Pipe Dream

Al Monaco, CEO of Enbridge, isn't related to Prince Albert II, of Monaco. But brothers from a different mother...

Both have been running tax havens for years. Albert II - the royal one - owns a casino and presides over the Principality of Monaco, one of the world's last true tax havens.

Similarly, our Canadian pipeline monarch has been running a tax haven hidden in plain sight. What else does one call the U.S. MLP (Master Limited Partnership) structure. Investors, lured by high distributions from these tax-free income streams, have been playing them like a casino game. It seems pipeline financing has a more in common with Baccarat than you would think.

And both 'Als' have an seemingly imperious disregard for their subjects/shareholders. Monaco, the country, has more than its fair share of the world's mega-rich. In Canada, our Monaco can live like a king on an $11mm annual comp package. Who cares if you nearly bankrupt the company in the process?

What makes this analogy timely is the news of a major hitch in Enbridge's expansion plans. The recent judicial rebuke of the company preferred version of the Line 3 expansion, combined with an untimely a peak in investor interest for MLPs, has the stock on it knees. All this while Suncor's stock price is soaring towards all-time highs.

Consequently, the Canadian 'Prince Al' is firmly in the crosshairs of disgruntled shareholders, who are now suffering from a 18 month long, 30% decline in share price. This is the reward for a questionable acquisition, Spectra Energy, which encumbered the company with mountain of debt at a time when the financing window for pipelines has all but shut because of rising rates. But just keep promising 10% dividend growth despite the negative free cash flow, you may keep fooling them long enough to squeeze out one more drop-down asset financing.

Don't for a moment think I'm jumping on a negative bandwagon after the fact. I was a conscientious objector to ENB stock as far back as I can remember. The stock, which I refused to own, was my nemesis during the 'Bull Market in Pessimism'.

At that time, I argued the valuation of Enbridge had became disconnected from reality. Risk averse investors, burned in the financial crisis, couldn't get enough of it, as well as the sidecar financing vehicles it sponsored. Remember, the 'low vol' craze was at its height. After 2008-09, shell-shocked investors wouldn't touch risk with a ten foot pole. By bidding up the high yielding pipelines, I argued, "people are replacing volatility risk with valuation risk". But to no avail. Dividend growth from the pipeline sector seemed like a sure bet and nobody was willing to be a contrarian.

The stock actually hastened the end of my career, as I was frustrated that nobody would listen to my story. I made presentation after presentation arguing Suncor was an equally good bet longer term. The two companies were ultimately in the same business and shouldn't prudence dictate some allocation to a manger who owns a bit of Suncor? But being a "growth manager" in Canada became a death sentence in the post financial crisis world. I continued to lose mandates to the so-called "value managers". You know ... the ones buying Enbridge at 16X EBITDA.

After the financial crisis, bond-like equities went on a five year run, crushing the commodity cyclicals. As bond yields collapsed, dividend yields on the long forgotten pipelines looked too good to pass up. Pension funds chased the winning trade by pouring into the sector. They were sucked in by the low volatility craze, just like retail investors.

But after a five year relative strength rampage, resultant valuations of Enbridge and Suncor were shockingly different. At one point, in early 2015, Enbridge was awarded a huge premium to Suncor as a stock . Price to replacement cost ... EBITDA multiple... balance sheet quality.... even dividend yield, favoured Suncor. But the herd mentality surrounding pipelines was firmly entrenched. Emboldened by burgeoning shale oil development, companies raced to the finance window, dangling their hockey-stick capex slides in front of yield starved investors.

The promise of rising dividends was an irresistible shiny coin trick for the crowd. Brokers fell into line, with their corporate finance pipelines looking as full as the real ones. Deal after deal hit the tape and were instantly bid higher. Analysts fell into line, gradually relaxing their entrenched valuation disciplines, hoping to leapfrog competitors to curry favour with the companies .

I see they're still hanging onto their $55 target for ENB, hoping to score the next deal, if it comes at all. Good luck with that one.

Now that the valuation shit has hit the volatility fan and Enbridge has lost its alchemic financing advantage, the market has evened the score. The once blissful yield-starved investors have now become disgruntled bag holders. (RIP Joe Granville)

Finally Suncor and Enbridge are in the same business again. And its tough for me to feel sorry for the coupon clipping crowd who stayed too long at Al's casino.

Risk Model: 4/5 - Risk On

Volatility has calmed and the sell-off in Gold has matched that of Copper. Both metals are being punished by the rising U.S. dollar, spurred by withdrawal of the U.S. from Iran deal, assumed to be announced today. These tensions should be relieved upon the actual announcement today, but interest rate differentials will continue to support the DXY.

I look for falling oil shortly as the worst case scenario in oil is being discounted currently. China will support Iran. Shell just hit the bid with their chunk of CNQ... Looks like a good sale. Thankfully I'm already out of the energy space. Commodities look lower to me for now.

As well, Emerging Markets are suffering the effects from the return of "King Dollar" as the carry trades get hit hard. Look for the pressure on the Fed to moderate their hawkish tone later in Q3 as the dollar reaches an extreme. Meantime, this story is being missed by most equity players. They still think inflation is rising. I think it just peaked.

Turkish debt looks particularly vulnerable. Argentina is going bust for ... I think the 17th time. Risk-off factors like these aren't being correctly priced - remember the Thai Bhat?. I like cash despite the model's optimism. Long Vol anybody?

Apple has garnered all the attention after Buffet's revelation that he was buying the Q1 weakness. Not sure how paying $185 is a good strategy on the news that "the Oracle" was buying it below $170.

I'm looking to short the pop here as volume expansion was unimpressive on the move and estimates aren't being revised higher yet.

For a refresher on the Risk Model (thanks Adam) see below. I think the AAII bears have it right.

Factor State

3Mo Vix <100 dma ... +

AAII Bull/Bear >30 wma ... -

Copper/Gold >50 dma ... +

XIU RSI >45-<60 ... +

XIU 200 dma 95% - 110% ... +