“You know nothing, Jon Snow.”
Fans of the HBO show Game of Thrones will be familiar with the memorable and often-heard quote directed to one of the show’s most popular characters. It’s entertaining to see the character’s reaction to being told that he knows nothing – a mix of confusion, anger and curiosity. Investors often feel that they are getting the same message from the “market,” and have the same reaction as Jon Snow to being told that they “know nothing.”
The downturn in energy Master Limited Partnerships (MLPs) provided that sort of message in the latter part of 2014, as investments that were thought to be somewhat insulated from falling commodity prices fell sharply during the oil bust. After the initial reaction to the downturn – confusion and anger – many investors moved on to the curiosity stage and asked whether the downturn created a buying opportunity.
The Asset Class
Energy MLPs have long been of interest to investors for their yield, capital appreciation potential and inflation-hedging characteristics. Distributing 90% of their income by law, MLPs have been a popular alternative for investors starved for yield in a low interest rate environment.
Energy MLPs are engaged in the production, transport, and refining of energy products such as crude oil, natural gas and natural gas liquids (NGLs) such as ethane, propane, and butane found in natural gas.
Those three main business activities – production, transport, refining – define the three segments of the energy MLP space.
- Upstream MLPs are mainly involved in production of oil and natural gas. These firms should do well in times of increased energy production, such as occurs with an expanding economy. They are sensitive to low energy prices, which reduce the profitability of their projects.
Oil price sensitivity tends to make upstream MLPs more cyclical than other energy segments – creating expectations of more volatile market prices and dividend payouts.
- Midstream MLPs supply the infrastructure to transport, process and store energy products. They are classically known as “pipeline” businesses, but their business activities can include gathering, treating, processing and logistics. Midstream MLPs thrive when they can expand cost-effectively into new infrastructure projects and when activity volumes are stable or increasing. Midstream MLPs have benefited greatly from the U.S. energy renaissance created by unconventional energy production techniques. Midstream MLPs are considered to be relatively insensitive to energy prices, because they primarily are paid fee-based prices based on volume rather than on the price of the energy. More than half of MLPs are in the midstream segment.
Many investors consider midstream MLPs to be a hedge against inflation, because their fees often increase in line with inflation, while their volumes tend to rise in tune with a growing economy.
- Downstream MLPs convert basic energy materials into value-added products. Downstream MLPs operate refineries and their products include NGLs as well as heating oil, gasoline and other fuel products.
As buyers or users of basic energy commodities, they may be adversely affected by high energy prices and fluctuations in demand. This is a diverse group with idiosyncratic performance drivers.
Major direct influences on performance include recent energy price declines caused by global over-supply as well as the current increase in energy production within the United States. MLPs are also an interest-rate sensitive investment, so the outlook for interest rates is an additional factor behind MLP performance.
The oil glut and resultant pressure on oil prices hit upstream MLPs the hardest. (See Chart 1 below) Almost all upstream MLPs cut their distribution rates in recent months; the average reduction of distributions was 50%. Industry observers warn that the highly leveraged nature of upstream MLPs make further distribution cuts almost inevitable should energy prices remain low.
Midstream MLPs held up comparatively well during the downward spiral of oil prices, though they’ve been laggards relative to the broad equity market. Short-term demand has picked up in the face of lower price levels. However, low prices have caused upstream MLPs to cut investment in extraction projects, which could have an adverse effect on future volumes.
The longer-term demand picture looks bright for the midstream segment, though. The energy renaissance means that the U. S. is still in need of major infrastructure projects to transport energy, and a further boost may come from increased demand caused by improving economic activity, though the economic picture is far from clear.
Downstream MLPs have benefitted from lower energy prices, but that has been balanced with sluggish economic activity. Results have been mixed.
Oil Decline Period is 7/31/2014 - 12/31/2014 Oil Trough Period is 12/31/2014 - 3/31/2015
Full Period is 7/31/2014 - 3/31/2015 Broad MLPs is defined by the Alerian MLP Index
Downstream MLPs is defined by the Yorkville MLP Downstream Index
Midstream MLPs is defined by the Alerian MLP Infrastructure Index
Upstream MLPs is defined by the Cushing Upstream Energy Income Index
Source: Bloomberg, index company websites.
M&A / Consolidation Activity
MLPs have been on center stage in the merger and acquisition parade in recent months. Three recent stories stand out in the news – Sunoco, Kinder Morgan and Williams.
In March 2015, Sunoco spun off its logistics business to form Sunoco Logistics Partners. Sunoco’s motivation was to “unlock” the value of low-volatility assets that were perceived as underpriced by the stock market. Hess has publicly stated that they plan a similar MLP spin-off.
But the MLP structure can be complex and some partnerships end up being squeezed by large payments they make to the sponsoring corporation that serves as the General Partner. The payments are meant to encourage the company's management to keep paying out more to investors, but can become a financial burden on the partnership as it tries to grow.
Kinder Morgan, an industry leader and pioneer in popularizing the MLP structure, last year did an about-face by consolidating its three MLPs back into the parent corporation. Kinder Morgan’s three MLPs were making high payments back to the general partner, payments that lowered the yield on the MLPs and hindered their stock market value. Kinder Morgan’s rationale was to simplify a structure that was becoming difficult to manage, provide greater dividend growth and visibility and obtain a lower cost of capital to pursue expansion opportunities.
Williams Companies, another major industry player, announced a similar consolidation in mid-May following the same rationale as Kinder Morgan. Analysts are expecting more simplification deals, and say the Williams merger likely won't be the last. A smaller midstream company, Crestwood Equity Partners LP, has already unveiled a $3.5 billion merger to simplify its structure by taking a master-limited partnership back in-house.
Taxes are a prominent consideration when selecting the type of vehicle to use when investing in MLPs.
Separately Managed Accounts
Direct ownership of MLPs in an SMA is on its face the simplest way to invest. With an SMA structure, the investor receives the full tax benefits of MLP ownership, namely tax-deferred distributions and avoidance of taxation at the partnership level.
For many investors, however, the complexity of the partnership structure creates personal tax complications. Each MLP issues annual K-1 tax forms, which often arrive late in the tax season. MLPs also create complications if owned in 401ks and IRAs.
Mutual Funds and Exchange Traded Funds
Mutual funds and ETFs have similar tax and regulatory issues related to MLP ownership.
Mutual funds and ETFs are effectively limited to owning no more than 25% of their portfolio in MLPs. Holding greater than 25% of the fund/ETFs in MLPs would negate the tax status of the vehicle, forcing the fund or ETF to be taxed as a C-corporation rather than a registered investment company. This means paying corporate taxes at the fund level before passing income along to fund shareholders. This corporate tax cuts into the yield and returns of the fund.
Maintaining less than 25% invested in MLPs avoids this double-taxation issue, but has a dilution disadvantage for investors. With only 25% in MLPs, the fund manager must invest the remainder of the portfolio in other assets such as stocks of energy corporations. These other stocks may offer similar sector exposure as MLPs, but likely lack the high yields and investment characteristics that make MLPs attractive to investors in the first place.
Exchange Traded Notes
Exchange traded notes (ETN) are fixed income instruments designed to reproduce the returns and yields of an MLP index, but without holding any of the underlying index holdings. The ETN structure offers several advantages over competing investment vehicles. There is no 25% MLP maximum to contend with. Tax consequences are equally simple; the fund company issues a Form 1099 for the income.
ETNs have disadvantages. All of the income from this debt instrument is taxed as ordinary income, with none of the deferral benefits of actual MLP ownership. As with any debt instrument, there is default risk.
Outlook and Recommendation
We believe that MLPs offer investors advantages that are not available from other investments and represent a good long term holding. We recommend MLPs as part of a diversified portfolio for income-focused investors, based on their income payouts, potential for capital appreciation and inflation-hedging characteristics.
The debate between active and passive management is as vigorous in the MLP asset class is in most asset classes. We see the virtues of both arguments, but are wary of active management in the MLP asset class. Much of the best recent performance among individual MLPs has come from deal-related activity, which is notoriously difficult to predict. Some of the worst performers have been pressured by financial stress caused by macroeconomic factors, also not easy to reliably anticipate. The MLP universe isn’t particularly large, which we think makes it difficult for an investor to gain a sustainable edge.
For the majority of clients, we recommend a passive ETN approach. The yields are sufficiently high and the taxes extremely straightforward. Also, performance is unhindered by added layers of taxes.
We considered raising our allocation to MLPs after the reversal of fortune they experienced in recent months. We’ve continued to hold MLPs, but haven’t raised our allocation because of the risks we see for the asset class. Because MLPs are required to pay out the vast majority of their earnings, they have to borrow to fund growth. Consequently, MLPs are dually vulnerable to rising interest rates, affected by increasing cost of capital as well as competition from fixed income investments that become more attractive competitors in a more normalized interest rate environment.
Though we are in the camp of rates staying “lower longer,” we recognize the risk of being complacent about the interest rate outlook. Another cautionary factor keeping us from raising our allocation to MLPs is their reliance on the capital markets for funding. Again, although our base case is for markets to “grind” higher and for liquidity to remain available, we consider there to be an elevated risk for a market reversal. A severe reversal could impair access to liquidity for MLPs.