Energy Infrastructure Investing with Greg Reid

[00:00:00] Welcome to Excess Returns, where we focus on what works over the long term in the markets.

[00:00:04] Join us as we talk about the strategies and tactics that can help you become a better

[00:00:07] long-term investor. Hey guys, this is Justin. In this episode of Excess Returns,

[00:00:22] Jack and I talked with Gregory Reid, President of Real Assets at Westwood Group Holdings

[00:00:27] Manager for the $2 billion Energy Investment Team. We start with Greg on the energy market

[00:00:31] and the assets and the types of investments that investors have to choose from, from MLPs, LNG,

[00:00:37] gathering and processing, storage and renewable energy producers. We then move to MLPs and why

[00:00:42] these are the types of investments he tends to favor. We conclude with a new investment

[00:00:45] strategy Westwood has deployed in an ETF wrapper to harvest an even higher yield than

[00:00:50] the typical MLP throws off. Lots of interesting info on this one. As always, thank you for

[00:00:54] listening. Please enjoy this discussion with Gregory Reid of Westwood Group Holdings.

[00:00:59] Greg, thank you very much for joining us today. You're welcome. Good to meet you guys.

[00:01:03] We were talking before the show and you know someone's dedicated when they've been flooded

[00:01:09] out of their house and they don't have energy and they're still, we're still fortunate enough

[00:01:13] to have guests that want to come on Excess Returns and talk to us in our audience. So

[00:01:16] we really appreciate it. You're welcome. What we wanted to do today is have you on to talk

[00:01:23] about what you've been investing in, I think most of your career and we're going to talk

[00:01:28] energy, real assets, MLPs and also I think some of the new strategies that you guys are

[00:01:34] developing to get even more yield out of some of these already higher yielding type vehicles.

[00:01:40] So it'll be I think a good discussion. We'll sort of start high level and then work our

[00:01:45] way down into specific investment strategy stuff which our audience always loves.

[00:01:49] You know energy, to me at least and you can kind of I'll let you sort of riff on this but it seems

[00:01:55] to me like energy now might people might be paying more attention to energy now more than

[00:02:04] ever just given sort of kind of what's happened in the world given what's going on with AI and

[00:02:09] the future demand for energy or maybe I'm just you know that's recency bias working in and I'm

[00:02:15] convincing myself to that or something but you know to start we thought it would be good to

[00:02:20] just have you give sort of a high level overview of the energy landscape and what sort of you're

[00:02:25] seeing as the current big trends today. Yeah no I think that's a great way to start

[00:02:31] and I think you're right people are more focused on energy right now because of the

[00:02:34] Russian attack in Ukraine and then more recently here the issues in Israel. Energy is an

[00:02:40] important part of everyone's conversation you know it's a pretty small part of the S&P 500 it's

[00:02:45] you know four percent but what we've all learned I think through the last three or four years is

[00:02:50] that we can't really run the world today without a meaningful amount of traditional

[00:02:58] oil and natural gas and unfortunately some coal to boot. Traditional energy is the most important

[00:03:05] fuel for the economy and as much as we all like to use more solar and wind we've learned

[00:03:10] they're not reliable and they can't be produced at large quantity at affordable prices

[00:03:16] so we're going to be stuck with traditional energy for decades to come

[00:03:21] and that's even before we started building these great big new data centers to drive AI

[00:03:26] that require a lot more energy and so what we've seen over the long run is energy demand

[00:03:31] for crude oil at least has been kind of in the one to two percent range for decades and the

[00:03:37] only thing that knocks it off that type one to two percent growth range is a big depression

[00:03:42] like 08 or COVID. Besides that it's kind of slow and steady and yes it may flatten out

[00:03:50] at some point in the future but it looks like you know many many parts of the world

[00:03:56] India and China in particular want to have our western standard living which requires a whole lot

[00:04:02] more energy to operate our economies and frankly all these devices that we all have computers and

[00:04:08] iPads and phones and transport all that stuff requires energy so that's that's kind of the

[00:04:14] direction we're going and the U.S. is the largest producer of oil in the world we're

[00:04:18] doing about 13.2 million barrels Russia's around 10 and Saudi's around 9 so many Americans really

[00:04:26] don't realize we're actually the largest producer oil and gas in the world OPEC is

[00:04:31] bigger in the aggregate but we're larger than Saudi Arabia and so we're a very important

[00:04:37] player in the traditional energy markets. Yeah that's kind of amazing like when did that

[00:04:44] amount of production sort of come online for the U.S. and just in terms of timing to put

[00:04:47] in perspective? Well you know we went we declined for 40 straight years until around 2000 when we

[00:04:56] invented the shell revolution basically and horizontal drilling and fracking basically

[00:05:03] turned the U.S. into a growth play and so we were a long-term secular decline with

[00:05:08] conventional production and really our new technologies allowed us to basically

[00:05:14] change that and we grew from about five million barrels a day up to about 13 million barrels

[00:05:20] a day of production. We unlocked a bunch of traditional oil and gas trapped in these

[00:05:25] these rocks underground and that really changed the global energy world you can only imagine

[00:05:31] if we were still shrinking and Russia and OPEC were the dominant oil producers in the world

[00:05:38] they would have a lot more power over the United States and Europe thankfully they don't

[00:05:42] because we're a larger producer and we can fight back with our energy power along with our military

[00:05:49] power so the fact that U.S. is the largest producer is really important geopolitically

[00:05:55] for us we have control of our own energy in a lot of places in the world like in Europe

[00:06:00] they don't they're importers and they have to rely on Russia or U.S. LNG imports to

[00:06:06] basically fuel their fuel their their power plants and their their manufacturing facilities.

[00:06:12] Is the U.S. a net exporter of energy at this point? Net exporter yeah we are a net exporter

[00:06:19] because we export a lot of LNG and a lot of NGLs natural gas liquid so we are exporting

[00:06:28] more than we import certainly if you add up you know crude oil plus NGLs we're actually

[00:06:34] producing about 20 million barrels a day which is substantial that's double Russia and

[00:06:39] Saudi Arabia when you add up natural gas liquids into the mix. On your website you list five

[00:06:48] significant areas within the energy industry and so we thought we could kind of maybe work

[00:06:55] through these in some detail to just get our arms around what exactly they are what types

[00:07:00] of businesses they are so the first is pipelines. Yeah so pipelines think of it like crude oil

[00:07:07] pipelines the best example the Permian in Texas produces around you know five million barrels of

[00:07:13] oil. You have to take it out of the ground and pipeline that back to say Houston where you

[00:07:20] move it into refineries and produce gasoline so the transportation of oil through a pipeline

[00:07:27] to a city or refining complex is really one of our main businesses and that's that there's

[00:07:34] crude pipelines natural gas pipelines and NGL pipelines so you have you have a variety of

[00:07:40] different kinds of pipelines but that's the basic building block of our industry is

[00:07:45] pipelining some product to a larger market center. What types of businesses exist like

[00:07:51] inside pipelines is it like a few major players or how does that work? Well you have a number

[00:07:56] of companies like Plains All American and MLP based in Houston is the largest crude oil

[00:08:00] pipeline then you have natural gas pipelines the two best examples are Williams and Kinder Morgan

[00:08:07] they have a lot of natural gas pipelines and gas you can imagine natural gas being a gas

[00:08:13] when you put it into pipeline yeah that's the way to transport it and the natural gas

[00:08:18] that is brought to largely a coastal market if you freeze that down you can create a liquefied

[00:08:25] natural gas which is LNG and you can export that on a ship so that's actually a very large

[00:08:32] growth engine Chenier is the best company that's an example of that that's the largest

[00:08:37] LNG export company in the world they're based here in Houston and they're growing rapidly

[00:08:43] because a lot of countries like Europe in Europe for example in Asia want to replace

[00:08:49] coal type power with natural gas and this is a cleaner burning fuel and more environmentally

[00:08:56] friendly than traditional coal would be for example so yeah you hit LNG I'll have to ask

[00:09:04] you offline Greg I have a get your feedback on a small speculative LNG stock but I don't I'm

[00:09:10] still waiting for okay I'm waiting for my I'm waiting for my my thousand bagger I don't

[00:09:14] think it's going to come anyways what about gathering and processing yes so gathering

[00:09:22] and processing is the company such as targa is a good example they're in the Permian basin large

[00:09:29] customers are exxon other public emp companies so every well that's drilled oil well produces

[00:09:37] oil natural gas and natural gas liquids it's not all one thing it's a mix of assets

[00:09:42] so someone has to basically create a pipe to each well to bring the commodities to a centralized

[00:09:50] processing plant so natural gas gathering is gathering and processing is gathering from every

[00:09:57] well these smaller lines to a major processing plant to basically treat that where it can be

[00:10:03] sent in larger quantities through a larger diameter pipeline so think of it like a

[00:10:08] thin straw gathers from every well and then when you get it you built bulk it up at a plant

[00:10:13] you put it in a 36 inch you know three foot wide pipeline to bring to Houston or Corpus Christ

[00:10:20] here somewhere else like that and in addition to just going back to LNG for a second in

[00:10:25] addition to chenille what other just a few other other major players there well unfortunately

[00:10:29] the only big one is chenille there are a couple small ones and the ones that are in our

[00:10:34] index are tellurian you know 56 cents and next decade is in the process of trying to build

[00:10:42] some LNG exports so there are two small companies that don't really have any any export

[00:10:47] capability and they're speculative stocks because they don't they don't really have

[00:10:52] the contracts and the plants built they're they're they're almost like options um you

[00:10:58] know they're they're you're buying the potential that they're going to have a plant

[00:11:01] in the future but cheney is a dominant player their investment grade they're the largest in the world

[00:11:08] and they're they're adding new plans and so now there should be three or four more cheneers

[00:11:14] there are private LNG companies in the United States but they've chosen to stay private

[00:11:19] because frankly a lot of investors just frankly aren't wanting you know to be public these

[00:11:24] days and energy you're not getting a lot of love from investors and if you can finance

[00:11:28] your business and stay private and keep control that that's a that's a pretty viable strategy

[00:11:33] to not deal with the public investor base that you know every quarterly conference call I ask

[00:11:37] you questions about ESG and what are you doing here and there and so if you can finance it

[00:11:43] privately that works pretty well too. And can you just comment on just um is there like some

[00:11:48] permitting issues around you know what the Biden administration sort of might allow permits

[00:11:54] for which also makes it maybe difficult for some of these companies? It's definitely difficult to get

[00:12:00] a permit for new pipeline construction we've seen the northeast mountain valley pipeline

[00:12:08] has struggled for years to kind of get their pipeline built and the environmentalists have been

[00:12:13] successful blocking it until just recently they actually finished they're finishing it up

[00:12:18] right now but they had I think four to five years of delays and cost overruns that doubled

[00:12:22] the cost of it so it's very difficult to get new permits to build you know any kind of new

[00:12:27] pipeline unfortunately. Just recently the Biden administration paused LNG new project approval

[00:12:37] on LNG that was a very political move it was a convenient nine-month pause to study the impact

[00:12:43] of LNG basically you know from like January this year until the election once the elections

[00:12:50] over there are planning to come out and say LNG is better for the environment. There have actually

[00:12:54] been five studies that have already been completed and every time they come back and said this

[00:13:00] actually reduces carbon relative to other things that are being used like coal and crude oil

[00:13:09] and therefore LNG is a cleaner burning fuel and the government said thumbs up in the past

[00:13:16] so that was really just a convenient way to basically try to gather some more votes

[00:13:21] from folks that are more climate focused and the pause will no matter who wins the election

[00:13:26] that pause will probably go away in the first quarter of next year. Yeah when you were talking

[00:13:31] about the pipelines and the different pipes that go into different places you know I was thinking

[00:13:34] we all take that for granted until it doesn't work like there's been a few major incidents

[00:13:37] I don't know in the past decade or so where a certain region is like dramatically affected

[00:13:41] by one of those things and you know it's not working you've got major issues on your hands

[00:13:45] it's kind of like Houston today okay so I told these guys before I'm in Houston we had a storm

[00:13:50] hit Thursday night our power went out and so you know utilities and power is something you

[00:13:56] take for granted until you don't have it and so my house has no power it's 95 degrees in

[00:14:01] Houston you can't air condition your house so you got to find somewhere else to live

[00:14:06] so I'm sitting here working in my nephew's house hoping he hadn't come back home

[00:14:11] he's in Europe right now so that's an example where you know it works until you're sitting there

[00:14:16] and in Europe and Russia cuts off your gas or charges you a lot more money and you basically

[00:14:22] have a massive problem on your hands yeah we're thankful you have AC here we would not have

[00:14:26] asked you to do your podcast at 95 degrees uh I guess that technically would have been

[00:14:30] putting you in the hot seat but uh we would not have done that exactly thank you

[00:14:35] the next the next area you had on your website is this the area of storage can you

[00:14:40] talk about what that is and look what major players are there yeah so storage um you know a

[00:14:45] great example that is um enterprise products and mlp in Houston they have underground storage

[00:14:52] in a place about an hour east of downtown Houston called mountain Bellevue and it's

[00:14:58] actually the largest underground salt cavern storage in the country so what they do is

[00:15:05] basically they pipeline ngls natural gas liquids and other other liquids to mount Bellevue and

[00:15:12] they stick them underground in storage and it's a natural storage container effectively salt

[00:15:18] you know forms a very natural safe way to store chemicals and or the product and so

[00:15:24] what they do they store it down there until they want to ship it and export that typically

[00:15:31] abroad and so that's a natural storage tank and you might have you know you could just store

[00:15:35] just six or 12 months for the most part you're just putting it there temporarily until you

[00:15:40] export it or use it in the refineries and so it's just a nice way of storing extra product

[00:15:48] the government itself stores crude oil underground the strategic petroleum reserve is another way

[00:15:54] saying storage they store store oil for a rainy day when we need it needed if oil spikes you know

[00:16:01] they've they've released oil from the spr to try to basically cushion the impact of higher

[00:16:07] commodity prices is that the spr is that something that's like spread across the country

[00:16:11] or something how does it work like where do they store it different different locations

[00:16:16] throughout the country exactly right typically you're going to store the spr close to refineries

[00:16:21] because crude oil in its raw form is mainly just used to make gasoline and diesel and things like

[00:16:28] that and so you want to store it close by the refineries so if you if you can't you can't

[00:16:33] import oil so for some reason say soy oil goes to 200 because of a war somewhere you want to

[00:16:39] use your own storage and oil to kind of run your refineries and try to bring down the

[00:16:45] cost of gasoline so during the russian war you know president biden drained the spr by about

[00:16:52] 30 i believe to try to cushion the impact of higher commodity prices and that that you know

[00:16:59] that drove that you know was partly responsible for driving inflation higher was high you know

[00:17:04] gasoline prices and so you can you can let them things out of storage to reduce the price

[00:17:09] impact for cut for consumers how about renewables you mentioned those a little bit earlier

[00:17:13] it didn't sound like you're too optimistic in terms of their ability to replace

[00:17:16] you know traditional forms of energy but how do you think about renewables

[00:17:19] so renewables are there's they're they're they're one of the many sources of energy

[00:17:24] and very important that we you know we are using more than there's actually a pretty good

[00:17:29] growth rate in the renewable space and we're seeing massive subsidies from you know president

[00:17:36] biden's ira that that went through you know four years ago roughly um there's a lot of

[00:17:42] money afforded to renewables the problem is that the returns don't well first of all

[00:17:51] they're not reliable because the wind doesn't always blow and the sun only shines half the

[00:17:55] time and then when it rains it doesn't shine so those two kinds of renewables aren't very

[00:18:00] reliable but everybody wants power 24 7 so they're an important part of the energy mix but

[00:18:08] they're not a very big percentile of that mix and what we found the last three years is that

[00:18:14] to make the math work for a lot of these renewable developers need lots of leverage

[00:18:20] well we're in a higher and straight environment so you can't leverage these renewable projects

[00:18:25] enough to make the the returns you need to subsidize them and so the truth is renewables

[00:18:30] are going to probably grow at a pretty high rate but from a small base and they're going

[00:18:36] to be more expensive forms of energy so that naturally is inflationary the more we we force

[00:18:42] renewables to grow and be a higher part of our energy consumption the more inflation we're going

[00:18:48] to have and the fed the fed's number one goal is to bring down inflation so they actually

[00:18:54] pushing more energy to renewables is actually inflationary and defeats the fed's number one

[00:19:00] goal of bringing down inflation so how about how about that you know we can't we can't use

[00:19:06] more without creating more inflation so you're not too optimistic then about the ability of

[00:19:11] renewables to take like significant market share from the traditional energy sources soon

[00:19:15] not going to happen okay almost impossible yeah and we found what did we see that now we're

[00:19:20] you know we're we're basically you know two years post the attack i mean we were all a

[00:19:25] lot more optimistic about renewables i'm not saying the evs can't replace a lot of combustion

[00:19:32] engine cars because that that is that is it's happening to some degree but we're even seeing

[00:19:39] there that you know hurts dumped a lot of their ev fleet and now now it's difficult to

[00:19:45] even sell evs on the new dealer lot so people just didn't like waiting in line the

[00:19:50] infrastructure wasn't really built to get the charges like you wanted and the the radius was

[00:19:56] only 250 miles and it's not very convenient for a lot of people so the blooms kind of off the

[00:20:01] rose to some degree on renewables the returns have not been good yeah returns have been

[00:20:07] pretty poor the last three years on clean energy in general and so it's just been a

[00:20:12] it's been you know a more challenging area for a lot of people so just on going back to

[00:20:17] the renewables and inflation i think that that's sort of very interesting and concerning because i

[00:20:22] think there are you know some regulations and states that are like requiring like utilities

[00:20:28] for instance to source you know certain percentage of their energy from these alternative

[00:20:34] sources and if you're saying that they're that's a more expensive form of energy

[00:20:39] then you could see how that like in terms of someone's power bill just a very simple example

[00:20:44] how that flows all the way down until you know more expensive energy and therefore higher

[00:20:48] inflation yeah that's right i think at the end of the day renewables are going to grow a lot

[00:20:53] and then that's that's a good thing you know it's better for the planet to lower carbon

[00:21:01] but it's going to be a more expensive form of energy that's less reliable

[00:21:06] and so we're going to have as consumers we're going to get used to paying more

[00:21:10] and we have to know inherently that moving from lower cost power sources to higher cost power

[00:21:16] means more inflation so it's going to be an expensive proposition for this planet

[00:21:24] to move to a lot more renewable sources of energy it's more expensive whenever you mean

[00:21:30] for the most part companies want to lower their expense structure wherever they can right they

[00:21:34] they move manufacturing to China the lower manufacturing costs well now

[00:21:39] the world's trying to figure out how to move a lot more traditional fossil fuel consumption

[00:21:44] which is lower cost reliable to higher cost less reliable how does that sound not very good

[00:21:52] good it's it's it's it's it makes you feel good that we're using renewable sources

[00:22:00] but then you're upset when you pay twice as much you know per unit of power and it's not as

[00:22:06] reliable and your power goes down so it's something we have to deal with as a world now

[00:22:11] the truth is the big opportunity in the world is getting China and India to stop building coal

[00:22:18] plants and use LNG that's the best thing we could do for the planet is not build more coal

[00:22:25] plants but rather get them to move into cleaner burning natural gas and yes some solar and wind

[00:22:33] the problem is they don't want to use higher cost forms of power they want to use low cost

[00:22:38] coal because they have a lot of it and so that's what's pulling the planet is all the coal

[00:22:44] fired power plants and guess what China's dealing with it they're they're fueling their

[00:22:50] EV cars with coal fired power plants so you're not really helping a lot by converting to EV

[00:22:59] if you're charging them with coal plants and that's the inherently the problem it sounds

[00:23:03] great you're selling more of EVs in China but you're you're fueling it with a lot of coal

[00:23:09] and that's making the planet a dirtier planet unfortunately do you know roughly like what the

[00:23:14] market share of coal is around the world like how much coal i have no idea about this like

[00:23:18] how much coal is still used um coal's large and you think i don't know the exact numbers up top

[00:23:23] of my head but you know many people would would guess coal peaked 10 or 20 years ago

[00:23:28] it hasn't even peaked yet it's still growing because you know when you have countries like

[00:23:33] China India with over a billion people that are building new new coal plants the global

[00:23:38] consumption of coal has been increasing i think for 50 years now now the growth rate is

[00:23:44] slower no question about it but what we want to do is actually make coal peak and decline

[00:23:51] that cleans up the planet faster so the U.S. for all the good we want to do the best

[00:23:58] we could do and this is another argument i want to make is that

[00:24:03] the best thing we can do because the U.S. is so ESG focuses tighter standards like we talked

[00:24:08] about earlier on pipeline construction we are actually the cleanest producer of fossil fuels

[00:24:13] like crude oil and natural gas far cleaner than OPEC in Russia so the best thing we can do if

[00:24:20] we're super focused on ESG is produce a little more natural gas in the U.S. and don't let Russia

[00:24:27] produce it because we're going to produce cleaner natural gas and we can hopefully sell

[00:24:32] that cheaper to China India and other countries that are building coal plants so

[00:24:37] that's really the best thing net net for the world is to produce more cleanly here

[00:24:42] and help transition away from coal as fast as possible but that's yeah that's another

[00:24:47] another story altogether as we talk to people who are experts in a wide variety of industries

[00:24:52] in the podcast we've been hearing a lot about how technology is really going to change the world

[00:24:56] you know say in the next 10 years and i'm just wondering like in the energy space

[00:24:59] are there things you're seeing like that in terms of things you're really optimistic about

[00:25:02] about how things will change significantly for the better i think ai is certainly a very

[00:25:08] popular topic and ai is really exciting we one of the growth opportunities for traditional energy

[00:25:18] is that these data centers are becoming larger and require a lot more power you know to fuel an

[00:25:25] Nvidia chip takes a lot more power than a traditional you know chip a computer chip

[00:25:33] and so the continued acceleration of ai and the size of the data centers looks like it's

[00:25:42] going to provide some additional growth opportunity for the traditional energy

[00:25:47] market and for utilities and so what we're seeing is some of these new data centers that

[00:25:52] are a significant scale be placed in Texas and Pennsylvania and Ohio close by natural gas

[00:26:00] power plants or natural gas sources that can fuel power plants i should say

[00:26:05] and so we that's not yeah that's going to drive the entire industry but it's additional growth

[00:26:11] for the sector that people just three years ago were questioning is there any terminal value

[00:26:17] for a natural gas pipeline well it looks like there is more demand needed over the next several

[00:26:23] decades for natural gas power and that kind of takes away the argument these these power plants

[00:26:30] or these natural gas pipelines don't have any real terminal value beyond let's say 10 years and

[00:26:35] so just having the longevity of that need for power helps helps make people believe that yes

[00:26:41] there actually is a long-term need for traditional sources of energy whether it's oil or natural

[00:26:46] gas or you know whatnot if we think about like the cost to deliver this stuff the cost

[00:26:51] to extract things from the ground is is technology making a big improvement there i mean

[00:26:55] i could think on one side that stuff is very highly you know manual it doesn't seem like

[00:26:59] technology would make a huge difference there but are there potential for big strides in terms

[00:27:03] of across the you know the chain here how we the cost of energy and how we get it to people

[00:27:09] well the big changes i'd say are largely occurred you know um moving from vertical wells

[00:27:16] that were straight down to horizontal wells that went down then fed out horizontally

[00:27:21] that was a huge technological change and then fracking the reserves underground or the rocks

[00:27:26] underground unlocked a lot more oil and gas than we thought existed and so i i think that

[00:27:33] has already happened now it's largely only being used in the united states um so to the

[00:27:40] extent that you know they did this over in the middle east or in russia or other parts of

[00:27:45] world they're more using conventional technology you can unlock some more oil and gas there

[00:27:51] so i'd say the big technological revolution already happened and so now we're probably

[00:27:55] more in a steady state type of situation um we don't need to grow a lot in united states now

[00:28:02] you know just fairly modest growth of three or four percent of years all you really need

[00:28:07] production growth uh to be to meet the world's needs um is the way i look at it so we're

[00:28:14] not looking for any major new revolutionary technology now where we really probably need

[00:28:19] it is on the renewable side battery power uh for storing you know energy and then also for

[00:28:26] nuclear and so if we could somehow you know crack the code and make small scale nuclear

[00:28:33] plants more efficient and affordable then you could see a lot more of those be built in

[00:28:39] united states and that's direction i think i'd like to see a lot more nuclear be built around

[00:28:45] the world than we have today unfortunately most of the world still so scared about Chernobyl and

[00:28:51] what happened in japan to allow nuclear to be built many countries aren't building nuclear in

[00:28:57] our experience here on large scale plants has been you know pretty abysmal um you know so

[00:29:02] many people have kind of said no more we just can't afford it's too too costly and uh

[00:29:08] too dangerous to to pursue the nuclear option so that's a long-term solution that if we can

[00:29:14] somehow improve technology there and prove it out that there could be some opportunity for

[00:29:19] growth there for the second half i want to shift and talk about mlps because you guys

[00:29:23] just launched a very interesting fund in the space um and to be honest i didn't know a lot

[00:29:26] about it mlps i did a lot of research before i talked to you to make sure i at least had

[00:29:29] some idea what i was talking about but just to start for people like me can you explain

[00:29:34] what an mlp is like the important characteristics of them sure yeah so mlp stands for master

[00:29:39] limited partnership and so what it is and these were developed back in the 1990s

[00:29:45] is they're publicly traded partnerships that don't pay any corporate tax and you have to

[00:29:50] have what's called mlp qualifying income meaning from natural resources such as oil and gas to

[00:29:55] qualify so you can imagine if you're a corporation making money if you can be in

[00:30:01] in a partnership structure not pay any corporate tax that saves you a lot of money

[00:30:06] and that's how mlps were created is to be effectively flow through vehicles for investors

[00:30:12] now 10 or 15 years ago mlps was 75 percent of the industry of energy infrastructure

[00:30:20] now they're only about 25 so mlp is just a tax structure is all it is so it's only a

[00:30:27] quarter of the space the three-quarter part of the industry are c corp companies so the broad space

[00:30:33] we call it is energy infrastructure that's comprised of mlps at 25 to 28 percent

[00:30:40] and c corp companies that are traditional corporations this year 1099 so the industry

[00:30:46] itself is really called midstream energy infrastructure and mlps are a relatively small

[00:30:52] part of it today many mlps have been rolled up by their c corp parent company and the space has

[00:30:59] kind of become more of a c corp type space why is that why are mlps so used so less so much

[00:31:05] less than they were um many investors don't want to get a k1 is the biggest reason it's

[00:31:10] a hassle you know if you if you own 10 mlps you get 10 k1s and it's a pain for filing your

[00:31:17] tax return they also produce ubti unladed business taxable income and so most mutual funds don't

[00:31:24] don't own mlps they don't want to deal with having to file k1s most people prefer a 1099 so

[00:31:30] that's the biggest reason and um i think that's why the space has become more c corp of nature

[00:31:37] and the truth is you don't need to have um you know a bunch of mlps out there you can get

[00:31:42] the yield benefit through a c corp structure and the companies themselves don't pay a lot of

[00:31:47] corporate tax because they have a lot of depreciation and so we find today a lot of public midstream

[00:31:52] companies like williams and kinder morgan they don't have a very high corporate tax rate

[00:31:57] anyway and so they issue a 1099 and don't have a very high corporate tax rate that's

[00:32:02] a pretty good solution for most investors can you explain use the term midstream and you

[00:32:06] see that all the time with these mlps can you explain what midstream means yeah the best way

[00:32:11] to think about it is the energy industry is around four percent of the s&p 500 that is

[00:32:17] comprised of about you know two and a half three percent upstream producers like exxon and chevron

[00:32:25] and diamondback that are producing oil and gas by drilling wells that's the majority

[00:32:30] then is energy industry then you have midstream that are natural gas and crude oil pipelines

[00:32:36] that we talked about earlier they're like the middleman and then the downstream part of the

[00:32:42] market are refineries so upstream produces oil and gas by drilling wells midstream transports it

[00:32:50] and refineries basically create gasoline for your car and those three segments are the energy

[00:32:58] industry kind of down midstream and upstream are the three component parts so it's it's

[00:33:04] basically kind of three ways to get the product to market is the way you think about it you got

[00:33:08] to find it you got to transport it and you got to refine it to create the usable ingredients for

[00:33:16] people like you know gasoline or diesel for your car or truck and what do you think is

[00:33:20] attractive about investing in the midstream area the midstream is attracted because as the middle

[00:33:26] man it's a pipeline infrastructure business we're not looking for oil we're not refining oil

[00:33:33] we're just trying to basically move it from point a to point b and so for the most part you're

[00:33:39] getting paid fees to move it from like the permean in midland texas to houston which is

[00:33:45] you know hundreds of miles away we charge a fee of like a dollar a barrel or a dollar fifty

[00:33:50] a barrel to move the oil to a market so it's like a transport conflict trucking

[00:33:57] and you're getting paid a fee to move that volume and you don't really

[00:34:01] you don't take the commodity risk you just kind of get paid a fee for for movement that's what

[00:34:05] i like about it we have a higher dividend yield in our space of about six percent

[00:34:10] whereas the upstream space only has a three percent dividend yield so it's a it's our has

[00:34:15] a our space has a higher dividend yield and more stability to it the correlation is only

[00:34:20] about 40 to 50 correlation to oil and so it's it's more like a infrastructure business

[00:34:29] and many people want the yield without the commodity risk that's what we offer is the

[00:34:34] income with less commodity risk and is it fair to say the mlp's pretty much operate exclusively

[00:34:39] in the midstream space um no they don't there are some squirrely little mlps out there that

[00:34:45] are involved in other segments like fuel distribution uh su n's and mlp um you know one

[00:34:53] actually well alliance bernstein a money manager actually is a is a mlp or what they call a ptp

[00:35:01] publicly traded partnership so there are a few other categories that are not midstream that are

[00:35:08] mlps as well and how many mlps are there um i think if you look at the index yeah larry

[00:35:15] and mlp index was around 14 mlps whereas in the in the midstream area overall there are

[00:35:22] like 25 stocks in the broad midstream index today and mlps will oh it seems like mlps always

[00:35:29] generate above average yields is there a reason for that um i think because they were built

[00:35:34] to attract uh retail investors they were always more of a yield product so your right

[00:35:39] mlps have about a seven and a half percent dividend yield as in the index um midstream

[00:35:45] overall has about a six percent yield so a little bit lower yield in midstream um and that's

[00:35:51] because of the corporate tax rate you know takes away some of the cash and then there are a couple

[00:35:56] of companies like targa and cheneer that have low dividend yields of one to three percent

[00:36:02] as a c corp you you don't tend to want to pay out all your cash and dividends you tend to

[00:36:08] keep more for reinvestment in-house whereas mlps have always been kind of built to pay out

[00:36:13] most of the cash flow to investors and so you find mlps have a higher yield to attract

[00:36:18] retail investors when you're looking at companies in this space what are the key metrics that you

[00:36:22] pay attention to uh the most common one today is just look at enterprise value to ebitda ev to

[00:36:29] evitda we look at all public companies using that that score card what you find is mlps are

[00:36:36] around eight times ebitda today c corp midstream companies are around nine and the sap 500 is

[00:36:43] around 13 to 14 so we're you know we are value equities trading at lower multiples

[00:36:50] and energy as a whole is less popular frankly with investors and so it they kind of tend to

[00:36:57] trade as value stocks with higher dividend yields so you mentioned before that mlps

[00:37:02] are about 25 percent of the universe like when you look at your fund is it similar to that

[00:37:05] do you have something similar to 25 75 we do in our fun we have to be below 25

[00:37:12] if we go to 30 or 40 the fund gets taxed at the corporate rate of that which is terrible

[00:37:19] so we have to stay below 25 every quarter now the truth is the overall industry

[00:37:26] is like 27 so it's not that hard to stay at 25 it's very strategic now if you go to an mlp

[00:37:35] only fund you're going to see that it has 15 mlps in it and almost no c corps but they're

[00:37:42] going to be paying tax at the fund level at 25 because you're paying corporate taxes at

[00:37:50] the national level plus state and local taxes in connecticut new york california etc and so

[00:37:56] the effective tax rate of seek on the c corp fund is 25 so naturally we want to minimize the tax

[00:38:04] drag on our phone we don't want to pay corporate tax so we we camp our mlp ownership at 25

[00:38:09] percent so when you think about taking the universe you mentioned and filtering it down

[00:38:13] to your actual portfolio can you talk a little bit about that process yeah so we start

[00:38:18] at the highest level and kind of look at the full universe we've been doing this now for

[00:38:22] about 20 years we have a six person investment team we do bottom up fundamental analysis on

[00:38:29] each and every company and it really is a bottom-up stock selection process what we find is there's

[00:38:34] some companies that frankly have a different form agenda totally in canada a couple of

[00:38:41] the larger companies have very high debt you know north of five times debt to evadal they're

[00:38:46] not generating free cash flow after cap ex and after dividends and so we find those companies

[00:38:52] less attractive and so they're they're very big parts of the index they're like nine and ten

[00:38:58] percent each of the index trans canada and tc energy and enbridge and so those are examples

[00:39:05] of companies that are running kind of a playbook that used to work five or ten years ago

[00:39:10] whereas in the u.s we find companies want to run less leverage enterprise products is only three

[00:39:16] times debt to evadal and it's generating lots of free cash flow and buying back shares so

[00:39:23] we find that doing bottom-up fundamental analysis is really the most reliable way

[00:39:28] to pick the best stocks and that we think generates superior returns we can't just go buy

[00:39:34] the index because some companies you know are running a different playbook they're trying to

[00:39:40] basically avoid cutting the dividend to fix their balance sheet and keep leverage high and

[00:39:45] we think that's a you know not a very successful strategy the best thing to do is

[00:39:50] you know perhaps perhaps to adjust your dividend lower pay down debt to three to four

[00:39:55] times evadal and cover your dividend higher with a lower dividend yield so anyway fundamental

[00:40:03] bottom-up stock selection effectively is the best way to run money in this business and so do you

[00:40:08] think the most important thing for you is filtering out the bad names like you said before

[00:40:11] versus maybe overweeding the ones you like the most i think yeah understanding the key drivers of

[00:40:18] the business and going back to your question earlier about what what kinds of assets do

[00:40:23] they own do they own crude oil pipelines which have less growth or do they have do they

[00:40:27] own natural gas and gathering and processing pipelines that potentially have more growth

[00:40:33] what what are they doing on the lng export size you know that's a growth engine if you don't have

[00:40:38] that you might trade a lower valuation so kind of understanding the assets you own is probably

[00:40:43] the most important thing and then looking at the capital of the balance sheet and the

[00:40:48] dividend coverage and doing that kind of work so definitely screening you know some of

[00:40:52] the dogs and cats is important i mentioned earlier you know justin asked there a couple of small

[00:40:57] companies in our space that frankly don't have any revenues and they're they're public but

[00:41:03] you could argue they shouldn't be public because they don't have any revenues or meaningful

[00:41:07] revenues out there they got to build assets and so we kind of prefer not to have stocks

[00:41:12] that are more speculative than our portfolio like that screening out companies like that

[00:41:17] just focusing on the core large cap safer investment grade or small to mid cap names

[00:41:22] that have a have have a core business it's very solidly profitable and for the names

[00:41:26] that you do own how do you think about position sizing within our mutual fund we typically

[00:41:32] keep things below 10 percent and we're somewhere in that kind of one to ten percent range

[00:41:38] high conviction names we could be 2x index weighting we don't feel any any need to own

[00:41:44] every stock in the index obviously we want to we want to pick the best stocks and actively

[00:41:49] manage the portfolio but we're in a relatively small universe today you know companies have

[00:41:54] consolidated down many mlps have been rolled up so it does kind of come down to more

[00:42:00] how do you weight the companies more so than which ones do you avoid and getting that

[00:42:05] weighing right is where you add your alpha and also there's a fair amount of volatility in our

[00:42:11] space you know being able to buy when things are weak and you know sell when they're expensive

[00:42:16] is a good thing a good way to add value do you see you already mentioned how you look at

[00:42:22] valuation but do you see like a wide range of valuation among the names in the index i mean

[00:42:26] is it pretty tight since they're similar type companies no we actually do the two canadian

[00:42:31] companies that i've mentioned to you were underweight you know trp and enbridge they

[00:42:36] trade it closer to 12 times evd but da whereas we have energy transfer down at eight times

[00:42:42] evd but da so eight to twelve pretty significant you know number there so in other words they're

[00:42:49] 50 percent higher valuation and they have 25 higher debt and like 25 lower dividend coverage

[00:43:01] it's like a no-brainer we want more of et and less of those two companies and they all

[00:43:07] they actually all are about nine or ten percent in the index earlier this year westwood launched

[00:43:13] a new i guess what would be considered an enhanced income strategy within an etf wrapper

[00:43:21] can you explain the underlying strategy there and what it produces in terms of yield and why

[00:43:30] an investor might sort of be attracted to it sure exactly so we did we kind of walked through

[00:43:35] in detail our stock selection process for building a portfolio we basically took that one step

[00:43:42] further we said okay let's build a quality midstream portfolio we use a rick structure

[00:43:48] so we cap the mlp exposure 25 percent so where we end up there is about a six and a

[00:43:54] portfolio and we said you know naturally energy is volatile because oil prices and natural gas

[00:44:00] prices move around let's do one more thing to add value let's sell a covered call on each and

[00:44:08] every stock and let's let's try to monetize volatility and give investors more income

[00:44:14] so we created an income solution so it turns out you can basically own that same portfolio

[00:44:20] write a one to two month covered call and make about five percent more income or yield so our etf

[00:44:29] ticker mdst has a 10.8 dividend yield and it's really just a combination of the underlying

[00:44:36] portfolio yield of six and a quarter and covered call writing that generates five to six percent

[00:44:43] annual yield and that that happens in the form of capital gains

[00:44:48] and so what we do is use the etf wrapper to try to tax efficiently manage the portfolio

[00:44:54] to try to minimize the amount of gains that we'll recognize over time meaning we can use

[00:45:00] the share creation redemption process to try to mitigate capital gains and offset some of that

[00:45:06] covered call income and so we're able to pay a yield that's double digit with the same

[00:45:12] underlying portfolio and that's really what we're trying to provide as an income solution most

[00:45:17] people we talk to are buying midstream because of the yield they're buying it because that five

[00:45:23] or six yields so if we can give them 10 to 11 and take away some of the volatility by

[00:45:28] selling covered calls out of the money i should have told you that these calls are on average

[00:45:33] about four to five percent out of the money so we're only capping our upside on a one month

[00:45:38] or two month basis five or six percent out of the money so we won't capture 100% upside

[00:45:45] we'll capture 85 or 90 that's good to know for most people if we can double the yield up to

[00:45:51] 10 and a half or 11 percent yeah i think that's attractive to a lot of investors that are looking

[00:45:56] for you know like you said even above the mlp something like 10 11 percent that's a nice

[00:46:02] that's a nice yielding portfolio what do you think are um i mean i i guess environments

[00:46:10] where there's less volatility this would tend to be maybe better than if there was a really

[00:46:16] volatile environment where those cover call options might sort of detract from returns but

[00:46:21] just talk about the when it would work and when it wouldn't possibly work as well so

[00:46:26] naturally um we're getting paid to sell option volatility so we actually want the market to be

[00:46:33] you know somewhat volatile that resulted more income on the premium so a little more

[00:46:38] volatility is is good up to a level um but we are capping our upside so we we want to

[00:46:47] we're not obligated to sell on every stock or every month and so we after a big correction

[00:46:53] for example if there's a five or ten percent correction we're less inclined to want to cap

[00:46:58] our upside up five percent because we expect it to rebound or might make it to rebound so

[00:47:04] um thankfully the last three or four years um last three years especially our markets have been

[00:47:11] pretty stable with an upward bias and so it tends to perform well in kind of a flat up market

[00:47:18] in a down market selling covered calls while perform a long-range strategy because the call

[00:47:24] premium gives you some downside protection so we're we'll so the ideal scenario is kind of in

[00:47:31] a down 10 to up 20 you know market environment for our industry covered call running should

[00:47:38] outperform with less risk if um if the if the index is going to do better than like 20 we'll

[00:47:46] leave some money on the table and if it falls 15 or 20 percent the money we make on covered

[00:47:52] call writing will be small relative to loss and so you probably shouldn't be in the space

[00:47:57] anyway um but it's hard to predict those big drawdowns so at the end of the day this should

[00:48:03] work most of the time um we're effectively just harvesting volatility in the market and getting

[00:48:09] paid to take equity risk is how we think about it so you have the flexibility to decide if you

[00:48:13] want to write the calls or which stocks you want to write them on that's right and some

[00:48:18] stocks just don't line up for example there are stocks trading at 37 that we own that

[00:48:24] you can only write calls at 40 or 35 and the 30 we're never going to sell it in the money call

[00:48:29] first of all we're only going to sell out of the money calls so we're never going to never

[00:48:34] going to sell in the money call so the 40 call mainly have a five cent bid we're not going

[00:48:39] to sell that call it's too not enough on a premium so in that stock we'll probably just sit

[00:48:44] here and hold it and get a five or six percent dividend yield and do nothing

[00:48:48] but if we own a stock at let's call it you know um 16 dollars and we can sell a call at 17 and make

[00:48:56] 30 cents every month that's a pretty good addition to the return so we'll do that and so

[00:49:03] there are just naturally on a one way actually the truth is every day we're creating a new

[00:49:08] model portfolio and some call strikes just don't line up and other other stocks we think are

[00:49:14] too cheap to write calls on so we expect to have covered calls on you know 90 of the portfolio

[00:49:21] but we're not obligated to we can we can make our numbers work if we if there was a large

[00:49:26] drawdown five or ten percent what we've typically seen is those kind of corrections you get a

[00:49:31] bounce back and so we would be hesitant to sell call for the next month we'd want to just

[00:49:36] let things rebound before we write more calls so we have the flexibility to to actively

[00:49:42] manage it and not cap ourselves too much after a big correction by the way this is one of the

[00:49:49] beauties of the etf right like five years ago you know a strategy like this might have been

[00:49:54] launched within a mutual fund but you know now it's like managers like your you know westwood

[00:49:59] and others i feel like it's more and more coming around to we're going to launch a

[00:50:04] strategy like the etf wrappers like superior and by the way i was looking i mean the fund

[00:50:09] has you know you launched it in early april of this year so we're a little bit over a month

[00:50:14] from the launch and the fund has 32 million in assets so out of the gate it's been

[00:50:18] well received by investors and i'm sure you had a lot of the people that follow you and westwood

[00:50:24] probably were interested in this type of vehicle but i mean 32 million in the first month

[00:50:28] effectively is a good is a good initial launch yeah we're off to a good start and i mean i

[00:50:33] um we for years i mean like over 10 years the question that we've never been able to answer is

[00:50:40] people have said can you give me your midstream strategy with less volatility i just want to get

[00:50:47] the yield well guess what selling covered calls lowers the volatility because you basically

[00:50:53] take a long-awaited product that you cap the upside up five percent and you get paid for

[00:50:57] that over and over and over again so we've run the strategy actually in separate accounts for

[00:51:02] about a year and a quarter now what we found is the beta of the index drops to about 0.85

[00:51:09] and we double our yield and so i think for a lot of people

[00:51:14] looking at ira accounts for example this is a perfect strategy for an ira you get 11

[00:51:20] percent dividend yield and you don't pay tax in your ira so the covered call income if

[00:51:26] it does come through some is short-term cap gain you don't care in ira and so for many people

[00:51:32] they're looking to get most of the upside with less downside risk it kind of fits the bill

[00:51:38] you're getting paid to take market risk now in a lot of other equities s&p 500 for example

[00:51:44] you don't get much dividend yield at all you're you're paying to take risk

[00:51:48] you hope it goes up and your your return is really from it going up well that that generally

[00:51:54] works but there are times it doesn't work so here you're getting paid to just have exposure

[00:52:00] and really kind of what you want to happen is flat to up a little bit and you make 11

[00:52:06] that's good so it's it's just a more it's a better way to uh to get paid to take market

[00:52:13] risk i think for energy products because energy naturally is volatile and so you might as well

[00:52:18] sell volatility as somebody else and i think too there's you know there's a big group of

[00:52:24] investors out there that sort of it's almost like it's there's never a guarantee return

[00:52:30] in investing but you're certainly i think you have to have more confidence in

[00:52:36] you know something like maybe a 9 to 11 percent yield versus with the s&p 500 over a five

[00:52:41] year rolling period you might have an average return of 10 but given the starting point you

[00:52:47] know that can that can be zero or it can be annualized 18 depending on when you get into

[00:52:53] the s&p if you get in on a bear market low or if you're investing one's really expensive

[00:52:58] so i think that there's a lot of investors out there that like a more consistent

[00:53:02] you know higher yielding strategy uh would be really appealing so yeah that's what we're

[00:53:09] trying to deliver and here i think part of it too is that the the negatives on our space

[00:53:14] historically have been volatility is too high and uh oil is just naturally a volatile i mean

[00:53:21] all commodities are volatile it's just nature of the commodity business well so the way you fix

[00:53:26] that or turn it on its head is you sell that high vol to somebody else who wants to speculate

[00:53:31] on the upside okay god bless them we'll sell you the upside every month you can have the

[00:53:37] portfolio return above five percent okay well we know from options is most of them expire worthless

[00:53:44] so we're kind of selling that upside to somebody else we're taking the more secure bet which is

[00:53:51] the house side we're betting on most of those calls expiring worthless and if it goes up so

[00:53:56] be it we made money if if we get called away it's because the stock went up a lot we made

[00:54:01] money so we're not going to cry if we don't make every every dollar if we if we only make

[00:54:06] 85 percent of an up 20 year you know what we're happy that's good we're not we're not going

[00:54:13] to go broke making 85 percent of the upside that's the trade-off now there's no downside

[00:54:19] protection we know on puts so we think the way we get comfortable there is the space itself

[00:54:27] is relatively low valuation nine times EBITDA it has a six percent dividend yield

[00:54:34] and most the companies are buying back shares so we don't think there's

[00:54:39] lots of downside in the space because it's so healthy you know so we think the downside is

[00:54:45] let's say 10 to 20 type of downside well we're getting paid six and dividend yield and

[00:54:52] five or six on covered call so we can stomach a down 10 market and still be flat

[00:54:58] that's fine that's good so that we kind of think the range of returns is probably down

[00:55:03] 10 to up 20 this strategy is designed to outperform in that that that period which

[00:55:08] is most of the that's that's probably 85 percent of return range is is down 10 to up 20

[00:55:14] so if the strategy wins in that environment it loses up 20 and above we don't make all

[00:55:20] the upside and down 10 and worse we we capture some of the downside but we don't lose as much

[00:55:28] that's good most investors want to lose less and down markets and make most of the upside

[00:55:34] this this is designed to basically win on both sides of the equation that's not perfect you

[00:55:41] know it's it's an energy infrastructure so you kind of size it appropriately you don't

[00:55:45] you put two or three or four percent of your portfolio in it as an income solution

[00:55:51] it's not going to ever be all your portfolio it's a it's a piece of an income solution is how we

[00:55:55] think about it this has been really great greg i i've learned a lot i know our audience

[00:56:02] is going to learn a lot from this and be very interested in what you've had to say

[00:56:05] um we do like to end with a standard closing question and you can go anywhere you want with

[00:56:11] but based on your experience in the market if you could teach one lesson to your average investor

[00:56:16] what would that be it's a warren buffett principle basically you know buy what other people

[00:56:24] don't want to own and in my case it's going to be energy if most people don't want to buy

[00:56:29] energy which is the case today it means those stocks are going to be cheap they're not

[00:56:35] popular and so buy high quality energy infrastructure companies that are not popular

[00:56:42] but are but are basically cash flow generators and then hold them forever because buying cash

[00:56:49] flow cheap is a winning strategy it's as simple as that and you know they're not they're not

[00:56:55] popular for for cocktail parties and some people are going to get pissed if you own

[00:56:59] fossil fuel companies but the end of the day just tuck them away and hold them for 20 or

[00:57:04] 30 years because cash flow makes you a lot of money over the long run it's stuff thank

[00:57:11] you very much greg we appreciate it all right thanks a lot guys appreciate it thank you

[00:57:16] this is justin again thanks so much for tuning into this episode of excess returns

[00:57:21] you can follow jack on twitter at practical quant and follow me on twitter at jj carboneau

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