The number and variety of master limited partnerships (MLPs) keep growing. In addition to traditional MLP businesses and business models, new entrants are expanding investors’ choices.
We asked several leading MLP experts for their thoughts on the recent performance of MLPs and their insights on new developments affecting the asset class.
This year’s panel includes:
- David Chiaro, Managing Director, Eagle Global Advisors, Houston;
- Len Edelstein, Senior Portfolio Manager, Yorkville Capital Management, New York;
- Kenny Feng, CFA, President and CEO, Alerian, Dallas;
- Quinn T. Kiley, Managing Director and Senior Portfolio Manager, Fiduciary Asset Management (FAMCO), a division of Advisory Research Inc., St. Louis;
- Kevin McCarthy, Chairman, CEO and President, Kayne Anderson MLP Investment Co. and its other public funds; Managing Partner, Kayne Anderson Capital Advisors L.P., Houston;
- Matthew Sallee, CFA, Senior Investment Analyst, Tortoise Capital Advisors, Leawood, Kan.; and
- Jerry Swank, founder and managing partner, Swank Capital LLC, Dallas
Which sectors of the MLP universe do you focus on?
David Chiaro, Eagle Global Advisors: Our investments focus primarily on MLPs that own pipeline and related infrastructure assets and their general partners, although we also model and stay updated on developments of energy MLPs broadly, such as those involved in exploration and production (E&P), refining, fertilizers, etc.
Len Edelstein, Yorkville Capital Management: We are opportunistic investors who research and invest in the entire MLP asset class. Our objective is to find partnerships with compelling valuations and attractive growth prospects to meet the needs of investors looking for a high-income investment vehicle with capital appreciation potential.
That being said, we find ourselves primarily focusing on the midstream sector of MLPs, because there is a consistency and predictably of distributions, which is what many income-oriented investors are interested in. However, when we see what represents compelling value, either upstream or downstream, we will take a position.
Kenny Feng, Alerian: Alerian does not manage assets or focus on a particular sector in the MLP universe. Our goal is to level the playing field in MLP investing by providing information and product access to the general public.
The two indices that have been adopted as sector benchmarks include the Alerian MLP Index (AMZ), which is a composite of the 50 most prominent energy MLPs, and the Alerian MLP Infrastructure Index (AMZI), which narrows the field to a midstream-focused subset of 25 MLPs.
Quinn T. Kiley, FAMCO: FAMCO MLP focuses on all of the energy infrastructure-related sectors. We focus on MLPS involved with the midstream natural gas and crude oil value chain. We also invest in marine transportation, coal, and upstream MLPs.
Kevin McCarthy, Kayne Anderson: We invest in virtually all subsectors of energy-related MLPs, but the overwhelming majority of our holdings are focused on midstream MLPs. We believe the midstream sector offers the best risk-adjusted returns for investors.
As an example, Kayne Anderson MLP Investment Company (KYN), our largest fund, has approximately $5.7 billion in assets invested in equity securities of MLPs and midstream corporations (or “C-Corps”). About 80% of the portfolio is invested in midstream MLPs. The remainder of KYN’s holdings is invested in midstream C-Corps, marine transportation MLPs and upstream MLPs.
Matthew Sallee, Tortoise Capital Advisors: We invest across the North American energy value chain through NYSE-listed closed-end funds, open-end funds and separately managed accounts. Four of our funds are specifically MLP-focused (TYG, TYY, TYN and NTG); our other funds are broader in scope but also energy/infrastructure focused.
Jerry Swank, Swank Capital: We cover all midstream, upstream, and general partner (GP) MLPs, along with all C-Corp GPs, variable distribution MLPs, and the broader energy sector. Specific to the midstream MLP group, although our client accounts with this strategy are invested across many aspects of the midstream supply chain, we currently have a particular focus on the crude oil & refined products infrastructure and general partner MLPs.
How did those sectors perform in early 2013 and 2012? Did the sectors’ results in early 2013 and 2012 differ significantly from your pre-2012 expectations? If so, what factors caused the unexpected results?
Chiaro: Since early 2012, there has been material variance in performance amongst the MLP subsectors. Total return for 2012 was 4.8% for the broad universe MLPs, if you use the Alerian MLP Index as a benchmark. However, for the same period, total return for general partner MLPs was 12.3%, followed by 7.5% for refined product pipeline MLPs, 6.1% for diversified MLPs, 4.4% for natural gas pipeline MLPs, and 0.7% for natural gas gathering & processing MLPs.
Sectors that have more direct commodity price sensitivity, which we avoided and underweight, performed poorly: -1.6% for exploration and production MLPs, -6.9% for propane MLPs and -8.7% for coal MLPs.
Our focus on pipeline MLPs resulted in material outperformance for our portfolios in 2012 relative to the Alerian MLP Index benchmark. There has been a very similar pattern for 2013 (through April), although the absolute level of performance has been much greater.
Total return through April for the Alerian MLP Index is 20.8%, again led by general partner MLP total return of 29.0%, followed by 27.2% for refined-product pipeline MLPs, 25.2% for natural gas gathering & processing MLPs, 20.9% for natural gas pipeline MLPs, and 18.9% for diversified MLPs.
While propane MLPs have outperformed year-to-date (up 25.1%), other more commodity-sensitive MLP subsectors continue to underperform, with coal MLPs up 13.7% and exploration and production MLPs up only 8.3%. As a result, our focus on pipeline MLPs continues to produce outperformance for our clients’ portfolios relative to the Alerian MLP Index benchmark.
We expect total return for any 12-month period to be approximately equal to the distribution yield plus distribution growth of the portfolio, or about 11%-13%. So, taken in isolation, we were a little surprised by the underperformance in 2012 and again by the sharp snapback that occurred in January 2013. However, when examined in aggregate, the total return of the sector from January 2012 until now is not materially higher than we expected at the beginning of 2012.
It’s always easier to look back and identify macro drivers of underperformance and outperformance than it is forecast them. In this instance, underperformance in 2012, especially in November and December, was likely the result of uncertainty regarding future tax policy changes; a misunderstanding as to how potential changes in tax policy would impact income, distributions, and gains from MLP investments; and a spike in equity offerings, which greatly increased unit supply while demand was weakening.
Some tax-loss selling or gain realization (in anticipation of higher capital gain rates) likely also contributed to the weakness. Many of these policy concerns were addressed at the end of 2012, resulting in a normalization of valuation and unit price appreciation.
Edelstein: Through the end of April 2013, the Yorkville MLP Universe Index (YMLPU on Bloomberg) has returned 20.9%. We were very surprised when MLPs returned only 5.8% in 2012, far under our forecasted total return of 12% to 15%.
Compelling MLP distribution growth fundamentals (MLPs had average distribution growth of 7.1% in 2012) were overshadowed by political headline risk associated with the fiscal cliff. After 2012 passed without a change in the tax status of MLPs, they appreciated significantly through the end of April 2013 to better reflect their attractive total return outlook.
Feng: During 2012, the AMZ gained 4.8% on a total return basis, while the AMZI gained 4.2%. Our expectations for 2012 revolved around a baseline of 6% yield plus 3%-5% distribution growth, for a total return of 9%-11%. However, throughout 2012, macro issues such as the Eurozone crisis and fears of tax reform prevented the sector from reaching those expectations.
Weakness in the latter half of 2012 revolved primarily around uncertainty concerning the fiscal cliff. Despite partnerships performing very well operationally, headline risk overshadowed solid fundamentals.
With the resolution of the fiscal cliff, MLPs quickly bounced back with the AMZ gaining 12.6% and the AMZI rising 12.9% in January alone. Not only did the asset class benefit from the removal of tax reform uncertainty, but dividend tax increases approved by Congress made MLPs an even more attractive investment option.
Since the majority of MLP distributions are considered a tax-deferred return of capital, higher dividend tax rates negatively affected traditional yield-bearing equities far more than MLPs. As a result, the asset class has surged ahead in 2013 with gains of 22.6% and 23.8% as of May 17, for the AMZ and AMZI, respectively.
Kiley: MLPs generally had a weak performance year in 2012, driven in large part by uncertainty around the election and tax policy. However, those MLPs focused on crude oil logistics performed very well, as domestic crude oil production grew 15% during the year. This new production creates pricing opportunities for existing infrastructure operators and the demand for new projects.
The fog around tax policy lifted somewhat in 2013, and MLPs have surged ahead on strong overall oil and gas infrastructure fundamentals. We urged some caution to our clients at the start of 2012, merely stating that MLPs had significantly outperformed other equities and we thought equities looked cheap.
From that standpoint, the fact that the S&P outpaced MLPs in 2012 did not surprise us. Our strong belief in the strength of the North American oil and gas story led us to think MLPs would have attractive long-term returns and that the current infrastructure build-out might front-load some of those returns.
That being said, the volatility we have experienced over the last 15 months or so has exceeded our already elevated expectation. Increased production, especially of natural gas and natural gas liquids, put added negative pressure on these commodities in 2012.
Fiscal concerns here and abroad created heightened sensitivity on tax policy and MLPs’ tax status during the fourth quarter. Fast forward to 2013 and improving economic data and some certainty around tax rates produced a strong equity market in which MLPs produced the best quarterly returns in their history.
McCarthy: From January 1, 2012, to April 30, 2013, the total returns (price appreciation plus distributions) were as follows: midstream-mid/small cap, 66.9%; general partners, 35.2%; marine transportation, 30.2%; midstream-gas storage, 29.9%; midstream-gathering & processing, 25.9%; midstream-large cap, 24.6%; MLP affiliates, 18.2%; propane, 17.2%; exploration and production (E&P), 6.8%; and coal, 0.4%. For the same period, the Alerian MLP Index had a total return of 26.6%, and the S&P 500 had a total return of 30.8%.
Last year, we said that we believed that the single most important factor would be asset location and exposure to increasing volumes from unconventional reserves. That certainly held true for the period we’re discussing.
One of the factors that influenced performance even more than we expected was exposure to crude oil price differentials. MLPs like Plains All American Pipeline and Sunoco Logistics Partners benefited from the oversupply of crude oil in certain regions where the production growth had gotten ahead of the infrastructure.
In terms of distribution growth, 2012 was pretty much right on top of our projected growth rate of 6%-7% that we forecasted at the beginning of the year. During the first four months of this year, we’ve seen more yield compression than we expected, which has caused the sector to outperform our expectations recently.
Sallee: Calendar year 2013 kicked off with a broad-based rally, as equity markets responded favorably to an averted U.S. fiscal cliff and upbeat U.S. economic data. Against this backdrop, MLPs posted a 23.7% total return year to date through May 15, approximately 6.4% more than broader equities. This period was marked by relatively steady momentum, although MLPs did take a breather in April, underperforming the S&P 500 Index, with performance relatively flat.
Within MLPs, midstream MLPs outperformed, generating a total return of 25.2%, driven in part by robust infrastructure build-out. We are expecting approximately $25 billion in MLP pipeline and related projects in 2013. Capital markets have been supportive of growth in 2013; year to date through April, MLPs have raised several billion in equity and debt.
Meanwhile, upstream MLPs, which posted a solid 13.7% return year to date, are benefitting from a shift among upstream C-Corps. Those entities, increasingly focused on developing their shale resources, are divesting their mature producing assets, and upstream MLPs have been quick to acquire them.
This more recent outperformance of MLPs in part reflects their recovery from 2012, a year in which MLPs underperformed broader equities by more than 10%. After a relatively flat first half of 2012, MLP and pipeline companies rebounded for much of the second half, until general uncertainty clouded the market leading up to and following the election in November. However, midstream MLPs and pipeline companies continued to show solid growth and healthy cash flows, once again demonstrating the benefits of their fundamental strength across market cycles.
The markets are a little more unpredictable in an election year, and 2012 was no exception, particularly as the year wound to a close. Uncertainty about the balance of power in Washington, a looming fiscal cliff, a slew of monetary policy, tax and regulatory issues and political gridlock all contributed to year-end volatility and, ultimately, a broad market sell-off, with the energy sector along for the downhill ride. We think everyone was a bit surprised at the speed and pitch of the drop—and the factors driving it, which certainly had nothing to do with the fundamentals of the energy sector; they remained solid throughout the sell-off and subsequent rebound.
Despite the election and political uncertainty, we had expectations of high growth heading into 2012, as we anticipated growing production volumes and new areas of supply would drive demand for incremental energy infrastructure. That proved to be the case in 2012, with more than $20 billion invested in MLP organic growth projects and even more when including acquisitions, and it’s a theme that continues to play out.
Also often unpredictable is Mother Nature, who demonstrated those qualities in early 2013. We experienced a prolonged winter in 2013, as the thermometer set record-low temperatures well into May. This caused a drawdown of natural gas inventories, which had reached a record high in November 2012, to below historical averages. Prices responded accordingly, moving from the mid-$3s at the beginning of the year to an 18-month high of $4.38 per million British thermal units in mid-April.
As we move into the summer weather, the level of coal-to-gas-switching in power generation will in turn affect inventory and pricing, as we believe production will be relatively stable.
Swank: For the year ended 2012, the crude oil & refined products infrastructure and general partner MLP sectors generated positive returns of 15.6% and 11.0% on a price return basis, respectively. Through the first four months of this year, the same sectors generated positive returns of 24.1% and 28.0% on a total return basis, respectively.
For comparative purposes, the MLP space as a whole was up 3.2% in 2012 and 23.0% through April 2013 on a total-return basis, as measured by the returns of the Cushing 30 MLP Index (MLPX). We were not too surprised that these MLP sectors outperformed the MLP space as a whole last year. If anything, we were a little disappointed with how the year ended for the entire MLP space post-election, but much of the expected performance was just shifted into the beginning of 2013.
For 2013, some MLPs have already achieved much of the results we had envisioned for the entire year, and we are growing a tad cautious on valuations for select companies. However, we remain mindful of the powerful momentum in the space being fueled by strong fundamentals, positive fund flows and a continued global low interest rate environment and thirst for yield.
These factors will each play into our portfolio construction for the remainder of the year as we balance opportunities for yield, growth, cash flow variability and liquidity of various MLPs. Currently, our portfolios continue to reflect an over-weighting in crude oil & refined products and general partners, as well as select natural gas gatherers & processors—particularly those with fee-based contracts and “drop-down” growth visibility.
Speaking more to recent near-term performance, we attribute this positive dynamic to: (1) investors putting money back into the market after the late ‘12 sell-off, driven in part by the presidential election, tax law change concerns, fiscal cliff fears, and considerable MLP equity issuances; (2) the continued search for yield in a low interest rate environment; and (3) solid MLP fundamentals. We have been making the investment case since 2004 that MLPs are similar to REITs, but with better cash flow stability and higher growth prospects.
We continue to believe that MLPs should be valued similarly to REITs and, like REITs, MLPs should capture incremental retail and institutional investment. This appears to be finally occurring as new MLP products have attracted not only retail, but also institutional investors such as RIAs and, increasingly, pension and endowment funds.
Which MLP sectors do you believe have the most favorable outlooks for the intermediate- and long-term? Why?
Chiaro: It is probably more accurate from our perspective to highlight factors of MLPs that result in a favorable outlook rather than subsectors. We believe MLPs that are able to successfully leverage their existing asset base to take advantage of (1) increased crude oil, natural gas, or natural gas liquids production from the shale plays, (2) an increased need to process and fractionate natural gas liquids, or (3) an increased need to export products, have the most favorable outlook. The success of these projects will likely result in accelerated distribution growth and, therefore, stock price outperformance.
Edelstein: We believe general partners have an extremely favorable outlook. The leverage general partners have relative to the growth of their underlying MLPs due to incentive distribution rights provides significant additional upside, both in the intermediate and long term. In addition, we expect substantial activity on the mergers and acquisitions (M&A) and consolidation fronts.
Feng: With crude oil inventories at Cushing, Okla., stubbornly floating near record high levels, and drillers happily exploring very profitable oil-rich shale plays, a significant opportunity persists for crude-focused midstream MLPs. The U.S. rig count reflects this oil-centric drilling focus, with over three-quarters of total drilling activity being directed at oil-rich plays rather than natural gas.
Today’s chief bottleneck is bringing that oil to markets where producers may receive favorable pricing. Crude is priced based on quality and location, and transportation methods often seek to take advantage of pricing differentials. The oversupply at the Cushing hub has driven West Texas Intermediate (WTI) to significant discounts compared to Light Louisiana Sweet (LLS) or Brent.
While rail is increasingly being used to give flexibility to producers, pipelines are still the safest and most economic option to bring these hydrocarbons to market. Until adequate takeaway capacity allows for the pricing differential to converge, we expect MLPs to continue to go with the flow and provide connectivity to reduce these pricing inefficiencies.
Furthermore, restrictions on offshore drilling have expired, revitalizing Gulf Coast drilling. These producers look to MLPs to bring their crude to favorable markets. Given that these producers currently have limited competition from inland drillers, additional opportunities may exist for midstream MLPs to cater to new development in the Gulf of Mexico.
In the long-term, the International Energy Agency (IEA) expects the shale boom in the United States to transform world energy markets. The country is expected to move from the world’s largest importer of crude oil to a net exporter over the next two decades. While the United States may have the potential and natural resources to become a global leader in energy production, infrastructure bottlenecks could pressure prices and hinder development.
Midstream MLPs have been at the forefront of the re-piping of North America by constructing new infrastructure, as well as repurposing existing infrastructure, to meet future needs. Traditional midstream infrastructure MLPs are best positioned to take advantage of these long-term trends in the market.
Separately, natural gas processing and transportation MLPs will continue to play a larger and larger role in the market, as natural gas replaces coal as the preferred fuel for power generation. Unfortunately, in the near term, depressed natural gas prices and basis differentials have reduced the appeal of investment in natural gas production.
The idea of liquefying and exporting natural gas has gained popularity, given the low cost of production and abundance of supply in the United States compared to other parts of the world. However, much of that is dependent on government policy as well as industry capability.
Kiley: We hold the view that continuing production growth will benefit oil and gas infrastructure, but this growth will also put downward pressure on these commodity prices in domestic markets. Thematically, we want exposure to this volume growth but through fixed-fee contracts that have limited commodity price exposure.
In this market, understanding the underlying assets and the type of contract exposure is as important as sector allocations. Generally, pipelines, fee-based gathering & processing, fee-based fractionation and the like should perform well.
McCarthy: We are bullish on the outlook for midstream MLPs and midstream C-Corps. We believe that the midstream sector is a direct beneficiary of the “shale revolution” that is unfolding in North America. The development of unconventional reserves (or “shale plays”) is creating demand for midstream assets that transport natural gas and crude oil to end markets.
The build-out of new pipelines, processing plants and storage facilities over the next 10 to 20 years presents a tremendous growth opportunity for midstream MLPs and midstream C-corps. In fact, we believe the outlook for growth is as good as it has ever been for the midstream sector.
Shale plays are the biggest story in the energy sector. Development of these reserves has fundamentally changed the domestic energy market and is having an increasing impact on the global energy market. The shale revolution continues to accelerate and is expected to have a major impact on the domestic economy.
Here are a few data points to help illustrate the magnitude of these shale plays: One, domestic crude oil production increased by 0.9 million barrels per day in 2012 (a 15% increase over 2011), which is the largest annual production increase in our country’s history! For 2013, domestic production is expected to increase by another 0.9 million barrels per day.
Two, the U.S. is the fastest-growing energy producer in the world. The shale revolution has helped the U.S. to become the largest producer of natural gas in the world and the third-largest producer of crude oil in the world. Believe it or not, many experts are projecting that the U.S. will become the largest producer of crude oil in the next five years. This is an amazing turnaround, because just 10 years ago, most experts believed that domestic production was in terminal decline.
Sallee: The dramatic change taking place in North American energy production and the accompanying build-out to alleviate infrastructure constraints will, in our view, continue to be significant drivers across the value chain. In fact, we anticipate more than $100 billion in MLP pipeline and related growth projects through 2015, the largest backlog we have seen thus far; adding in potential drop-downs and acquisitions, the magnitude is larger.
More specifically, we believe refined-products & crude oil pipeline MLPs stand to benefit not only from these organic growth projects, but also from volumes driven by the increased production in North American shale basins as well as an inflation escalator. Over the longer term, we see a positive overall outlook for gas pipelines, underscored by developing demand for newfound supply.
Swank: We believe the MLP sectors that have the most favorable outlooks for the intermediate- and long-term are crude oil & refined products and those MLPs associated with natural gas liquids (NGLs) infrastructure. In the near to intermediate term, we believe select crude oil & refined products MLPs should continue to perform well, given the identified project backlog and our expectation for above-average distribution growth.
Longer term, we think select natural gas gatherers & processors offer attractive risk-reward opportunities given their higher yields and accelerating distribution growth tied to fee-based opportunities in developing basins.
Interest continues to grow in U.S.-based natural gas as an energy source for a variety of purposes. Do you see this trend continuing and if so, how can investors profit from it?
Chiaro: We do see this trend continuing, as long as there is not a material change in the regulatory environment. Since interest in natural gas as an energy source is driven by the low price of natural gas relative to competing fuel sources, we believe investors can profit by either correctly identifying industries or companies that can replace higher-cost fuels with lower- priced natural gas or by investing in natural gas infrastructure companies that benefit from the increased demand of natural gas pipelines, storage and related infrastructure.
Due to current and forecasted commodity prices, we expect E&P companies to focus their activity in areas of wet gas—natural gas that contains a lot of natural gas liquids, such as ethane, propane, and butane—as the value of the NGLs greatly enhances the value of overall production.
While numerous MLP have the ability to benefit from the need for incremental gathering, processing, transporting, storage or exporting of natural gas or NGLs, we have identified a select few MLPs that can do so in the most economic manner, generating incremental cash flow well in excess of their cash cost of capital, which should result in distribution increases and stock price appreciation.
Edelstein: We have never been more bullish on U.S. energy. Natural gas as an energy source is a game-changing development. According to the U.S. Energy Information Administration (EIA), shale gas production has increased from less than 10% of total dry gas production in 2007 to 40% of production today. Moreover, the U.S. recently passed Russia as the largest producer of natural gas.
The International Energy Agency (IEA) says the global energy map “is being redrawn by the resurgence in oil and gas production in the United States.” Shale gas states, such as North Dakota, are becoming global leaders in energy.
The energy boom will continue for the foreseeable future as access to a cheap domestic energy sources fuels manufacturing and other areas of the U.S. economy. Against this backdrop, we believe the U.S. will need an additional $300 billion in infrastructure investment to meet demand and realize the goal of energy independence. As a result, infrastructure-based MLPs in the midstream and gathering & processing sectors and near the major basins (e.g., Marcellus and Bakken) should see the most opportunity.
Feng: In the coming years, natural gas demand will grow as it displaces coal in power generation. The process will be slow and steady until there is more certainty within the natural gas markets in terms of supply, infrastructure, regulation, and exports—all of which have an impact on costs. Despite the price of natural gas at low levels and because of these uncertainties, traditional utilities have taken a more measured and diversified approach with their energy resources to include a combination of coal, natural gas, nuclear, and renewable fuels.
Investors can profit from this trend by investing in the MLPs that provide services along the natural gas value chain, particularly natural gas gathering, interstate transportation and storage. The use of natural gas as a transportation fuel will ultimately depend on how supportive the regulatory and political environment will be. There has been an increased amount of commercial trucks and public transportation mediums, such as taxis and buses, that have converted their fleets to be powered on natural gas.
This sort of trend can be implemented easier at a local level, because the activity is regularly scheduled for certain distances, and fuel stations can be built and placed accordingly. The biggest hurdle for national viability will be ensuring that there is adequate infrastructure both on the front end (pipelines and storage) and back end (natural gas pumping stations).
Kiley: Natural gas is readily available, and we believe production can be boosted in short order if demand can be identified. Interest in natural gas as a transportation fuel or for export as LNG are longer-term sources of new demand, and we think they will materialize in some form over time. Both require policy inputs, and it is not clear how or when the political process will attend to these issues. For that reason, we are more focused on increased demand from traditional users of natural gas, which will come from continued economic recovery and growth.
McCarthy: One of the benefits of the shale revolution is that most people now believe that natural gas will remain a low cost source of energy for years to come. Without the wild price swings that we’ve seen in the past, energy-intensive industries are willing to invest the capital to build power plants, petrochemical complexes and other manufacturing facilities. Because of the price disparity between natural gas and crude oil on an energy equivalent basis, we are also seeing increased interest in natural gas as a fuel source for transportation fleets.
Additionally, there is significant interest in exporting liquefied natural gas to international markets, where natural gas prices are several times higher than those in the U.S. While these trends will not happen overnight, we think investors will benefit by taking a long-term view and investing in MLPs that have the right assets, skill sets and track records to help them to satisfy this demand growth.
Sallee: Last year the U.S. produced 24 trillion cubic feet of natural gas, making it the world’s leading producer of this valuable resource. Approximately 95% of the natural gas we use is domestically produced, making us essentially self-sufficient. But there’s so much more to the story.
The range of uses of natural gas and natural gas liquids is both broad and deep. Dry gas (almost entirely methane) is an abundant, clean, reliable and affordable source of power generation and is increasingly finding broader applications.
But with our increased oil and natural gas production, we’re also getting lots of gas liquids (NGLs), which are used as feedstock (raw materials) for the manufacture of a wide range of products, especially plastics. In fact, this robust supply of NGLs has enabled North America to emerge as a global cost leader in the production of plastics and a leading exporter of liquefied petroleum gas (LPG), otherwise known as propane and butane.
The robust U.S. natural gas production has positive implications for natural gas infrastructure MLPs. There are approximately 1.5 million miles of long-distance and local-distribution natural gas pipelines in the U.S., serving almost all areas within the lower 48 states. This is the largest natural gas pipeline network in the world, yet it is not sufficient to meet the growing shale gas production.
We project several billion dollars will be invested in natural gas and NGL-infrastructure MLP growth projects in the near to medium term. We aim to capture this trend via our Tortoise MLP Fund (NTG), which is focused on midstream natural gas infrastructure MLPs. We believe this theme also bodes well for upstream production companies and was very much part of the strategy behind the development of our newest closed-end fund, the Tortoise Energy Independence Fund (NDP), which focuses primarily on North American oil and natural gas.
Swank: We believe the trend toward U.S.-based natural gas as an energy source is a dominant theme that will continue to play out over the near term. However, we believe this theme is not just limited to U.S. natural gas as an energy source (i.e. natural gas fired power), but also [includes] natural gas as a feedstock for U.S.-based petrochemical & industrial companies (e.g. manufacturers of plastics, etc.).
On the power front, the coal industry continues to be under assault by various governmental, regulatory, and environmental agencies. Natural gas (especially at the current and foreseeable levels of $4.00-$5.00/million British thermal units, or Btu) offers a lower cost and cleaner alternative to traditional coal-fired power plants.
Not only is this a competitive pricing structure as a coal alternative here domestically, these prices are a tremendous cost saving opportunity for manufacturing companies with U.S. domiciled facilities. We see one of the best opportunities for participating in this continued build-out of the natural gas infrastructure to be with those MLPs involved with natural gas liquids (or NGLs) infrastructure, as opposed to the more traditional dry natural gas.
Estimates of U.S. natural gas reserves have increased along with a renewed interest in LNG exports. What are your thoughts on the outlook for LNG exports in the intermediate- and long-term? How might growth in LNG exports affect the MLP sectors you follow?
Chiaro: Several projects have received federal approval and are currently under construction to export liquefied natural gas (LNG), the first of which should commence operation in 2015. Simply put, many natural gas producers are in favor of exporting LNG, because it provides another source of demand, which could provide price support. On the other hand, many large natural gas consumers are not in favor of exporting natural gas, as they would prefer lower prices for domestic demand.
Our view is that several additional LNG projects (beyond the ones currently under construction) are likely to be approved, although the issue has become very political (much like the Keystone XL Pipeline), and therefore incremental announcements regarding the approval or delay of projects are likely to result in price volatility for affected and related securities. Nonetheless, our view is that as long as prices remain in a range that is high enough to not negatively impact production but also low enough to not throttle demand, we are relatively indifferent on the outlook for LNG exports as the same amount of pipeline and related infrastructure is needed whether natural gas is consumed domestically via a utility or industrial complex or internationally with the consumption point being the LNG export facility.
The LNG facilities themselves could provide an attractive fee-based investment opportunity for MLPs, on the margin, but our expectation is that investment opportunities in the related infrastructure will be far greater.
Edelstein: LNG will be exported, starting in 2015 through Cheniere’s LNG facilities (already approved and under construction). We believe that many more LNG export trains will be approved and coming online over the next five to seven years. We are excited by this export potential and its role as a catalyst for continued extensive development of our natural gas extraction.
We are also looking for increased domestic consumption of natural gas. The low-hanging fruit here is the switching of fleets from diesel fuel to liquid natural gas or compressed natural gas (CNG). We have read estimates that up to a-third of Class-8 trucks could make the switch by 2016, saving 500,000 barrels of diesel fuel per day.
We also expect a continued resurgence in the U.S. petrochemical industry. More than $110 billion of new petrochemical plants and manufacturing facilities are currently planned or under construction in the United States. These projects will create high-paying construction and manufacturing jobs. Naturally, the gathering & processing MLPs will benefit the most from the growing production of natural gas.
Feng: The outlook for LNG exports ultimately lies in the hands of the Department of Energy (DOE). Currently, U.S. exports of LNG are only allowed to be sent to Free Trade Agreement (FTA) countries. However, the majority of countries that desire LNG exports from the United States are non-FTA countries.
In December 2012, the NERA Economic Consulting group, which was commissioned by the DOE, concluded in an independent study that despite higher natural gas prices, overall the U.S. economy would be stronger if LNG exports were permitted. This is due to higher GDP from increased production, export revenues/tariffs and more job creation domestically.
Growth in LNG exports would be an overall positive for the MLP sector, because the increased production would drive the need for pipelines to be expanded to support export facilities, more storage to satisfy peak demand and more processing plants to separate the natural gas stream.
Kiley: If large-scale LNG exports do come to fruition, that demand may cause differentials—variances in gas prices between two geographically distinct pricing points—to increase, which could positively impact the long-haul natural gas pipeline sector. That being said, with significant natural gas reserves in relatively close proximity to potential export locales, the impact may be somewhat muted over the long term.
McCarthy: We agree with other industry observers that 6 billion to 8 billion cubic feet (Bcf) per day of LNG export capacity will be built in the U.S., primarily along the Gulf Coast. Currently, the Cheniere project (roughly 2 Bcf per day) is the only one permitted to export to non-FTA (Free Trade Agreement) countries, and construction is already underway. The Department of Energy (DOE) recently announced that Freeport LNG has received conditional approval to export up to 1.4 Bcf per day to non-FTA countries. Other projects are waiting on approval by the DOE for export to non-FTA countries or are planning to export only to countries where the U.S. has a free trade agreement.
If LNG exports reach expected levels, producers are likely to increase domestic production of natural gas, which is good for MLPs with gathering assets. LNG export facilities—once they are built and have long-term contracts—are suitable assets for MLPs. Because each project will cost billions of dollars, we believe that only the largest MLPs will be able to own these types of assets.
Sallee: We are seeing an increase in both production and LNG exports and in the potential for supportive regulation. On a positive note, the Department of Energy recently completed a third-party study that concluded the U.S. would gain net economic benefits from allowing LNG exports. LNG operators must obtain authorization from the DOE to export LNG to non-free trade countries (as deemed by the World Trade Organization), such as Japan and China. LNG operators also must receive authorization to build liquefaction terminals from the Federal Energy Regulatory Commission, which prepares environmental assessments or impact statements for all proposed LNG facilities.
There currently are 23 U.S. LNG export projects pending or proposed to support export capacity of approximately 32 Bcf per day, and we expect a portion of this to be approved. While this activity is obviously good for upstream producers, we also see opportunity for additional MLP pipeline and related infrastructure build-out to support transportation from areas of supply to these export terminals and even own the terminals themselves.
Swank: With the recent approval of Freeport LNG’s application by the U.S. Department of Energy, there are now two facilities (Cheniere Energy being the other) that have been approved to export LNG to countries without free-trade agreements with the U.S. We anticipate over the next year or two that there will be an additional four to six projects that receive similar approval, although there is some uncertainty around the timing and political landscape.
With respect to the near-term, we believe it will be another 18 to 24 months before we see the first of these facilities come online, but in the interim these initiatives are supporting the need for additional infrastructure. Taking a longer-term perspective of our country’s LNG export business, we acknowledge that it will likely support natural gas prices to an extent, but producers have become very efficient with their ability to raise production in a relatively short period of time.
The fact that natural gas production has turned into a precision manufacturing process leads us to believe that the country’s abundant and growing supply will outpace the ability to bring exporting capabilities on-line, thus keeping the domestic price advantage relative to most other countries fairly sustainable. MLPs that will benefit from the LNG opportunity will be those with projects to build LNG export facilities and those with natural gas pipeline systems that feed those facilities.
What new developments could push petroleum-focused MLPs in new directions and/or produce new results for these petroleum-focused MLPs?
Chiaro: The need for crude oil pipelines and terminals has increased significantly over the last few years as crude oil production in the Eagle Ford shale, Permian Basin, and Bakken shale (to name a few) has increased dramatically. Pipeline construction has lagged production growth resulting in large basis differentials (i.e., the price of crude is materially different from region to region), since there is not sufficient pipeline capacity to transport the crude from producing regions to refinery centers.
MLPs are addressing the pipeline shortfall two ways: (1) They are constructing pipelines to transport the crude to the refinery centers, and (2) They are converting or reversing existing pipelines that are currently underutilized to transport crude.
While returns on new construction have generally been in line with historical averages, providing the MLP with an accretive project, returns on converted or reversed pipelines have typically been much higher. This is due to the fact that the cost associated with such a conversion is materially lower than new construction costs, the regulatory burden is generally easier, and the time to get a project into service is generally quicker.
We tend to invest in MLPs that have this type of opportunities, as current valuation usually undervalues growth associated with pipeline conversions. Often, an owner of crude oil pipelines also owns refined-product pipelines and terminals, and a growing opportunity for this segment is gasoline blending. Most gasolines are required to contain a specific, or minimum, percentage of ethanol, and at certain times of the year can be blended with butane.
Gasoline blending is usually completed at the refined-product terminal, an asset type most often owned by MLPs. Since the price of butane is now below the gasoline price and is expected to stay that way for an extended period due to the increased production levels of natural gas liquids, while ethanol blending is driven by governmental mandates, blending operations have become a source of material incremental cash flow with minimal incremental investment.
Edelstein: The development of tight oil is as significant as shale natural gas. This part of the U.S. energy growth story is being largely overlooked. The U.S. has grown its domestic daily oil production by 2 million barrels per day over the past two years. This growth alone is close to two-thirds of the total daily output of Iran, Iraq or Kuwait, which each produce 3 million barrels per day. North Dakota has gone from a non-producing energy state to the second-largest energy-producing state in less than five years.
We expect to see more tight oil development in non-traditional energy producing states. The approval of the much delayed and anticipated Keystone XL Pipeline will provide a substantial boost to exports of petroleum and its derivatives, creating a greater world dependency on U.S. energy, fueling additional demand and opportunity.
Feng: On the crude oil front, increased production from areas such as the Bakken, Permian and Canada are pushing MLPs to grow their asset base in the immediate future, particularly through rail and repurposing pipelines. Over 50% of crude travels out of North Dakota via rail, and MLPs are participating in this movement by expanding rail facilities and terminals along rail routes.
The rail trend is expected to continue, as the shorter nature of contracts and multiple rail points gives producers more flexibility to access various end markets. In order to provide more takeaway capacity of Canadian and Bakken crude to various markets, MLPs have begun converting existing natural gas pipelines to transport crude oil or reversing the directional flow of current crude pipelines to reach more efficient markets.
For refined petroleum products, growth in overall volumes has been fairly muted, particularly as higher fuel efficiency requirements for cars place an invisible cap on total domestic demand. That said, there is still cash-flow growth on the refined-product side for MLPs due to inflation-indexed tariffs and international terminal projects, particularly around the Caribbean islands serving major export and cruise ports.
The amount of domestic refined-product opportunities tends to be less than crude oil opportunities. As such, many MLPs that used to be more of a refined product pure-play, such as Magellan Midstream, NuStar Energy, and Sunoco Logistics have actively grown their crude oil logistics businesses these past few years. We expect this trend to continue, as well.
Kiley: We think we are already seeing dynamic shifts in the oil infrastructure sector. Public attention is focused on the Keystone XL Pipeline, but there are several billions of dollars in capital expansions already on going all across North America. Crude oil MLPs valuations reflect this activity, as the market has paid up for those entities exposed to the most attractive projects.
McCarthy: Crude oil infrastructure has been one of the most active areas for MLPs and other midstream companies over the past year. The rapid increase in domestic production has created numerous bottlenecks and dislocations between producing areas and the refiners that consume the crude oil. The most notable bottleneck is at Cushing, Okla., the pricing point for the domestic benchmark West Texas Intermediate (WTI) crude.
Increasing supplies in the mid-continent (most notably from the Bakken Shale in North Dakota) and constraints in transporting the crude to Gulf Coast refiners have resulted in a steep discount in the price of WTI relative to Brent, which is the international benchmark. This “differential” in prices has fluctuated over the last two years, but has been much higher than historical norms.
We expect that differentials will remain abnormally wide in the near-term and will narrow over time as new pipelines relieve the logistical constraints at Cushing. As a result of wide price differentials in the U.S., MLPs have begun focusing on regional crude oil infrastructure.
Some are using railroads to move crude oil out of the Bakken Shale and the Permian Basin in West Texas. Others are building new pipelines or “repurposing” existing natural gas or refined-product pipelines to transport crude oil to market centers. Midstream MLPs with the capability to move the regionally oversupplied crude to higher-value markets have been very profitable over the last couple of years, and we expect that trend to continue for the next few years.
Sallee: There are several scenarios we are watching. We continue to see a bright horizon for petroleum-infrastructure MLPs. As an example, driven by additional build-out, the bottleneck at Cushing, Okla., which has pushed U.S. crude inventories to near-record highs, will see some relief.
The Seaway Pipeline at Cushing, which went online in 2012, is ramping up capacity and is expected to move 850,000 barrels per day from Cushing to the Gulf Coast by mid-2014. Additionally, the southern leg of the Keystone will provide relief starting later this year, delivering a greater supply of cheap domestic crude to Gulf Coast refiners.
Over the long term, this should help narrow the spread between the price of West Texas Intermediate and Brent crude oil to the cost of pipeline transportation. Interestingly, there is also talk of swapping U.S. light sweet crude with Mexico, because its refineries can accommodate it, in exchange for Mexican heavy crude, which is what many U.S. facilities are built to refine. This would require government approval, and we are by no means banking on this. But if it gets the green light, we anticipate the resulting environment would be opportunistic.
Swank: First and foremost is the continued increase in our domestic production of crude oil from new or underdeveloped basins from an infrastructure standpoint. This changing dynamic is creating a myriad of opportunities for those MLP companies that have significant and/or focused operations in the transportation and logistics of crude oil and refined products.
To highlight a couple of the interesting dynamics driving activities and opportunities in this space, I would point to: (1) the bottlenecks that exist from Cushing, Okla., down to the Gulf Coast’s refining complex, and (2) the lack of infrastructure that exists to allow East and West Coast refiners to participate in the country’s burgeoning lower cost domestic crude oil production.
We’re seeing some growth in the number of “non-traditional” MLPs from companies that provide refining, fertilizers, chemical processing and frac sand, for example. What is your investment outlook on these MLPs? And how should investors evaluate the prospects for these MLPs? Do you expect there to be more non-traditional MLPs in the years ahead, and why?
Chiaro: We typically do not invest on these types of non-traditional MLPs. Our view is that investors often under-appreciate the cash flow volatility and subsequent risk that the MLP is able to sustain a fixed distribution level. This risk can result in stock price volatility that is well above the traditional pipeline MLP. However, since these types of MLPs often trade at a higher yield, they have become attractive to investors more focused on current income.
Edelstein: For the appropriate investors—and even for the more risk-averse investors as modest additions to their core portfolios—we are quite positive. That being said, business models need to be evaluated on a case-by-case basis and positions need to be monitored closely due to market factors and the cyclicality of their businesses.
Feng: Non-traditional MLPs are a relatively new use of the MLP structure. In order to be an MLP, a company must generate at least 90% of its income from qualifying sources as defined by the IRS. Originally, those sources were only the transportation, processing, and storage of natural resources and minerals.
If a company thinks a form of income may qualify, it can apply to the IRS for a Private Letter Ruling (PLR) to clarify the law according to the specific situation. In the past 10 years, 58 PLRs have been issued, but 18 of those came in 2012. These clarifications and expansions are shaping the scope of the MLP space and driving the growth of the non-traditional MLP.
Recently, we’ve seen a great deal of growth related to those activities related to hydraulic fracturing and the shale plays. The IRS has been interpreting the law to include assisting in the fracking process as qualifying income. The IRS is very clear that the services necessary to support fracking, as well as broader exploration and production, are considered qualifying income.
Kiley: We have not been buyers of these non-traditional MLPs in a meaningful way. Many have variable payouts that make the yields unpredictable, which is unsuitable for many of our clients. For that reason, we don’t see these entities becoming a big part of our portfolios, although we do expect more of these assets to come public in the future.
McCarthy: In our opinion, the MLP structure is best suited for businesses that generate stable cash flows and provide a critical service for its customers. Volatile businesses are generally not as well suited for the MLP structure, because most MLP investors can’t assess what will happen to the earnings power of these MLPs as they return to more “normal” operating conditions.
Despite these caveats, we have invested in some of these non-traditional MLPs. We’ve been opportunistic and have relied on our broader understanding of the energy markets to buy equities that we believed were being mispriced by the market. We think it’s extremely important for investors to value these companies based on mid-cycle economics, which is not an easy task.
Sallee: Over the past five years, more than 40 MLPs have launched—some quite successfully, some not so much. Today, there are more than 115 MLPs, with 20 in non-energy related businesses. Within energy, the assets can vary widely, and investors who are interested in non-traditional MLPs have many from which to choose.
Additionally, more non-traditional energy related companies are now going public. In 2012 and 2013 year to date, seven non-traditional energy MLPs have raised more than $2 billion in initial public offerings. In that same time frame, nine non-pipeline energy MLPs have also raised more than $2.4 billion in initial public offerings.
Swank: I think it is fair to say that we have a cautious but constructive view of the non-traditional MLP structure as a whole. To further clarify, we do not have a philosophical opposition to the inclusion of these tangent business lines into the MLP qualifying definition. In fact, we believe that it speaks to the validity of the MLP structure as a way to encourage private capital into expanding the build-out of our nation’s energy “renaissance.”
That being said, and like with any expanding frontier or business adaptation, we believe investors should proceed with caution. Similar to an evaluation of traditional, time-tested MLPs, investors should (or require their managers to) focus on bottom-up fundamental research and thoroughly understand the dynamics of both the industry and company-specific economics, along with their associated risks.
Are there any trends in MLP investing or in a particular MLP sector that you would like to highlight?
Chiaro: One of the biggest changes we have seen in MLP investing over the past several years has been the emergence of MLP closed-end funds. These closed-end funds have raised billions of dollars, largely from smaller retail investors unwilling to deal with the K-1s or from institutional investors concerned about UBTI. These funds have been very beneficial to the MLPs, allowing them to raise a tremendous amount of capital at very attractive prices to fund the construction of assets supporting the production increases in the US.
We do not believe that MLPs would have been able to raise nearly as much capital over the last two to three years to fund these projects if it were not for the emergence of the closed-end funds. However, many of these funds have been less beneficial to the investors themselves. Due to a variety of issues related to tax and the restrictions placed on the management of mutual funds, most closed-end funds add an additional layer of tax at the fund level, a tax that an investor would not incur had it owned the MLP securities directly. We will be monitoring the continued growth of these funds to help determine the availability of capital for MLPs for their continued investment.
Edelstein: In last year’s Research MLP Roundtable, we mentioned that we own several general partners (GPs). In our opinion, these partnerships still represent excellent value because of the higher growth rates that they offer and because of their Incentive Distribution Rights (or IDRs). While investors in MLPs are interested in yield, those wishing to forgo some current income in exchange for additional capital appreciation will find that GPs are an excellent addition to a portfolio.
MLPs are an asset class in growth mode. In our quarterly MLP update, we discussed the significant growth opportunities and growth in distributions in the asset class. In the first quarter of 2013, distributions for constituents of the Yorkville MLP Universe Index grew by an average of 7.8% quarter-over-quarter annualized, which is above historical averages. Using the MLP total return formula (current income plus income growth and price appreciation equals total return) implies a forecast total return of 13.7% for the asset class.
When considering MLPs may be entering a trend in yield compression as institutional flows pick up to capture distribution growth rates, price appreciation may even outpace distribution growth. Total returns above the mid-teen levels in a 12-month timeframe could be easily surpassed.
Feng: There have been so many access products for MLPs launched in the past several years. With 61 access products investing in 102 MLPs (as of May 15, 2013), we may soon see more access products than operating companies. Obviously, we’re joking, but the numbers do indicate that the MLP investor market is much more heterogeneous than has been previously believed. There are closed-end funds, mutual funds, ETFs, and exchange-traded notes (ETNs). In a list of the top 10 products ranked by assets under management, each one of these products is represented.
There is no one best or most appropriate way to invest in the MLP space. For instance, for a U.S. taxable investor, comfortable building his or her own portfolios and taking on the single-security risk and filing K-1s, a direct investment in MLPs will always be the most efficient way to access the MLP market. Those circumstances do not fit everyone, however.
When investing in the MLP space, investors should begin by considering: Will the investment be in a tax-advantaged account; whether they’re interested in active or passive management; if they are comfortable with a fund using leverage and, if so, how much; if they are comfortable with single-source credit risk and from which sources; and what their capital market expectations are—specifically, do they think the return from MLPs will come primarily from price appreciation or are they looking for after tax yield?
The learning curve for MLP investing has always been rather steeper than that of other sectors. Even with the amount of available access products, it behooves investors to continue to do their homework.
Kiley: There has been a significant increase in the flow of funds into MLP exchange-traded products over the last two years, especially into index-based vehicles. As a result, an MLP being added to an index that these products follow has been a significant boost for that MLP’s valuation. It wouldn’t surprise me to see some of the smaller MLPs that have seen huge price appreciation in recent quarters suffer a meaningful correction when flows slow down or reverse.
McCarthy: The MLP success story is well documented and well understood by market participants. What a difference 13 years makes! Today there are approximately 100 MLPs with an aggregate market capitalization of close to $400 billion. In 2000, there were only 20 MLPs with an aggregate market cap of $16 billion.
MLPs are now seen as a distinct asset class and as a “must have” for yield-oriented investors. Given what is happening in the domestic energy market, we are very excited about how the sector will develop over the next 10 years.
Sallee: As new and different players come into the fold, we believe it is increasingly important to understand and assess their differences—they are not all created equal. A rising tide may lift all boats, but market cycles will separate quality MLPs from those with weaker business models. We believe this will play out as the MLP market evolves and business cycles ensue. This thinking forms the basis of Tortoise’s investment philosophy: Steady wins.
Swank: We believe the shale revolution in natural gas and crude oil is changing the energy infrastructure in the U.S. as never before, creating massive opportunities for MLPs, but also disrupting long-standing infrastructure economics. Nowhere is this demonstrated so vividly as with the long-haul natural gas transmission businesses.
Historically, pipelines that take natural gas from the Gulf Coast to the Midwest and both the East and West Coasts were secured by attractive long-term, firm commitments from investment-grade utility customers. With the rapid growth of the Marcellus Shale (2007-present), which is now the largest natural gas field in the U.S. (producing over 9 bcf/day out of 70 bcf/day of total U.S. supply), much of this Gulf Coast natural gas now needs to find a new home.
This development and other factors have driven lower volumes/earnings and discounted (or altogether lapsed) contractual commitments for these once “gold-plated” lines. To their credit, though, many of the natural gas transportation & storage MLPs are aggressively doing what they can to at least mitigate their sector challenges, including M&A, converting legacy natural gas pipelines to other product services (like crude oil or NGLs), finding new outlets for their gas such as various growing power and industrial markets, or other optimization strategies like backhaul service (particularly heading away from the Marcellus).