Rich Kinder's Wild RideEarnings season is here, and with it the quarterly ritual ofthe earnings conference call. Quite a few MLPs have declaredtheir distributions, and of the 32 that we’ve seen so far nonehave cut while half have announced increases. Those we careabout include Western Gas Equity Partners (WGP), whichannounced a year-on-year increase of 19.2%. Its MLP WesternGas Partners grew at 10.7% year-on-year, illustrating thefaster growth enjoyed by General Partners. Similarly, EQT GPHoldings and EQT Midstream, increased their 2Q16 distributions63% and 22% respectively over 2Q15. Magellan Midstream (MMP)grew at 10.8% year-on-year, while Crestwood Equity Partners(CEQP) was flat after cutting its distribution in April (seeCrestwood Delevers and Soars). CEQP still yields over 11%.

Kinder Morgan (KMI), no longer a Master Limited Partnership(MLP) but nonetheless a bellwether of the sector, reported asolid quarter and maintained its dividend (slashed by 75% inDecember) unchanged. KMI is big enough that their fortunes aresomewhat reflective of the overall energy infrastructureindustry. Chairman Rich Kinder can scarcely have had a wilderride than the last three years. In January 2014, frustrated bythe weakness in KMI’s stock price in the face of relentlesscriticism from a small research firm, Kinder famously said,“You sell. I’ll buy. And we see who comes out best in the longrun.”

Kinder no doubt believes the long run is longer than the timesince he spoke those words, because KMI is still substantiallylower than it was back then. Kinder was still bullish at thetop, and his antagonist remained bearish at the bottom. Atleast they both have conviction. Like other MLPs, KinderMorgan identified growth opportunities beyond the appetite oftraditional MLP equity investors to provide financing. In 2013MLPs were raising more in equity capital than they were payingout in distributions (see The 2015 MLP Crash; Why and What’sNext). The Shale Revolution had created the need for moreinfrastructure, but it still strained their traditionalfinancing model almost to breaking point. Kinder of courseabandoned the MLP model altogether and became a conventionalcorporation (a “C-corp”), which made their stock available toany global investor and not just the limited pool of U.S.taxable, K-1 tolerant buyers. For the rest of the MLP sector,new mutual fund and ETF buyers provided an additional sourceof equity capital for a time, but falling prices caused some

of them to exit. Every MLP investor by now knows how 2015ended. KMI hoped to maintain the MLP distribution payout modelof returning approximately 100% of Distributable Cash Flow(DCF) to investors. Finally, with the double-digit yield ontheir stock communicating a complete absence of gratitude forthis largesse, they accepted the inevitable and slashed thedividend so as to delever their balance sheet (see KinderShows The MLP Model is Changing).

Which brings us to the most recent earnings call. Successful,big companies don’t shift strategy every quarter, even ifsell-side analysts desire more “market-responsive” (i.e.fickle) planning. KMI had long argued that a Debt/EBITDA ratioof 5.5-6.0X was appropriate given their diversified business.The strategy shift triggered by the dividend cut in Decemberwas accompanied by a new, relentless focus on bringing thisleverage ratio down to 5.0X. The cash saved by reducing thedividend was earmarked for paying down debt and financinggrowth projects, resulting in a less levered, self-financingKMI.

December 2015 to July 2016 is scarcely the long run by moststandards. Nonetheless, analysts on the recent call were heardasking why KMI couldn’t finance some of its backlog of growthprojects by issuing debt. Their $13BN backlog has acapex/EBITDA multiple of 6.5X, and is currently financed fullywith internally generated cash (i.e. equity). This is downfrom 7.5X at their Analyst Day earlier this year, the resultof “high-grading” their backlog (i.e. dropping the lessattractive ones). With a 15% unlevered after-tax returntarget on projects and a borrowing costs in the low singledigits one can begin to see the appeal of debt financedgrowth.

Two quarters ago, sell-side analyst questions revolved aroundthe speed at which KMI could reduce its leverage. Today,they’re being asked why they don’t increase leverage. One canhear the sighs of exasperation in the management team as they

respond to the shifted goalposts such questions represent.It’s why running a private company can be more attractive – infact, we often noted last year that if MLPs were unlisted andinvestors had to rely fully on financial statements in theirevaluations, they would have concluded that not a great dealhad changed. But this rapid shift in sentiment is what createsthe opportunities for those that are able to keep their eye onthe ball. Happily, Barron’s is shifting gears rather moreslowly, with their first cautiously positive piece on MLPs inrecent memory (see MLPs: Is It Safe to Dive Back Into the PoolYet?). Skepticism is good.

We are invested in CEQP, KMI, MMP and WGP

Coals to NewcastleThe expression “like sending coals to Newcastle” can be traced

back to the 17th century, reflecting the insight that whateverelse Newcastle needed in those days did not include coal. Thiswindswept port on the North Sea was conveniently located nearsome of the biggest coalfields of northern England. During itsheyday, American trader Timothy Dexter defied common sense andsent a shipment of coal to Newcastle, causing anticipation ofa substantial loss. However, perhaps by luck he had the goodfortune for his cargo to arrive during a miners strike,thereby profiting from unusual and temporary demand. Coalexports have long since ceased along with local coalproduction. Today’s Newcastle possesses little of note beyondan English football stadium with capacity well in excess oftheir local team’s ability (they were just relegated from thePremier League). Meanwhile, Newcastle in the Australian state

of New South Wales has become the world’s most prolific coalexporting port.

LNG to the UAE doesn’t quite roll off the tongue as easily asCoals to Newcastle, but it might be a modern-day equivalent.The Middle East has 2.8 quadrillion cubic feet of provednatural gas reserves, enough to meet current global demand for23 years. OPEC reports that the United Arab Emirates (UAE)holds around 10% of this. And yet, earlier this year theEnergy Atlantic LNG tanker unloaded 3.38 BCF (Billion CubicFeet) of natural gas at the port of Jebel Ali, near Dubai,following an almost seven week journey from the Sabine PassLNG terminal in Louisiana.

Somehow the power of economics (see Why the Shale RevolutionCould Only Happen in America) has overwhelmed the logic ofgeographic proximity to make such a delivery commerciallyreasonable in spite of abundant local resources. To show thiswas no fluke, more recently the Creole Spirit unloaded asimilar amount in Kuwait, also sourced from Sabine Pass. Theregion hasn’t developed sufficient energy infrastructure toproperly exploit its resource domestically.

The story of America’s Shale Revolution was built on the

single-minded pursuit of unconventional fracking technology bymany independent exploration and production (E&P) companies aswell as some extraordinary chutzpah by a few. The Frackers byGreg Zuckerman memorably tells the story of some of them.Cheniere Energy (LNG) under then-President Charif Souki wasonce intent on importing LNG into the U.S. to take advantageof relatively high domestic prices. Cooling natural gas to anear-liquid state (at -260° F) so it can be moved in acondensed form by ship requires a substantial investment (i.e.US$BNs) to create such a facility, as does the construction ofa regasification plant on the receiving end. Souki’s careerwasn’t obviously suited to leading Cheniere on this journey,having been primarily focused on raising money for bankingclients in his native Lebanon and elsewhere in the MiddleEast. His past also included a stint as restaurant owner ofMezzaluna, the now infamous Los Angeles eatery where NicoleSimpson ate her last meal on June 12, 1994 before being slainby O.J. Simpson (ahem…allegedly).

Undaunted by the absence of any relevant experience, asPresident of Cheniere Souki set out to use his former bankingties to finance their new business. The Shale Revolution ledto a collapse in domestic natural gas prices and turned theeconomics upside down, causing Cheniere to turn fromprospective LNG importer to exporter.

The facility that can regassify LNG for normal use is not thesame one that can liquify it for long distance transport.Converting an LNG import facility to an export one is not thesame as reversing a pipeline, and many more $Billions wererequired for Cheniere to be ready for business. Just asexport operations began, Souki was pushed out by its board ofdirectors which included Carl Icahn. The boss’s substantialrisk appetite was by now well known, but his latest plan toadd a gas trading business was a risk too far for investorswho could finally see actual cashflows on the horizon. Souki’scompensation over the years had matched his ego, but

recognizing that his risk appetite didn’t match ours we havenever invested in Cheniere.

The Sabine Pass facility began exporting late last year and iseventually expected to handle 3.8BCF per day. Some of itssupply travels from the Marcellus shale in Pennsylvania alongthe Transco pipeline network owned by Williams Companies(WMB), in which we are invested. A few weeks ago I had theopportunity to be presenting in Laceyville, Pennsylvania to agroup that included landowners receiving royalty checks fromthe production of natural gas under their property. As wenoted last week, few countries assign mineral rights to theowner of the land beneath which they sit.

For just a moment, step away from the prosaic question of themarket’s near term direction and consider this: an Egyptian-born Lebanese former restaurant owner raised $Billions toexport liquefied natural gas over 11,000 miles to a region ofthe world whose wealth is totally reliant on hydrocarbons. Itcouldn’t have happened anywhere else, except America.

We are invested in WMB

Why the Shale RevolutionCould Only Happen in AmericaA few weeks ago we wrote Why Oil Could Be Higher for Longer,and since then it has elicited quite a few comments back to usfrom clients and blog subscribers. We won’t repeat it indetail here since readers can simply click on the link aboveto see it. But our view is that the outlook for U.S. crudeproduction over the intermediate term is very constructive,and certainly better than current consensus. This relates to

the superior economics of shale wells compared to conventionaldrilling, and the associated ability of shale Exploration andProduction (E&P) companies to quickly respond to changingprices by adjusting drilling activity faster than their peers.

“Shale wells,” (i.e horizontal wells drilled into source rockand stimulated by fracking) have many competitive advantagesover conventional wells that give us confidence Americanproduction of Oil, Natural Gas Liquids (NGLs), and Natural Gaswill greatly exceed consensus expectations to meet new energydemand and fill the void left by depleting fields.

A recent article in the Financial Times expanded on this theme(U.S. shale is lowest-cost oil prospect). A chart accompanyingthe article showed the break-evens of twenty potential futureprojects and the cheapest half-dozen are U.S. shale plays. Infact, shale oil development benefits from many of theadvantages that are inherent in the U.S. Most Americans takefor granted that property ownership comes with mineral rightsfor anything found below their property, but around the worldthis is by far the exception. In most countries mineral rightsbelong to the government. Getting a farmer to agree to allowdrilling on his land is easier if he’s able to negotiate amonthly royalty check as opposed to a central authority simplyexercising its control.

Although many of the cheaper sources of new oil are U.S.shale, Wood Mackenzie doesn’t believe there’s enough tosatisfy the world’s consumption at current prices. Depletionof existing fields plus new demand create a need for roughly

6MMBD (million barrels a day) of additional supply annually.The market will clear at the marginal cost of the mostexpensive barrel needed to balance the market – a price thatlooks a good bit higher than today’s spot price. And for thosewho think offshore drilling can be attractive, BP justannounced the final charge of $5.2BN for the 2010 DeepwaterHorizon spill in the Gulf of Mexico. Their total costs forthis one incident add up to $61.6BN, a hit only a few globalcompanies could absorb. You can be sure that any offshoredrilling in U.S. continental waters has to account for thispossibility in its risk analysis.

Critically, low-cost U.S shale wells can be drilled much morequickly and come on with significantly higher initialproduction (IP) rates with steep decline curves. In fact, anew shale well can go from planning to full capital paybackbefore most new conventional projects are even producing. This fast decline rate also allows shale oil producers tohedge the bulk of their production, which occurs in the firstseveral years, in the futures market which is only liquid fora few years out. It’s worth noting that the quicker thepayback the quicker shale E&Ps can plowback cash into newshale drilling. The chart below from the U.S. EnergyInformation Agency highlights how IP rates have improved overthe past few years (click on image to expand).

Geographically, the U.S. is blessed with generally sufficientwater supplies close enough to the shale plays that theysupport, since fracking requires a lot of water.Entrepreneurial drive is as strong a force in America asanywhere, and that combined with highly developed capitalmarkets make access to financing and substantial wealthaccumulation possible for those who are able to profitablyexploit this resource. And continued technological innovationspurred by entrepreneurs is relentlessly driving costs downfaster than most expected and faster than conventional plays,further increasing their competitive cost advantages, playingto another American strength.

Even with all the American advantages and helped by thetailwind of high commodity prices it still took a decade forshale drilling to have a meaningful impact on output. Majorshale drilling anywhere outside the U.S is a long way off,providing a huge first mover advantage.

In other words, the shale revolution is occurring because ofall these inherent strengths in the U.S. On top of which,energy independence which is where we’re heading as a result,is in our national interest and highly likely to remain thatway. The entire story is built on U.S. advantages and orientedtowards U.S. interests. From a strategic perspective, givenwhat we know today, it seems to us that perhaps the bestsecular investment theme available is the continuation of thistrend, to the obvious benefit of the midstream infrastructureMaster Limited Partnerships (MLPs) whose support is critical.

It’s no longer the case that a distribution cut is bad for anMLP. In April, Crestwood Equity Partners (CEQP) cut itsdistribution at the same time as announcing a JV with ConEdison and steps to reduce its leverage (see CrestwoodDelevers and Soars). Last week Plains GP Holdings (PAGP)announced a simplified structure with its MLP Plains AllAmerica (PAA) and an 11% distribution cut at PAGP. Both stocksmoved sharply higher on a perceived lower cost of capital andtherefore improved growth prospects. Williams Companies (WMB)is likely to cut its dividend so as to reduce leverage, but ata 12% yield there can be few who would be surprised by this. Adistribution cut in support of a stronger balance sheet seemsto attract more buyers than sellers nowadays.

Lastly, we note that ShellChemicals is investing $6BN in anew ethylene facility in SWPennsylvania near Pittsburgh(artist’s impression from Shellat left). It’s located there tobe close to its supply of ethanein the Marcellus and Utica shale

areas, of which it expects to consume 90-100 thousand barrelsa day. The facility will in turn produce 1.5 million tonnesper annum (MTPA) of ethylene and 1.6 MTPA of polyethylene,widely used in everything from food packaging to automotive

components. This is not a region that has seen a new largeindustrial project such as this in living memory. It’s anotherexample of the tangible results of the shale revolution.

We are invested in CEQP, PAGP and WMB

More Thoughts on Brexit; AMLPReaches a MilestoneThe Brexit vote is now two weeks behind us and I still watchdevelopments with jaw agape. Rarely in history has theconsequence of a popular vote led so directly to a recession.The IMF has forecast that the UK economy will shrink by 1.5%through 2019 if they agree to a Norway-style EU access (i.e.similar EU budget obligations, lack of immigration controlsand submission to EU regulations but with no ability toinfluence them, not exactly what Brexiteers voted for). Or, ifEU access conforms to the World Trade Organization (WTO)tariff framework, the UK economy will shrink by 4.5%. LeadingBrexit campaigners such as Boris Johnson and Nigel Farage haveexited stage left now that their goals have been achieved.Brexit voters gamely advise that everything will be OK, whiledecision makers prepare for a recession. Fewer UK jobs willlikely reduce immigration anyway, although this is hardly thebest means of achieving that goal. And yet, in theory theentire non-UK EU population of almost 450 million people couldhave relocated to the UK, at which point the country wouldhave resembled a Piccadilly line tube train at 5pm. Freemovement of people, a core, inviolable principle of the EU, isabsurd.

Nonetheless, Brexit was not a carefully considered response

but a visceral reaction with far-reaching and poorlyconsidered consequences. Churchill once said, “The bestargument against democracy is a five-minute conversation withthe average voter.” Brexit leaders have led their followers tothe cliff and then retired to the pub for a drink while theywatch the leaderless deal with the aftermath.

One result is that bond yields globally have fallen tohitherto unimaginable levels. The Barclays Aggregate Index is+6% YTD, beating the S&P500. Regular readers will be familiarwith our past illustration of the paltry returns available onbonds whereby we compare a barbell of stocks and cash with theten year return on bonds. In our April newsletter we wroteabout The MLP Risk Premium. With reasonable assumptions aboutMLP distribution growth rates and prevailing valuations in tenyears, you could swap out your bond portfolio for as little as10% in MLPs with the rest in cash while still achieving abond-like return. MLP yields have fallen since we wrote thatin April, but so have bond yields so the broad set of choicesstill favors almost anything over bonds but certainly stillMLPs.

Federal Open Market Committee (FOMC) minutes released lastweek confirmed what we’ve long noted, that Janet Yellen willnever miss an opportunity to avoid raising rates. Ignore theirwords and try considering this Fed’s actions as if they’dannounced the solution to excessive debt was to keep rates lowfor a long time. The rhetoric doesn’t reflect such a strategybut their actions most assuredly do. Waiting for rates highenough to justify an investment requires substantial patience,during which time investors are steadily pursuing equity-typerisk with its better return prospects.

Tallgrass Energy GP (TEGP) raised its quarterly distributionby 16.7% quarter-on-quarter and 84.2% year-on-year from itspro-forma 2Q15 level. Not every MLP or GP is raising itsdistribution by any means, but less than six months ago suchwould have been unthinkable. Meanwhile, the Alerian MLP ETF

(AMLP) reached a milestone of sorts, in that the recentrecovery in MLPs has finally moved AMLP to where it once againhas unrealized gains on its portfolio. As we noted in March(see Are You in the Wrong MLP Fund?) this is the point fromwhich AMLP investors will now earn only 65% of any subsequentupside since the U.S. Treasury will take 35% through corporatetax. Indeed, the tax drag has already had an effect, sinceAMLP’s YTD performance through June 30 is +10.7% versus theAlerian Infrastructure Index +13.1%. Those AMLP investors whoare bullish on the sector (which presumably includes all ofthem) will, if right, contribute modestly to Federal financesat the expense of their own investment results and reputationfor careful analysis. AMLP is the refuge of those who stop atPg 1 of a prospectus rather than examining Pg 23, FederalIncome Taxation of the Fund. This is part of the reason why amore thoughtfully designed, non-taxable, RIC-compliant MLPfund (which we run) has done very well.

We are invested in TEGP.

Will Energy Transfer Act withIntegrity?As regular readers know, the proposed merger between EnergyTransfer Equity (ETE) and Williams Companies (WMB) has been arich source of material. Last week a judge’s ruling enabledETE to cancel the deal since a needed tax opinion was notforthcoming. WMB found it convenient to say the least thatETE’s tax counsel Latham Watkins, having originally providedinformal guidance that no adverse tax outcome was likely,later changed their minds coincident with their client souringon the deal. However, Judge Sam Glasscock III found no

coincidence and absent a tax opinion that the deal was tax-free, ETE had its escape hatch.

We didn’t think the deal would get done, but we remaininterested in the fate of the convertible preferred securitiesETE issued in March. As we wrote before (see Is EnergyTransfer Quietly Fleecing Its Investors?), a select group ofETE insiders representing 31% of the common units outstandingwas given the opportunity to swap their units for preferredsecurities with a guaranteed dividend which could bereinvested in more common units at $6.56 per share (ETE closedFriday at $13.80). Ostensibly this was to shore up ETE’sbalance sheet given the $6BN cash payout they had agreed tounder the merger. But it had the additional result ofdevaluing ETE units for all the other holders, including WMBinvestors who would be receiving new securities linked invalue to ETE. WMB naturally sued. This looked like a veryaggressive, almost scorched earth negotiating strategy by ETEin their efforts to force a renegotiation on WMB. However, aswe noted in May, ETE CEO Kelcy Warren indicated that thesesecurities would remain outstanding even if the merger wascancelled.

WMB’s lawsuit of these securities didn’t receive a ruling fromJudge Glasscock. He recognized his ruling on the tax opinionwas likely to scupper the deal anyway, rendering WMB no longeran injured party. However, the same judge is hearing a lawsuiton this issue from other plaintiffs.

Without doubt, the abovementioned securities represent fraudby ETE’s management. Every ETE investor would welcome theopportunity to swap their common units for the ones Kelcy andhis friends own. He has a fiduciary obligation to other ETEinvestors which this action clearly violates, transferringsubstantial value (we estimated $1.3BN) from investors in thesame class of units to the insiders. Since ETE no longer facesthe prospect of finding $6BN, the apparent need for thesecurities themselves has disappeared and we await their

cancellation.

So we’re watching to see if ETE acts with integrity andvoluntarily cancels the convertible preferreds. Or will theyseek to retain this wealth transfer with a differentjustification? It’s going to be hard for ETE to negotiatefuture deals credibly following the WMB experience, butespecially so if they choose wrong on this issue. One canforgive the second thoughts on the merger, because the marketmoved sharply against MLPs last year. This was an issue ofjudgment. But a CEO who openly defrauds his public partnershas lost his reputation for good. What use to the world is adishonest billionaire, beyond donating his money to have acouple of buildings named after him? In future dealings withKelcy and the other insiders, including John McReynolds(President of ETE’s General Partner), Matthew Ramsey(President of Energy Transfer Partners), Marshall McCrea III(Group Chief Operating Officer) and Ray Davis (retired, co-founder), you’d always have to assume that they could onceagain fail to act in good faith having done so before. Basedon the data we analyze about our blog subscribers, we knowsenior managers at ETE are reading this.

It may surprise, but we remain invested in ETE. We believeKelcy Warren will cancel these securities. He and his teamhave built a fantastic business. They are enormously talented.They can avoid any loss of face by simply saying thesecurities are no longer needed. This is the right thing todo. You won’t find any sell-side analysts asking toughquestions on this issue out of fear of causing offense. At SLAdvisors we are free to say what many other analysts aremerely thinking, because our only interest in ETE is that itsvalue appreciate and its stock price rise. In this way, we arecompletely aligned with our clients and free to call it as wesee it.

Kelcy, do the right thing.

We are invested in ETE and WMB