Despite the divergence and volatility in underlying commodity prices, master limited partnerships (MLPs) in the energy business continued to perform well for investors. As of April 30, 2012, the Alerian MLP Index (AMZ) generated an 8.4% one-year annualized return with a three-year annualized return of 32.1%. Income-investors also benefitted from MLPs as the stocks in the Alerian index had a yield of 6.1% versus 2.1% for the S&P 500.
We asked six leading MLP-fund and portfolio managers for their thoughts on recent market action and the industry’s outlook. This year’s participants include:
- James J. Cunnane Jr., Managing Director and CIO, FAMCO MLP (a division of Advisory Research Inc.), St. Louis;
- Jim Hug, Senior Portfolio Manager, Yorkville Capital Management LLC, New York;
- Kevin McCarthy, President and CEO, Kayne Anderson Energy Closed-End Funds, Los Angeles and Houston;
- Daniel L. Spears, Partner & Portfolio Manager, Swank Capital LLC, Dallas;
- Rob Thummel, President, Tortoise North American Energy Corp., Tortoise Capital Advisors, Leawood, Kan.;
- Sean D. Wells, Vice President, SteelPath Fund Advisors, Dallas; and
- Roger Young, CFA, Portfolio Manager/Research Analyst, Miller/Howard Investments Inc.; Woodstock, N.Y.;
Which sectors of the MLP universe do you focus on?
James Cunnane, 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.
Jim Hug, Yorkville Capital Management: Yorkville focuses on the entire asset class. We classified the publicly traded partnership universe earlier this year into 15 composite and sector indices based on research identifying each partnership’s primary business drivers. This provides us with a clear, logical way to view the whole space.
We offer an MLP core-income separately managed account in which we employ a fundamentally driven investment strategy. We endeavor to identify MLPs where we believe changes are taking place that will meaningfully support current distributions and augment future cash flow growth.
This strategy notched its 10th year of performance in 2011 and currently concentrates in the infrastructure sector with exposure to pipelines, terminals, and processing. We also pursue tactical MLP investments in special situations outside of infrastructure with a portion of the portfolio.
Yorkville also sponsors a high income MLP ETF (YMLP), which began trading in March and focuses primarily on high quality yield opportunities in the commodity sector with investments in natural resources, marine transportation, propane, and exploration & production partnerships. It employs a rules-based investment strategy that leverages Yorkville’s extensive experience researching and investing in MLPs, which emphasizes quality and quantity of distribution by placing current income, distribution coverage ratio and distribution growth foremost.
Kevin McCarthy, Kayne Anderson: Our largest fund — KYN (Kayne Anderson MLP Investment Company, with $4.4 billion in total assets) — focuses on publicly traded MLPs. Roughly 75% of our portfolio is allocated to midstream MLPs, and the remainder is allocated to general partners, shipping MLPs, propane MLPs, coal MLPs and upstream (exploration & production) MLPs. (This figure is calculated using two of our standard SEC reporting categories: Midstream MLP and MLP Affiliates, which comprised 67% and 9%, respectively, of KYN’s long-term investments as of April 30, 2012.)
Daniel Spears, Swank Capital: We focus on all energy-MLP sectors.
Rob Thummel, Tortoise Capital Advisors: At Tortoise Capital Advisors, we focus on companies that own and operate midstream pipelines which gather, process, and transport energy commodities. In addition, we invest some of our clients’ funds in companies that operate outside of the midstream sector, including upstream and shipping MLPs and also companies in the broader North American pipeline universe (which includes both pipeline corporations and MLPs).
Sean Wells, SteelPath Fund Advisors: We focus on MLPs that provide midstream energy services and predominantly generate fee-based, or fee-like, cash flows rather than cash flows that are overly exposed to commodity prices. These are the assets that we believe optimize the reward-to-risk ratio and allow our investors to sleep easier at night.
We believe that by focusing on those names with the ability to generate cash at a sustained level during a variety of commodity price scenarios, our portfolios should outperform in the long run, through cycles, and provide a superior value proposition.
Roger Young, Miller/Howard Investments: We focus on all the publicly traded master limited partnerships, basically from soup to nuts; although, from a portfolio structure standpoint, we can’t use some of the smaller less-liquid names.
How did those sectors perform in 2011?
Cunnane: 2011 was a great year for the largest and highest-quality MLPs and a tough year for the smallest and lowest quality MLPs, so the strongest performers tended to be midstream oil and diversified gas MLPs. The weakest were involved with propane, marine transportation and coal. Two outliers were the upstream and natural gas gathering & processing MLPs, which we view as higher-risk MLPs. Those two sectors performed very well in 2011.
Hug: Our separately managed account (SMA) portfolio gained 23.8% before fees in 2011, due in part to our exposure to companies in the gathering & processing and refined products pipelines sectors. The indices we developed to track these sectors were up 27.9% and 16.3%, respectively, last year.
We also owned several publicly traded general partners that offered above-average distribution growth potential and, as a result, attractive capital appreciation opportunities. Our general-partners index was up 11.1% last year.
The gathering & processing space is interesting in that it is moving toward fee-based income. This sector used to be dependent on keep-whole contracts and other forms of compensation tied to commodity spot prices. Partnerships in this sector are more likely to offer the toll-road characteristics investors covet in MLPs, and are therefore considerably more reliable today.
McCarthy: For calendar year 2011, the total returns (price appreciation plus distributions) were as follows: Midstream/Gathering & Processing: 22.0%; Midstream, Large Cap: 17.5%; Upstream (exploration and production): 13.5%; General Partners: 12.2%; Midstream, Mid/Small Cap: 5.5%; Coal: 3.4%; Shipping: -3.9%; Propane: -7.5%; and Midstream/Gas Storage: -31.5%. For the same period, the Alerian MLP Index had a total return of 13.9%.
Spears: The top performing sub-sectors for 2011 were the General Partner MLPs and Natural Gas Gathers and Processors. The sub-sectors performing the worst were Natural Gas Storage, Propane and Coal.
Thummel: Midstream MLPs comprised the best performing MLP sector in 2011. On average, MLPs operating pipelines delivered returns of 14 to 20% in 2011, while gathering and processing MLPs produced returns of 25%.
Wells: Sectors dominated by fee-based partnerships generally did well. Of course, over the period crude oil pricing was firm, and as a consequence, so was the pricing for natural gas liquids (NGLs), so entities with outsized exposures to those commodities did well, too.
Our caveat to investors is to not mistake a period of fortuitous commodity-price behavior for low-risk margin. Obviously the margin environment for natural gas storage continued to spiral far below where most experts only a year ago thought possible, and as a result, companies with exposure to that market suffered some pretty wide losses. Coal pricing also weakened over the period and, as a consequence, MLPs with coal exposure generally sold off as well.
More broadly, it seems 2011 price performance was tied to market-cap positioning to an unusual degree. For instance, large-cap names finished the year up 18.6% compared to the 5.1% from mid-caps and -9.0% from small caps. Given the relative valuations between these groups today, we believe a continuation of that pattern is unlikely and perhaps may reverse to some degree.
Young: In the portfolio, our bias and portfolio weightings are primarily in the natural gas area with a heavy emphasis on the natural gas liquid sector. Also, we favored the crude oil transportation and storage sector. They were good performers in 2011.
Did the sector results in 2011 differ significantly from your pre-2011 expectations? And, if they did, what factors caused the unexpected results?
Cunnane: We expected higher-quality MLPs to perform well in 2011, so the 2011 results were generally consistent with our expectations. We were also favorable towards gathering & processing going into 2011 due to favorable industry dynamics. The strong results of several lower-quality upstream MLPs were not aligned with our expectations.
Hug: Their results did not differ greatly from our expectations, but it is fair to say that the continued low-interest-rate environment has helped performance. Low rates attract money to MLPs because of the attractive spread they offer over U.S. Treasuries, in addition to the distribution-growth opportunity.
MLPs can also attribute their lower-weighted average cost of capital to the reduced funding costs that result from low rates. We are finding a number of MLPs lengthening their borrowing duration 10 to 15 years out to lock in historically low interest rates, which is an excellent expense hedging strategy that will support current and future distributions.
For example, Energy Transfer Partners recently issued 30-year bonds with an average coupon of 5.85%. That’s only 270 basis points over the 30-year Treasury.
McCarthy: In our roundtable discussion last year, we mentioned two points in our outlook for the coming year. 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 — would drive the construction of new energy infrastructure to transport energy products to major population centers. We expected this to be a catalyst for distribution growth in the MLP sector, especially for pipeline MLPs.
Another factor driving MLP returns would be the continuation of a robust NGL market. Due to high prices and the current supply/demand imbalance, we expected NGL volumes to grow as E&P companies reallocated rigs to drill in liquids-rich areas, as opposed to drilling for natural gas.
Many gathering and processing MLPs announced plans to increase capacity for fractionation, or separation of NGLs into individual products such as ethane, propane, butane, and natural gasoline. Other MLPs announced projects for processing plants and pipelines to handle these NGLs.
The year unfolded as we expected. Gathering and processing MLPs and large-cap midstream MLPs had total returns of 22.0% and 17.2%, respectively, strongly outperforming the Alerian MLP Index, which had a total return of 13.9%. We’re pleased with our decision to overweight these two sectors going into 2011, as our investors were the beneficiaries.
Spears: No.
Thummel: A simple way to forecast returns for MLPs is to add current yield plus expected growth. In 2011, we expected MLPs to generate returns of between 10 to 12% through a combination of current yield (approximately 6% as of January 1, 2011) and anticipated growth of between 4 to 6%.
The broad MLP sector produced results slightly higher than our expectations by delivering a total return of approximately 14%. Additionally, midstream MLPs exceeded our expectations for two reasons. First, the increased need for additional energy infrastructure boosted both their current and future growth projections. Second, investors searching for current income continued to discover and invest in MLPs. They’re recognizing what Tortoise’s founders have believed for over 10 years now — that MLPs are a must-own portfolio component. The increasing need for energy infrastructure, coupled with the cash flow resiliency they demonstrated in 2008, have made MLPs increasingly popular with investors.
Wells: Generally, the fee-based group performed well and in line with our expectations. Entering 2011 we had not anticipated the degree of large-cap outperformance that was exhibited, but we think this was in part due to “flight to quality” investor behavior as a consequence of the market volatility experienced from late summer through the fall on Eurozone fears.
More broadly, we think the biggest surprise for the sector in 2011 was the reversal in outlook for coal-related names. We tend to take only limited exposure to names with aggressive exposure to commodity pricing, as in the coal sector, but looking at this part of the MLP space provides an interesting case study.
The coal subsector provided a well-above average 21.5% simple return in 2010, but for 2011 posted a loss of 17.4% as the outlook for the commodity worsened. Few also anticipated the depths to which natural gas storage fundamentals would sink.
Though there are only a couple of pure-play natural gas storage operators, both held firm in 2010. Further, over that period there were a number of natural gas storage-asset acquisitions consummated at very high multiples, suggesting (obviously) that these strategic buyers felt confident the dynamics for storage were likely to improve before long. However, over 2011 those fundamentals continued to falter to historically poor levels.
Young: There were no significant differences as far as performance. The bright spot in the year was the continued investment opportunities in the gas liquids and crude oil sectors. Additionally, the MLP industry raised a record amount of new capital last year; these monies will be utilized to finance future growth projects and that in turn gives visibility to future distribution growth.
The trends in oil and natural gas prices have diverged substantially. Has that divergence affected your investment strategy?
Cunnane: During 2011, we had a significant percentage of our portfolios in gathering & processing and diversified natural gas MLPs. Many of the MLPs in these groups have been benefiting from the significant differential in the price of natural gas and crude oil. Some have also been benefiting from the substantial regional price differences for natural gas liquids and crude oil during 2011. These price disparities provided many of our MLP investments with significant growth opportunities to build new infrastructure and take advantage of changing market dynamics.
In 2012, we have also been positioning portfolios to take advantage of opportunities related to positive crude oil economics, expanding our investment in liquids pipelines and storage.
Hug: This price-trend divergence has not really affected the investment landscape outside of a couple sectors. It has negatively affected exploration & production MLPs that are structured as royalty trusts, since their distributions are tied more directly to commodity prices. However, the divergence has positively affected some gathering and processing MLPs.
MLPs in general are somewhat insulated from spot-price volatility, because of the way many manage commodity exposure via long-term contracts or sophisticated hedging programs. The idea of a fixed ratio where crude oil should trade relative to natural gas no longer exists.
Crude oil spot prices are based on the international market, while natural gas trades on domestic factors. We expect the crude oil-to-natural gas ratio will remain favorable to investors for the foreseeable future.
McCarthy: MLPs with greater exposure to crude oil and natural gas liquids are expected to outperform those with greater exposure to “dry” natural gas. We have limited our exposure to E&P MLPs, focusing on MLPs that we believe will benefit from NGLs and from higher unconventional gas production.
Spears: Yes, it has. Our investment thesis is centered on the sub-sectors that benefit from high crude prices and low natural gas prices. The crude oil industry is undergoing a renaissance driven by horizontal drilling and favorable economics. This has presented several MLPs with robust infrastructure opportunities, such as converting underutilized natural gas pipelines to crude service, building new crude oil terminals and storage facilities, etc.
Additionally, given the crude oil to natural gas price dynamic, there is strong demand for natural gas liquids, and this too has driven significant infrastructure opportunities related to processing, transportation and fractionation. While we have avoided the sectors that are hurt by low natural gas prices, such as natural gas storage, propane and coal, we have invested in businesses like fertilizer MLPs that benefit from low natural gas prices
Thummel: In Tortoise’s view, one of greatest benefits of investing in midstream MLPs is that they have historically experienced minimal exposure to commodity price volatility over the long-term. In addition, Tortoise seeks to build portfolios designed to withstand varying market cycles, including low as well as high commodity price environments.
The rise in crude oil prices helped to speed up the pace of development in emerging areas — such as the Bakken in North Dakota and the Eagle Ford Shale in Texas. This development also benefits the midstream MLPs that transport crude oil and natural gas liquids, as significant additional infrastructure is needed to support the expanding domestic production.
The decline of natural gas prices created some short-term challenges for natural gas storage operators. Also, low natural gas prices have driven down the price of coal, which is a sector that we have typically avoided due to its sensitivity to commodity prices.
Wells: Obviously our conscious effort to limit exposure to commodity pricing helps to mitigate the impact of natural gas price weakness. However, there are secondary price impacts to consider. For instance, natural gas storage has suffered, not because margins for this business are tied directly to the absolute price of the commodity, but rather by a contraction in seasonal spreads.
Also, there has been a radical shift in producer drilling plans away from “dry gas” basins to prospects where well economics are enhanced by the presence of natural gas liquids, which may impact gathering volumes within those out-of-favor dry gas basins over coming quarters.
Lastly, the divergence between liquids pricing and natural gas pricing has resulted in processing spread economics well above historic norms for a sustained period. In response, the industry is quickly developing additional processing and fractionation capacity.
Though we are confident that volumes are likely to remain robust even if processing spreads contract from current highs, we are cognizant of the fact that processing spreads may certainly retrace towards historic norms as new infrastructure begins to impact supplies.
Young: Given our investment strategy in the natural gas area, with a focus on natural gas liquids, the weakness in the gas prices has created an even more favorable fundamental outlook for natural gas liquids (NGLs). The upstream producers of natural gas liquids and the midstream area (transporters, processors and the fractionation segments) of the MLP industry have been doing quite well, and the prospects are bright.
Two world-scale ethylene plants have been announced in the United States, one by Royal Dutch Shell and the second one by Dow Chemical. Other large-scale ethylene projects are in development.
These new chemical facilities are big users of NGLs, most particularly ethane and propane. The additional ethylene capacity that is coming on stream in the next three to five years will absorb the expected increase in NGL production.
Crude oil and NGLs have become the focus of the upstream exploration & production (E&P) drilling budgets. There may be some temporary bumps in the road regarding the NGL-ethylene balance; however, the secular trend is quite favorable.
Secondly, the weakness in natural gas is creating some structural change in the consumption of natural gas. You read every day about fuel switching (coal to gas). A low gas price environment is an enabler for electric power generating companies to justify closing down older coal-fired power plants and replacing them with natural gas-fired power plants.
Fundamentally a weak price has a greater impact on gas producers. MLPs are the energy infrastructure toll road of the gas value chain. A toll road benefits from rising traffic. Rising consumption of natural gas is, in a sense, the analogy to more traffic going through the tollbooth. The weakness in the price of natural gas is more reflective of the oversupply situation as distinct from a demand situation.
Which MLP sectors do you believe have the most favorable outlooks for the intermediate- and long-term, and why?
Cunnane: We believe that the major long-term theme for energy infrastructure is the significant increase in domestic production due to the shale opportunities. We expect natural gas-related infrastructure to benefit from low natural gas prices combined with an apparent political preference for natural gas over coal and crude oil.
This suggest to us that demand for natural gas will be higher in the future, as more natural gas is burned for electricity, heating and transportation, and LNG (liquefied natural gas) exports increase. So longer term, we expect to be overweight natural gas-related infrastructure, such as pipelines, gatherers & processors, and storage.
Hug: Publicly traded General Partners can be great growth vehicles that should continue to improve MLP portfolio returns. If you believe you’re right on a particular MLP, and there’s an opportunity to invest in its General Partner, it should outperform in terms of capital appreciation.