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“In the middle of the journey of our life I found myself within a dark woods where the straight way was lost.” – Dante’s Inferno

I begin this write-up of our largest current investment with the opening line from a 14th century epic poem about an expedition through the nine concentric circles of hell because that’s pretty much what our multi-year journey of investing in Energy Transfer Equity, LP (ETE) has felt like. In the past three years, ETE has, at various times, managed to find itself overleveraged in the face of a once-in-a-generation commodity price collapse, the instigator of one of the most publicly disastrous hostile M&A attempts, the primary antagonist of every climate change AND Native American rights activist in North America and the textbook example for why management incentives matter and how the MLP structure allows general partners to place their interests above their limited partners.  If there were a bottle of “investor repellent” then you’d pretty much have the ingredient list right there. However, I think things are about to change in a dramatic way. The mega-sized infrastructure projects that resulted in death threats and almost imploded a balance sheet as debt swelled to +$40B are about to be completed. The IDR waivers that ETE granted Energy Transfer Partners, LP (ETP) to keep the LP’s head above water are about to expire, and there is plenty of coverage to pay the increased rent. And at some point, probably well before the company’s stated “late 2019” target, the MLP structure will collapse (likely in a final act that serves one more turd sandwich to LPs), a C-corp of some type will get formed (obviating the regurgitated critique that MLP’s are a narrow asset class), and the wounds of transgressions of the past will, likely, be forgotten. With shares of ETE trading like they might infect the owner with an incurable disease, we think events over the next year (or so) offer an opportunity to more than double your money.

If this analysis reads like a teenage girl screaming into a pillow, it’s because that’s exactly what it is. At the risk of sounding hyperbolic, it’s inconceivable to me that the combined Energy Transfer complex (ETE and ETP, reference hereafter as “Energy Transfer”) trades at less than 9x stabilized EBITDA (versus 13x for peers) in the current environment. Let’s start at the top. Global GDP growth is +3.5%, driving oil demand growth of nearly two million barrels per day. Global production and supply are currently balanced and likely headed into deficit following three years of historically low investment. Brent is at $71 (highest in three years), and Saudi Arabia reportedly wants to see it at $80. Either way, the dearth of investment in new projects continues. US oil export bans have been lifted, and shale is literally feasting on global market share; lower-48 production is growing at a heady +15% annualized rate (with the Permian growing +36% yoy) and, depending on the week, we are now exporting over 2 million barrels per day (over 20% of total production). The chart of export volumes (below) looks like a cryptocurrency price graph.

This is the golden age of American energy production that we dreamed about (in my teenage rant motif – THIS WAS SUPPOSED TO BE THE HAPPIEST TIME OF MY LIFE). We thought the payout would be handsome. Energy infrastructure stocks should be on a tear. They are not. Instead, we are footing a truly ridiculous bill of underperformance. The one, three and five year total returns (meaning it includes a mid to high single digit annual yield) for the Alerian MLP Index (AMZ) are: -19%, -27% and -20%, respectively. Now I concede that there are some problems with the periods we are referencing – maybe a dropdown MLP for Transocean shouldn’t have been trading at +20x distributable cash flow in 2014 when oil prices were above $100 – but the pendulum has just swung way too far. High-quality MLPs shouldn’t be trading at a +2 turn discount to mall REITs on an EV/EBITDA basis. Even more to the point, Energy Transfer, arguably the highest quality asset footprint in the universe, should not trade at a 6x turn discount to these secularly challenged, future sites of the Third Assembly of the Sixth Day Adventist Church (no offense to readers who may be members of said religious institution).

Energy Transfer is the largest energy infrastructure company in the United States. Their systems are located in counties where 70% of the oil and gas rigs are currently drilling in the US. Energy Transfer has a large and growing footprint in each of the major oil and gas basins, with a substantial presence in West Texas. In a recent meeting with a team from East Daley (in my opinion, one of the best sell-side options for energy research) I asked them to compare Energy Transfer’s position in the Permian to peers. Before I even finished my question they said “unparalleled.”

Energy Transfer’s full service offering is competitively advantaged. They are one of only two companies (ETE and EPD) that have a complete wellhead-to-end-market service offering. Several parts of this value chain, notably the fractionation and storage of NGLs at Mont Belvieu, have extremely high barriers to entry. No other company can put the following slide into their investor presentation.

The growth that will ensue from this collection of assets is significant. Exxon has committed to spend $50B in the Permian over the next five years to triple production in the basin. Energy Transfer, through its acquisition of Southern Union which itself had acquired Sid Richardson Energy Services from the Bass family, owns most of the infrastructure that is connected to Exxon’s Permian acreage. The amount of new infrastructure – gathering and processing facilities, liquids fractionation plants and takeaway pipes – adds up to several billion dollars. Sure Energy Transfer has its fair share of legacy assets in undesirable basins (most notably some interstate gas pipelines that serve now defunct first generation shale gas plays), but we estimate that the total impact from contract renewals over the next four years is less than 5% of EBITDA. Given their dominant footprint in the largest and fastest growing basin in the US, we expect that EBITDA should be growing organically at a mid-single digit rate through the first few years of the 2020s.

With ~$9B in EBITDA by the end of 2019, the company will have grown EBITDA at a 20% CAGR from 2010. Their growth came from both an incredibly aggressive M&A campaign that saw Energy Transfer and its related companies acquire five public peers (Regency Energy Partners, Southern Union, Sunoco, PVR Partners and PennTex), innumerable asset packages and a capex program in which they invested almost $40B. This doesn’t include the three public companies (Targa, Williams and NuStar) that they tried to buy but didn’t, or the +$12B Lake Charles LNG export facility that was supposed to be under construction right now, before the world became awash in LNG (a scenario which we think is coming to an end). Suffice to say, Energy Transfer has spent most of the last ten years looking like a garter snake digesting a passenger bus. In recent years, the skin was stretched so tight that it almost split. But it didn’t.

From 2016-2018, Energy Transfer will have put over $18B worth of growth capex projects into service. Here is a list that was compiled by Raymond James.

By comparison, over this period the sum of the second and third largest capex programs in the industry (Kinder Morgan and Enterprise Products) was just shy of $20B. To put this further into perspective, this means that in a three year period that included some of the most volatile market conditions in the last thirty years Energy Transfer has basically created a midstream company the size of ONEOK ($33B EV; $2.274B consensus ’18 EBITDA; 14.3x ’18 EBITDA) or Plains All American ($30B EV; $2.326B consensus ’18 EBITDA; 12.8x ’18 EBITDA). These projects should all be online sometime this year.

Executing this investment cycle in the most benign environment would have been a challenge. And things have been pretty benign, right? Well, not exactly. Oil prices collapsed, causing US oil production to nose dive, only to do a U-turn and power through prior tops as efficiency improvements went into high gear and pad drilling opened the spigots (particularly in the Permian). Gas prices also collapsed, and although production was more resilient, the gas markets have been turned on their heads – TWICE – following an explosion of Northeast gas production, and, in recent months, greater associated gas contributions from the Permian. The net result of it all is that the US is now (or is about to be) the largest oil producer in the world, and with domestic crude prices approaching $70 the rate of growth is likely to accelerate. Bizarrely, energy infrastructure stocks only reflect the first part of this story.

Yes, the MLP asset class burned everyone involved during the energy recession. Retail investors who had been promised steady and rising distributions were betrayed by cut or eliminated payouts. The financing lifeblood of the industry – equity issuance – turned from a deep pool of capital to a barren cash desert. As costs of capital rose, growth projects morphed from valuable assets to unfunded liabilities. And, perhaps most acute in the case of Energy Transfer, this distress exposed the underbelly of what happens when times get tough and general partners use their control to extract pounds of flesh from limited partners. It’s been a nightmare. But it’s not nearly as bad as people seem to think. Let’s take Dakota Access Pipeline (“DAPL”) as our case-in-point.

I suspect that most investors would characterize DAPL as a negative part of the ETE story. Considering that the 2016 pre-DAPL fiasco unit price was 20% higher than where ETE is currently trading, when WTI was in the low $50s and domestic oil production was almost 20% below current levels, it’s hard to disagree with that perspective. However, DAPL was one of, if not THE most value-creating energy projects constructed in the last five years. All in, DAPL cost around $4.8B. Initially, it was a 75%/25% JV between Energy Transfer and PSX. The project was funded with $2.3B of equity and $2.5B of asset-level debt. In August 2016, five months before the project was supposed to ship its first barrel of oil, Energy Transfer sold 49% of their interest for $2B to a JV between Marathon and Enbridge. This means that before the project was even complete, Energy Transfer got all of their equity investment back (and a little more), and retained a 38% equity interest in a project that currently generates around $600MM in annualized EBITDA. Put another way, Energy Transfer found a way to create an annual stream of $230MM in EBITDA for free during a time when Bakken oil production was declining at a 17% rate.

DAPL created nearly $3B of value (assigning a 7% DCF yield) in a god awful energy market and yet the investing community has tagged the company with some sort of scarlet letter for this project. When you add in additional creative value enhancing moves such as 1) selling down part of Rover (a pipeline that most consider to be a lower return project with weak counterparties) before it was complete to Blackstone at a 20% premium to cost, or 2) selling $160MM of compression EBITDA to USAC that sell-side had valued at 6x EBITDA for 10x (implying $640MM of value creation), or 3) the highly telegraphed, and we think likely, Mariner East 2 JV with a strategic partner that will both A) value the existing project at more than the invested capital and B) provide visibility into future high-return expansion opportunities one starts to get an appreciation for how wrong investors are for valuing Energy Transfer’s equity at a +50% discount to peers. It just doesn’t make sense.

When all is said and done, Energy Transfer will have put to work $60-65B in capital over a ten year period and grown EBITDA by about $8B, implying around an 8x multiple. With peers trading at 13x EBITDA, I think it’s reasonable to say that Kelcy Warren and pals have created around $40B in value. So why does no one want to invest with him?

Our due diligence on Mr. Warren over the years has always revealed him to be self-serving and aggressive. We knew that both traits represented risk, but we dealt with it by making sure we were usually on the same side of the table (ie own ETE, not the LPs). This worked quite well for a long time, until March 2016 when Kelcy found a way to subjugate public ETE holders by temporarily converting his (and his cronies) ETE shares into a preferred class which receives distributions partially in cash and partially in units at a fixed price of $6.56 for nine quarters (ending May 2018). The move was sold to investors as a way to avoid cutting the distribution (which, in fairness, they would have had to do in light of the IDR waivers that were granted to ETP) but the fixed PIK price was egregious. I’m not going to defend the action in any way, but I think it needs to be put into the right context. The preferred conversion is arguably the biggest reason why ETE’s market cap is $7B less than it would be if it were valued in line with peers. The total cost of the conversion (value of the equity issued, less the cash saved by not paying out distributions) is less than $700MM. And there might not be any economic cost at all.

Angry shareholders are suing insiders, claiming the conversion violated the partnership documents and that the “independent committee” that approved the transaction was not in fact comprised of any independent members. We obviously believe the suit has merits. We should have an answer soon. Post-trial arguments are happening today, April 16th, and a decision is expected soon thereafter. Regardless of the outcome, we expect that the likelihood of this kind of self-service is extremely unlikely to happen again. As bad of a guy as Kelcy has been to his LPs, the consolidation of ETE and ETP will mostly eliminate the motivation (and therefore risk) of further bad acting. We anticipate that this consolidation will occur sooner than the market expects, and that it will be more favorable to ETE than any sell-side analyst has predicted.

Let’s step back for a second. The MLP asset class is radically evolving. The model of LPs being used as a funding vehicle to build assets and drive IDR cash flows for a general partner will likely disappear forever. Given how f’d up everything has become, I view this transition as very healthy for the industry. The re-rating opportunity across the entire Alerian Index is meaningful, but the upside at ETE is somewhat staggering.

In the fall of 2107 Energy Transfer first identified a likely consolidation. On their Q3 earnings call, the CFO stated, “I just want to reiterate that we do not expect to evaluate any internal restructuring transactions to occur before late 2019 at the earliest.” While establishing this future milestone has done more harm than good since it introduces uncertainty to a story that is already way too complex for most investors, a consolidation of ETE and ETP is an extremely positive catalyst. In our view, the carrots and sticks that determine when a consolidation occurs point to this happening sooner than the late 2019 timetable.

In the months since consolidation was first introduced several things have happened that should accelerate the timing. At an industry level, MLP stocks are languishing in an even worse fashion than they were last year (AMZ is down 8% YTD) while fundamentals (commodity prices and volume growth) have improved materially. This means that costs of capital are higher at a time when growth projects are more plentiful. In as much as a consolidation either results in a re-rate of your equity price or it allows you to reset your distribution policy so that you can use retained cash flow for growth projects, consolidation is more attractive today than it was last year.

Based on recent commentary, we believe that Energy Transfer would consolidate today if they could. Unfortunately, consolidated leverage between ETE and ETP is in the 5.5x range, above the 5x level that rating agencies typically require to assign investment grade ratings. On the heels of a Q4 earnings report that beat consensus EBITDA by +8%, and in the midst of nearly every fundamental factor improving (including volumes, oil prices, crude to gas ratios, Midland oil and Waha gas basis differentials) we think that consolidated leverage should dip below 5x by the end of this year. We think that once the rating agencies give the green light, the consolidation will happen almost immediately. So what will it look like?

If you want to see what it will NOT look like then I’d encourage you to look at sell-side notes like the excerpt below from a recent UBS piece.

This scenario posits that ETE (the entity that the most self-interested CEO in the industry owns) will buyout its limited partner (the stock that said CEO owns almost zero of) at a 15-22% premium, resulting in ETE’s IDR cash flow getting an 8.9x valuation (versus several recent transactions that valued similar-ish IDR cash flows at 15x). This isn’t going to happen.

The only time that GPs buyout their LPs is when the GP is structured as a C-corp and the goal of the transaction is to exit the MLP structure and create a tax shield by buying in the LP at a premium (this is what ONEOK did). Instead, we believe that ETP will buy out ETE at anything between a modest premium (5-10%) and a very large premium. How large could the premium be? We estimate that if ETP were to buy out ETE on the basis of a “market multiple” for its IDR cash flow then ETE would get valued at a +50% premium to its current price. And there really isn’t much that ETP could do to control the size of the premium. While ETP unitholders would have to approve an acquisition of ETP by ETE (preventing a take under), ETP does not get a vote if they are the buyers of ETE. The only gatekeeper here is the “independent committee” that would get formed to preside over the transaction, and we have already seen how fake that control is. In our best guess outcome, we think that ETE gets acquired at a ~20% premium, which results in ETE’s share of the total cash flow going from the current 40% to 50% (it might be hard to justify getting more cash flow than the high splits). When you add that return to the uplift from rerating to peers that would occur following simplification (either on an EV/EBITDA or P/DCF basis), we think that ETE’s unit price roughly doubles from today. Any broad recovery in the space is additional upside.

There are two final points that I want to make but don’t want to spend time finding a way for them to not seem like hangers-on. Sorry. The first is how the recently announced change in how FERC handles income tax allowances has virtually zero impact to Energy Transfer and the second is that I expect Energy Transfer will find a way to float a C-corp which will dramatically expand the potential investing universe for the company.

On March 15th the FERC announced that they would no longer give MLPs credit for an income tax allowance (ITA) when calculating rates of return for setting max tariffs. This announcement sent shock waves through the MLP universe. In a worst case scenario, a pipe could see its tariff reduced by 35%. That would be really bad news for Energy Transfer. But it would also be fake news. The change in how the FERC treats ITA has virtually zero impact to Energy Transfer. The ruling only applies to interstate gas pipes (18% of ETP’s EBITDA) that are currently charging max tariffs (<3% of EBITDA). Florida Gas Transmission (FGT), a 50/50 JV with Kinder Morgan, is the only pipeline that charges max tariffs. Since FGT is owned by Citrus LLC, an entity that has elected to be taxed as a corporation, and this change only applies to pipes owned by MLPs there is literally zero impact to their current business. While there could be a small impact on interstate liquids pipes, through a modification to the way that CPI adjustments get calculated, we are talking about very very small numbers. I’ll again give a plug for East Daley by recommending that anyone who wants to learn more about ITA watch this webinar -

https://www.youtube.com/watch?v=WkBSzGStXJk&feature=youtu.be

As for my comments about creating a C-corp, I believe that Energy Transfer will create (either by way of acquisition or formation) a C-corp security that will allow shareholders to convert their LP interests into a security that will be taxed as a corporation. This should dramatically widen the potential investor base (which today is as narrow as anything we are aware of in the public markets; sometimes I think that we are the only investors sitting in the center of the Venn diagram drawn to define people who A) do energy, B) do MLPs, C) are able to digest the complexity of Energy Transfer, and D) are willing to invest alongside a self-serving risk taker/empire builder).  

I’ve posted a few tables below that set out sell-side estimates of EBITDA for ETE* and its two best public comps – OKE and EPD. For what it is worth, we think that the ETE estimates are too low for outer years. It seems unlikely that OKE and EPD will grow faster than ETE given the latter’s superior exposure to growing basins. As the company de-levers, the most commonly cited reasons for Energy Transfer’s discount to peers (leverage and GP/LP structure) should subside. As we’ve stated throughout this rather long analysis, we expect that this will drive a material improvement in ETE’s unit price.

*Given some differences that emerge when handling consolidated JVs, we have used numbers from Morgan Stanley, Raymond James, Goldman Sachs, JP Morgan and Wells Fargo to assemble our ETE estimates.

Risks

Management finds another way to disadvantage public unitholders

Project execution

Commodity prices

Longer term degradation in hydrocarbon demand

Disclosures / Disclaimers

This is not an offer to buy or sell a security. The ideas expressed in this posting are the views and opinions of the author of this posting (Author). Author has no obligation to update any of the information contained herein and has no obligation to update the posting to reflect any changes in the Author’s opinion on any of the companies or topics contained herein. This posting contains forward looking statements and predictions that are inherently uncertain, because the matters they describe are subject to known (and unknown) risks, uncertainties and other unpredictable factors. No representations or warranties are made as to the accuracy of such forward looking statements and predictions. Do not rely upon the information contained in this posting for making investment decisions; prepare your own analysis or contact your financial advisor. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note. Past performance is not necessarily indicative of future results, and there can be no assurance that targeted or projected returns will be achieved.

Catalyst

Company specific: completion of major projects, which delevers the business, which allows for consolidation, which drives a re-rating to peers

Industry: MLPs convert to more traditional businesses and people realize how cheap they are and how well positioned the US is to take share in the global hydrocarbon market