From the February 2013 issue of Research Magazine • Subscribe!

January 23, 2013

Full Speed Ahead for Midstream MLPs

Portfolio managers and analysts explain why they are generally upbeat on the “toll road” model and what it can mean for investors.

The role of natural gas as an energy source continues to expand as the United States moves toward energy independence. That bodes well for the companies that transport gas and other fuels and that provide infrastructure to the industry. Research asked several master limited partnership (MLP) fund managers and analysts to share their insights into what is driving and should continue to drive the performance of Midstream MLPs. 

This year’s roundtable participants include:

  •  Kenny Feng, CFA, president and CEO, Alerian, Dallas;
  •  Jim Hug, senior portfolio manager, Yorkville Capital Management LLC, New York; 
  •  Brian Kessens, CFA, senior investment analyst, Tortoise Capital Advisors LLC, Leawood, Kan.; 
  •  Quinn T. Kiley, managing director and senior portfolio manager, FAMCO MLP, a division of Advisory Research Inc., St. Louis; 
  •  Erin Moyer, vice president and senior analyst, OFI SteelPath, Dallas; and 
  •  Daniel L. Spears, partner and portfolio manager, Swank Capital LLC, Dallas, Texas.

Research: How did the Midstream MLPs that you follow perform in 2012?

Kenny Feng, Alerian: Alerian does not manage assets. The Alerian MLP Infrastructure Index, a benchmark for Midstream Energy MLP performance, returned 7.7% on a total return basis through Nov. 30, 2012.

Jim Hug, Yorkville Capital Management: We have been particularly positioned in the general partners (GPs) for reasons that we have discussed in the past; namely, if we are correct in our analysis of the underlying partnership (and our opinion that the underlying securities are attractive) then the return to the general partner is magnified. 

Brian Kessens, Tortoise Capital Advisors: 2012 was a good year for pipeline companies. The energy infrastructure sector, including MLPs and pipelines, delivered sound performance. 

Distribution growth accelerated to 7%, following the tremendous need for additional pipeline infrastructure to support greater production from emerging shale basins. 

Throughout the year, pipeline companies steadily increased their anticipated level of capital investment due to the heightened level of opportunity for new projects to transport increasing volumes of crude oil and natural gas liquids. 

There also was a healthy appetite for acquisitions, which further enhanced the opportunity set in the sector: Total acquisition activity topped $40 billion. 

Demonstrating the resilience of this sector, this growth and opportunity occurred despite slower economic growth, a contentious election and a lack of consensus in Washington related to fiscal policy. 

Quinn Kiley, FAMCO MLP: Generally, Midstream MLPs performed well. If you look a little deeper you see that MLPs that focus on certain sectors did better than others. 

MLPs focused on building and operating crude oil infrastructure performed exceedingly well during the year. This stems from a continuing shift in rig activity towards crude oil and liquids-based reserves. Those MLPs with price exposure to natural gas liquids lagged, as these commodity prices were depressed due to production exceeding demand.

Erin Moyer, OFI SteelPath: At OFI SteelPath, we focus on energy infrastructure opportunities and follow all Midstream MLPs closely. Importantly, that does not necessarily mean we consider all Midstream MLPs appropriate energy-infrastructure investment candidates, because risk profiles within the group can vary dramatically. In fact, there was fairly dramatic dispersion in performance across Midstream MLPs throughout the year based in part on these different risk profiles. 

On average, petroleum transportation-focused names performed very well, with average price returns above 10%, and a number of individual names soaring 20% or more. However, names with margin exposure to natural gas liquids pricing generally did much worse, with most of those names experiencing a modest to significant correction over the year. 

More broadly, names that were able to offer very visible paths to robust distribution growth performed well, whereas those that were unable to provide such visibility, whether due to commodity price exposure or company specific issues, performed poorly. Importantly, we think such performance bifurcation can often lead to opportunity, as market behavior in such times can exhibit exaggerated price performance relative to underlying fundamentals, both on the upside and the downside.

Daniel Spears, Swank Capital: The Midstream MLPs that we follow had a very good year. We continue to focus on those MLPs with greater exposure to crude oil transportation and natural gas liquids infrastructure. 

Did those 2012 results differ significantly from your pre-2012 expectations? If they did, what factors caused the unexpected results?

Feng: These results were roughly in line with our expectations of 9%-11% total return (6% yield and 3-5% distribution growth) for the sector. MLPs experienced strong gains in the beginning of the year, but macro issues such as the Eurozone crisis and post-election fears of tax reform pared back some of those gains.

Hug: We did not see any significant surprises in 2012. The fundamentals remained strong and the outlook remains highly favorable. 

We would say the one statistic that is somewhat surprising is the enormous spread between the average yield on the Midstream MLPs and the 10-year Treasury (450 basis points). Over the last ten years this space has averaged 320-330 bps. 

While we acknowledge that interest rates are at historically low levels and have nowhere to go but up, we believe we will eventually experience some compression in MLP yields. This would parallel what occurred in REIT yields. The average yield for REITs decreased from 7.4% in the 1990s to 5.7% in the 2000s, down to 3.7% from 2010 to present as the asset class gained wider investor acceptance.

Kessens: Sector growth this year met the high expectation we held going into 2012. We anticipated growing volumes of U.S.- and Canadian-produced crude oil, natural gas and natural gas liquids (NGLs) to result in increased demand for energy infrastructure, which proved to be the case. 

We also expected natural-gas- fired power generation to continue to displace coal-fired generation due to lower natural gas prices versus coal. While this occurred, the absolute level exceeded our expectation at times, as coal to natural gas switching stretched north of 6 billion cubic feet per day (Bcf/d). 

To a lesser extent for pipeline companies, we believed NGLs’ prices would move lower following the increased level of NGL production without an obvious source of immediate demand. The relatively warm winter of [2011] exacerbated this impact to price. Indeed, we continue to work through higher NGL supplies.

Kiley: We generally expected crude oil and NGL infrastructure [MLPs] to perform well during 2012. Performance for the year was highly correlated to an MLP’s valuation at the beginning of the year and distribution growth during the year. The end result is a story of haves and have-nots for 2012. This was somewhat surprising as high-yield MLPs fared poorly, despite the strong “yield trade.”

Moyer: We didn’t expect MLPs to repeat their 2009 or 2010 performances, but we certainly felt that given the strong positive fundamentals that the sector might perform better than the broader market for 2012. By most any measure, whether on a market-cap-weighted basis or equal-weighted basis, Midstream MLPs underperformed the broader markets by a fairly large margin. 

We think there are a couple reasons for this. First, we saw approximately $25 billion in equity supply hit the market, which is a staggering sum for the market to digest. For comparison, equity supply in 2012, through IPOs and secondary offerings, into the sector was 20% more than in 2011, which was also a record year.

Secondly, the dramatic drop in natural gas liquids pricing impacted those with exposure and even some that really only have minimal exposure seemed to have corrected in sympathy. Further, late in 2012 it appeared the sector was subject to selling from investors looking to capture gains ahead of potential 2013 tax changes.

Spears: We generally expected mid-teen type returns for MLPs in 2012, which was a function of both yield and distribution growth. There were certainly names within the crude oil andNGL infrastructure sectors that performed better than we expected. 

We were positively surprised by both the sheer number of and accretion from organic opportunities within those businesses, as well as how much of that accretion management teams were willing to pay out in distributions. As an example, Sunoco Logistics Partners increased its distribution by approximately 10% sequentially for each of the past two quarters. 

What potential upside do you see for Midstream MLPs for the next six or 12 months, and why?

Feng: There are several areas with enormous opportunities for MLPs to relieve crude pipeline takeaway constraints, such as in the Bakken and Niobrara shales, as well as from Cushing, Okla., to the Gulf Coast. 

Midstream MLPs addressing such issues stand to see potential upside over the next 6 to 12 months. For the Bakken and Niobrara, a solution that bypasses Cushing—which is already congested—may be more optimal for producers. 

On the natural gas liquids (NGLs) front, if additional chemical companies restart their domestic facilities or relocate operations currently handled abroad, these decisions would catalyze stable and long-term demand for NGLs domestically, particularly ethane. Midstream MLPs with NGL exposure—through processing, fractionation, or storage—would be the beneficiaries of such NGL demand.

Hug: We have been positive on MLPs since the founding of Yorkville and prior to that back to the mid-1990s, when we first began to follow the MLPs. We believe the “MLP Story” is more powerful today than at any time since we have followed the industry. 

The reason for this is quite simple: the shale energy revolution that is taking place in the U.S. because of horizontal drilling and hydraulic fracturing. We buy into the story that the U.S. could become energy independent by 2020. This will have profound implications for the U.S. economy and for the MLP sector.

Kessens: We think Midstream [MLPs] continue to offer an attractive risk-versus-reward tradeoff over the next year. We anticipate petroleum pipelines will continue to benefit from two tailwinds.

First, significantly higher crude oil volumes, especially in the Permian and Bakken plays, are expected to drive increased volumes. Second, a higher inflation-tariff escalator should boost cash flows.

The outlook for natural gas pipelines is one of consistency, because contracts are anchored by a reservation fee. Producers continue to focus on generating value through the liquids uplift. Hence, we expect gathering and processing activity to remain strong, especially in the Marcellus and emerging Utica and Eagle Ford shales. 

We think assets will continue to migrate into the MLP structure. Several companies are in registration to become public as MLPs, recent IRS private letter rulings are supportive, and the upstream companies’ capital needs facilitate the sale of their midstream assets to MLPs. 

This should continue to drive sector growth, along with management-team focus on robust growth, capital investment execution and pipeline integrity maintenance. This backdrop leads us to expect a 6-8% distribution growth in 2013, supporting a total return expectation in the low double-digits.

Kiley: Given the sell-off we have experienced since the [November 2012] election, it is conceivable that MLPs post a total return in the high teens for 2013. We would expect Midstream MLPs to outperform commodity-price-exposed MLPs, as the oversupply situation in domestic commodity markets continues.

Moyer: Generally, we don’t like to set expectations over short-term periods, because the short term can be dominated by non-fundamental factors such as the performance of the broader markets or the broader energy sector. 

MLP units are, after all, equities, and though long-term correlations to other asset classes have been relatively weak, short-term correlations are higher. With that caveat, however, and assuming the broader markets remain supportive, we believe the sector could perform above our long-term expectation over the next six to 12 months, simply due to the fact that this [past] year’s record-setting equity supply and late year tax-management related weakness has left the sector attractively priced. 

We believe fundamentals remain very supportive, and long-term growth prospects for most MLPs are even clearer today than they were heading into 2012. Importantly, a number of MLPs have growth projects that have been underway for several quarters or more, but which are expected to enter service in coming months, potentially allowing investors to benefit from those investments.

Spears: Barring extreme negative macro- or policy-driven outcomes, we think MLPs are poised for double-digit returns over the next year. We believe that the crude oil infrastructure build-out is in the early stages of development, similar to where the natural gas industry was a decade ago. 

The continued increasing domestic production of crude oil from existing mature basins like the Permian and new basins like the Eagle Ford and Bakken have created the need for new infrastructure. Additionally, as the MLP space matures, new investment products should continue to attract significant capital.

How do you expect the Midstream MLPs to perform in in the intermediate and long term?

Feng: Due to new drilling techniques and technologies, there has been a resurgence of oil and natural gas production over the past few years. The most recent International Energy Agency (IEA) report indicates that the U.S. could potentially be the world’s largest oil producer by 2020. And the U.S. now has such a large supply of natural gas that companies with facilities that import it are now filing applications with the government to export it. 

With a shift in both supply (the Marcellus Shale in Appalachia) and demand (U.S. population growth in the South), the need for energy infrastructure is now greater than ever. 

Pipelines, storage tanks, and processing plants are not cheap, and they will not be built overnight. A single pipeline can cost $2 million to $3 million per mile, and take one to three years to build. 

Al Monaco, the new CEO of Enbridge, summarized the current environment well when he said, “North America is in the process of being re-piped.” 

Midstream MLPs will be at the center of such re-piping, either by building new infrastructure or by repurposing existing infrastructure—flowing pipelines in different directions or moving different product—to meet current needs. All of this translates into cash-flow growth for Midstream MLPs. 

Over the past five years, MLPs have spent at least $15 billion annually on new infrastructure, resulting in average distribution increases of 6% per year. 

As such, we conservatively expect Midstream MLPs to grow their distributions by 3%-5% annually. This, on top of a current yield of 6%, translates into our total return expectations of 9%-11% on an annualized basis over the long term.

Hug: Midstream MLPs are an asset class in growth mode. For reasons previously discussed, there will need to be significant energy infrastructure investment in order to develop these unconventional shale deposits. 

Currently, the market capitalization for the industry is approximately $320 billion. It is estimated that $250 billion to $300 billion of investment is going to be needed to develop these reserves. This investment will drive Midstream MLP distribution growth for decades. 

In addition to this organic growth, we expect that there will be growth via acquisitions, as well. Just look at this year when Energy Transfer Equity LP (ETE) acquired Southern Union Company (SUG) for $ 9.3 billion, and Energy Transfer Partners LP (ETP) acquiring Sunoco Inc. (SUN) for $6.8 billion.

While these were unusually large acquisitions, we anticipate that acquisitions will play an important role in growing MLP assets.

Kessens: We see a clear and ongoing need for increased pipeline-takeaway capacity due to growing crude oil, NGL and natural gas production from unconventional drilling. 

In 2005, there were two primary unconventional plays: the Barnett Shale in Texas and the Canadian Oil Sands. Today, companies are producing oil and gas from more than 10 unconventional basins, and we expect this number to continue to increase over the course of the decade. 

As of the end of the third quarter [of 2012], production in the onshore lower 48 states was up 21% year-over-year, primarily from the middle of the country in the Permian Basin, the Eagle Ford shale and the Bakken formation. 

We anticipate $122 billion of capital investment in upstream in 2012 alone, and a total of $4.3 trillion in capital investment is expected by 2035. This capital investment requires additional pipeline infrastructure over the same extended time frame. 

In just the next three years, we estimate $75 billion in Midstream needs. Market activity for both debt and equity has been supportive of this growth, and we expect it to remain so. 

Combined year to date [through mid-December 2012], equity and debt MLP offerings topped $44 billion, $4 billion more than the elevated levels of 2011. We would not be surprised if 2013 measures well against the previous two years. 

There is reason to believe the elevated level of growth likely in 2013 is sustainable over the next few years as cash flow follows investment. Over the longer term, there is visibility to growth from a larger population, inflation protection inherent in pipeline contract structures and incremental internal projects.

Kiley: The rapid growth of domestic oil and gas production [and] associated infrastructure projects, and low interest rates for the next several years may produce higher returns, if the economy continues to recover and capital markets remain healthy. 

We continue to believe the MLP space can deliver 8-10% total returns over the long term. We get to this expectation by assuming 6% yields, 4-6% distribution growth, and the specter of rising rates over the long term acting as a headwind. 

Spears: The macro-landscape continues to be front and center, and we have seen certain key risks reduced while others remain. On the positive side, there have been signs that the U.S. economy is improving. Additionally, accommodative central bank policy action here and globally has been astounding. On the negative side, key risks include China’s “hard landing,” Eurozone economic weakness, the budget debates in the U.S., and Middle East instability.

Nonetheless, we remain positive about the long-term opportunities for MLPs. As we have noted before, we believe ongoing discovery and development of shale gas and crude oil will continue to drive demand for energy infrastructure. 

We believe the current slate of accretive, fee-based projects coupled with positive underlying sector fundamentals support our estimates of multi-year annual distribution growth in the range of 6-10%. We believe this growth, in addition to a current yield of approximately 6%, presents a very compelling total return story going forward.

Valuations for MLPs are within historical averages, and given the Fed’s expectation of low interest for the next several years, we think the thirst for MLP yield in a low-yielding environment will continue.

Additionally, if projected fiscal-policy changes come to fruition and ordinary dividend tax rates are increased, there could be further interest in MLP-structured equities, as MLP distributions are largely a return of capital and largely tax deferred until sale. 

What do you see as the advantage of the Midstream MLPs’ toll road model for investors?

Feng: The main advantage of the Midstream toll road business model is that cash flows tend to be more stable and predictable. This is a function of the inelasticity of energy demand, which has grown at a 1% average annual clip over the past 30 years. 

Additionally, all interstate liquids pipelines have a federal mandate to increase their tariffs (or tolls) annually by the Producer Price Index plus 2.65%. 

And finally, the majority of Midstream MLPs own assets with fee-based contracts, which significantly reduce their exposure to fluctuations in commodity prices.

Hug: Consistency of distributions is the primary advantage. Midstream MLPs generally derive fee-based revenue with no commodity price risk. Investors like the reliable and growing fee-based income produced by these partnerships. The market generally rewards partnerships possessing these characteristics with premium valuations, lower yields and a lower cost of capital.

Kessens: We believe the advantage of the “toll road” business for investors is the stability of cash flows the business model affords. Companies are able to distribute a certain level of cash flow quarter after quarter, year after year. And with the increased level of hydrocarbon supply due to technology advances in energy, there is a need for more toll roads in the U.S. This leads to not only stable, but also growing cash distributions for investors. 

In addition, because of the fee-based nature of cash flows and the fact that energy use is relatively inelastic, the model is somewhat immune from political uncertainty and economic cycles. For this reason, the sector is a bit of an oasis in a world that continues to be mired in deep fiscal and economic challenges. 

More broadly, the business model ensures reliable transport and distribution of energy across the country, enabling economic sustainability and growth.

Kiley: Generally, we think the “toll road” model reflects about 75% of the cash flow in the space, so investors must pay close attention to the remainder of the business they are buying. Many MLPs own assets with very different cash flow volatilities. 

For example, Williams Partners (WPZ) owns a premier suite of federally regulated, interstate natural pipelines. However, almost 60% of its cash flow comes from gathering, processing, and fractionation activities and half of that has some commodity price exposure. 

Another example is Enbridge Energy Partners (EEP), a predominantly crude oil focused MLP, but it suffered along with other MLPs when gathering and processing margins took a hit from falling NGL prices during the first half of 2012, despite only having about 16% of its cash flow exposed to commodity prices. 

In the end, when you purchase an equity security for the long-term, you are buying the entire company, not just the assets that may currently be in favor. Buyer beware—very few Midstream MLPs are pure plays on the “toll road model.”

Spears: Investors who are seeking current income benefit from the fee-based contract structure that most Midstream MLPs strive to have. The advantages of this model are the consistent and steady or growing distributions that get paid to unitholders on a quarterly basis. 

What potential risks should Midstream-MLP investors monitor?

Feng: With fiscal cliff and tax reform discussions, the largest current risk comes from headlines regarding potential legislative reform in MLP tax status and accelerated depreciation provisions. 

While headline risk is a real risk for unit prices, most MLP industry analysts view the signing into law of actual legislation affecting MLPs as highly unlikely. 

The fundamental thesis for investment in the asset class remains intact. MLPs are an integral part of domestic energy infrastructure and critical to securing energy independence. They create jobs and, according to the Congressional Joint Committee on Taxation, would only generate $300 million per year in tax revenues. 

Many investors also worry about dividend tax reform. If this were to occur, all dividend paying entities would be impacted; however, MLP distributions are mostly tax-deferred return of capital (70%-90% is typical), with the balance being characterized as ordinary income. So, lower after-tax dividends in other yield-oriented asset classes like utilities and REITs might actually serve as a catalyst for inflows into MLPs.

Hug: The capital markets are currently very receptive to MLP equity and debt. MLPs are shrewdly issuing long-term debt taking advantage of record low rates. We have seen many partnerships issue 30 year-plus paper in 2012. That said, MLPs are dependent on the capital markets to fund their ongoing business growth. 

Concern of change in tax laws is another potential risk. Very little tax revenue would be raised by eliminating the MLP structure. In January, the U.S. Congressional Joint Committee on Taxation estimated such a change would raise $200 million to $300 million in tax revenue (de minimis relative to our current trillion-dollar deficit). 

Eliminating the MLP structure would raise cost of capital and hinder the build-out of energy infrastructure, thus delaying the United States’ move toward energy independence. Such a [tax] move would also hurt the creation of high-paying construction and manufacturing jobs that accompany the build-out of energy infrastructure. 

Kessens: We don’t expect any event resulting in what might be labeled a crisis. But we realize that because of increased activity in the energy sector, there will potentially be a greater regulatory and tax focus. 

With Washington’s resources focused on the election for much of 2012, not a lot of progress was made with respect to energy regulation. Related to the election, it was our belief ahead of the vote that the result would have little impact on MLPs, as both candidates realized energy is one of the few sectors creating jobs and enhancing economic growth. Over the past four years, MLPs thrived under the Obama Administration. 

There has been concern about the continuation of MLPs’ favorable tax status, though there is not any direct legislation aimed at changing the tax status of MLPs. In fact, recently a bipartisan group of U.S. Senators and Representatives sent a letter to President Obama asking that MLPs be a priority in an all-of the-above energy strategy. Specifically, the letter is seeking support to include renewable energy sources as qualifying income for MLPs. We’re encouraged by this initiative. 

Providing additional assurance, a recent study conducted by the Joint Committee on Taxation estimated MLP taxation would generate only $1.5 billion over five years, a relatively inconsequential amount compared to other proposals. These efforts and facts lead us to conclude any potential elimination of MLPs’ tax advantaged status is unlikely. 

The other area where we receive questions relates to advances in drilling techniques. We expect and welcome more standardization of best practices related to the safety of drilling practices. We think the industry’s chemical disclosure registry at www.fracfocus.org is a good step in that direction. 

Of note, though, a draft of the EPA’s report on the potential impact of hydraulic fracturing on drinking water resources is due for release soon. The report won’t be finished until 2014, but the draft may provide an early indication as to the regulatory path the Obama Administration may take related to energy production. 

Kiley: The two most impactful issues for 2012 were tax risk and commodity price risk. There has been, and remains, a risk that MLPs will be caught up in a broad tax overhaul. 

We believe the likelihood of a tax change that specifically targets MLPs is unlikely. That being said, tax rumors, well-founded or not, put selling pressure on the MLP asset class at least five times over the last three years. 

On the commodity front, investors should be aware that volatile moves in commodity prices will impact MLP trading over short periods. We broadly expect commodity prices to be lower than the futures curve, and therefore fee-based MLPs may produce better returns in the medium term.

Spears: Even more so today, not all MLPs are created equal. As more companies utilize the MLP structure, investors need to be careful about hidden pitfalls. There are significant differences among MLPs in the contracts, asset locations, growth opportunities, management teams and balance sheets. 

When evaluating an MLP, performing due diligence and analysis of the MLP’s contract (both its terms and structure) and the underlying credit risk of the counterparty are equally important. 

The domestic energy sector is undergoing dramatic changes from a variety of different angles. Supply centers are changing, flow directions are changing, and storage destinations are being refitted and redirected. Evaluating the impact of these macro changes is critical to the process of determining which MLPs are likely to be able to accomplish their objectives.

 
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