Emerging Markets: Promises Unfulfilled, Time to Upgrade into MLPs

Most MLP investors are attracted by the regular distributions paid out by midstream infrastructure businesses. Some though, are wary of a repeat of the heightened volatility of 2015 even though evidence increasingly supports our analysis from early last year that an improbable confluence of circumstances was responsible (see The 2015 MLP Crash; Why and What’s Next).

I had just this conversation with a financial advisor last week, and I offered him the following perspective: if MLPs are too volatile to be an income substitute, an alternative approach is to consider them as a replacement for equity sectors that have similar volatility and with whom they share a meaningfully positive correlation.

Many advisors recommend an allocation to Emerging Markets (EM). The theory behind this is that because developing countries have faster GDP growth than developed countries, they should offer commensurately higher equity returns. The problem with this theory is that the transmission mechanism from GDP growth to equity returns is not uniformly effective all over the world. Weak corporate governance and property rights, uncertain contract law and government corruption can all interfere with a foreign investor’s GDP insight translating into appreciation of stock holdings.

Since 1996 (the inception of the Alerian Index, AMZX) the correlation of monthly returns on the MSCI Emerging Markets Index (MSCI-EM) with AMZX is 0.42. But it’s been rising, and over the past ten years it’s 0.53 and for the past five 0.55.Because the U.S. High Yield bond market is dominated by Energy issuers, when investors flee more risky borrowers their actions tend to ripple across Energy as well as EM. Asset class correlations generally have been rising, diminishing the benefits of some types of diversification. MLPs also have only around 80% of the volatility of EM. Moreover, since 1996 AMZX has returned 13.2% annually, almost four times the MSCI-EM’s 3.4% even though 2015 was a terrible year for the energy sector. Switching out of EM and into MLPs offers just this type of opportunity for a portfolio upgrade that doesn’t increase overall risk.

Some years ago when I was with JPMorgan, I was in India and had the opportunity to chat with a senior member of the Reserve Bank of India (RBI), the country’s central bank and securities market regulator. We had been meeting with Indian hedge fund managers while we considered the wisdom of adding an Indian investment to our portfolio.

“How many insider trading cases does the RBI prosecute in a typical year?” I casually enquired. “Oh none. There is no insider trading in India.” was the barely credible response. To which the only rational conclusion is that if your Indian investment manager isn’t actively using inside information, you’re unlikely to make much money. A JPMorgan due diligence questionnaire that sought an affirmative response on this question would have taken internal meetings with Compliance in a wholly unhelpful direction. We did not invest in India.

Most global companies have revenues and profits linked to EM. They have to allocate capital where they see the best opportunities, and navigate their way through each country’s business practices, laws and taxes to realize an appropriate return. The collective capital allocation decisions of the management of the S&P500 companies is almost certainly far better than that of any EM money manager screening locally listed stocks. If Coca Cola, P&G, Nike, Apple and so on in aggregate seek 3% exposure to Brazil, it takes a substantially mis-directed degree of self-confidence to assume one knows better. Therefore, many investors can hold their large cap equity positions and consider their optimal EM exposure achieved as well.

The S&P500 has generated an annual return of 8.6% since 1996, handily beating the MSCI-EM return of 3.4% noted earlier. In fact, the EM index is still 30% below its high from 2007, before the Financial Crisis. The figures clearly show that the relatively faster GDP growth of Developing Economies doesn’t translate into higher equity returns. Those investors seeking direct exposure are getting severely penalized.

Given the history and figures listed above, switching EM into MLPs is pretty compelling. The lower volatility of MLPs combined with their increasing correlation with EM means that the switch is likely to improve your portfolio’s risk characteristics. More importantly, it should substantially improve your return profile. MLPs regularly beat EM; since 1996, the one year trailing return on MLPs has beaten EM by at least 10% fully 48% of the time (the reverse statistic is only 24%). By contrast with EM, your domestic energy infrastructure investment benefits from attractive valuation, the tailwinds of America’s path to Energy Independence and a White House that is clearly supportive. Disputes over trade, a strengthening dollar or the overthrow of a foreign potentate are all challenges for the EM manager that will leave the MLP investor blissfully unharmed.

So if you’d like to participate in the secular growth in U.S. energy infrastructure that is driven by the Shale Revolution but are wary of classifying it as an income generating investment, use your EM bucket and improve your overall portfolio quality. If the K-1s put you off, look for a RIC-compliant mutual fund that provides 1099s.

What Matters More, Price or Volumes?

If you talk to investors about U.S. energy infrastructure, you’re pretty soon going to get to crude oil. A view on one is seemingly predicated on the other. Some investors mutter darkly about assertions in years back that Master Limited Partnerships (MLPs) are a toll-like business model with limited sensitivity to commodities. Although it remains largely accurate, such talk is rarely heard nowadays because it’s so at odds with recent market history. Fee-based cashflows and a pipeline network that is 93% non-crude oil (natural gas is a more frequent pipeline user) don’t sway people. So here are some charts and numbers to help.

Visually, MLPs and crude have had strong and weak relationships. We’re currently in a period of high correlation, because part of the MLP story relates to volume growth versus infrastructure capacity. Natural gas prices and MLPs have no statistical connection.

As we noted in MLP Investors Digest Supply, getting granular involves forecasting hydrocarbon output versus take-away capacity. The chart below on the Permian Basin illustrates.

Crude oil production and the means to transport it away are both expected to grow. Exploration and Production (E&P) companies co-ordinate closely with infrastructure providers to match oil supply with take-away capacity. An E&P company with no ability to get its output in a pipeline network is no happier than the owner of an empty pipe. Future Gathering and Processing take-away capacity has more visibility than does future output, but both sides are trying to match expectations. And of course there are many players of all sizes, which makes it a complex dance.  If you own infrastructure in the region you want output to grow faster than expected, increasing demand for your scarce resource. Higher oil prices make this more likely. Hence, some sensitivity between crude oil and MLPs makes sense, although not to the degree seen recently.

Over the last decade, U.S. crude oil and natural gas output have steadily increased, with a modest pullback in 2015-16. The above chart also shows that on an energy equivalent basis we produce almost twice as much natural gas as crude oil, which is why we often note that U.S. energy infrastructure is more of a natural gas story. As the chart below shows, natural gas production has expanded rapidly, seemingly oblivious to steadily declining prices. Dramatic improvements in efficiency are the reason, and the same thing is happening with shale production of oil.

Higher volumes have driven the need for more infrastructure and growth for MLPs. This is the more important relationship, and as the chart below shows, volumes have tracked MLPs better than prices. So a positive view on MLPs today rests on a forecast of continued growth in output. On Friday the weekly Baker Hughes U.S. rig count leapt by 21 to 789, up from 476 a year ago. The continued increase following the drop in crude prices shows that the domestic energy industry is less worried about falling oil than MLP investors seem to be.

Forecasting prices is difficult, but steadily higher volumes over time look like a much safer bet. As we noted last week in Shale Upends Conventional Thinking, demand for short-cycle projects is causing a shift in capex to the U.S. because that’s where a lot of those projects are. Long-cycle projects whose capital recycling extends out beyond the liquidity of the futures market (two-three years) are a bet on prices. That’s far more risky nowadays following last year’s collapse in crude pricing. The Energy Information Administration’s recent Annual Energy Outlook 2017 forecasts steadily rising crude oil production and continued near 4% annual growth in natural gas output. Crude prices matter in the short term, but over the long term volumes will drive returns.

Why Shale Upends Conventional Thinking

Long time subscribers will recall that back in 2015 this blog sought ever more creative and different ways to communicate the same message, which was that MLP prices had fallen far enough and represented compelling value. Bear markets have an unfortunate tendency to last longer than their opponents would like. Although the sector rebounded strongly in 2016, some of those 2015 blog posts were premature.

One lesson is that if you’re going to write constructively during a bear market, marshall your arguments and prepare to spread them over more weeks than you might anticipate. Last week MLPs and crude oil rediscovered their once close relationship, to the detriment of investors in energy infrastructure. Forewarned, your blogger will not expend all his constructive thoughts right away.

Prior to the Shale Revolution, MLPs were fairly described as having little correlation with commodity prices. Pipelines were a toll-like business model whose returns were driven by volumes. Today, much of the point of investing in the sector relies on the growth prospects made possible by the Shale Revolution. Ten years ago the need for new investment was limited; today it’s clear that to exploit newly accessible hydrocarbons, infrastructure needs to support these new locations. North Dakota was not known for oil, nor was Pennsylvania known for natural gas.

Therefore, the returns on energy infrastructure investments are nowadays more sensitive to growing domestic production and the consequent utilization of existing as well as planned infrastructure. To take one example, Plains GP Holdings (PAGP) anticipates a substantial increase in EBITDA if growing oil production absorbs more of its available pipeline capacity. Oil production reacts to prices; PAGP’s prospects are linked to those of its customers.

Last November’s strategy shift by OPEC to cut production was an ignominious admission that their prior effort to bankrupt the U.S. shale industry through low prices had failed. It represented a watershed event, the moment when it became clear that a new paradigm was in place, as we noted in The Changing Face of Oil Supply.

“Short-cycle opportunities” are what every oil company needs. Shale now counts the biggest integrated oil companies among its proponents. Exxon (XOM) CEO Darren Woods recently noted that a third of their capex budget is devoted to such opportunities. The key here is the liquidity of the oil futures market. If your project’s timeframe extends beyond the availability of hedge instruments, your IRR is going to be driven by things you can estimate but not control. The real revolution of shale is its short capital cycle; numerous wells are drilled cheaply, with fast but sharply declining production. Capital invested is returned with a year or two and risk can be hedged. Conventional projects require huge upfront commitments with long payback times and consequently uncertain economics.

The recent sharp drop in oil prices hasn’t been pleasant for producers anywhere. But consider the planners of a conventional project – a Final Investment Decision to proceed is a little less certain. Once capital is committed beyond a certain point, there’s little choice but to press on and accept whatever outcome markets deliver. Whereas shale producers, the group whose success ostensibly caused the 2015 crash, can cut back activity with comparative ease. They can just stop drilling, and wait. They can take advantage of even brief rallies in crude futures to hedge production and increase output.

This is why capex on conventional projects continues to fall, as shown in the attached chart from a recent presentation by Lars Eirik Nicolaisen of Rystad Energy. The longer term problem is shaping up to be insufficient investment in new supply to offset depletion of existing fields and new demand (estimated to require around 6% of new supply annually, about 6MMBD, or Millions of Barrels a Day).

The recent drop in crude demonstrates no shortage of supply currently, but also makes providing new supply less attractive in the long run.

MLP investors easily recall the 50.8% drop in the Alerian Index from August 2014-February 2016, its low coinciding to the day with that for oil. We don’t know where crude prices will go over the short term, but it’s becoming increasingly clear that the U.S. is set to gain market share because its short-cycle opportunities represent a substantially more attractive risk/return than conventional projects.

Reaching the long term requires navigating the short term. While you’re doing that, consider how you’d seek your company’s Board approval for a conventional oil project requiring ten years of output to recover its upfront cost. Those shale guys in the Permian could wreck your assumptions, and then protect themselves from the damage they’d wrought by quickly cutting their own capex and production. Without an adequate response, you might feel like moving to West Texas.

We are invested in PAGP

A few weeks ago I did an interview with friend Barry Ritholtz for his Bloomberg series “Masters in Business”. It was just posted online, so for those that are interested you can find it here. Comments on MLPs are at the 65 minutes mark.

MLP Investors Digest Supply

My partner Henry Hoffman and I spent Thursday last week at the Capital Link MLP Investing Forum in New York. The mood was cautiously optimistic but certainly wary of another commodity-linked swoon in prices. Meeting one-on-one with company managements is often the best part of such events. We had a very useful discussion with Crestwood’s (CEQP) Heath Deneke, COO and President of their Pipeline Services Group, along with Josh Wannarka, Investor Relations. We gained an improved understanding of CEQP’s strategic partnerships with long-time sponsor First Reserve and JV partner Con Edison. Both these relationships are important to CEQP’s growth prospects and represent a key differentiating feature.

Companies have been reporting 4Q16 earnings over the past few weeks. For Master Limited Partnerships (MLPs), the generally positive outlook has been at odds with market performance. In February the “Trump Bump” rally in the S&P500 was only weakly reflected in MLPs, resulting in +4.0% versus +0.4% respective performance.

The Permian Basin in West Texas remains the hottest area for shale production in the U.S. Earnings calls with those companies active there focused on growing production and whether the existing take-away infrastructure would be sufficient. The U.S. produces around 9 MMB/D (Millions of Barrel per Day) of crude oil. Approximately half of that is “tight”, and half of that comes from the Permian Basin (currently producing around 2.25MMB/D). When combined with Permian natural gas output on an energy equivalent basis, production is almost 3.5MMB/D.

Permian output was the most resilient of any of the major shale plays through 2015-16 with production continuing to grow almost oblivious to the collapse in pricing. This was entirely due to the ongoing productivity improvements that have led to high single digit annual cost improvements for Exploration and Production companies operating there. The Energy Information Administration (EIA) forecasts U.S. crude production will increase by another 0.5MMB/D 2017-18, and much of that is likely to occur in the Permian.

Reflecting the increased production forecast by E&P companies, several MLPs with Permian assets announced plans to increase take-away pipeline capacity where needed. These include 60MB/D (Thousand Barrels per Day) on Plain’s All American (PAGP) Cactus pipeline to Gardendale, Texas, 100 MB/D on the BridgeTex line into Houston (jointly owned by Magellan Midstream (MMP) and Plains All American (PAGP)) and 300 MB/D on the Permian Express II to Nederland, TX owned by Sunoco Logistics (SXL). In addition, Energy Transfer Partners (ETP) has an existing 100MB/D pipeline that is currently idle but could be restarted if demand was there. In summary, industry debate on this issue revolves around the ability to move increasing volumes.

This increased production is not necessarily consistent with OPEC’s objectives when they announced their own production cuts late last year. A gently rising oil price with minimal variability is their preferred scenario. Reports indicate that some OPEC members would like to see $60 oil so as to stimulate additional long term investment in new supply, thereby lowering the odds of a short-term, ruinous price spike that could hurt demand. As we’ve noted before (see The Changing Face of Oil Supply), conventional projects with their large up-front capital commitments and long payback times are vulnerable to U.S. shale production in a way that wasn’t previously contemplated.

Relying on the spot price of oil in assessing a 10+ year project is nowadays recklessly simplistic, making investments in conventional new supply riskier than in the past. Although U.S. production is growing, it won’t be sufficient to meet new global demand plus make up for depletion from existing fields (estimated at 6MMB/D, see Listen to What the Oil Price is Saying). Gently higher prices remain the most likely outcome but there’s more risk of a sharp move up rather than down.

Exxon Mobil (XOM) CEO Darren Woods reflected this new mindset in recent comments: “More than one third of the capex [capital and exploration spending] will be invested in advancing our large inventory of … short-cycle opportunities. They are primarily Permian and Bakken unconventional plays and short-cycle conventional work programs. This component of our investment plan is expected to generate positive cash flow less than three years after initial investment.”

In other words, long payback times are risky. Short payback projects are in the U.S.

The MLP investor who feels she’s missing out on the recent equity rally is rather non-plussed by this optimistic analysis. “If you’re so smart, how come I’m not richer?”

One reason is the overhang of equity being issued by some MLPs, to strengthen balance sheets and fund new projects. PAGP issued $1.3BN in equity; Targa Resources (TRGP) issued $450M to help fund it’s acquisition of Permian focused Outrigger Energy. There was also a sale of 7.2MM shares in Targa Resources (TRGP) by a private equity investor who converted warrants acquired a year ago, booking a nice profit. And a few weeks earlier Williams Companies (WMB) raised $1.9BN. The table shows the many issues of new equity in recent weeks, as well as inflows to mutual funds and ETFs. It’s an incomplete picture, and by definition the almost $6BN in equity sales has been matched with an equal amount of buying. The use of this new capital, mainly to strengthen balance sheets and fund accretive growth, is definitely positive. But over the near term this new supply approximately absorbed 1Q distributions paid by MLPs.

Another headwind is that it’s once again been a mild winter. Rapidly receding snow has plenty of appeal, but the downside is that it reduces natural gas demand. MLPs care about volumes, and we’re using less natural gas than expected to heat homes in the north.

Nonetheless, valuations remain compelling. For the momentum investor it’s easy to feel good buying stocks. But for the more discerning who care about values, at a time when most sectors of the stock market are close to all-time highs, the Alerian Index yields around 6.8%, 4.6% above the ten year treasury and still 1.2% wider than the 20 year average. We may have bounced 75% off the low of February 11th, 2016 but still remain 27% off the August 2014 high.

We are invested in CEQP, MMP, PAGP, TRGP, & WMB

Shale Security

America’s path to Energy Independence is taking place through myriad advances in hydrocarbon output, driven by the many advantages we possess. In America Is Great! we noted the benefits of America’s energy sector’s large skilled labor force, access to capital, culture of entrepreneurialism, constant drive for productivity improvements, ready availability of water, vast network of infrastructure and private ownership of mineral rights as key elements driving the Shale Revolution.

Take a step back though and consider the broader implications of an America no longer reliant on foreign sources of energy. We can all be armchair geopolitical analysts as we ponder the ramifications. Peter Zeihan has done just this in his latest book, The Absent Superpower: The Shale Revolution and a World Without America. It follows up on his previous 2014 book, The Accidental Superpower: The Next Generation of American Preeminence and Coming Global Disorder, and contemplates the shifting alliances and security needs of both world and regional powers. They were published a couple of years apart, and the world had changed only somewhat during this intervening period which results in certain sections appearing as if they would be at home in either book.

Absent Superpower, the more recent volume, is worth reading just for Part I: Shale New World. Zeihan runs through an absorbing account of shale drilling including its history, numerous technological advances and why America is pretty much the only game in town. He then moves from energy sector expert to examine the broader global implications. Geopolitical trends can unfold at the pace of demographic change, which is to say they’re fascinating to look back on but not likely to drive investment returns over anything shorter than multi-year intervals. An America secure in its energy needs can more readily disengage from maintaining the global security order. War in the Middle East and a disruption in crude oil shipments would still harm us, but not nearly as much as in the past. Since World War II, America has acted on its interests but has often defined those interests broadly enough so as to include spreading democracy and free markets around the globe. Although Absent Superpower was finished before the 2016 election, Zeihan identifies the growing populism which demands clearer payback for the application of American power. If we care less about the rest of the world, or acknowledge limitations on our ability to right every wrong, the resulting power vacuum will draw in others.

Here Zeihan embarks on a series of specific and invariably violent forecasts of armed conflict (“the Disorder”), most notably between Russia and its European neighbors. This is driven by Russia’s need for the coherent geographical borders that made the former Soviet Union more easily defensible than allowed in its shrunken form today. Such precise expectations are almost guaranteed to be wrong; Zeihan clearly hasn’t studied Behavioral Finance, which shows that humans often have unreasonably high confidence about their predictions, whether of stock returns or the number of jellybeans in a jar. And disappointingly, although perhaps unsurprisingly given the rapid publication of his second book after the first, themes and arguments are repeated in Absent Superpower to the frustration of one who’s read both. Zeihan works his underlying theme, which is that Geography and Resources are Destiny, to explain much of human history in ways that are often compelling. He fearlessly builds on his conclusions to make sweeping forecasts.

However, he’s virtually certain to be wrong in specifics. For example, consider the following, “…the British Navy will sink the entirety of the one Russian naval force that might have been able to sail to the Baltic warzone; the Northern Fleet, based near Murmansk” It’s hard to imagine this happening without the subsequent use of nuclear weapons, which both antagonists possess but Zeihan ignores. Later, he describes, “the East Asian Tanker War” with “Japan and China the primary competitors.”  So pass these off as speculative prose reflective of just a couple among many possibilities. On more solid ground, Zeihan graphically illustrates the shifting flows of trade in hydrocarbons, with North America eventually dropping imports from west Africa and the Middle East in favor of supplies at home.

A less engaged America, secure in its resources and defense, responding to political shifts that demand greater attention at home, seems highly likely. Zeihan describes the United States as, “the only power with global power and global reach…but…without global interests.” A critical supporting pillar of this evolving stance is energy independence. So while the future is always uncertain, it does seem reasonable to assign a value to domestic hydrocarbons greater than their pure economic one. In other words, national security and the Shale Revolution are far more intertwined than you might think. Quickly approving the Dakota Access and Keystone XL pipelines are examples of the new Administration making decisions that fit within the type of policy framework described. The rolling back of regulations that impede domestic energy similarly fall within the same sphere. The White House has published An America First Energy Plan which leads with the goal of maximizing, “…the use of American resources, freeing us from dependence on foreign oil.” In this new world, a bet on public policy being increasingly supportive of the domestic energy sector seems like a good one.

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