‘We’re In Total Insanity Mode’

Jay Hatfield, fund manager of the actively managed InfraCap MLP Exchange-Traded Fund (NYSE: AMZA), spoke with our correspondent Jennifer Warren on Jan. 12, the day oil prices fell below $30 per barrel for the first time in 12 years. Hatfield is a co-founder of NGL Energy Partners (NYSE: NGL).

JW: MLPs have been hit hard in recent months, while more recently producer stocks had recovered some value. Do you expect valuations of MLPs to recover by the second half of 2016 when supply is expected to tighten, raising oil prices?

JH: The large-cap stocks of the Alerian MLP Infrastructure Index (AMZI) are what I consider the investible asset class of MLPs. For retail investors, I do not recommend small-cap MLPs, or shipping and sand MLPs. Because of the crash in upstream MLPs, the lower quality ones like shipping and non-MLPs like Kinder Morgan (NYSE: KMI), MLPs have become virtually 150% correlated with oil prices and oil stocks. For example, oil stocks are down 2% today, and MLPs are down 5.8%. They have become one of the riskiest asset classes in the U.S. stock market. There is a very major disconnect. They are probably not going to rally significantly until oil rallies. Even if that’s irrational, we believe that to be the case.

JW: What is your primary explanation for the decline in the MLP sector overall? Has the negative sentiment been warranted or is it a bit too panicky?

JH: We think that some decline was warranted. However, we’re in total insanity mode at this point. At this point, there’s no analysis going on. Today Plains All American Pipeline (NYSE: PAA) announced a pretty big equity deal with a private placement, convertible preferred units, and they will maintain their distribution. That’s the third-largest partnership in the AMZI. (There are only 22 components.) Three were most at risk. NGL Energy Partners (NYSE: NGL), which sold an asset for 40X cash flow, reaffirmed their dividend and de-levered. ONEOK  Partners (NYSE: OKS) reaffirmed their dividend, and the stock rallied 20%. Plains re-affirmed their dividend, and the stock went up 20%. All the data points to the positive, but nobody cares.

JW: Did the announcement by Enterprise Products Partners (NYSE: EPD) of a planned 5% increase in distributions for 2016 bolster the market?

JH: We think so. We think there’s going to be more private equity investments in corporate securities or buying assets. There could even be major acquisitions because the disconnect is so profound. Again, I’m not sure anyone is going to care except for that day — unless oil prices rally. I believe they should rally off of this $30 level, but now it is also subject to short-term irrationality. Economically it should, but I can’t guarantee it from a trading perspective.

Normally all the markets calm down once you get into U.S. earnings season, including the commodity markets because they are correlated. Normally the craziness around China goes away too. But this is so crazy, I’m hesitant to make a call on that.

For example, Williams Partners (NYSE: WPZ), which is a high quality company, is not likely to cut their distribution. They have issues. They are still investment grade,  though recently downgraded. They are yielding 18%; it should be at 10-11%. If they are now 18%, why can’t they go to a 36% yield? My point is: once you disconnect from reality, then who knows what the limit is? Eighteen does not make any sense at all. And so why can’t it be 36? We are beyond — there are no buyers. Predicting irrational behavior is a fundamentally flawed exercise. All things being equal, the oil market will bounce somewhere, if it’s not $30, then it’s $25. Who knows?

Based on economics, it will not stay at $30; it can’t. Therefore MLPs will rally. And therefore people will become rational. It’s not entirely clear when. It should happen by the second half of 2016, but it should have probably happened the beginning of this year too. Here we are again at the lows. This would normally be the lows for MLPs and oil. There’s a 60% chance we are as close to the lows as we could be.

JW: Has Kinder Morgan with its structure change from an MLP to a C-corp, followed by a distribution cut of 75%, set off panic in the MLP space?

JH: Yes, they did, because people treated them like an MLP. In my opinion, they validated the MLP structure because corporations do not have anything in their charter to pay out their distributable cash flow, whereas MLPs do. I think of it in the opposite way, that this was positive for the sector. It was the exception that proved the rule. Obviously I am in the minority of investors [laughs], or WPZ would not be trading at an 18% yield.

JW: Are there any standout companies and partnerships that are being unfairly punished in your mind?

JH: It’s mostly reflected in valuations, so that’s hard to say. Do Williams Partners and Williams (NYSE: WMB) have a potential issue? Yes they do. Should they be at an 18% yield? No.  Is it unfair relative to everything else? Not necessarily.  We think probably the Williams situation is the most crazy. There are questions about whether the merger between Energy Transfer Equity (NYSE: ETE) and Williams will go through. If the merger goes through, you get ETE stock at effectively $6. ETE and Williams is the group trading the craziest and most unfairly punished. The stock is trading as if the merger deal is not happening, and they have not announced that. ETE is at 13% yield. If you buy Williams and get ETE stock, you get a 25% yield.

Why does the market suspect the merger won’t go through? Because of Williams being downgraded. There is nervousness about Chesapeake Energy (NYSE: CHK), which is counterparty risk for Williams [with ~20% of WPZ’s revenue]. Our models show that’s priced in. Definitely stocks are trading like the merger won’t happen. The level of panic surrounding this is high. This isn’t like the normal odds of these outcomes. It is not a rational process in the ETE/WMB complex. If the deal isn’t going through, then isn’t ETE a buy at a 13.5% yield? What is the scenario people are pricing in? There’s no dividend cut or indication of going under.

The fact that both stocks are down approximately 15% on the day, their individual stories do not reflect that reality. The market is acting irrationally, and a rally may happen just because of the recent craziness.

JW: How would you characterize the state of America’s energy renaissance?

JH: I think longer term, its really bullish for MLPs. The most likely scenario is that U.S. onshore [production] takes market share from global offshore. There’s robust demand for natural gas and gasoline in the U.S., and we are probably exporting them. Unfortunately nobody cares, and won’t for a while.

JW: A distinguishing characteristic of your fund is the inclusion of MLP general partners. Can you discuss why that might be important given the current state of the market?

JH: Well, they have massively underperformed, so they have the potential to outperform as energy prices stabilize. They have more beta and upside to increase in a positive market. For example, ETE could go up 10-fold in the next two years, particularly if you can buy Williams at a crazy low number.

JW: Your fund was launched at a difficult time in the market, October 2014. What can you say about the timing and your outlook? In what ways do you think being actively managed is a bonus?

JH: Truthfully, we have had a couple of situations where we have been able to add value like buying some puts at a time which was going to be clearly horrible. It’s been a challenge because, for us as asset managers, it’s hard to predict this level of irrationality. It would have been far easier to add value in a more reasonable market.

JW: What is important about the U.S. energy infrastructure advantage in the future with respect to exports of an array of hydrocarbons?

JH: In the long run, the U.S. energy and infrastructure industries are likely to be strong beneficiaries of this new global dynamic. We are a low-cost producer and we are way below offshore production costs. So the U.S. is likely to gain strong market share. This will benefit U.S. industry with low-cost natural gas, a byproduct of producing oil.  We can continue to expand our chemicals business, infrastructure, along with LNG, oil and ethane exports. It should be a large growth driver; it just does not feel like it when it’s happening.

JW: Is there anything else on your mind?

JH: It’s strange, until oil moves higher no one will care. Markets don’t seem to care about the fundamentals, which are more positive than stock prices indicate. In the large caps there are no distribution cuts, a lot of investment, some gains in distributions, assets sales — and valuations are at all time lows.

JW: Disconnect seems to be the word.

JH: Once irrationality sets in, it seems there aren’t even rational people looking [at this] who care. Arguably, MLPs should be up today — all of them. They have been able to raise capital, and private equity thinks they’ll be fine. But does it not matter that oil went to $30 and bounced?  A warm winter does not help. There are lags in demand and supply response, and so oil prices have to overshoot. Everyone agrees it’s an overshoot. How do you predict irrationality? There is a process we have to go through to find equilibrium. I think $30 is pretty low. If I had to call it, I’d call it at $30. And MLPs will be down that day even if it doesn’t make sense.

It’s a weird time. There is certainly the most dislocation and uncertainty surrounding the WMB/ETE merger.

Maybe not this year, but MLPs will be one of the big opportunities for the decade, and it won’t necessarily feel like it, until it is.

(Jennifer Warren is a financial services industry veteran and an experienced journalist with a focus on energy and finance.)


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