Quarterly Commentary Q3 2017

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1 EGA Master Limited Partnerships From the EGA Portfolio Management Team There is Nothing Permanent Except Change - Heraclitus Quarterly Commentary For only the second time in history the Houston Astros won 100 games in a single season and the rookie quarterback for the Houston Texans has so far justified his first round selection in last year s NFL draft. Tragically, Hurricane Harvey landed a direct hit on Houston and the Texas Gulf Coast, the first hurricane to do so since Hurricane Ike in 2008, dropping a record 40 inches of rain in Houston and over 50 inches in surrounding areas over a 3-4 day period. Watching the Texas community come together was truly inspirational. From an energy perspective, oil prices increased 12% in the third quarter as reports suggest Hurricane Harvey will have only a short-term impact on the industry. It s times like these when you appreciate just how important Texas and the energy industry is to the rest of the nation and world. The ability to manage during crisis is critical to the success of a company and its industry, and midstream management teams answered the call. However, in regards to long-term strategy, management teams have lost significant credibility. We believe this loses sight of the forest for the trees, as a paradigm shift is occurring in midstream that should result in a more efficient, self sufficient, and healthier business model. No One Said A Paradigm Shift Would Be Painless We have worked through numerous oil price cycles over the last 15 years, some long and others short in duration. For particularly sharp downward cycles there is a desire to search inward for what went wrong and adjust, perhaps even throw out the entire playbook and start from scratch. For midstream, the answer has been available for some time. We are referring to the Enterprise Products Partners (EPD) model, which promotes asset integration, operational efficiency, and financial self-sufficiency. It also seems to be the direction the sector is moving, which we believe would be warmly received by the investor community. Strategically located, integrated. The investor community has focused on asset returns and capital discipline, a typical reaction in a bear market. While this might be the correct approach in a normal down cycle, maybe it s not in a Lower for Longer environment of range-bound oil and natural gas prices. Assets strategically located Eagle Global Advisors, LLC 5847 San Felipe, Suite 930 Houston, TX

2 in the key producing fields and demand centers allow companies to form an integrated asset network that should enhance profitability. An integrated asset network should be less susceptible to swings in cash flows in volatile or stagnant commodity markets, and can also be bootstrapped in providing additional growth opportunities. In our view, it s better to trade a stranded asset in one field for the ability to integrate further in another field. Source: Enterprise Products Partners We realize this may not necessarily be a new revelation to management teams, though we have recently seen a greater focus by companies to build an integrated network. For example, a major initiative for Magellan Midstream Partners (MMP) is to extend its crude oil pipeline network into gathering Permian Basin volumes much in the same way it has been able to acquire / build assets to connect its crude pipelines to storage facilities and refineries on the U.S. Gulf Coast. To date, Magellan has been unable to execute on this initiative, mostly because current valuation of a potential acquisition would be dilutive to MMP distribution coverage or growth rate. However, in the long-term the company may find itself at a strategic disadvantage if it can t direct volume growth from key producing fields into its own integrated network. Perhaps there are other ways The recipe for operational efficiency calls for joint venture. Joint ventures allow companies to improve their asset network while reducing financial and operational risk and also enhance operational efficiency through cooperation and enhanced asset integration. A hot topic in midstream is a Permian-to-Corpus Christi oil pipeline. Many investors believe the winning pipeline will be a partnership of multiple companies. Separately, the Dakota Access Pipeline (DAPL) generated a lot of negative publicity for Energy Transfer (ETP) earlier this year, though in reality the pipeline is jointly owned by multiple companies. Another variation of this cooperation is the pipewithin-a-pipe that came about when Magellan combined its Saddlehorn Pipeline project with NGL Energy 2

3 Partners (NGL) Grand Mesa Pipeline. The theory is this collaboration may help reduce the potential for overbuilding midstream infrastructure as multiple projects with just enough volumes to support construction are combined. We Believe Absence Of IDRs Is A Long Term Winner Tangentially, we think the greater use of joint ventures and partnerships also increases the probability of sector consolidation. Perhaps collaboration begets collaboration, enhancing intercompany asset integration until it 31% 49% becomes obvious that companies should combine. It is also encouraged by the trend of simplification Simplicity is the ultimate sophistication. We ve said it 69% With IDRs before, we ll say it again. Enterprise Products Partners pioneered simplification back in 2002 when the general partner (GP) eliminated its top 50% split (for no compensation) 51% No IDRs and then eliminated the rest of its Incentive Distribution Rights (IDRs) in 2010 through a GP buyout. EGA avg AMZ The rationale was basically to remove the large burden Source: Alerian MLP Index, Eagle Global Advisors its IDRs placed on Enterprise s cost of capital. A company and its management shouldn t need incentives to grow in an efficient and prudent manner, because it should already be at the core of what managers aim to achieve. Since 2014 we ve seen a slew of companies eliminate their IDRs, even though in several cases it was the result of distress, it still sets these companies up for future growth. It also greatly lowers the hurdle for sector consolidation as acquirers don t have to negotiate or figure out how to incorporate the value of the general partner into the equation. It s true that we haven t seen much in regards to sector consolidation as of yet, though we believe that s more a function of managerial priorities being focused on right sizing their financials for the new paradigm Achieving financial self-sufficiency. Net fund flows are challenged, and equity capital raises have been less than impressive this year. However, underneath everything is a silver lining that major growth projects are nearing completion, At-The-Market (ATM) programs are healthy, and a combination of increasing EBITDA and prior equity raises are improving balance sheets. Once again we focus on Enterprise as an example because of their healthy balance sheet and high distribution coverage ratio. Before oil prices crashed in late 2014 Enterprise was an outlier as it maintained a high coverage ratio even though investors clamored for stronger distribution growth. However, Enterprise management insisted excess cash would be better used if applied to organic growth and reducing reliance on capital market access. We now find midstream management gravitating towards this approach as increasingly demanding equity investors and credit agencies forced several companies to choose between investment grade ratings and current distribution payments. An added bonus of financial self-sufficiency and the elimination of GP IDRs is that it is highly supportive of the coveted investment grade credit rating. As part of the Tesoro-Western Refining merger, underlying MLP Andeavor Logistics (ANDX) bought in WNRL and eliminated its IDRs and was subsequently rewarded with a credit upgrade to investment grade. 3

4 A Few Final Thoughts... Regulatory Successes. In what has been an under the radar positive for energy infrastructure is the regulatory successes this year. Projects at multiple stages of development have been progressing nicely, and several projects are now delivering stable, de-leveraging cash flows to further support balance sheets and drive distribution growth. We make a special highlight of the Federal Energy Regulatory Commission s (FERC) decision to remove New York state authorities from a Clean Water Act requirement for the expansion of the Millennium Pipeline. Infrastructure opponents have more recently taken to pressuring local authorities with the hope of slowing or stopping needed expansions. This decision against local authorities bent on obstruction should comfort those worried about what had been a disturbing trend during the prior administration. Hurricane Harvey. Hurricane Harvey unloaded on Houston, Corpus Christi, and much of the Texas Gulf Coast in late August. We expect the storm will impact third quarter results. Producing fields were shut down in anticipation of downstream bottlenecks, which we expect will have a modest negative impact on pipeline volumes though perhaps a small positive effect on storage. It appears the largest impact was on petrochemical crackers that were still in various stages of restart several weeks post the storm, and to a lesser extent the NGL feeder systems to those facilities. We stress the impact is temporary, will likely have a very minor impact on third quarter results, and no impact on the long-term outlook. Energy data points still support a healthy fundamental outlook. Given the bullish view we outlined in our last Quarterly Commentary, we wanted to update a few relevant indicators of energy market health. To us the most meaningful takeaway is that the sharp drop in sentiment was not matched by the data. The U.S. rig count at the end of the third quarter was in line with the end of the second quarter, though it did slip down in August after strong additions in July. Meanwhile, net inventory continues to trend lower while production moves higher. Reiterating once again the great midstream paradox: midstream companies generate revenues based primarily on volumes, not energy prices. As long as energy prices are high enough to incentivize production growth, volumes should increase benefiting the midstream sector. Total rig count is up 133% since May 2016 trough Horizontal rigs account for 90% of the recovery 2, ,750 1,500 1,250 1, Total Horizontal Horizontal Other (50) Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Source: Baker Hughes Source: EIA 4

5 Source: EIA The conundrum continues. We continue to be perplexed by the bifurcation of CDS spreads and equity distribution yields, which implies debt holders are valuing a materially lower risk profile than equity owners. Over time these two risk measures tend to track together given the only material difference is their place on the capital hierarchy. Since we believe the midstream sector is far along the way towards repairing itself and is set up to benefit in the new energy framework, we expect the two risk measures to converge. bps 240 CDS Distribution yields (right axis) 10.0% bps 180 CDS Distribution yields (right axis) 8.0% % 8.0% % % % % 5.0% % % Dec 14 Feb 15 Apr 15 Jun 15 Aug 15 Oct 15 Dec Dec 16 Feb 17 Apr 17 Jun 17 Aug % Source: Bloomberg Source: Bloomberg Access To Capital, Fundraising and Cost of Capital The third quarter was relatively quiet, which within the context of capital access and corporate actions could be viewed positively or negatively. The good news is a large majority of our investments do not need access to the capital market for the rest of 2017 (and for some a large chunk of 2018) though a healthy capital market would improve investor perception of the sector. Among the third quarter s notable corporate actions, two stick out: (1) PAA s distribution cut, and (2) the initial public offering of Oasis Midstream (OMP). For PAA, the company altered its distribution policy to be supported by its ratable transportation business segment, after its marketing business posted another weak 5

6 quarter and admitted a lack of visibility. The end result was a 45% distribution cut and severe stock price underperformance. For OMP, the IPO was just the third since 2014 and the second of The stock priced below the range and has traded just below deal price since its mid-september offering, though we take solace that it was successfully placed despite challenged market conditions and sentiment. Outside of OMP s IPO, access to capital in the third quarter compares marginally better than the second quarter. Leading the way was Energy Transfer Partner s (ETP) $1 billion equity offering to help fund its major growth initiatives. Taking a cue from other large cap companies, ETP indicated it would not be coming back to the equity market until mid-2018 in the hopes it would remove perceived equity overhang as it works through its large growth program. The preferred equity market continued to strengthen for MLP offerings, with three offerings in excess of $400 million completed during the quarter. Meanwhile, while the At-The-Market (ATM) programs raised over $1 billion, it was down about $1 billion versus third quarter of Finally, monthly fund flows were consistently positive following June s negative data point. Total inflows for the quarter of $1.4 billion were up 108% and 5% from the prior quarter and the prior year. Fund flows have taken a step back from where they were earlier this year, driven by what we believe is still a market clearly in show me mode. We believe that if the midstream sector can show evidence the strong fundamentals translate into cash flow and distribution growth, then enthusiasm (and inflows) will return to healthier levels experienced as recently as February of this year. As of 9/30/2017 Source: US Capital Advisors 6

7 MLP Team Update There were no significant team related news items to highlight this quarter. We continue to focus on the research and portfolio execution effort, and are in constant dialogue with industry experts and management teams. In addition to the multiple midstream conferences we attended in the third quarter and expect to attend in the current quarter, we have intensified interactions with insiders beyond our midstream skill set. We believe this is prudent given our view that we are in the early stages of an energy upcycle, and see data points collected outside of midstream as necessary in helping us evaluate our midstream investments. We thank you for your continued patronage of Eagle Global Advisors. We believe the long-term return outlook for MLPs remains attractive, and we look forward to communicating the results of your investment in an Eagle managed MLP account next quarter. - The Eagle MLP Team 7