Oh, The Drama Of Energy Equity Investing

Includes: D, NFG, OXY, TPL
by: George Fisher

Too often companies get diverted from their primary business of generating shareholder returns by getting swept up in various soap opera-ish dramas.

Investors need to separate stock fundamentals from the impacts of short-term dramas.

Companies overly influenced by current dramas add to uncertainty and surprises – both of which are disdained by most long-term investors.

Wealth building can be a tedious and arduous task. Some investors hope decision-making is only an infrequent and occasional chore, with a few saying it's akin to trips to the dentist. Fixed income and cash assets are pretty much drama-free: you choose your desired level of risk to principal (aka type and grade of credit), your maturity date, and your desired cash yield on principal. While in truth these are all interconnected, investors usually lean on one of two of these financial goals more heavily than others. For example, younger investors could be looking to take on added risks with extended maturities and decide longer-term, high-yield, low credit-rating selections are more suitable while those in retirement could favor shorter maturities with less credit default risk – and lower yield. As the bond cycle is relatively long, investors don’t typically closely monitor bond investments.

As I am in a distribution mode for my retirement accounts, current income and overall portfolio risk becomes a bit more paramount. In my cash and bond portfolio, I have a combination of a standard money market account and nice position in the PIMCO Enhanced Short Maturity Active Exchange-Traded Fund (MINT), plus a ladder of various bank CDs with maturities extending out to December 2020. When one CD matures, I scan the short-term horizon for the “best” yield going out 24 months. As I have become a duration scaredy cat, my bond portfolio comprises exclusively of Invesco date-specific bond ETFs with a ladder out to 2026. These investments are almost on autopilot, except to consistently review the money market balance to make sure we don’t run out of cash and an annual review of my bond ETFs as the closest rung is swapped out for a longer maturity ETF. Typically, these are very low drama selections requiring only a bit of monitoring.

The balance of my investments are in equities, usually segregated into those bought primarily for income and those primarily bought for capital gains potential. It is here where investment drama usually lives.

I tend to favor value over growth, with a focus on basic fundamentals. Important considerations include 2020 PEG ratios, SPGMI Quality rating, yield, and broker consensus recommendations. While I could be considered more of a “buy and hold” investor, I usually have a three-year horizon for my investment thesis to be successful. If, at the end of this period, the thesis is different or has changed and the decision-making process has proven to not be one of my best, it is usually decided its time to move on. Other times, if my selection zooms into extreme overvaluation, taking profits off the table is strategically considered. I tend to nibble in and nibble out of long-term positions.

However, sometimes a company falls into a “Soap Opera” mode, which I describe as a state where stock fundamentals and good judgment is made a bit opaquer by a soap opera of events. The crux of the daytime or evening soaps are the same – long, drawn out, open narratives with seemingly little or few actual resolutions of conflicts, with each episode leading into the another. Most episodes end with a promise or story-line that is then continued in the following episode, and various soap opera story-lines will run concurrently, intersecting from time to time, and leading to further developments.

BBC Radio's The Archers, first broadcast in 1950, is the world's longest-running radio soap opera. Popular daytime soaps include the venerable All My Children (1970-2011); General Hospital (1963-present), the longest-running American soap opera still in production; and Guiding Light (1952-2009), the longest-running TV drama in American history. Some even claim the current run of Game of Thrones to be the bloodiest, most bizarre of all TV soap operas. In a recent study of its initial 40 TV drama shows, Game of Thrones ranked second in deaths per episode, averaging 14 deaths. Many an hour has been spent by American viewers watching both daytime and nighttime soaps.

Occasionally, businesses will become mired in seemingly open-ended narratives with peers, competitors, or overseers, which could turn otherwise rosy prospects into a virtually unpassable thicket like the Haunted Forest north of the Wall. These corporate dramas come in the form of unexpected and controversial mergers/hostile takeovers, proxy battles, and infrastructure construction delays caused by judicial review. Examples of current companies playing out a soap opera theme are Occidental Petroleum (OXY), Texas Pacific Land Trust (TPL), and Dominion Energy (D).

The back and forth narrative of the hostile nature, and interesting financing (why pay 8% when the current cost of OXY debt is 4.5%) has put Occidental in the spotlight. I believe there is a premium being paid above 10-yr bond rates and question the timing of this financial move over issuing notes. One advantage of the preferred offering is the potential to use the remaining available credit down the road for other opportunities. Selling non-core assets is consistent with many energy mergers, and OXY’s jettisoning of African, midstream, and GOM assets should be expected. Trimming these assets also reduces OXY’s post-merger capital expenditure footprint.

Of interest to me is Credit Suisse’s estimate of just over $9.00 in operating cash flow per share for 2019 and 2020, rising to almost $11.00 in 2021 as promised synergies fall to the bottom line. 2018 OCF was $10.24. Free cash flow is expected to be a positive $898 million in 2020, after $8.6 billion in expected cap ex and $2.8 billion in dividends. Dividend investors should not expect much growth over the next few years and will have to settle for a high current yield of 5.7%, based on $3.12 payout and share price of $54.90.

Overall, I think the buyers of the preferred shares and warrants, Berkshire Hathaway (BRK.B) (NYSE:BRK.A), received an excellent risk/reward and OXY management needs to demonstrate its ability to turn this financing premium into higher earnings and dividends over the next few years. The risk to shareholders is based on execution and realizing the synergies outlined in its releases, in addition to overall industry-wide energy price risk.

The acquisition soap opera for Occidental will play out over the next few years, and until management proves it meets forward expectations, drama will continue to swirl around this stock. However, at OXY’s current price and yield, the stock offers interesting potential for buyers at this level.

Texas Pacific Land Trust should become a classic business-school case study of how management should not act during a proxy fight. While TPL is a very quirky investment with very unique attributes, one potential severe problem for long-term investors is its implementation of corporate governance, or lack thereof. With an understanding that its was formed in the 1880s and, until recently, owned what could be considered as a breeding ground for tumbleweed, TPL sits on conservatively billions in oil and gas royalties in the Permian basin. What had a market capitalization of $33 million 10 years ago is now worth 181 times that valuation. What was a “lazy, west Texas” grazing and easement landowner is now a powerhouse in the oil and gas royalty business, but with 100+ year-old governance. For example, the business is managed not by the usual board of directors with limits to their term but rather by three trustees with a lifetime position. With the recent passing of one of the three trustees, TPL is venturing into only its 3rd shareholder vote since 2001 but also only the 4th shareholder meeting in 30 years. There are two candidates running for the open seat – one with the backing of management and one backed by the trust’s largest voting bloc.

The ugly rhetoric surrounding the objections of TPL’s major shareholders, with a combined 25% of shares, and the controversial moves by the two current trustees makes me ponder what the future of the trust may be. If the current trustees win with their candidate, shareholders should expect more of the same – a lack of transparency, most likely only token changes to future governance, a continued lack of accountability through regular shareholder voting, and the possibility of additional decisions favoring insiders and trustees, such as substantial pay raises coupled with the potential for sweetheart deals. If the vote is in favor of the large investor’s choice, shareholders are not guaranteed a change for the better, but the chances of meaningful governance improvements escalates exponentially.

An example of the trustees' arrogance and lack of concern for its shareholders can be found in its recently revealed offer to meet in secret with these large shareholders to hammer out a non-proxy fight resolution, in addition to their stated unwillingness to cooperate with their choice, should the dissents prevail. The following is an except of an email received from the trustees this week, as published by the investor group. It is most interesting and revealing:

You surely realize that your best-case scenario means that you'd end up with only one out of three trustees. Consequently, even if you'd prevail in the election contest, you could not achieve any of your ultimate goals without our cooperation until another vacancy opens up (and it may be another decade until that happens). At the same time, your campaign made it abundantly clear that you – and many other shareholders – would like to see significant change at TPL. We recognize that and remain open to working with you to achieve that change in a manner that respects the interests of all shareholders.

Therefore, we would propose an in-person meeting of you and us to explore a collaborative resolution of the overall situation. We believe it would be most constructive to meet without the candidates (even though we'd be happy for you to meet General Cook, who is objectively an outstanding individual).”

The soap opera surrounding this mid-cap and vastly under-followed stock will continue to swirl well past the now-twice delayed shareholder meeting and proxy vote. I am starting to question the high valuation the market is current placing on share prices, as reflected in its Price to Sales ratio. TPL currently trades at a 14.2 P/S ratio while other oil and gas royalty peers trade at lower valuations, with my preferred holdings in the 6.5x to 8.1x range - Dorchester Minerals (DMLP) 7.9x, Viper Energy Partners (VNOM) 6.5x, Cross Timbers Royalty (CRT) 8.1x, Sabine Royalty Trust (SBR) 12.6x, and Permian Basin Royalty Trust (PBT) 11.3x. Investors looking for a highly speculative energy play could take a small position in TPL and watch the drama play out.

I expect the investor’s candidate will prevail, and with the new blood, I expect the tone and actions of the trustees to become more shareholder friendly over time. If the trustees’ candidate wins, I expect a drop in share prices as disgusted shareholders flee to the exits and the “business as usual” dark cloud continues to overshadow its prospects for the foreseeable future, especially since a very bright spotlight has been brought to illuminate the crevices of this otherwise very unclear investment. The drama generated by these two opposing forces is very much worthy of its soap opera designation.

Dominion Energy is a major regulated multi-utility in the eastern half of the US, with a large position in midstream energy assets, mainly pipelines and an LNG export terminal outside Baltimore. Servicing a geography adjacent to the unparalleled resources of the Marcellus shale gas, D is relying on natural gas to generate a large portion of its future power need. Much like other neighboring electric utilities, their game plan is to replace coal generating assets with newly built natural gas fueled power plants. There are large cost-effective fuel supplies within a few hundred miles of these new power plants, but the trick is to transport the gas from its current location embedded in shale rock in Ohio, Pennsylvania and West Virginia to parts of Virginia and the Carolinas. It is the transportation of the gas that is causing the soap opera for Dominion and others.

Dominion is the lead company in the construction and operation of the Atlantic Coast Pipeline (ACP) running from West Virginia to North Carolina. Like many Northeast and Mid-Atlantic pipeline construction projects, ACP has become mired in a legal soap opera pitting environmentalists and “green revolutionaries” against pipeline builders and operators. The tactics of stall and deflect are front and center with the legal challenges in these cases. The twists and turns of the legal maneuvering are becoming a fight over states’ rights vs. federalism – and who has the ultimate veto power over energy infrastructure projects. Although the project received the necessary permits from federal and state regulatory agencies, a network of anti-pipeline organizations have filed lawsuits against five of the agencies to stop construction.

With Dominion now vowing to take its case to the Supreme Court, the drama of this project is far from over. While its outcome will have an impact on the future growth profile of Dominion, it is not a do-or-die proposition for the company.

In addition to Dominion’s judicial soap opera, there are several similar energy infrastructure projects in NY that could fall into this category. For example, NY regulators have stalled the construction of the Constitution and Northern Access Pipelines, being proposed to carry more Marcellus natural gas to NY. National Fuel Gas (NFG) is one of the firms with interests in both the projects. As a gas utility with pipeline and drilling businesses, NFG is very much affected by the drama surrounding the efforts of NY regulators to block various pipeline construction projects, both currently and in the future.

As a potential choke point for the movement of Marcellus natural gas to the Northeast, these soap opera legal maneuvers by opponents are beginning to have a negative impact on the region. Recently, Consolidated Edison (ED) announced a moratorium on new natural gas hookups in Winchester County, with the reason being a lack of long-term supply needed for customer expansion. The ban was lifted when an existing pipeline operator offered to increase capacity on one of its existing pipelines. However, this is not a viable solution to the longer-term increase in demand for northeast natural gas as a substitute for historical use of coal and oil for power generation and home heating. Of interest is to me is the Russian Artic LNG, carried in French-flagged tankers, offloading in Everett, MA, just north of Boston, while our own natural gas from Pennsylvania is being blocked.

Investors need to not only evaluate a stock’s fundamental valuation but to also ascertain the level of drama surrounding their business. As investors don’t usually like uncertainty and surprises, and these attributes are a mainstay in soap operas, determining the current dramas circling their stocks should be part and parcel of one’s due diligence.

Disclosure: I am/we are long D, DMLP, OXY, NFG TPL, VNOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.