Full Speed Ahead for Midstream MLPs

The role of natural gas as an energy source continues to expand as the United States moves toward energy independence. That bodes well for the companies that transport gas and other fuels and that provide infrastructure to the industry. Research asked several master limited partnership (MLP) fund managers and analysts to share their insights into what is driving and should continue to drive the performance of Midstream MLPs. 

This year’s roundtable participants include:

•  Kenny Feng, CFA, president and CEO, Alerian, Dallas;
•  Jim Hug, senior portfolio manager, Yorkville Capital Management LLC, New York; 
•  Brian Kessens, CFA, senior investment analyst, Tortoise Capital Advisors LLC, Leawood, Kan.; 
•  Quinn T. Kiley, managing director and senior portfolio manager, FAMCO MLP, a division of Advisory Research Inc., St. Louis; 
•  Erin Moyer, vice president and senior analyst, OFI SteelPath, Dallas; and 
•  Daniel L. Spears, partner and portfolio manager, Swank Capital LLC, Dallas, Texas.

Research: How did the Midstream MLPs that you follow perform in 2012?

Kenny Feng, Alerian: Alerian does not manage assets. The Alerian MLP Infrastructure Index, a benchmark for Midstream Energy MLP performance, returned 7.7% on a total return basis through Nov. 30, 2012.

Jim Hug, Yorkville Capital Management: We have been particularly positioned in the general partners (GPs) for reasons that we have discussed in the past; namely, if we are correct in our analysis of the underlying partnership (and our opinion that the underlying securities are attractive) then the return to the general partner is magnified. 

Brian Kessens, Tortoise Capital Advisors: 2012 was a good year for pipeline companies. The energy infrastructure sector, including MLPs and pipelines, delivered sound performance. 

Distribution growth accelerated to 7%, following the tremendous need for additional pipeline infrastructure to support greater production from emerging shale basins. 

Throughout the year, pipeline companies steadily increased their anticipated level of capital investment due to the heightened level of opportunity for new projects to transport increasing volumes of crude oil and natural gas liquids. 

There also was a healthy appetite for acquisitions, which further enhanced the opportunity set in the sector: Total acquisition activity topped $40 billion. 

Demonstrating the resilience of this sector, this growth and opportunity occurred despite slower economic growth, a contentious election and a lack of consensus in Washington related to fiscal policy. 

Quinn Kiley, FAMCO MLP: Generally, Midstream MLPs performed well. If you look a little deeper you see that MLPs that focus on certain sectors did better than others. 

MLPs focused on building and operating crude oil infrastructure performed exceedingly well during the year. This stems from a continuing shift in rig activity towards crude oil and liquids-based reserves. Those MLPs with price exposure to natural gas liquids lagged, as these commodity prices were depressed due to production exceeding demand.

Erin Moyer, OFI SteelPath: At OFI SteelPath, we focus on energy infrastructure opportunities and follow all Midstream MLPs closely. Importantly, that does not necessarily mean we consider all Midstream MLPs appropriate energy-infrastructure investment candidates, because risk profiles within the group can vary dramatically. In fact, there was fairly dramatic dispersion in performance across Midstream MLPs throughout the year based in part on these different risk profiles. 

On average, petroleum transportation-focused names performed very well, with average price returns above 10%, and a number of individual names soaring 20% or more. However, names with margin exposure to natural gas liquids pricing generally did much worse, with most of those names experiencing a modest to significant correction over the year. 

More broadly, names that were able to offer very visible paths to robust distribution growth performed well, whereas those that were unable to provide such visibility, whether due to commodity price exposure or company specific issues, performed poorly. Importantly, we think such performance bifurcation can often lead to opportunity, as market behavior in such times can exhibit exaggerated price performance relative to underlying fundamentals, both on the upside and the downside.

Daniel Spears, Swank Capital: The Midstream MLPs that we follow had a very good year. We continue to focus on those MLPs with greater exposure to crude oil transportation and natural gas liquids infrastructure. 

Did those 2012 results differ significantly from your pre-2012 expectations? If they did, what factors caused the unexpected results?

Feng: These results were roughly in line with our expectations of 9%-11% total return (6% yield and 3-5% distribution growth) for the sector. MLPs experienced strong gains in the beginning of the year, but macro issues such as the Eurozone crisis and post-election fears of tax reform pared back some of those gains.

Hug: We did not see any significant surprises in 2012. The fundamentals remained strong and the outlook remains highly favorable. 

We would say the one statistic that is somewhat surprising is the enormous spread between the average yield on the Midstream MLPs and the 10-year Treasury (450 basis points). Over the last ten years this space has averaged 320-330 bps. 

While we acknowledge that interest rates are at historically low levels and have nowhere to go but up, we believe we will eventually experience some compression in MLP yields. This would parallel what occurred in REIT yields. The average yield for REITs decreased from 7.4% in the 1990s to 5.7% in the 2000s, down to 3.7% from 2010 to present as the asset class gained wider investor acceptance.

Kessens: Sector growth this year met the high expectation we held going into 2012. We anticipated growing volumes of U.S.- and Canadian-produced crude oil, natural gas and natural gas liquids (NGLs) to result in increased demand for energy infrastructure, which proved to be the case. 

We also expected natural-gas- fired power generation to continue to displace coal-fired generation due to lower natural gas prices versus coal. While this occurred, the absolute level exceeded our expectation at times, as coal to natural gas switching stretched north of 6 billion cubic feet per day (Bcf/d). 

To a lesser extent for pipeline companies, we believed NGLs’ prices would move lower following the increased level of NGL production without an obvious source of immediate demand. The relatively warm winter of [2011] exacerbated this impact to price. Indeed, we continue to work through higher NGL supplies.

Kiley: We generally expected crude oil and NGL infrastructure [MLPs] to perform well during 2012. Performance for the year was highly correlated to an MLP’s valuation at the beginning of the year and distribution growth during the year. The end result is a story of haves and have-nots for 2012. This was somewhat surprising as high-yield MLPs fared poorly, despite the strong “yield trade.”

Moyer: We didn’t expect MLPs to repeat their 2009 or 2010 performances, but we certainly felt that given the strong positive fundamentals that the sector might perform better than the broader market for 2012. By most any measure, whether on a market-cap-weighted basis or equal-weighted basis, Midstream MLPs underperformed the broader markets by a fairly large margin. 

We think there are a couple reasons for this. First, we saw approximately $25 billion in equity supply hit the market, which is a staggering sum for the market to digest. For comparison, equity supply in 2012, through IPOs and secondary offerings, into the sector was 20% more than in 2011, which was also a record year.

Secondly, the dramatic drop in natural gas liquids pricing impacted those with exposure and even some that really only have minimal exposure seemed to have corrected in sympathy. Further, late in 2012 it appeared the sector was subject to selling from investors looking to capture gains ahead of potential 2013 tax changes.

Spears: We generally expected mid-teen type returns for MLPs in 2012, which was a function of both yield and distribution growth. There were certainly names within the crude oil andNGL infrastructure sectors that performed better than we expected. 

We were positively surprised by both the sheer number of and accretion from organic opportunities within those businesses, as well as how much of that accretion management teams were willing to pay out in distributions. As an example, Sunoco Logistics Partners increased its distribution by approximately 10% sequentially for each of the past two quarters. 

What potential upside do you see for Midstream MLPs for the next six or 12 months, and why?

Feng: There are several areas with enormous opportunities for MLPs to relieve crude pipeline takeaway constraints, such as in the Bakken and Niobrara shales, as well as from Cushing, Okla., to the Gulf Coast. 

Midstream MLPs addressing such issues stand to see potential upside over the next 6 to 12 months. For the Bakken and Niobrara, a solution that bypasses Cushing—which is already congested—may be more optimal for producers. 

On the natural gas liquids (NGLs) front, if additional chemical companies restart their domestic facilities or relocate operations currently handled abroad, these decisions would catalyze stable and long-term demand for NGLs domestically, particularly ethane. Midstream MLPs with NGL exposure—through processing, fractionation, or storage—would be the beneficiaries of such NGL demand.

Hug: We have been positive on MLPs since the founding of Yorkville and prior to that back to the mid-1990s, when we first began to follow the MLPs. We believe the “MLP Story” is more powerful today than at any time since we have followed the industry. 

The reason for this is quite simple: the shale energy revolution that is taking place in the U.S. because of horizontal drilling and hydraulic fracturing. We buy into the story that the U.S. could become energy independent by 2020. This will have profound implications for the U.S. economy and for the MLP sector.

Kessens: We think Midstream [MLPs] continue to offer an attractive risk-versus-reward tradeoff over the next year. We anticipate petroleum pipelines will continue to benefit from two tailwinds.

First, significantly higher crude oil volumes, especially in the Permian and Bakken plays, are expected to drive increased volumes. Second, a higher inflation-tariff escalator should boost cash flows.

The outlook for natural gas pipelines is one of consistency, because contracts are anchored by a reservation fee. Producers continue to focus on generating value through the liquids uplift. Hence, we expect gathering and processing activity to remain strong, especially in the Marcellus and emerging Utica and Eagle Ford shales. 

We think assets will continue to migrate into the MLP structure. Several companies are in registration to become public as MLPs, recent IRS private letter rulings are supportive, and the upstream companies’ capital needs facilitate the sale of their midstream assets to MLPs. 

This should continue to drive sector growth, along with management-team focus on robust growth, capital investment execution and pipeline integrity maintenance. This backdrop leads us to expect a 6-8% distribution growth in 2013, supporting a total return expectation in the low double-digits.

Kiley: Given the sell-off we have experienced since the [November 2012] election, it is conceivable that MLPs post a total return in the high teens for 2013. We would expect Midstream MLPs to outperform commodity-price-exposed MLPs, as the oversupply situation in domestic commodity markets continues.

Moyer: Generally, we don’t like to set expectations over short-term periods, because the short term can be dominated by non-fundamental factors such as the performance of the broader markets or the broader energy sector. 

MLP units are, after all, equities, and though long-term correlations to other asset classes have been relatively weak, short-term correlations are higher. With that caveat, however, and assuming the broader markets remain supportive, we believe the sector could perform above our long-term expectation over the next six to 12 months, simply due to the fact that this [past] year’s record-setting equity supply and late year tax-management related weakness has left the sector attractively priced. 

We believe fundamentals remain very supportive, and long-term growth prospects for most MLPs are even clearer today than they were heading into 2012. Importantly, a number of MLPs have growth projects that have been underway for several quarters or more, but which are expected to enter service in coming months, potentially allowing investors to benefit from those investments.

Spears: Barring extreme negative macro- or policy-driven outcomes, we think MLPs are poised for double-digit returns over the next year. We believe that the crude oil infrastructure build-out is in the early stages of development, similar to where the natural gas industry was a decade ago. 

The continued increasing domestic production of crude oil from existing mature basins like the Permian and new basins like the Eagle Ford and Bakken have created the need for new infrastructure. Additionally, as the MLP space matures, new investment products should continue to attract significant capital.

How do you expect the Midstream MLPs to perform in in the intermediate and long term?

Feng: Due to new drilling techniques and technologies, there has been a resurgence of oil and natural gas production over the past few years. The most recent International Energy Agency (IEA) report indicates that the U.S. could potentially be the world’s largest oil producer by 2020. And the U.S. now has such a large supply of natural gas that companies with facilities that import it are now filing applications with the government to export it. 

With a shift in both supply (the Marcellus Shale in Appalachia) and demand (U.S. population growth in the South), the need for energy infrastructure is now greater than ever. 

Pipelines, storage tanks, and processing plants are not cheap, and they will not be built overnight. A single pipeline can cost $2 million to $3 million per mile, and take one to three years to build. 

Al Monaco, the new CEO of Enbridge, summarized the current environment well when he said, “North America is in the process of being re-piped.” 

Midstream MLPs will be at the center of such re-piping, either by building new infrastructure or by repurposing existing infrastructure—flowing pipelines in different directions or moving different product—to meet current needs. All of this translates into cash-flow growth for Midstream MLPs. 

Over the past five years, MLPs have spent at least $15 billion annually on new infrastructure, resulting in average distribution increases of 6% per year.