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January 23, 2013

Midstream MLPs: Why They Are Attractive to Investors

We believe that Midstream MLPs are very attractive businesses, and we think investors should allocate a portion of their portfolios to this asset class. 

When considering investing in Midstream MLPs, investors should consider the attractive total returns, high current yields, fee-based nature of midstream assets and the strong outlook for distribution growth resulting from the development of unconventional reserves.  As we will review in more detail in this article, we believe Midstream MLPs compare very favorably to other yield-oriented investment alternatives. 

Total return. MLPs are attractive to investors who seek current income and attractive total returns (price appreciation plus cash distributions).  

Since Dec. 31, 1999, the outperformance of the MLPs has been striking in comparison to the S&P 500, as shown in Figure 1.  Including distributions, MLPs (as measured by the Alerian MLP Index) have generated a total return of 839% since Dec. 31, 1999, compared with only 25% for the S&P 500 (as of Dec. 19, 2012).  

Yield.  Many income-oriented investors invest in MLPs, because their yields are significantly higher than those of other income-producing investments such as municipal bonds, CDs, government bonds, utilities and REITS.  

As shown in Figure 2, the yield for the MLP Index  was 6.5% as of Dec. 19, 2012, which is almost 2 percentage points higher than Baa bonds and almost 5 percentage points higher than the 10-year U.S. Treasury.  More importantly, these yields are projected to grow over time.

Tax-advantaged distributions.  In addition, distributions from MLPs are generally tax-advantaged.  Typically, between 80% and 90% of an MLP’s cash distributions are treated for tax purposes as “return of capital.”  

Return of capital reduces an investor’s cost basis in the investment, and as a result, the taxes on the portion treated as return of capital are deferred until the investor sells the investment or until the adjusted cost basis reaches zero.  We encourage investors to consult their tax advisors before making an investment in Midstream MLPs.

Attractive characteristics of midstream energy assets.  Midstream assets are strategically important, because they provide the backbone of our nation’s energy infrastructure.  

Midstream MLPs own assets that are engaged in energy logistics, including assets used in transporting, storing, processing, gathering, distributing or marketing of energy-related commodities (natural gas, natural gas liquids, crude oil or refined products).  These long-lived assets are essential to the transportation of energy products from the point of production to end users.

Midstream assets typically have very high barriers to entry: permitting costs and environmental review make certain assets irreplaceable. 

Most Midstream MLPs generate the majority of their revenue from fee-based contracts that have limited exposure to changes in commodity prices.  This enables them to generate predictable levels of cash flow and allows them to consistently pay out the vast majority of their cash flows to investors in the form of quarterly cash distributions.

Distribution Growth Drives MLP Performance

Earlier we saw a chart of the performance of the MLP Index relative to the S&P 500.  What has been the primary driver of this performance?  The answer is distribution growth.  

If we assume that yield investments normally trade within a certain yield range, then any increase in the income stream from that investment will translate into a higher price for such investment.  For example, if MLPs increase their distributions by 7% in any one year, then we would expect the price to go up by 7% for that year, assuming that MLP yields remain the same. 

Figure 3 shows that since 2000, MLP distributions have grown by 8.7% annually, which is well above the rate of inflation.  MLP distributions grew 7.3% in 2012, and Kayne Anderson expects growth of approximately 6% in 2013.

The next question naturally is: What will fuel distribution growth going forward?  The answer is unconventional reserves. 

The Changing Domestic- Energy Market

The biggest trend in the energy sector is the development of unconventional reserves, which are more commonly referred to as “shale plays”.  The term “unconventional reserves” refers to oil and natural gas reserves produced using advanced drilling and completion techniques.

 


This trend has accelerated in recent years, and the development of unconventional reserves is one of the biggest stories as it relates to the long-term impact on the domestic economy.

As shown in Figure 4, examples of unconventional reserves include the Barnett Shale, Haynesville Shale, Woodford Shale, Fayetteville Shale, Eagle Ford Shale, Marcellus Shale, Bakken Shale, as well as developing plays such as the Utica Shale, Niobrara Shale and Tuscaloosa Marine Shale. 

Unconventional reserves are becoming increasingly important to domestic energy supply, and development of these reserves is the primary reason domestic production of crude oil and natural gas have grown 25% and 16%, respectively, over the past four years.  

In fact, the United States is the fastest-growing energy producing country in the world, and several experts are predicting that in the next 10 years the United States could overtake Saudi Arabia as the largest producer of crude oil in the world. These are amazing statistics, when you consider that just 10 years ago the opinion among many experts was that domestic production of natural gas and crude oil was in terminal decline.

Significant amounts of capital are being spent by energy companies to develop these reserves. As a point of reference, approximately two-thirds of all domestic capital expenditures in 2013 by exploration and production (or E&P) companies will be spent on unconventional resources. 

After shunning domestic opportunities in favor of international projects for many years, major oil companies are now devoting significant capital and resources to domestic unconventional resources. We believe their technical expertise, capital discipline and financial resources will ensure these reserves are developed in a prudent fashion for many years to come.

This trend is very important for MLPs, as development of these new reserves will require substantial amounts of new midstream infrastructure.  A report by the Interstate Natural Gas Association of America estimates that $250 billion of new midstream infrastructure will be required over the next two decades. 

As a result, the visibility for growth projects is as good as it has ever been in the MLP sector. We believe this will provide attractive investment opportunities for MLPs and help drive future distribution growth.

The impact of unconventional reserves extends well beyond the domestic energy industry. Many experts are beginning to highlight the impact of unconventional reserves on domestic manufacturing and the broader domestic economy. 


Not only will these new infrastructure projects create jobs, but the abundance of low-cost energy supply is making domestic production of many derivative projects (such as plastics) more competitive. It has been a very long time since the United States was a low-cost energy producer, and this is having a very positive impact on the domestic manufacturing industry. 

Recent Market Developments

While MLPs hit an all-time high in October of this year, MLPs have traded off since the election.  Many believe that this pullback was due to general market uneasiness, while others speculated it was due to fears that Congress may change the tax status of MLPs.

We strongly believe that the tax treatment of MLPs will not change in the next Congress.  Since the Tax Reform Act of 1986, MLPs have played a significant role in developing our nation’s energy infrastructure.  

One could make the case that of all the types of infrastructure we have in this country – roads, bridges, sewer systems, and electrical transmission – energy infrastructure has been the best maintained and has expanded to meet our country’s needs. 

We believe that even if comprehensive tax reform discussions do occur in Washington, MLPs have bi-partisan support for several reasons:

1. Their contribution to job growth, estimated to create or maintain 300,000 jobs a year;

2. Their investment in infrastructure, estimated to be over $250 billion over the next 25 years;

3. The important role MLPs are playing in helping our nation achieve energy independence; and

4. Many MLP investors are retail, or individual, investors who are at or near retirement age and who own these partnerships because of their reliable income streams.

Importance of Stock Selection

From everything we’ve discussed, it may be easy to conclude that all MLPs have performed equally well.  In reality, there has been a significant variation in performance between the best performers and the worst performers, as shown in Figure 5 for the time period between Dec. 31, 2008 – at the depths of the financial crisis – and Dec. 19, 2012.  

The best performer delivered performance that was 14 times better than the worst performer.  Even between the MLPs in the 75th and 25th percentiles, the performance differential is more than 2.3 times.

In our view, stock selection remains more important than ever.  Ten years ago, most MLPs were very simple to understand – their assets were largely comprised of interstate pipeline systems.  

Today, the MLP sector is much larger with a more complex set of assets and businesses that, in addition to midstream assets, include upstream MLPs, gas storage, refining and marketing, petrochemicals, frac sands, wholesale fuel distribution, offshore drilling, compression services, and coal.  The challenge for investors is to separate the wheat from the chaff and to identify MLPs that have a high likelihood of success.

We believe that Midstream MLPs will generate low double-digit total returns for the next few years and that investors should allocate a portion of their portfolio to Midstream MLPs. 

Further, we believe that investors – given the importance of stock selection – can benefit from professional portfolio management. Kayne Anderson has a team of 20 investment professionals dedicated to the MLP sector, and we believe our investors benefit greatly from this team’s expertise. 

Kevin McCarthy is the chairman, president and chief executive officer of the four publicly traded closed-end funds (KYN, KYE, KMF and KED) and co-managing partner of Kayne Anderson Capital Advisors, L.P.

 
 
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