2021 Pipeline Outlook The Blogs You Liked, Part 1 - SL Advisors

2021 Pipeline Outlook

The Blogs You Liked, Part 1
Writers care what their audience thinks, and we monitor
pageviews and comments to learn what resonates. For pipeline
investors, a few months into the year it was looking like the
mother of all bear markets. The sector had been persistently
lagging the S&P500 since peaking in 2014, and pre-Covid the
fundamentals were improving strongly. Fortunately, the
recovery since then has repaired much of the damage to
portfolio values, if not the emotional scars from extreme
volatility. The American Energy Independence Index is –13% for
the year, compared with –51% at the end of 1Q.

In reviewing the year’s most popular blogs, they can be
divided into (a) commentary on the energy market, and (b)
politics, especially around climate change. Part one of this
two-part, year-end review will focus on the market blogs.

Most of all, investors want to understand why stocks are
moving as they are. Pipeline stocks bottomed in March, and
crude oil in April when it briefly traded at negative
prices. Can An ETF Go Negative? looked at the United States
Oil Fund, LP (USO), an ETF that provides exposure to crude
oil. It’s a result of our Balkanized regulatory structure
which separates stocks from futures. That the SEC and
CFTC persist as separate entities is because their overseers
are separate Senate Committees (Banking and Agriculture,
respectively). Merging them would eliminate campaign
contributions to one Senate committee’s members, a battle
successive Administrations have avoided.

Different oversight means different rules, so firms tend to
offer either stocks or futures, but not both. Buying crude oil
futures would be a more efficient way for oil bulls to express
a view but preferring to keep assets at one firm they buy USO
instead. USO then buys oil futures, increasing the friction
for the ultimate investor.

A regular theme is the diminishing importance of the MLP
structure. The shrinking pool of MLP buyers, caused by serial
distribution cuts, has reduced MLPs to only a third of North
America’s midstream energy infrastructure sector (see The
Disappearing MLP Buyer). It’s also created problem for MLP-
dedicated funds, which are becoming increasingly concentrated
in the few remaining names (see Today’s Pipelines Leave MLPs
Behind and Are You In The Wrong MLP Fund?).

MLP closed end funds offer a target-rich environment for
criticism (see MLP Closed End Funds – Masters Of Value
Destruction). As Warren Buffett said, if you’re not going to
kick a man when he’s down, when are you going to? They are a
dumb idea, and if they didn’t already exist no responsible
fund manager would fill the void. Most recently,
the Fiduciary/Claymore Energy Infrastructure Fund (sporting
the delightfully inappropriate FMO ticker — Fear of Missing
Out) announced an “income tax accrual adjustment” following “a
further review and change in understanding” of the tax rules
under which they operate. Markets and the tax code are too
much for this hapless fund, -86% YTD.

In a year of superlatives, pipelines have surprised by

maintaining strong growth in Free Cash Flow (FCF) despite the
pandemic. During the collapse in transportation demand that
culminated with April’s briefly negative crude prices, any FCF
growth appeared implausible. Nonetheless, even by May the
outlook was improving (see Pipeline Cash Flows Will Still
Double This Year), and one of our most read pieces was from
two days before the low (see The Upside Case For Pipelines).
We were bullish then, but as regular readers know we usually
are, so won’t claim any credit for foresight.

The outlook remains very positive, with FCF expected to
increase by a further 50% next year supported by lower
spending on new projects. Incoming President Biden is likely
to be an impediment to growth capex, a welcome development.

  We are invested in all the components of the American Energy
Independence Index via the ETF that seeks to track its
performance.

Churchill,                   The           Greatest
Briton
It is the time for nostalgia. I fondly remember Christmases
from my childhood in England with a close friend and our two
families. Here in New Jersey, my wife maintains many of our
English culinary traditions, since they’re from her childhood
too. Christmas pudding (also called Plum pudding) was acquired
weeks ago. None of our children will touch it, a disdain I’ve
wasted little time trying to reverse since it means there’s
enough left for Boxing Day too.

Covid has canceled bits of Christmas, including our annual
Christmas Eve fish dinner with friends. And a virtual church
service remains a poor substitute for live Christmas carols. I
admire our rector for gamely pressing on in solitude in front
of a camera, but this year organized religion has offered less
when some needed more, leaving it with a diminished role.

I’m currently reading These Truths: A History of the United
States, by Jill Lepore. It was on Bill Gates’ summer reading
list. An engaging read, it covers much but rarely in depth,
since it’s a single volume. I have reached the 1940s. Winston
Churchill knew that Britain could only prevail against Germany
if the U.S. could be persuaded to enter the war. Following
World War II, Churchill referred to his bonding with President
Roosevelt thus, “No lover ever studied the whims of his
mistress as I did those of President Roosevelt.”

My old country could use Churchill’s leadership today. Most of
the population is under virtual Covid house arrest, and
they’ve agreed a Brexit deal with the EU very different than
voters were led to expect during the 2016 referendum. I have
never regretted growing up there, nor leaving for the U.S.

How ironic that British PM Boris Johnson’s wonderful biography
The Churchill Factor: How One Man Made History represents a
bigger tribute than his current leadership of the country.

Few individuals produce enough lifetime material for a book of
humorous quotes, but my library includes The Wit and Wisdom of
Winston Churchill, boasting over 1,000 entries. Browsing
reveals gems such as, “Although always prepared for martyrdom,

I prefer that it shall be postponed.” Another favorite is,
“There’s nothing more exhilarating than to be shot at without
result.” When a close friend of mine with Covid risk factors
survived an extremely mild case, I read this quote to him.

Churchill’s mother was American, and he felt strong affection
for our country. During a speech to Congress in 1941, he noted
that, “… if my father had been American and my mother British,
instead of the other way around, I might have got here on my
own.” This overlooked the constitutional requirement that a
U.S. president be born here, but still drew appreciative
laughter.

Some of Churchill’s descriptions of America remain true today.

“The Americans took but little when they emigrated except what
they stood up in and what they had in their souls. They came
through, they tamed the wilderness, they became a refuge for
the oppressed from every land and clime.”

“There are no people in the world who are so slow to develop
hostile feelings against a foreign country as the Americans
and there are no people who once estranged, are more difficult
to win back.”

In the House of Commons when a veteran member offered
disjointed criticism of Churchill’s war leadership, the PM
warned that his critic, “…will run a very grave risk of
falling into senility before he is overtaken by age.”

Churchill’s ready wit was often deployed in social settings to
parry criticism. Nancy Astor was a Virginian who became
Britain’s first female member of the House of Commons. Astor
was part of a clique that admired Hitler, prompting Churchill
to describe appeasers as those who, “…feed the crocodile
hoping that it will eat him last.” At a dinner party Astor
told Churchill, “Winston, if I were your wife, I’d put poison
in your coffee.” To which he replied, “If I were your husband,
I’d drink it.”

Perhaps his most famous exchange was with an unknown woman who
complained that he was drunk. “My dear you are ugly, but
tomorrow I shall be sober and you will still be ugly.” he
replied.

It’s been a testing year in so many ways, with little of
recent humor to offset it. I hope you and your family are
healthy, and that you’ve enjoyed Christmas and the holiday
period under whatever Covid restrictions allowed. We all have
much to look forward to next year.

We are invested in all the components of the American Energy
Independence Index via the ETF that seeks to track its
performance.

A Cheap Bet On Inflation
“If I seem unduly clear to you, you must have misunderstood
what I said” was Fed chair Alan Greenspan’s response during
testimony to the Senate in 1987. Transparent communication has
come a long way since then. Greenspan continued the policy of
obfuscating responses, reflecting a belief that it improved
the Fed’s operating flexibility by disguising mistakes. This
inspired Secrets of the Temple: How the Federal Reserve Runs
the Country, William Greider’s 1989 scripture describing
faith-based monetary policy.

Today, the Fed’s projections are public. Their meeting minutes
are published. The mystery has gone, although they still are
the most important market participant. Transparency allows for
comparison between market forecasts of interest rates and the
Fed’s. Of course, the latter has the advantage of being able
to make their forecasts correct through their actions, should
they be so moved. Fortunately, the Federal Open Market

Committee (FOMC) is not burdened with excess vanity, so
serially inaccurate interest rate projections do not bother
them.

In recent years it’s been mildly amusing, in a nerdy sort of
way, to show how the FOMC’s long term forecasts for inflation
and the Fed Funds rate have followed bond yields lower,
conceding the market’s prescience. Fixed income investors have
been ahead of this for years, exhibiting greater accuracy
about Fed policy than the FOMC itself (see Bond Market Looks
Past Fed). Covid made such games irrelevant, but as markets
look beyond the pandemic, revisiting FOMC Projection Materials
is becoming worthwhile again.

In August, Fed chair Powell gave a speech where he addressed
persistently low inflation and how this had caused FOMC
members to continually lower their rate forecasts. He
explained how 2% inflation remained their definition of price
stability, but since recessions typically cause it to
undershoot, the FOMC would henceforth be more tolerant of
greater than 2% during a strong economy. The inference,
reflected in subsequent FOMC projection materials, is that
short term rates will remain low for a long time, at least
long enough for inflation to exceed 2%.

The chart compares the futures market with the FOMC’s
forecasts. There is some judgment involved – the FOMC provides
annual estimates through 2023 followed by a long-term
assumption. The chart assumes that the long run is five years
away. The market, as has been the case for years, is assuming

lower rates than the FOMC.

Rates probably will stay low. Betting on higher inflation has
been a fool’s game for longer than the average investor’s
career. But these are unusual times. M2 money supply growth is
24%, higher even than when we were trying to whip inflation in
the 70s and 80s. The fiscal outlook is as bad as ever, with
debt projected to exceed the wartime highs of 1945, and stay
there.

Modern Monetary Theory (MMT) as explained by Stephanie Kelton
in The Deficit Myth: Modern Monetary Theory and the Birth of
the People’s Economy, holds that deficits don’t matter until
they cause inflation. MMT has been widely panned by mainstream
economists and isn’t regarded as a serious framework for
fiscal policy. But the reality is that deficit hawks win few
votes nowadays. We are, in truth, already pursuing the
unlimited government spending that MMT advocates. Higher
inflation is the only remaining obstacle, as we noted on
Sunday in Deficit Spending May Yet Cause Inflation.

Low inflation remains likely, so betting against this is
unbelievably cheap. The eurodollar futures curve offers
precise forecasts of short-term interest rates, which in 2022
are expected to rise only 0.06%; that is, the spread between
the December ‘21 and December ‘22 futures contracts is 0.06%.

Suppose that the economy emerges from Covid by the spring, as
the vaccines allow a return to our previous lives. Consider
whether a desire to live for the present promotes a vigorous
economic rebound, as people catch up on experiences, trips and
visits long delayed. The Roaring 20s followed the 1918 Great
Influenza, although the still fresh horrors of World War I
also played a significant role in the zeitgeist.

If inflation does pop above 2% next year, markets will start
looking more carefully at near-zero Fed Funds and its
longevity. No rate hike until 2023 will look to some like an

awfully long time. The 0.06% spread between the December ‘21
and December ‘22 futures contracts could easily move to 0.25%,
still representing only a single rate hike over that year.

The question is whether the odds offered by the market are
sufficiently different from the odds of such happening, the
minimum criteria to justify a trade. The money market curve is
unlikely to invert, so the loss if nothing happens is a few
basis points. The risk/return on this trade is a long way from
50/50, but the odds of an inflation jump are low too. Call it
the MMT trade.

Some investors are already contemplating higher inflation.
Bitcoin buyers are among them. There are cheaper ways, with
well-defined downside, to express such a view. The eurodollar
futures curve is one of the best. Your blogger has already
initiated this trade.

We are invested in all the components of the American Energy
Independence Index via the ETF that seeks to track its
performance.

Deficit Spending                           May         Yet
Cause Inflation
The biggest question for long term investors is why bond
yields remain so low. The Equity Risk Premium (see Stocks Are
Still A Better Bet Than Bonds) has favored equities for most
of the time since the 2008 financial crisis. Inflation
expectations remain well-anchored and are noticeably lower
than a year ago. Investors don’t expect it will even rise to
the Fed’s 2% target within the next three decades, despite the
Fed’s professed objective to overshoot this.

Should inflation, and therefore interest rates, move
surprisingly higher, a key support for the bull market would
be knocked away.

Betting on higher inflation, or even worrying about it, has
been a wasted effort for as long as any of us can remember. My
own career began in 1980, around the time inflation peaked.
Bond yields have been falling ever since. Jim Grant’s Interest
Rate Observer has been warning of resurgent inflation for this
entire period. That he retains so many subscribers shows how
erudite prose beats accurate forecasts.

The most likely outcome remains low inflation. However, it’s
safe to say that few investors are prepared for a surprise.
Should it happen, the resulting market response is likely to
be traumatic.

There are reasons to worry. M2 is rising faster than at any
time in the past 50 years, exceeding even the inflationary
late 70’s and early 80’s. The link between money supply and
inflation appears to have broken, and any analysis of current
conditions must consider that Covid has affected everything.
Nonetheless, 24% year-on-year growth means something.

The Federal deficit, invariably nowadays the subject of
hand–wringing but inaction, is forecast to be $3.3TN this
year, at 16% of GDP the highest since 1945. The Congressional
Budget Office expects total debt outstanding to reach 109% of
GDP by 2030, exceeding the 1945 peak at the end of World War
II. Unlike then, it is expected to remain at elevated levels.

Fiscal discipline has gone because there are few votes to be
had in it. Past and present fiscal profligacy has caused
little visible damage, as measured by the bond market. The
burden of proof increasingly lies with the advocates of
prudence.

Believers in Modern Monetary Theory (MMT) should be pleased.
MMT holds that countries with a fiat currency, the prevailing
global standard nowadays, can never go bankrupt. This is
because the government can always issue itself money to pay
any bill. Therefore, deficits don’t matter, as explained by
Stephanie Kelton in The Deficit Myth: Modern Monetary Theory
and the Birth of the People’s Economy (you can read our review
here). Or at least, deficits don’t matter until excessive
government spending leads the economy to exceed its productive
capacity, which is inflationary.

MMT remains at the fringes of political discourse, embraced by
the same progressive Democrats who love the Green New Deal
(see The Bovine Green Dream). It’s not conventional economic
policy.

And yet, the deficit trend suggests that we are embarking on a
great MMT experiment. $1TN is now a round lot for stimulus

spending, rebuilding our creaking infrastructure, forgiving
student debt or combating climate change. Proposing less
betrays a lack of urgency. Derisively low bond yields deny
fiscal conservatives their most potent weapon. MMT advocates
must retain a disciplined silence, in case the rest of us
comprehend that we are unwittingly doing their bidding.

Years of costless Federal profligacy have caused voters to
become so disinterested in budget discipline that inflation is
the only remaining constraint. We will continue testing the
limits until we get a different result. MMT has become our
fiscal policy. Higher inflation is assured, eventually. We
don’t know when, but until then fiscal hawks will remain
defenseless, disarmed of empirical arguments.

Therefore, every investor needs to consider how their
portfolio will cope with higher inflation. Though the timing
of such is unclear, it is inevitable. Gold and Bitcoin suggest
that some see warning signs ahead.

The point of investing is to preserve purchasing power. For
years, simply earning positive returns was almost sufficient.
Companies with pricing power offer some protection. If
inflation is 5%, Coca-Cola will pass that through to
customers, like so many companies with a strong brand and
barriers to entry.

Real assets are another good choice. The rising cost of
pipeline inputs (steel, concrete, labor) will increase the
value of what’s already built. The next few years will in any
case see few new pipelines. President Biden and relentless
legal challenges from environmental extremists will add value
to existing assets that have become hard to replicate.

This is why planned spending on new pipelines is continuing
its downtrend. Investors are welcoming the resulting boost to
free cash flow, which has spurred a series of buyback
announcements (see Pipeline Buybacks To Shift Fund Flows).

Oil is a global commodity whose recent price rise is partly to
compensate for a weakening US dollar. Natural gas is similar,
although relatively high transportation costs allow greater
regional price disparities. And much of the North American
pipeline network operates with tariffs that include inflation
adjustments.

Inflation remains dormant, but America is probing for the
conditions which will change that. MMT proponents are getting
their wish. Pipelines offer protection for every portfolio.

We are invested in all the components of the American Energy
Independence Index via the ETF that seeks to track its
performance.

Clean Energy Isn’t Just About
Renewables
Technological advances in solar, wind and batteries receive
widespread media coverage. Costs are falling and battery back-
up is improving, vital to cope with renewables’ intermittency.
As Enbridge CEO Al Monaco noted last week (listen to our
podcast, Oh Canada’s Pipelines!), the world is going to use
more energy, and consumption of every form of energy will
increase. While the media focus is on renewables, fossil fuels
represent 80% of global energy consumption. Improving what
already works, by dealing with emissions, is also a recipient
of considerable R&D.

Hydrogen is receiving increasing attention. It has a
reputation for being perennially five years away from cost
effectiveness – but investors are certainly taking note of
anything that’s hydrogen-related. A couple of months ago we

noted how New Fortress Energy (NFE) had seen their stock
triple this year on little more than vague plans to ship
hydrogen (see Hydrogen Lifts an LNG Company).

The emission benefits of using hydrogen depend on how it’s
produced. The most common method is methane pyrolysis, which
uses heat to separate hydrogen from carbon (methane is CH4).
Another process applies electrolysis to water, which separates
the hydrogen atoms from oxygen, Both require energy as an
input.

Most hydrogen in use today is “gray”, meaning fossil fuels are
used in its production. “Blue” hydrogen is derived from
methane, with the CO2 that’s produced as a by-product being
captured. That’s already a pretty good result. “Green”
hydrogen relies on energy from renewables to power the
extraction process.

Hydrogen is an appealing solution if costs can be brought
down, because burning it produces water, not CO2. Compared
with methane it is less dense, and causes the steel used in
pipelines to become brittle, which means it can’t currently be
moved in a pure form through existing infrastructure.

But hydrogen is already being added in small quantities to
existing supplies of natural gas (methane). For example, Los
Angeles is currently adding 4% hydrogen to their natural gas
supply and is hoping to get to 10%.

Pipeline companies are watching this area closely, awaiting
solid evidence that it can be made commercially viable. If

hydrogen use does gain traction, today’s midstream
infrastructure businesses are well positioned to benefit,
since hydrogen transportation will be via pipelines. The
industry will surely find a technical solution to the problems
caused by direct interaction of hydrogen with steel – perhaps
by applying a protective coating to the inside.

Recently, United Airlines announced an investment in
1PointFive, a joint venture between Occidental (OXY) and
Rusheen Capital Management that aims to extract CO2 from the
atmosphere. Airlines know that renewable energy won’t help
them curb emissions – batteries are far too heavy to be built
into an airplane. And jet fuel has the added benefit of being
burnt as it’s used, decreasing weight.

Aviation is estimated to produce over 2% of global CO2
emissions. Post-Covid, flying is likely to resume its upward
path in developing Asia at a minimum, even if a full return to
normalcy is five years away as some airline executives fear.
Nonetheless, it highlights that solar and wind offer a limited
set of solutions, which means ongoing need for liquid fuels.

Extreme weather events have caused a jump in solar panel
insurance. Last year a hailstorm in Texas caused $70MM in
damage to a solar farm. California wild fires damaged three
sites earlier this year. Solar panels are easily damaged, and
insurance rates are 20-30% higher than a year ago.

“We have seen projects that were achieving their expected
returns no longer able to do that, as a result of the change
in the cost of insurance,” said Michael Kolodner, US power and

renewables practice leader at Marsh, an insurance broker.

Those who blame these and other extreme weather events on
climate change will not appreciate the irony.

Another non-renewable, clean energy solution is NetPower’s
emission-free natural gas turbine (see Clean Fossil Fuels May
Be Coming). The company explains that their patented “Allam-
Fetvedt Cycle burns natural gas with pure oxygen. The
resulting CO2 is recycled through the combustor, turbine, heat
exchanger, and compressor.”

NetPower says they have, “Multiple projects are in development
worldwide for rapid global deployment of commercial units.”

Cleaner ways of burning natural gas; extracting harmful CO2
out of the atmosphere; commercially viable hydrogen. These are
all potential solutions to the problem of lowering emissions
that don’t rely on solar panels, windmills and batteries.
These are the types of breakthrough that could quickly put
today’s pipeline companies at the forefront of combating
climate change. What’s clear is that innovation is happening
in many more areas than simply the use of sun and wind.

We are invested in all the components of the American Energy
Independence Index via the ETF that seeks to track its
performance.

Pipeline Buybacks To Shift
Fund Flows
The pipeline sector’s increasing Free Cash Flow (FCF) has
quietly allowed several companies to initiate buyback
programs. We calculate that over $8.5BN in buyback programs
have been announced this year, including $3.5BN following 3Q
earnings.

One of the biggest headwinds to improved equity returns this
year has been selling by funds. There was the forced selling
in March (see MLP Closed End Funds – Masters Of Value
Destruction), which was likely in the $1-4BN range, and $6.4BN
in steady redemptions from open-ended funds all year.

Recent buyback announcements have improved the buy/sell
balance in the sector, such that companies could be absorbing
investor sales with their own excess cash. Of course, buyback

programs don’t have to be executed if, for example, prices
rally to less attractive levels. This flexibility adds to
their appeal. And while it’s impossible to predict what fund
investors will do, their total AUM sank as low as $24BN in
November before rising prices increased values.

It’s likely that positive investment returns will turn
outflows to inflows before too long.

Increased buybacks, if combined with a shift in investor
appetite for the sector, would represent a substantial change
in flow of funds into pipeline stocks. Valuations have been
attractive for months (see May’s post, Pipeline Cash Flows
Will Still Double This Year). Fund flows are starting to
reflect this.

Next year the continued growth in FCF will leave excess cash
after dividends. Over the next two years, we estimate that the
sector will generate $25BN in excess FCF after dividends. This
should leave room for further buyback announcements over the
next few quarters.

The market has been slow to recognize this, but pipelines are

becoming cash-generative businesses. Enbridge (ENB) reflected
this shift on a slide at their investor day last week. Large
capital projects are being replaced with a focus on boosting
returns from existing assets. Funding is now internally
generated cash rather than the capital markets. And they are
making investments in     renewables as part of the energy
transition, as long as returns justify it.

Related to the energy transition, on Thursday United Airlines
announced an investment (amount unspecified) in 1PointFive,
itself joint venture between Occidental (OXY) and Rusheen
Capital Management. They are developing technology to extract
CO2 from the air and convert it into pellets that can be
stored.

It’s possible to by cynical about such efforts – United
Airlines, like every public company, has an ambitious ESG
agenda. The requirements to score well on ESG criteria are
extremely flexible. For example, Lockheed Martin has been in
the Dow Jones Sustainability Index for seven years (see
Pipeline Buybacks and ESG Flexibility). Think green bombs. In
many cases there’s more style than substance to ESG-
initiatives. Nonetheless, this illustrates that the R&D to

combat climate change isn’t limited to improving battery
storage to compensate for renewables’ intermittency.
Commercially viable carbon capture would recast the debate
about climate change. It’s worth watching.

We are invested in all the components of the American Energy
Independence Index via the ETF that seeks to track its
performance.

MLP   Closed   End   Funds   –
Masters Of Value Destruction
When MLP investors cast around for characters to blame for the
past few years of underwhelming equity returns, management
teams are the obvious target. Like their upstream clients,
midstream businesses embraced the endless volume growth of the
Shale Revolution with sharply increased growth capex. By 2018
they’d heard the message from investors that stability trumps
growth and begun to pull back. This year, as a result of
continued capex frugality, free cash flow will double. Given
the pandemic, which even led briefly to negative crude prices
in April, this result is extraordinary and only now beginning
to register with investors.

Although recent equity returns for pipelines have been
sparkling, few will soon forget the trauma of March when
wholly indiscriminate selling drove prices to unfathomable
depths. Management teams are responsible for operating
performance and while this drives equity returns over the long
run, in between quarterly earnings reports stock prices gyrate
on investor opinion, guesses and hunches. March was miserable
for everyone involved in midstream, but chief among the
villains of that sector-wide margin call are the managers of
MLP Closed End Funds (CEFs).

These vehicles have been around for years, holding MLPs in an
inefficient, tax-paying c-corp structure. They were Wall
Street’s first attempt at separating the K-1 from the sought-
after retail buyer. The corporate tax liability, an expensive
haircut to returns, was obscured by the tax-deductible
interest expense on leverage.

MLPs were once considered a fixed income substitute. Borrowing
money to buy bonds in a closed end fund structure can be
defensible if the underlying assets are very stable. MLPs long
ago lost the advantageous reputation of “income-seeking
substitute” as their rush for Shale Revolution growth stressed
balance sheets and led to higher volatility. Nonetheless, MLP
CEFs retained their leveraged model, even though most were
forced into distressed sales during the 2014-16 slump when
depressed MLP values tripped risk limits.

Moreover, they stuck with it even while the pool of MLPs
shrunk. This now unrepresentative set of securities is a third
of the American Energy Independence Index, our broad-based

index of North American midstream energy infrastructure. By
comparison, MLPs are smaller, less creditworthy, more
liquids/less natural gas focused, and offer weaker corporate
governance. In short, nobody is contemplating an IPO of an MLP
closed end fund today. If they hadn’t been created years ago,
they wouldn’t be around.

The problem with investing with leverage is that it leaves you
exposed to even a brief sharp fall in your holdings. If you
buy $100 of securities with $30 in debt, a 40% market drop
takes your leverage from 30% to 50%. If that’s beyond your
lender’s risk tolerance, sales must immediately follow. Once
done, recouping the locked in losses is almost impossible. The
leveraged investor assumes risk to the path of short term
returns that the cash buyer does not.

To see how dumb an idea closed end MLP Funds had become,
consider that leverage at MLPs had been coming down in recent
years as rating agencies tightened the standards required of
an investment grade rating. Debt:EBITDA of 4X became the new
target, and MLPs either reached it or planned to.

A portfolio of MLPs is not a diversified equity portfolio.
Individual security returns will differ to be sure, but the
group will largely move together — especially so when prices
are falling hard. So, when the closed end fund MLP portfolio
manager adds leverage to this homogeneous basket of securities
he (and it most assuredly is he, for such imprudence requires
excess testosterone) is asserting that pipeline companies are
managed too conservatively. Never mind that the industry and
its rating agencies have settled on 4X Debt:EBITDA as
appropriate, the MLP PM believes 5-6X is fine.

The intellectual arrogance in this stance is breathtaking.
Because the holdings of an MLP CEF will track each other more
than any other sector, this amounts to increasing each
individual company’s leverage to 5-6X. The only possible
justification for this is if the PM has both the plan and the

skill to reduce leverage just before the crash. As we saw in
March, they had neither.

March is a memory, although still raw for many. At the low on
March 18, the sector was briefly –63% YTD. MLP CEFs lost
almost their entire value through forced sales. Tortoise’s
fund closed –92% for the year on that date. Even now MLP CEFs,
including those run by Goldman Sachs and Kayne Anderson as
well as Tortoise, have still lost half to three quarters of
their value since January 1. They have barely participated in
the sector’s strong recovery, now -10% for the year.

MLP CEFs could never make up for their forced sales in March
when leverage limits kicked in.

If you were invested in pipelines but avoided MLP CEFs you
probably feel unaffected. You’d be wrong. When these funds
sold, they defined the low and caused prices to fall more than
they would have absent the forced deleveraging. Your portfolio
consequently fell more than it had to as well. The excessive
volatility doubtless induced other investors to exit, tired of
the distress. It’s permanently part of the price history of
the sector, guiding future buyers in their assessment of risk.
In short, today’s holders require more conviction in their
investment thesis to compensate for the risk history suggests
they’re taking.

The villains in this episode are the PMs of funds run by
Goldman Sachs, Kayne Anderson and Tortoise, to name a few.
They all persisted with the arrogantly leveraged structure
right into the maw of the March collapse. Goldman Sachs knows
about risk, and the firm emerged from that period of
heightened volatility relatively unscathed. Their fund blowing
up simply means the PM didn’t get the memo from Risk
Management to cut back.

But Kayne Anderson and Tortoise are dedicated MLP investors.
Their risk management function should have had little else to

confuse it. They clearly had no risk management, no judgement,
or neither.

The silver lining is Darwinian, in that such incompetence
destroyed sufficient capital that MLP CEFs are no longer big
enough to matter to anyone other than their hapless investors.

If you own one of these wretched vehicles, consider the
stewardship practiced by your PM and whether it’s worthy of
your money.

We are invested in all the components of the American Energy
Independence Index via the ETF that seeks to track its
performance.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Inflation Fund

Investors Continue To Rotate
Into Energy
The pipeline sector continued on its tear last week. The
catalyst was Pfizer’s vaccine announcement a month ago, but
cheap valuations have drawn increasing attention as prices
have risen. The buybacks announced by several companies added
further support.

For many months, we’ve argued that the biggest problem with
the sector was negative sentiment. Since peaking in 2014,
midstream energy infrastructure has lagged the S&P500
significantly. The industry began to acknowledge investor
criticism of over-investment back in 2018. That’s when growth
capex peaked. Since then, the path to growing free cash flow
has been clear – but sentiment is often the last piece to fall
in place.

Rising stock prices are starting to do that. This is
persuading investors that what appears cheap perhaps really
is. We are seeing it in our own business, where inflows have
returned and investors are increasingly prepared to commit
capital. The energy sector ETF XLE is on track for a record
year of AUM growth.

Energy is part of the broader shift from technology to value,
including small cap. The widely-watched QQQ/IWM ratio solidly
crossed its 200-day moving average to the downside last month,
and has continued its new trend.

Since the beginning of October, the American Energy
Independence Index has rallied 32%. At –8% YTD, it’s not
inconceivable that it could claw back its remaining losses for
the year. At the end of March, it had lost more than half its
value over the prior three months.

So it’s worth pausing to examine valuation.

The components of the AEITR still yield 7.5% — still
sufficiently high to suggest healthy skepticism regarding
sustainability. Yet all companies except for Energy Transfer
paid quarterly dividends at least as high as before. We
calculate that payouts are now covered almost 2X by
Distributable Cash Flow (DCF).

Free Cash Flow (FCF) should come in at $23BN for the year, up
from $8BN in 2019. We entered 2020 expecting FCF to double,
and by May reaffirmed that forecast (see Pipeline Cash Flows
Will Still Double This Year).

The increase is fully driven by reduced growth capex. We see
it rising to $44BN next year, an 11% FCF yield which is more
than 2X that of the S&P500.

One of the reasons we like our prospects with incoming
President Biden is that pipeline spending plans are likely to
remain constrained. New projects are almost impossible
nowadays. Environmental extremists have figured out how to use
the court system to introduce unpredictable legal delays into
any project. We are not unhappy with this (see Pipeline
Opponents Help Free Cash Flow).

Long term capital commitments to fossil fuels face significant
uncertainty with respect to public policy. While this will

disappoint executives who love to build, investors like us
will find much to like. Less building means less execution
risk as well as more cash for buybacks, dividend hikes and
debt reduction. How ironic that a Democrat president is likely
to create an improved environment for investors – such was the
exuberance unleashed by Trump’s pro-energy, deregulatory push.

Meanwhile, the U.S. Energy Information Administration reported
that natural gas fired power generation increased in most of
the U.S. over the past five years. Natural gas is going to see
demand growth for years to come, especially from developing
countries intent on raising living standards. Don’t be
distracted by all the media attention to renewables. What
counts is what’s actually going on.

We are invested in all the components of the American Energy
Independence Index via the ETF that seeks to track its
performance.

Enterprise Products Keeps On
Going
November was a month of records for stocks, including for the
energy sector. The American Energy Independence Index
(AEITR) was +20.8%. This year has seen the top two months, and
it’s still –16.1% YTD.

Crude oil grabs most of the attention, but propane is an
under-appreciated area of rising production that’s driving
higher exports. It’s generally used for heating by
businesses, industry and homes, but is also used for cooking
in rural areas that are not reached by natural gas
(methane).

Propane exports have been rising steadily for the past
decade, growing at a 26% compound annual rate since 2010. We
crossed the 1 million barrels per day threshold in 2017. The
Covid pandemic is barely a blip.

One reason for this is increased demand in India. Propane is
often produced as a by-product of oil refining, but in the
U.S. it’s found naturally in gas wells where it’s separated
out from the methane.

Tens of millions of households in India rely on bottled
propane for cooking and heating. The drop in gasoline demand
earlier this year lowered local refinery runs, depressing
propane production. So India turned to the U.S. for imports
(see Energy Does More Than Move People).

Enterprise Products Partners (EPD), the biggest MLP, is one of
the winners from this business. They include propane in their
Natural Gas Liquids (NGL) segment, and they’ve participated in
this growth as much as any company.

NGL exports volumes are now similar to crude oil, though few
outside those following EPD would know that. Propane dominates
the segment.

This has driven EPD’s margin from NGL pipelines and
services to a 9% compound annual growth rate over the past
five years. Based on the first 9 months, 2020 looks set to be
another record year for NGLs.

This all highlights the resilience of their business model.

Nonetheless, EPD’s stock price has lost a third of its value
this year, even after a 17% gain in November.
This reflects continued loss of appetite among investors for
the sector. EPD’s $1.78 dividend currently yields almost 9%
and looks secure since the company has bought back $225MM in
stock this year out of an announced $2BN program.

Investors often ask whether EPD will convert to a c-corp.

There can be little doubt that, if accessible to a far broader
set of buyers, their stock would rally. However, insiders own
32% of the company, and they have concluded that subjecting
their profits to corporate taxes doesn’t justify the
potentially higher valuation. Although EPD never had to cut
its distribution, unlike most of its MLP peers, it suffers
guilt by association with many poorly run brethren. CEO Jim
Teague usually runs a colorful quarterly earnings call –
regular listeners look out for the Vietnam references (i.e.
he’s been in tougher spots than 2020).

We are invested in all the components of the American Energy
Independence Index via the ETF that seeks to track its
performance.