While the energy sector is a small % of the S&P 500, the energy companies like CVX and XOM in that index have benefited from passive investing flows and are trading at a much higher price-to-sales ratio than they did in the past. See https://chartinsight.com/Energy
Only C-Corps are eligible for the S&P 500 and other popular indexes so MLPs haven't seen as much passive investment and are more attractively priced. An example of a company that switched from being a partnership and then benefited from a lot of passive investing flows as it got added to the S&P Small cap and then S&P Midcap is https://chartinsight.com/VNOM-Viper-Energy
I do my own taxes and was very frustrated by the confusing K-1 for Blackstone Minerals (where royalty income is taxed at a higher than normal rate) so have sworn off K-1s while I still work full-time. Washington State doesn't have a state income tax and if there is another oil price crash in the future I'll be tempted to sell a MLP for a down payment on real estate. So I'll stick to REITs and C-Corps.
In terms of impacts of higher interest rates, there was a great analysis of S&P 500 sectors that noted how the real estate sector "is carrying debt that has a much shorter maturity profile than the overall index, with more than 60% of its existing stock of debt scheduled to reach maturity by 2030":
The debt load and short maturity schedule hurt REITs the most during the Fed's hiking cycle. I have about 7% of my public investments in EPR. As we've discussed, it's a non-office REIT that is likely getting discounted due to its short maturity schedule. After using the revolver to pay the $136.6 million in notes due August 22, 2024, the next sizable maturity is $179.6 million due August 22, 2026 and the rate on that is likely lower than what they could get now with another 10 year loan. The revolver had $169 million on it as of Sept 19th and the SOFR rate will decrease with Fed cuts: https://www.sec.gov/ix?doc=/Archives/edgar/data/1045450/000104545024000080/epr-20240919.htm
If Fed Funds goes to 3% but the 10 year stays around 4%, EPR should be fine. It's only if the 10 year goes back to 5% that I would get worried. That could happen if US shale really runs out of inventory and US oil and gas production declines, leading to persistent increases in oil and gas prices. However, Novi Labs and others make a convincing case that there is at least 5-10 years of undrilled inventory remaining.
Thanks, Eric, for sharing those remarks and experiences. A few responses: As to pricing of XOM, CVX, or really anything, two things bother me about what you showed. First is the use of a ten-year window. For oil that makes the doldrums from the teens with oil at $50/bbl seem far too typical. Second, I don't like price to sales as a metric. Sales are not profits. If for example you look at price to cash flow then these two do not seem overpriced today:
As to oil and gas, there may be less than 10 years of proved reserves remaining, but that is where it makes sense for the industry to operate not where any limits are. I used to read articles in the 1970s about how the world would run out of oil in 10 years. One can always write them. It is not clear when the US resources may decline, but even that will only make their oil more expensive. And the Canadians clearly already have known resources that will last decades.
As to the Canvas post, it is one of those macro story-building exercises that are fun to produce and read but often are wrong in detail and rarely prove to predict anything accurately. An example here is that they claim a 4% annual drag on real estate EPS from steady refinancing at a 3% interest rate increase. First, EPS is the wrong (and incompetent) metric for real estate.
Second, I have analyzed the impact of that interest rate rise on numerous specific REITs. For those with steady maturities, the impact is about 1% annual drag on CfO/sh. Since they can grow at CfO/sh about 4% per year without issuing new stock, this reduced their base growth rate by 25%. That's not ideal but also has a relatively small impact on value. This includes the story for EPR. I also don't buy their story about the impact of interest rates on valuation. Certainly an idea being worked on in a garage has much more distant earnings than any REIT, but the only way to make quantitative sense out of REIT pricing is to include decades of cash earnings. For typical, lightly indebted REITs the impact of interest expenses on value is far smaller than the impact of discounting.
But you have to get down in the weeds and analyze specific examples to see that clearly.
As an aside, these guys misunderstand modern REITs in another way. This statement is false:
"many of its companies are REITs that are legally unable to retain and reinvest the majority of their profits, and that therefore have to rely on external funding, including debt funding, to grow."
Yeah the 2010 start year is not ideal but that's when GAAP financials were first available in XML SEC filings. Initially in 2012 I was paying $5,000/year for Morningstar data that went back decades but the App Store revenue didn't cover it so I got another full-time job and built the free site as a hobby using the free XBRL data. You've mentioned that you don't like when computers import financials but I did build a mapping tool to map custom tags and handle multiple classes of stock (for corporations like VNOM that own a private partnership.) My day job is iPhone app development so I'm just maintaining the site as is.
Changing the dropdown to "Cash from Ops" also shows Net Cash from Ops per share. I tried using charts of cash from ops or earnings in the lists of companies but the quarterly charts were very noisy.
The point I was trying to make is that an oil price spike seems to be required to create sustained inflation above 5% and fracking opens up a lot of inventory that reduces the chance of that happening. I've invested in shale royalty companies like VNOM and STR (and the predecessor company Brigham Minerals) so I'm comfortable that there is at least 10 years of inventory for the US-based companies, with decades more in Canada and around the world. I do wonder whether it is better for companies with depleting assets to buy back shares as XOM and CVX have done. Tourmaline famously doesn't buy back shares whereas VET is trying to do that without much success at boosting the stock price.
I've been buying more EPR because I agree with your assessment of the impact of refinancing now that the Fed is cutting rates. A year ago when the 10 year was at 5% and Jamie Dimond said it would go to 7%, cost of refinancing was a greater risk for non-office REITs.
Yeah, most analysts don't understand REITs or midstreams deeply due to the impact of depreciation. Warren Buffett noted that depreciation on Burlington Northern didn't cover the cost of maintenance CapEx but for most other companies depreciation overstates maintenance costs.
Good job on that importing of financials. Did you also solve the issue that the sign of many entries on the cash flow statements flips from year to year? I might trust something I had written.
I had a chat a year or two ago with Brad Thomas where he said his service was going to fix the issues "using AI". And of course "using AI" came out as a magic incantation. I objected and he did not push it.
While I would agree that an oil price spike can have a short-term inflationary impact, only increases in the money supply (or velocity) enable sustained inflation. This is really just math.
And indeed you focus on a main complaint about buybacks. Usually I don't care if I own incrementally more of the company. I care if the stock price goes up and it often does not.
The refiner-midstream-lubes business HF Sinclair (https://chartinsight.com/DINO-HF-Sinclair) is an example of a lower-priced alternative to the refining/midstream portion of CVX and XOM or the big 3 refiners. DINO bought-out the rest of their midstream MLP (Holly Energy Partners) so it has a high % of revenue and cash flow from stable sources (midstream, lubes, Sinclair retail distribution) and the same 4.33% dividend yield as CVX. In November 2021 when Shell was forced to reduce its emissions, HollyFrontier bought Shell's refinery near Seattle that is connected to the TransMountain pipeline for $350 million. That refinery alone made roughly double that in profit 2022. Now it is benefiting from the TMX pipeline reducing costs for crude (both diluted WCS and Alaska North Slope.)
They also bought Sinclair Oil from the Holding Family and have been buying back the 60 million shares that were issued for that acquisition. The Holding family has been selling down their stake to around 5% and that has caused it to underperform other refiners since August 2022 https://www.sec.gov/edgar/browse/?CIK=0001915451
Instead of CVX or XOM, the average dividend yield will be higher buying a lower-priced midstream/downstream midcap like DINO with a Canadian upstream company like CNQ or TOU. DINO is 14% of my Roth and I have VET for upstream exposure.
The sign in the XML is almost always correct even when the text presentation switches from negative to positive. The bigger challenge with calculating quarterly cash flows is that they are reported as a 3 month total for Q1, a 6 month total for Q2, a 9 month total for Q3 and then audited annual values for the 10-K. The import process subtracts subtotals to calculate the quarterly values. That works except when companies have discontinued operations since those are reported separately and often not tagged correctly. My automated import log errors when it detects discontinued operations so I can fix it manually.
Sadly FFO and AFFO is almost never tagged correctly in XML. As you point out it is important to understand what each company counts in FFO and AFFO.
I've paid a bit of attention to refiners for several years. For me, the investment risks have never seemed clear. Risk assessment is a huge issue for me. And with regard to my question of the present moment, I see CVX or XOM as a more secure diversifier. The point there is not to make huge gains.
I've come around to the point of view that it rarely is worth the trouble to look at company decisions around FFO and AFFO. The important story generally can be found from CfO, capital expenditures, and capitalized interest.
Thanks. I have not dug into those assets in detail. That said, note that the purchase price is in the ballpark of 5% of the CNQ market cap. So they aren't a big needle mover. The headline numbers give $77k per flowing barrel, which is pricey. But CNQ is generally about buying inventory not flowing barrels. We likely will get more color on the earnings call. Overall I expect this will prove to be quite positive when we get more details.
Objectively I agree about the value of deferral. But IMO two factors enter: 1. Many institutional investors are disallowed from investments in MLPs. 2. A surprising number of investors live in fear of K-1s.
This article made me stop and think—a good thing. I need to pay a lot of attention to the current gains on the energy stocks you own because, as a recent buyer of these, I likely won't see these gains--though I'll still benefit from great dividends, which is why I own them in the first place. If you decide to sell a midstream or two, and my holding of it is in the red, I will be reluctant to sell at a loss. I will review each of your gains to compare them to mine. I hope that makes sense.
I am in the same time frame as Mr. Keith here with regard to entering the energy stocks in a bigger way recently. Since I am primarily a retired income investor, I am also reluctant to sell holdings in the red unless the income forecast has changed. I am also becoming a bigger believer in Canadian energy stocks since joining this forum.
I certainly agree that avoiding sales of red positions is in general a good policy. Sometimes I exit something to fund a position I see as more promising in some way. But I resist exiting anything that is more than a few points in the red.
Hi Paul. Thank you for this article. I believe EPD was absent from this one. To me, it seems like the one high quality, fortress balance sheet, midstream with a greater than 7% yield. I know it is an MLP but I consider that a benefit because I hold it in a taxable account and do not have to pay taxes on the distributions as long as they remain classified as return on capital.
Regarding broadening out, I have been reducing the position in some of my better performing stocks (e.g. TRP) and writing OTM calls on others (e.g. CPT and MAA) and placing funds in ETFs like SGOV, JAAA, and SCHD until the next market downturn. Sometimes I do not have another individual stock ready to deploy sales proceeds so this has been my approach. I note you don't own any ETFs but wondering if you think this is an okay approach for stabilizing/diversifying the portfolio when you don't see any fat pitches.
You are welcome, Ryan. As you likely know, I hold a max position in EPD. And am delighted to collect the MLP premium in their dividends. I do think we will see sensitivity to interest rates there going forward, perhaps somewhat muted compared to less exceptional firms.
I didn't mention it, but because of the K-1 MLPs are questionable for portfolio diversification. At best, they will only work for some investors.
No objection here to using ETFs to hold funds. I did some of that a while back. But do be wary of leverage.
I find it interesting that K-1's are mostly viewed in a negative light (and manifested in discounted prices) but not much talk of how valuable they are in taxable accounts. I mean, LT capital gains and qualified dividends are at best case 15% taxed. I only want growth and RoC dividends in my taxable accounts. Investors complain about one more tax form to deal with, then go out and pay Uncle Sam minimum 15% on their investment gains. Doesn't make sense to me but to each their own...
Well yes, Phil. But many non-US investors are not allowed to hold such securities at all. And holding them in tax-advantaged accounts is risky. Plus if you trade them you incur depreciation recapture on the distributions, taxed at ordinary rates. For US citizens, in taxable accounts, and either traded frequently or never, they are great.
Thank You, very interesting and helpful. Im also interested on your opinion as to the cnq / chevron deal.
I think it is a good time to think about this, so thanks. Looking forward to part II
Thanks Paul - I like the topic and the article...looking forward to part II
While the energy sector is a small % of the S&P 500, the energy companies like CVX and XOM in that index have benefited from passive investing flows and are trading at a much higher price-to-sales ratio than they did in the past. See https://chartinsight.com/Energy
Only C-Corps are eligible for the S&P 500 and other popular indexes so MLPs haven't seen as much passive investment and are more attractively priced. An example of a company that switched from being a partnership and then benefited from a lot of passive investing flows as it got added to the S&P Small cap and then S&P Midcap is https://chartinsight.com/VNOM-Viper-Energy
I do my own taxes and was very frustrated by the confusing K-1 for Blackstone Minerals (where royalty income is taxed at a higher than normal rate) so have sworn off K-1s while I still work full-time. Washington State doesn't have a state income tax and if there is another oil price crash in the future I'll be tempted to sell a MLP for a down payment on real estate. So I'll stick to REITs and C-Corps.
In terms of impacts of higher interest rates, there was a great analysis of S&P 500 sectors that noted how the real estate sector "is carrying debt that has a much shorter maturity profile than the overall index, with more than 60% of its existing stock of debt scheduled to reach maturity by 2030":
https://canvas.osam.com/Commentary/BlogPost?Permalink=climbing-the-maturity-wall-of-worry
The debt load and short maturity schedule hurt REITs the most during the Fed's hiking cycle. I have about 7% of my public investments in EPR. As we've discussed, it's a non-office REIT that is likely getting discounted due to its short maturity schedule. After using the revolver to pay the $136.6 million in notes due August 22, 2024, the next sizable maturity is $179.6 million due August 22, 2026 and the rate on that is likely lower than what they could get now with another 10 year loan. The revolver had $169 million on it as of Sept 19th and the SOFR rate will decrease with Fed cuts: https://www.sec.gov/ix?doc=/Archives/edgar/data/1045450/000104545024000080/epr-20240919.htm
If Fed Funds goes to 3% but the 10 year stays around 4%, EPR should be fine. It's only if the 10 year goes back to 5% that I would get worried. That could happen if US shale really runs out of inventory and US oil and gas production declines, leading to persistent increases in oil and gas prices. However, Novi Labs and others make a convincing case that there is at least 5-10 years of undrilled inventory remaining.
Thanks, Eric, for sharing those remarks and experiences. A few responses: As to pricing of XOM, CVX, or really anything, two things bother me about what you showed. First is the use of a ten-year window. For oil that makes the doldrums from the teens with oil at $50/bbl seem far too typical. Second, I don't like price to sales as a metric. Sales are not profits. If for example you look at price to cash flow then these two do not seem overpriced today:
As to oil and gas, there may be less than 10 years of proved reserves remaining, but that is where it makes sense for the industry to operate not where any limits are. I used to read articles in the 1970s about how the world would run out of oil in 10 years. One can always write them. It is not clear when the US resources may decline, but even that will only make their oil more expensive. And the Canadians clearly already have known resources that will last decades.
As to the Canvas post, it is one of those macro story-building exercises that are fun to produce and read but often are wrong in detail and rarely prove to predict anything accurately. An example here is that they claim a 4% annual drag on real estate EPS from steady refinancing at a 3% interest rate increase. First, EPS is the wrong (and incompetent) metric for real estate.
Second, I have analyzed the impact of that interest rate rise on numerous specific REITs. For those with steady maturities, the impact is about 1% annual drag on CfO/sh. Since they can grow at CfO/sh about 4% per year without issuing new stock, this reduced their base growth rate by 25%. That's not ideal but also has a relatively small impact on value. This includes the story for EPR. I also don't buy their story about the impact of interest rates on valuation. Certainly an idea being worked on in a garage has much more distant earnings than any REIT, but the only way to make quantitative sense out of REIT pricing is to include decades of cash earnings. For typical, lightly indebted REITs the impact of interest expenses on value is far smaller than the impact of discounting.
But you have to get down in the weeds and analyze specific examples to see that clearly.
As an aside, these guys misunderstand modern REITs in another way. This statement is false:
"many of its companies are REITs that are legally unable to retain and reinvest the majority of their profits, and that therefore have to rely on external funding, including debt funding, to grow."
Well it would not past the plot. I will put it in the chat.
Yeah the 2010 start year is not ideal but that's when GAAP financials were first available in XML SEC filings. Initially in 2012 I was paying $5,000/year for Morningstar data that went back decades but the App Store revenue didn't cover it so I got another full-time job and built the free site as a hobby using the free XBRL data. You've mentioned that you don't like when computers import financials but I did build a mapping tool to map custom tags and handle multiple classes of stock (for corporations like VNOM that own a private partnership.) My day job is iPhone app development so I'm just maintaining the site as is.
Changing the dropdown to "Cash from Ops" also shows Net Cash from Ops per share. I tried using charts of cash from ops or earnings in the lists of companies but the quarterly charts were very noisy.
The point I was trying to make is that an oil price spike seems to be required to create sustained inflation above 5% and fracking opens up a lot of inventory that reduces the chance of that happening. I've invested in shale royalty companies like VNOM and STR (and the predecessor company Brigham Minerals) so I'm comfortable that there is at least 10 years of inventory for the US-based companies, with decades more in Canada and around the world. I do wonder whether it is better for companies with depleting assets to buy back shares as XOM and CVX have done. Tourmaline famously doesn't buy back shares whereas VET is trying to do that without much success at boosting the stock price.
I've been buying more EPR because I agree with your assessment of the impact of refinancing now that the Fed is cutting rates. A year ago when the 10 year was at 5% and Jamie Dimond said it would go to 7%, cost of refinancing was a greater risk for non-office REITs.
Yeah, most analysts don't understand REITs or midstreams deeply due to the impact of depreciation. Warren Buffett noted that depreciation on Burlington Northern didn't cover the cost of maintenance CapEx but for most other companies depreciation overstates maintenance costs.
Good job on that importing of financials. Did you also solve the issue that the sign of many entries on the cash flow statements flips from year to year? I might trust something I had written.
I had a chat a year or two ago with Brad Thomas where he said his service was going to fix the issues "using AI". And of course "using AI" came out as a magic incantation. I objected and he did not push it.
While I would agree that an oil price spike can have a short-term inflationary impact, only increases in the money supply (or velocity) enable sustained inflation. This is really just math.
And indeed you focus on a main complaint about buybacks. Usually I don't care if I own incrementally more of the company. I care if the stock price goes up and it often does not.
The refiner-midstream-lubes business HF Sinclair (https://chartinsight.com/DINO-HF-Sinclair) is an example of a lower-priced alternative to the refining/midstream portion of CVX and XOM or the big 3 refiners. DINO bought-out the rest of their midstream MLP (Holly Energy Partners) so it has a high % of revenue and cash flow from stable sources (midstream, lubes, Sinclair retail distribution) and the same 4.33% dividend yield as CVX. In November 2021 when Shell was forced to reduce its emissions, HollyFrontier bought Shell's refinery near Seattle that is connected to the TransMountain pipeline for $350 million. That refinery alone made roughly double that in profit 2022. Now it is benefiting from the TMX pipeline reducing costs for crude (both diluted WCS and Alaska North Slope.)
They also bought Sinclair Oil from the Holding Family and have been buying back the 60 million shares that were issued for that acquisition. The Holding family has been selling down their stake to around 5% and that has caused it to underperform other refiners since August 2022 https://www.sec.gov/edgar/browse/?CIK=0001915451
Instead of CVX or XOM, the average dividend yield will be higher buying a lower-priced midstream/downstream midcap like DINO with a Canadian upstream company like CNQ or TOU. DINO is 14% of my Roth and I have VET for upstream exposure.
The sign in the XML is almost always correct even when the text presentation switches from negative to positive. The bigger challenge with calculating quarterly cash flows is that they are reported as a 3 month total for Q1, a 6 month total for Q2, a 9 month total for Q3 and then audited annual values for the 10-K. The import process subtracts subtotals to calculate the quarterly values. That works except when companies have discontinued operations since those are reported separately and often not tagged correctly. My automated import log errors when it detects discontinued operations so I can fix it manually.
Sadly FFO and AFFO is almost never tagged correctly in XML. As you point out it is important to understand what each company counts in FFO and AFFO.
I've paid a bit of attention to refiners for several years. For me, the investment risks have never seemed clear. Risk assessment is a huge issue for me. And with regard to my question of the present moment, I see CVX or XOM as a more secure diversifier. The point there is not to make huge gains.
I've come around to the point of view that it rarely is worth the trouble to look at company decisions around FFO and AFFO. The important story generally can be found from CfO, capital expenditures, and capitalized interest.
Nice article. I'm curious what your thoughts are on the CNQ purchase of Chevron's assets in western Canada?
Thanks. I have not dug into those assets in detail. That said, note that the purchase price is in the ballpark of 5% of the CNQ market cap. So they aren't a big needle mover. The headline numbers give $77k per flowing barrel, which is pricey. But CNQ is generally about buying inventory not flowing barrels. We likely will get more color on the earnings call. Overall I expect this will prove to be quite positive when we get more details.
Thank you Paul.
I honestly don't understand why MLP's trade at a discount. Being able to defer your taxes on distributions is pretty valuable.
Objectively I agree about the value of deferral. But IMO two factors enter: 1. Many institutional investors are disallowed from investments in MLPs. 2. A surprising number of investors live in fear of K-1s.
This article made me stop and think—a good thing. I need to pay a lot of attention to the current gains on the energy stocks you own because, as a recent buyer of these, I likely won't see these gains--though I'll still benefit from great dividends, which is why I own them in the first place. If you decide to sell a midstream or two, and my holding of it is in the red, I will be reluctant to sell at a loss. I will review each of your gains to compare them to mine. I hope that makes sense.
That absolutely makes sense.
I am in the same time frame as Mr. Keith here with regard to entering the energy stocks in a bigger way recently. Since I am primarily a retired income investor, I am also reluctant to sell holdings in the red unless the income forecast has changed. I am also becoming a bigger believer in Canadian energy stocks since joining this forum.
I certainly agree that avoiding sales of red positions is in general a good policy. Sometimes I exit something to fund a position I see as more promising in some way. But I resist exiting anything that is more than a few points in the red.
Hi Paul. Thank you for this article. I believe EPD was absent from this one. To me, it seems like the one high quality, fortress balance sheet, midstream with a greater than 7% yield. I know it is an MLP but I consider that a benefit because I hold it in a taxable account and do not have to pay taxes on the distributions as long as they remain classified as return on capital.
Regarding broadening out, I have been reducing the position in some of my better performing stocks (e.g. TRP) and writing OTM calls on others (e.g. CPT and MAA) and placing funds in ETFs like SGOV, JAAA, and SCHD until the next market downturn. Sometimes I do not have another individual stock ready to deploy sales proceeds so this has been my approach. I note you don't own any ETFs but wondering if you think this is an okay approach for stabilizing/diversifying the portfolio when you don't see any fat pitches.
You are welcome, Ryan. As you likely know, I hold a max position in EPD. And am delighted to collect the MLP premium in their dividends. I do think we will see sensitivity to interest rates there going forward, perhaps somewhat muted compared to less exceptional firms.
I didn't mention it, but because of the K-1 MLPs are questionable for portfolio diversification. At best, they will only work for some investors.
No objection here to using ETFs to hold funds. I did some of that a while back. But do be wary of leverage.
I find it interesting that K-1's are mostly viewed in a negative light (and manifested in discounted prices) but not much talk of how valuable they are in taxable accounts. I mean, LT capital gains and qualified dividends are at best case 15% taxed. I only want growth and RoC dividends in my taxable accounts. Investors complain about one more tax form to deal with, then go out and pay Uncle Sam minimum 15% on their investment gains. Doesn't make sense to me but to each their own...
Well yes, Phil. But many non-US investors are not allowed to hold such securities at all. And holding them in tax-advantaged accounts is risky. Plus if you trade them you incur depreciation recapture on the distributions, taxed at ordinary rates. For US citizens, in taxable accounts, and either traded frequently or never, they are great.
I assume you mean "traded infrequently"?