of the 2015-16 oil price collapse is due in large part to dramatic improvements in productivity. Exploration and Production companies have strived to achieve more while using less of everything. Fewer rigs, for shorter times; less cement by drilling multiple wells on a pad; less water by recycling, and so on. But there’s one commodity whose volumes are growing substantially. Sand.

Hydraulic fracturing (“fracking”) involves pumping water combined with some other chemicals and sand (called “proppant”) into wells at high pressure. The rock cracks in millions of places as a result, and the sand allows the hydrocarbons to flow as the grains prop open these numerous cracks.

As fracking techniques have evolved, it’s turning out that more sand is better than less. Finer sand props open tinier cracks as well as being easier to transport. The need for more sand per well along with the increasing rig count have led to a big jump in sand use by the industry. A year ago I was at a dinner at which a senior executive from Antero Midstream (AM) described how this was playing out. Subsequently we’ve seen E&P companies such as Pioneer Natural Resources (PXD) note the advances made through increased sand utilization.

Goldman Sachs sees 36% annual growth in sand use by the industry, far faster than projections of oil and gas production. It means the price per ton of sand is increasing, and success for suppliers relies heavily on logistics.

Sand is heavy, so proximity to customers saves on transportation. Wisconsin is a key supplier of sand to the Bakken Shale in North Dakota. Illinois ships sand to the Permian in West Texas, although in-state Texan mine sources clearly have a big edge. Access to rail transportation is another key differentiator for suppliers, as are improvements in ease of delivery. Faster drop-off reduces truck waiting times and helps profitability. U.S. Silica (SLCA) is a leading supplier of sand to the oil and gas industry. They have positioned themselves as a consolidator in an industry still wrestling with too much debt. Their advantages include ready access to four large rail networks as well as substantial assets in Texas, both of which allow them to deliver sand more cheaply than their peers.

Last year SLCA acquired a company called Sandbox. Sandbox shipping containers allow for easier handling of sand, cutting delivery times as well as reducing the release of silica dust. SLCA has ambitious goals for their patented container technology, aiming to increase market share from 10% to 40-50%. Sandbox represents a form of vertical integration by SLCA using better technology as they seek wider margins in a tightening market. It’s one of the less well known stories in the Shale Revolution, but provides an example of the type of innovation that is driving increased output as we head towards Energy Independence. Notwithstanding its drop on Thursday following earnings, we continue to like its longer term prospects.

We are invested in SLCA

The Changing Face of Oil Supply

There’s a developing paradigm shift under way in the oil market. It is manifesting itself through the quarterly earnings reports of many energy sector companies. At a high level, discoveries of new oil and gas fields recently fell to a 60-year low. Last year there were 174 oil and gas discoveries, compared with 400-500 a year until 2013. 8.2BN barrels equivalent of oil and gas were found, a fifth of the equivalent figure in 2010 and a level last seen in the 1950s.

Capex budgets for conventional exploration have been slashed. Chevron (CVX) cut their $3BN 2015 budget to $1BN last year. ConocoPhillips (COP) is pulling out of new deepwater projects altogether. Baker Hughes (BHI), who provide services to the industry, saw weakness in their non-U.S. business that was partially offset by strength in the U.S.

But not everyone is cutting back. Marathon Oil (MPC) is doubling its investment in new shale projects. Continental Resources (CLR) is spending $1.7BN which they expect will drive 20% annual growth in oil and gas output through 2020. Devon Energy (DVN) is planning to add rigs in the Barnett Shale where they’ll exploit advances in technology to “refrac” previously drilled wells. On DVN’s recent earnings call, CEO David Hager described their plans to use modern drilling and completion technology in areas that had previously exhausted their commercially viable output.

These companies and others like them are the customers of the energy infrastructure businesses that we own. For example, Enlink Midstream Partners (ENLK) is the direct beneficiary of DVN’s activity because their increased output will flow through ENLK’s infrastructure. It doesn’t hurt that ENLK’s General partner, Enlink Midstream LLC (ENLC), is owned by DVN. So we follow the plans of domestic Exploration and Production (E&P) companies even though we’re not directly invested in them.

The crude oil market (and to a lesser extent natural gas),  is shifting in ways that are incredibly favorable to  the U.S. The key lies in the differences between shale and conventional production.

The reasons are in the table above, and were described in America Is Great! Conventional oil projects take a long time to implement and earn back their capital investment. Shale projects are the opposite. To understand how the U.S. is the big winner, consider how you would evaluate a conventional oil project costing, say, $1BN up front with a ten year payback period that is profitable only with oil above $50.

Once you commit, you can only hedge your crude exposure out for two or three years. You can analyze the oil market and arrive at reasonable price projections, but it was at $26 a barrel a year ago. So it might get there again. Shale technology keeps improving, so you have to assume that breakeven costs for shale output will continue to fall. It was shale output that caused the last crash. In approving the $1BN investment you have to make a judgment on the probability of a ruinously low oil price making your project unprofitable. And you can’t hedge this risk.

People often ask me what is the breakeven for U.S. shale production. There is no specific number, it varies from less than $20 per barrel in some places to well over $100. The production that is profitable takes place, and the unprofitable doesn’t. Profitability isn’t binary, with the industry all making profits above $X per barrel and losing money below. Costs can be substantially different even within the same play. It’s not a homogeneous industry. It’s more accurate to think of a finely graduated supply curve that increases output by 25-50K barrels a day for each $1 increase in price. Their short response time allows shale producers to drill and complete additional  wells within months in response to improved economics.

Over the next ten years crude oil might stay above the $50 breakeven in the hypothetical project described above, and yet the project never get done because the risk of a price collapse was ever-present, hanging over the project’s IRR like the sword of Damocles. In this way, supply that could have been produced commercially will not come to market, allowing the nimble producer with a short response time to benefit from prices higher than they might have been otherwise. Because shale producers don’t face the same magnitude of price risk, they are in a far stronger position. Last week, the U.S. exported 1 MMB/D of crude oil. BP CEO Bob Dudley recently said that U.S. shale production will keep a check on any spikes in oil prices.

Price cycles in crude oil should be milder in the future, because the market has a shorter response time for new supply. Costs will continue to fall for “tight” oil and gas. America’s energy business has extraordinarily strong prospects.

We are invested in ENLC

A Year After the MLP Crash

A year ago, on February 11th, the Alerian MLP Index (AMZX) put in its low. Following a relentless 58.2% drop from its peak on August 29th, 2014, the selling was finally exhausted. As a retired bond trader friend of mine has said, “Down was a long way”. And indeed it was. The biggest and longest bear market in the history of the index since its creation in 1996. As one whose portfolio holds MLPs in rather more abundance than most readers, I shan’t soon forget the wonder with which we regarded such wholesale liquidation. We never accepted that operating performance of midstream businesses was correctly reflected in those prices. Our conclusion about 2015 was that the real issue was one of the industry needing more growth capital than was available from its fairly narrow traditional investor base (who must generally be U.S., high net worth, taxable and K-1 tolerant). We first articulated this view in The 2015 MLP Crash; Why and What’s Next. The subsequent rebound seemed to support this, since operating results for midstream MLPs generally continued to be within expectations. More recently, in MLPs Feel the Love, we continued with this theme of different investor segments by reviewing how the need for capital was causing some energy infrastructure firms to adapt their corporate structure.

The Alerian Index shows distribution growth that never faltered, dipping only slightly from 6.3% in 2014 to 5.1% in 2015. How could any sector fall so far while continuing to grow payouts? In truth, it does present a slightly rosy picture, as the historic growth figures are based on today’s components of the index. Those MLPs (mostly Exploration and Production, not midstream) who cut or eliminated distributions were ejected from the index, and they took their past with them. Some might find this revisionist history somewhat Orwellian, although hedge fund index providers routinely “backfill” their index series with performance of new additions while removing all trace of those who drop out. Since good performance tends to get you in an index and bad performance gets you out, the consequently recalculated past results are not so easily attainable. Investors who held a cap-weighted portfolio of MLPs seeking to track the index in real time experienced a rather bumpier ride. Nonetheless, today distributions are increasing. Based on quarterly earnings reported so far, R.W. Baird notes 3.0% year-on-year growth in MLP payouts.

Readers should not assume any smugness on our part simply because MLPs have rebounded 77% from the low of a year ago. Such would surely invite the Market Gods to react. There’s always downside, but it does at least appear that today’s MLP investors have committed capital with more thought than the cohort who exited in 2015. All it takes is a glance at recent history to see what the downside might look like if repeated. It wasn’t pretty, but the energy infrastructure industry has upgraded its financiers. Those whose research consists of a price chart have been replaced with a crowd of deeper thinkers, to everybody’s benefit. Many of today’s MLP investors came in because of values, not momentum.

Views on energy infrastructure became synonymous with crude oil over the last couple of years, for good reason. We long ago ditched the slide showing a low correlation between the two. Although the relationship has varied substantially over the past two decades, the Shale Revolution has probably shifted things. Since MLPs care about volume, before domestic energy production was expanding the basic question concerned utilization of the existing network of infrastructure. Now that America can see its way to Energy Independence, supported by increasing domestic production, investors reasonably ask if the additions to infrastructure will be fully utilized. Fluctuations in oil and gas prices do impact production, and large swathes of the U.S. now benefit from higher oil whereas traditionally, lower crude was regarded as a tax cut. Moreover, the Energy ETF XLE now includes energy infrastructure names such as Kinder Morgan (KMI) and Spectra (SE), as well as other energy names that own infrastructure assets. This will inevitably strengthen the relationship between moves in the energy sector and the infrastructure that supports it.

Although the correlation has been falling recently, a stronger positive relationship is likely in the future. We believe there is a good case for rising crude prices (see Why Oil Could Be Higher for Longer) which will further underpin MLP performance. BP just revealed that their business model is predicated on a $60 price for oil by the end of 2018, higher than where it is today.

One of the minor positives of recent media coverage has been the absence of many bullish articles in the financial press. Regrettably, Barron’s finally found the confidence to move out along the ledge with a cautiously optimistic piece last weekend. Is It Too Late To Get In on MLPs’ Latest Bull Run does at least acknowledge in the title that 77% and 12 months after the low they are not exactly catching the proverbial falling knife. Fortunately, constructive articles are not yet an onslaught, so it’s still possible to own MLPs without fearing that it’s everyone’s favorite trade. A year ago bearish articles were abundant, including MLPs: Is the Worst Over? Within days of the low, this Barron’s piece (originally titled The Worst Isn’t Over as its URL betrays) countered its cautiously optimistic heading by quoting a breathless young analyst, “We’re in the early innings of the MLP down-cycle…we had a 15-year up-cycle, and now we’re a year and a half into the downturn.”

The investment writer unburdened by responsibility for managing other people’s money can draw comfort from the knowledge that the victims of poor advice may be few or even non-existent. Much is written and read on investments without being acted upon. Our own constructive tone in writing on MLPs in 2015 contrasted rather painfully with investment results that mocked our prose. One client memorably noted that it would be nice if the quality of our writing was matched by investment performance!

The fee-paying deserve the privilege of offering such feedback. Assuming the writing has remained interesting, over the last year its congruence with returns has improved dramatically.

On a separate note, from time to time fears surface that MLPs will lose their special tax status and be taxed like regular corporations. It’s highly unlikely, but in any event the status quo received support recently from Congress’s Joint Committee on Taxation which estimated foregone revenues from 2016-20 at $4.9BN, down $1BN from prior estimates.  Part of the reason is that some MLP investors pay tax on their holdings, notably investors in AMLP and other taxable, C-corp MLP funds (see Some MLP Investors Get Taxed Twice). Not only are such investors hurting themselves, but they’re helping the rest of us by making a revision of MLP tax treatment even less likely. A generous bunch.

We are invested in KMI and SE

MLPs Feel the Love

The early part of 2017 has been kind to MLP investors. The generally reliable year-end effect has seen prices rise (see Give Your Loved One an MLP This Holiday Season). President Trump’s unabashedly supportive stance towards energy infrastructure has certainly helped sentiment, as have a number of corporate finance moves. The Alerian Index is up almost 8% so far this year (through Friday, February 3rd),  as investors have acted on the positive news. MLP CEOs are Trump fans because they see lots of positives for their industry in his policies.

But behind the scenes, some of the C-corps whose General Partners (GPs) control their MLP are reassessing the GP/MLP financing model. In 2014 Kinder Morgan led the way by consolidating their structure. The MLP is a good place to hold eligible assets; the absence of a corporate tax liability (because MLPs are pass-through vehicles) lowers their cost of equity capital. Countless corporations over the years have “dropped down” energy infrastructure assets into an affiliated MLP in order to take advantage of this. However, the Shale Revolution has ironically challenged this model.

This is because the universe of MLP investors is limited to U.S. taxable investors. In practice, it’s further limited to high net worth (HNW) investors because the dreaded K-1s provided by MLPs (rather than 1099s as is the case with regular corporations) are only really acceptable to people who have an accountant prepare their tax return. Tax-exempt and non-U.S. investors face formidable tax barriers which largely eliminate their interest. Although investors in U.S. equities are mostly institutions from around the world, these considerations mean MLPs are mostly held by U.S. taxable, HNW, K-1 tolerant investors. This group is a small subset of the universe of global equity investors.

The Shale Revolution has created a need for substantial investments in America’s energy infrastructure (see the chart America’s Infrastructure – More Growth to Come in America Is Great!). Traditional MLP investors (U.S. taxable, HNW, K-1 tolerant) are not willing or able to provide the financing needed. This most obviously manifested itself in 2015 when MLP prices crashed under the weight of the need for growth capital (see The 2015 MLP Crash; Why and What’s Next). Kinder Morgan to some degree anticipated this when they simplified their structure. By moving their assets from Kinder Morgan Partners (KMP) to Kinder Morgan Inc. (KMI), they vastly increased their potential investor base.

In the process KMI took advantage of tax rules that allowed them to create a substantial tax shield. When they bought the assets from KMP, their value was stepped up from carrying value to current market. Normally, if Company A buys Company B for $100 and Company B’s book value is $60, the $40 premium to book value sits on Company A’s balance sheet as Goodwill. This is a balancing item, since you can’t spend or depreciate Goodwill. However, KMI showed that when buying a partnership (or more precisely, the assets held by the partnership), those assets are in effect revalued at $100 (using our prior example). There’s no Goodwill, simply assets whose carrying value is now their current market value. In the case of KMI, depreciation was then calculated from this higher level, allowing KMI to offset its taxable income with depreciation charges totaling $20BN over many years. The flip side of this was that KMP investors wound up with an unexpected tax bill. KMP was widely held by MLP investors, and this unwelcome tax surprise has left many with a bitter taste ever since. For more on this, see The Tax Story Behind Kinder Morgan’s Big Transaction.

Oneok (OKE) basically did the same thing last week when they bought up the units of Oneok Partners (OKS) that they didn’t already own, thus consolidating into a single entity. OKE has an estimated $14BN tax shield, helping to fuel faster growth since they’re not paying taxes for a few years. OKS investors will get an unwelcome tax bill just as was the case with KMP. It’s not a terrible transaction other than the pricing. Once again, the advice provided by their investment bank was poor. In fact, I’m reminded of Ronald Reagan’s quip that the nine most terrifying words in the English language are, “I’m from the government and I’m here to help.” If Reagan was an MLP investor today, he would update his warning to be, “I’m from Wall Street, and I’m here to help.”

MLPs have been the victims of so much bad advice lately from highly paid investment bankers that it’s hard to remember any actions that were the result of good advice. Most recently, OKE somehow convinced themselves that a 23% premium to the prior day’s close was an appropriate price at which to buy OKS units, even though they already owned 40% and controlled the entity. In this case, JPMorgan Securities and Morgan Stanley are the banks whose advice destroyed value for OKE. A premium of 5-10% would have been more than sufficient reward to OKS holders. They would have shared in the $14BN tax shield anyway through swapping their OKS units for shares in OKE. A big premium wasn’t necessary. Morgan Stanley investment bankers are active purveyors of wrongheadedness – only a few weeks ago their advice to Williams Companies (WMB) led to a sharp drop in their stock price when it emerged they’d given up their Incentive Distribution Rights (IDRs) too cheaply (see Williams Loses Its Way). WMB raised $1.9BN in equity which was then funneled to Williams Partners (WPZ), illustrating that they regard the C-corp as the better way to access investors but in the process weighing down the peer group of C-corps.

Putting aside the cost of lousy investment bankers, the theme behind these and other moves is that U.S. energy infrastructure has tremendous growth ahead of it. OKE and WMB are positioning themselves to be able to finance this growth in the most efficient way possible. They may in time need more financing than traditional MLP investors will provide. Other recent transactions, such as Plains All American’s (PAGP) $1.2BN investment in a Permian Basin gathering system, or Targa Resources Corp’s (TRGP) secondary offering to finance up to a $1.5BN investment (also in Permian gathering assets) similarly reflect growth opportunities. The market was non-plussed with both of these, in part because they involve new sales of stock by each company. But there are increasing signs that Permian crude oil output will challenge the existing take-away capacity from the region, improving the pricing power for those pipelines already in place.

In total, all this activity has been good for MLPs, thanks in part to Wall Street bankers guiding their pliant clients to overly-generous deal terms. Somewhat for the same reason, it has been less good for the C-corps that control these and other MLPs. However, the driver behind all this activity is the road that takes America to Energy Independence. Energy infrastructure managements are reconsidering the structure and making new investments precisely because of the growth opportunities they see. Through all this there is a certain life-cycle to the GP/MLP. Since it’s hard to do better than hold assets in a non-tax paying entity, the MLP is hard to beat:

  1. Energy corporation “drops down” assets to MLP it controls through its GP stake. GP earns IDRs, creating Hedge Fund Manager/Hedge Fund type relationship
  2. Combined enterprise grows and reaches point where IDR payments to GP start to drag on MLP cost of equity capital, and need for equity financing demands access to global equity investor base
  3. Corporation buys back MLP, acquiring assets whose carrying value has been depreciated down far below market. Resetting the assets allows depreciation from this higher level, eliminating tax obligation for some years which fuels faster cashflow growth while saddling MLP investors with unwelcome tax bill.
  4. As assets are depreciated down, holding assets in the corporation becomes less efficient as they start owing taxes again. Creating an MLP (Version 2) becomes increasingly attractive.
  5. Return to #1

The largest energy infrastructure businesses are concluding that they need to be a corporation. If the balance sheet value of their assets is high enough the resulting depreciation charge can, for a time, offset their taxable income. A non-tax paying C-corp can be preferable to an MLP, because you can access more investors. But in time the depreciation charge loses its ability to offset taxable income. At that time you might see some of these companies create MLPs again, repeating the cycle.

The GP/MLP structure remains attractive for a great many businesses whose enterprise value is below the $30BN or so level at which size seems to become an issue. And because of the tax shield, the bigger firms are finding ways to hold infrastructure assets with many of the advantages of an MLP. Whether held in a C-corp or MLP, America’s energy infrastructure is largely exempt from paying corporate taxes, allowing more of the returns to flow to the owners.

Change and Uncertainty

As I watched President Trump’s inauguration speech on January 20th, I was reminded of Paul Kennedy’s 1987 book, The Rise and Fall of the Powers. Kennedy charts the arc of many great empires over the last couple of millennia. He finds a repeated cycle of geographic enlargement through technological and economic dominance followed eventually by what he calls “Imperial Overstretch”, as maintaining control exceeds the resources available. It’s a big topic well beyond the scope of a monthly newsletter to adequately address; many will challenge the notion of the U.S. as an empire, and will reject that decline in any form is imminent. But America’s share of global GDP is shrinking simply because other countries are catching up. Greater geopolitical competition makes staying ahead ever more costly.

What prompted this thought was the vision of an America more ready to examine the payback from neighborly interactions. The post-World War II period began with America investing in rebuilding a broken Europe and Japan out of an unquestioned faith that benefits would accrue back. Perhaps we are now acknowledging that if the world doesn’t bother us we’ll leave it to its own devices; a more transactional approach will govern sovereign relations. Other countries have plenty of resources too. The wars in Iraq and Afghanistan following 2001 have cost up to $5TN by some estimates, echoing Kennedy’s warning about foreign entanglements ultimately exhausting resources.

“We do not seek to impose our way of life on anyone, but rather to let it shine as an example. We will shine for everyone to follow.” If you focus on the words and not the speaker, this is not a radical statement. While not soaring rhetoric, many could agree with the sentiment. Support for a more inward-looking America is not a new phenomenon, and finds adherents across the political spectrum.

Public policy is likely to shift in ways that will impact investment returns, more so than in many years. The great challenge in writing on such topics is to be non-partisan. Following the most divisive election in living memory, strength of feeling on both sides has not obviously weakened. Considering the investment impact of, or even support for, Trump Administration policy moves doesn’t imply endorsement of the candidate. We are just trying to allocate capital thoughtfully.

To pick one current example, on the first business day following his Inauguration Trump formally withdrew the U.S. from the Trans-Pacific Partnership (TPP). Obama had long pushed for the TPP as a way to bind the countries of Asia more closely together through trade and therefore shared prosperity. The European Union was originally conceived as the European Coal and Steel Community to end the string of three successive military defeats France had suffered against Germany by increasing trade links, making conflict prohibitively costly.
Trump’s assessment of the TPP was that the U.S. should negotiate bilateral trade agreements with other TPP countries. It may not appear quite so visionary, but there’s a certain industrial logic to a series of one-off deals. They’re simpler to negotiate, and the U.S. must enjoy a stronger position in any one-on-one discussion than as the largest in a room of twelve.

More broadly, if you’re looking for reasons to worry about the future there is plenty of material. Trump’s negotiating style rests on making demands that invite failure before agreement; how else to ensure the best terms have been achieved? Uncertainty is fuelled by the absence of prior government experience and unpredictability. These are positives or negatives depending on how you voted. Holding extra cash as protection against a negative surprise is understandable; it’s a comfortable, highly defensible posture and if worst fears aren’t realized the subsequent deployment of a lot of this cash will likely push stocks higher.

For investors in the energy sector, Trump has provided much to cheer and little of concern. Support for American Energy Independence and a renewed focus on infrastructure can only be good for the businesses that own the pipelines, storage facilities, fractionation plants and related properties that get hydrocarbons where they need to go. The sorry saga of the Dakota Access Pipeline (DAPL) built by Energy Transfer Partners (ETP) reflected poorly on President Obama’s capricious decision making. Having been properly approved by the U.S. Army Corps of Engineers and virtually completed, this $3.8BN project was delayed by the outgoing Administration, which in effect rescinded prior approvals without ever finding fault with the process ETP had followed.

The proposed pipeline under Lake Oahe in North Dakota passes below an existing pipeline. When completed, DAPL will move crude oil to market in the Midwest and reduce reliance on Crude by Rail (CBR), which is more expensive and more prone to accidents. The Washington Post, not exactly a stridently Conservative mouthpiece, noted that crude spills were significantly more likely with CBR than by pipeline when adjusted for volumes and distance traveled. The 2013 disaster in Lac-Megantic, Quebec when a trainload of crude oil exploded and killed 47 people led some to refer to CBR as “bomb trains.”

Meanwhile, $3.8BN in capital was kept waiting to produce a productive return while government policy was changed with little regard for the chilling impact on future projects or even basic fairness. This is a narrow issue and not an election-deciding one for most people. But few can be surprised at Energy Transfer Equity (ETE, ETP’s General Partner) CEO Kelcy Warren’s happiness at Obama’s departure – a sentiment shared by many energy industry executives. Trump’s swift approval of this project and the Keystone pipeline (another political hostage) were encouragingly pragmatic and certainly cheered MLP investors.
Most of the bad scenarios the concerned investor can imagine should not impact domestic energy infrastructure much at all. The likely thrust of policy will be supportive. Many equity sectors and individual stocks are close to all-time highs, exposed to the commensurate downside that can accompany lofty valuations. MLPs retain plenty of upside.

We are invested in ETE

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