Five MLP-fund managers spoke recently with Research magazine for the 2011 Guide to Master Limited Partnerships regarding the sector’s recent performance and its outlook, as well its potential risks and rewards.
This year’s panel includes:
• Jeff Fulmer, senior advisor, Tortoise Capital Advisors, L.L.C., Leawood, Kan.
• Quinn Kiley, senior portfolio manager, Fiduciary Asset Management (FAMCO), St. Louis;
• Kevin McCarthy, president and CEO, Kayne Anderson Energy Closed-End Funds, and co-managing partner, Kayne Anderson Capital Advisors, Houston;
• Jerry Swank, managing partner and founder, Swank Capital, Dallas;
• Brian Watson, director of research, SteelPath Fund Advisors, Dallas.
What factors are likely to boost MLPs over the next few years?
McCarthy: Generally, we believe that new energy infrastructure development will be a catalyst for distribution growth in the MLP sector. Production in unconventional basins—especially the Marcellus Shale in Pennsylvania, the Eagle Ford Shale and Barnett Shale in Texas, and the Haynesville Shale in Louisiana—will drive the construction of new energy infrastructure to transport energy products to major population centers.
We believe that MLPs are the most direct way to capitalize on this trend. Another factor that will drive MLP returns is the continuation of a robust NGL market. Due to high prices and the current supply/demand imbalance, NGL volumes are expected to grow as E&P companies reallocate rigs to drill in liquids-rich areas, as opposed to drilling for natural gas.
Many gathering and processing MLPs have announced plans to increase capacity for fractionation, or separation of NGLs into individual products such as ethane, propane, butane, and natural gasoline.
Other MLPs have announced projects for processing plants and pipelines to handle these NGLs.
Finally, with the current environment providing ample access to capital, public MLPs are once again focusing on acquisitions and growth projects that we expect will lead to distribution increases. MLPs’ 2010 capital spending for acquisitions and expansions was over $40 billion, the highest total we’ve seen since 2007 and more than double the level in 2009, and we expect that trend to continue in the near term.
Swank: I think the industry assets’ size has become so big, $300 billion, that I think you’re going to have more institutionalization, and I see it happening in two ways. One is more products: more closed-end funds, mutual funds, ETFs, ETNs, etc., to allow a larger base, and that’s pretty much the retirement-plan pension business.
On the other side, you’ll continue to get institutional investors now, such as big state funds—kind of like what happened in the REIT market in the late ‘90s. On the fundamental side, this whole oil and natural gas liquids play is in the second inning here, and I believe it’s going to drive infrastructure, build-out connectivity and earnings and dividend growth of these MLPs for the next few years.
Fulmer: Robust growth through project build-outs and acquisitions should bode well for MLPs in the near term and lead to increased investor distributions. Capital investments targeting liquids-rich shale plays, notably the Eagle Ford shale in Texas, the Marcellus shale in Pennsylvania and West Virginia, and the Bakken shale in North Dakota are expected to be pronounced and should result in accretive growth.
Pipeline takeaway capacity remains short of peak production in all three of these regions and both MLPs and C corp pipeline companies are coming to the rescue. We think MLPs will invest over $20 billion in the next three years for needed infrastructure to connect regions of supply-push to areas of demand-pull.
Substantial momentum is also evident in the acquisition arena and likely to continue, with over $9 billion invested during the first five months of 2011. Over the next three years, we are projecting over $35 billion of M&A in the sector.
Kiley: We continue to think investors will be drawn to MLPs’ attractive yields and the fact that the majority of MLPs are increasing their quarterly distributions.
Recent events would support the idea that the near term will continue to be volatile, although we do believe prices are going higher from current levels.
Increased merger and acquisition activity and accelerated capital expenditures on new infrastructure are the most likely drivers of positive performance over the short term.
Although we currently view the MLP group as fairly valued and with an attractive return outlook, headline risk around energy tax policy could create some choppy waters in the weeks and months ahead.
Watson: To be clear, our primary focus is on long-term performance and, in fact, we base our investment decisions on the assumption of a five-year holding period. Nonetheless, over the next three years the continued development of domestic shale and unconventional resource basins will allow these businesses to grow substantially.
We expect MLPs will be the dominant builders and operators of the logistical assets needed for this development and to connect these supply regions to the points of demand.
Triple digit year-over-year increases in rig counts in the Eagle Ford, Niobrara, and Bakken shales have strained takeaway capacity from these as well as other basins as current infrastructure is insufficient. Further, we expect the pace of acquisitions of midstream assets by MLPs from existing C corps will continue at a healthy clip.
Lastly, we believe investors will continue to diversify away from the REIT and utility sectors into the MLP sector. Each of these trends should be supportive of the space.
Which MLP sectors do you believe will be the strongest performers in the near term and why?
Swank: You have those that are in the natural gas gathering business that are the closest to areas mostly on the wet gas side; a name like MarkWest (MWE) is exposed to the Granite Wash and the Marcellus. You have a WES (Western Gas Partners), which has good exposure to the whole Niobrara, D-J Basin kind of play. Atlas is right in the middle of all the West Texas, Granite Wash liquids production. So, those firms are probably the more risky plays but they’re exposed at the very front end.
The businesses are doing very well (with) the frac spread because the oil and gas ratio is so high. Longer term, obviously, the firms like Enterprise, Targa and ONEOK that are exposed to the liquids fractionation along the entire value chain are going to have it very good for a long time, too.
Fulmer: We believe that long-haul pipeline MLPs have the most concrete growth plans and are also positioned to be the beneficiaries of an improving economy, which leads to increased consumption.
Refined product demand grew 1.5% in 2010, and according to the EIA is expected to grow in 2011 as well—by about 1%.
In addition, beginning in July of this year, oil pipeline tariffs tied to FERC indexing will receive a favorable tariff bump of 6.8%, calculated as PPI plus 2.65%.
Beyond that, if the Producer Price Index simply remains flat for the remainder of 2011, we project a tariff escalator of 8.6% in July of 2012.
Long-haul oil pipelines require strategically placed storage facilities to operate, and oil storage assets continue to be attractive due to spreads between crude grades and demand for additional refined product blending terminals.
The natural gas transmission sector remains strong with advantageous long-term, fee-based contracts. Opportunities abound within the sector for infrastructure investment related to emerging shale supply basins.
Upside also exists in the gathering and processing sector, as we continue to see a migration to fee-based contracts and less direct commodity price exposure.
Kiley: Those MLPs exposed to growing production of oil and gas from nonconventional reserves will continue to benefit as the ramp up in production continues. This means the geography of an MLP’s operations is as important as the sector one assigns to it.
We favor growth from the “oily” reserves like Eagle Ford or Bakken, more so than “gassy” reserves like Haynesville, for example.
I would caution that the development of these reserves to full capacity is still years away, but early movers into these plays should benefit over the short and long term.
Watson: Obviously if crude oil and NGL prices continue to rally, those sectors with the most commodity-price sensitivity will benefit. Alternatively, if that trend reverses, then those MLPs will likely similarly suffer.
Otherwise, we believe those with the most advantaged footprints around the emerging oil shales and the most skilled management teams will be able to capture new growth opportunities and will be rewarded by the market.
McCarthy: In the near term, we believe that pipeline MLPs and gathering and processing MLPs with exposure to developing shale plays will perform well.
While valuations for these partnerships have been higher in recent months, we still see MLPs with valuations that do not reflect their strong growth prospects.
Which MLP sectors do you believe will be the strongest performers in the long term and why?
Kiley: We believe that over the long term, there will be more growth generated by natural gas infrastructure MLPs. Identifying stable cash flows to investors is a central tenet of MLP investing, but delivering growing cash flows is the biggest differentiator over the long run. When properly executed, new infrastructure delivers growing cash flows.
Watson: Long-haul, fee-based or fee-like pipelines, storage and terminals are our top picks for long-term performance, as they are less influenced by specific drilling programs or commodity prices and have natural monopolies on the majority of transportation routes. The midstream sector’s ability to steadily generate cash during a variety of commodity price scenarios will allow the group to outperform other MLPs in the long run, particularly on a risk-adjusted basis.
McCarthy: We believe the single most important factor will be asset location and exposure to increasing volumes as a result of the continued development of the unconventional reserves. This includes large MLPs that are well positioned to transport new volumes over interstate pipelines, as well as smaller gathering and processing MLPs that have more direct exposure in the specific basins such as the Marcellus, Eagle Ford or Haynesville Shales.
Swank: One trend we’re seeing is that non-MLPs that own these kinds of [shale fracking] assets are turning them into MLPs. For example, Williams has basically turned into an MLP. El Paso continues to do it. We think all these other firms will eventually do that, and then there are other kinds of MLPs. Now, we have natural gas storage MLPs. The shipping business is getting much bigger in the MLP space.
The E&P MLPs are getting much bigger. Thus, I think that longer-term trend will continue to create more and different asset-type MLPs.
Fulmer: We expect MLPs that provide “at length” solutions to connecting newfound and evolving oil and natural gas supply with demographic demand will lead the pack.
We expect that quality MLPs who derive the majority of their revenue from long-haul natural gas, crude oil and refined product pipelines tied to long-term contracts will continue to provide their investors with stable income and attractive total returns. These are the companies that successfully weathered the financial storms and catastrophes of the past decade while delivering sustained growth.