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).