What’s Driving the Strong Outlook for MLPs?

Kiley: Natural gas is readily available, and we believe production can be boosted in short order if demand can be identified. Interest in natural gas as a transportation fuel or for export as LNG are longer-term sources of new demand, and we think they will materialize in some form over time. Both require policy inputs, and it is not clear how or when the political process will attend to these issues. For that reason, we are more focused on increased demand from traditional users of natural gas, which will come from continued economic recovery and growth.

McCarthy: One of the benefits of the shale revolution is that most people now believe that natural gas will remain a low cost source of energy for years to come. Without the wild price swings that we’ve seen in the past, energy-intensive industries are willing to invest the capital to build power plants, petrochemical complexes and other manufacturing facilities. Because of the price disparity between natural gas and crude oil on an energy equivalent basis, we are also seeing increased interest in natural gas as a fuel source for transportation fleets.

Additionally, there is significant interest in exporting liquefied natural gas to international markets, where natural gas prices are several times higher than those in the U.S. While these trends will not happen overnight, we think investors will benefit by taking a long-term view and investing in MLPs that have the right assets, skill sets and track records to help them to satisfy this demand growth.

Sallee: Last year the U.S. produced 24 trillion cubic feet of natural gas, making it the world’s leading producer of this valuable resource. Approximately 95% of the natural gas we use is domestically produced, making us essentially self-sufficient. But there’s so much more to the story.

The range of uses of natural gas and natural gas liquids is both broad and deep. Dry gas (almost entirely methane) is an abundant, clean, reliable and affordable source of power generation and is increasingly finding broader applications.

But with our increased oil and natural gas production, we’re also getting lots of gas liquids (NGLs), which are used as feedstock (raw materials) for the manufacture of a wide range of products, especially plastics. In fact, this robust supply of NGLs has enabled North America to emerge as a global cost leader in the production of plastics and a leading exporter of liquefied petroleum gas (LPG), otherwise known as propane and butane.

The robust U.S. natural gas production has positive implications for natural gas infrastructure MLPs. There are approximately 1.5 million miles of long-distance and local-distribution natural gas pipelines in the U.S., serving almost all areas within the lower 48 states. This is the largest natural gas pipeline network in the world, yet it is not sufficient to meet the growing shale gas production.

We project several billion dollars will be invested in natural gas and NGL-infrastructure MLP growth projects in the near to medium term. We aim to capture this trend via our Tortoise MLP Fund (NTG), which is focused on midstream natural gas infrastructure MLPs. We believe this theme also bodes well for upstream production companies and was very much part of the strategy behind the development of our newest closed-end fund, the Tortoise Energy Independence Fund (NDP), which focuses primarily on North American oil and natural gas.

Swank: We believe the trend toward U.S.-based natural gas as an energy source is a dominant theme that will continue to play out over the near term. However, we believe this theme is not just limited to U.S. natural gas as an energy source (i.e. natural gas fired power), but also [includes] natural gas as a feedstock for U.S.-based petrochemical & industrial companies (e.g. manufacturers of plastics, etc.).

On the power front, the coal industry continues to be under assault by various governmental, regulatory, and environmental agencies. Natural gas (especially at the current and foreseeable levels of $4.00-$5.00/million British thermal units, or Btu) offers a lower cost and cleaner alternative to traditional coal-fired power plants.

Not only is this a competitive pricing structure as a coal alternative here domestically, these prices are a tremendous cost saving opportunity for manufacturing companies with U.S. domiciled facilities. We see one of the best opportunities for participating in this continued build-out of the natural gas infrastructure to be with those MLPs involved with natural gas liquids (or NGLs) infrastructure, as opposed to the more traditional dry natural gas.

Estimates of U.S. natural gas reserves have increased along with a renewed interest in LNG exports. What are your thoughts on the outlook for LNG exports in the intermediate- and long-term? How might growth in LNG exports affect the MLP sectors you follow?

Chiaro: Several projects have received federal approval and are currently under construction to export liquefied natural gas (LNG), the first of which should commence operation in 2015. Simply put, many natural gas producers are in favor of exporting LNG, because it provides another source of demand, which could provide price support. On the other hand, many large natural gas consumers are not in favor of exporting natural gas, as they would prefer lower prices for domestic demand.

Our view is that several additional LNG projects (beyond the ones currently under construction) are likely to be approved, although the issue has become very political (much like the Keystone XL Pipeline), and therefore incremental announcements regarding the approval or delay of projects are likely to result in price volatility for affected and related securities. Nonetheless, our view is that as long as prices remain in a range that is high enough to not negatively impact production but also low enough to not throttle demand, we are relatively indifferent on the outlook for LNG exports as the same amount of pipeline and related infrastructure is needed whether natural gas is consumed domestically via a utility or industrial complex or internationally with the consumption point being the LNG export facility.

The LNG facilities themselves could provide an attractive fee-based investment opportunity for MLPs, on the margin, but our expectation is that investment opportunities in the related infrastructure will be far greater.

Edelstein: LNG will be exported, starting in 2015 through Cheniere’s LNG facilities (already approved and under construction). We believe that many more LNG export trains will be approved and coming online over the next five to seven years. We are excited by this export potential and its role as a catalyst for continued extensive development of our natural gas extraction.

We are also looking for increased domestic consumption of natural gas. The low-hanging fruit here is the switching of fleets from diesel fuel to liquid natural gas or compressed natural gas (CNG). We have read estimates that up to a-third of Class-8 trucks could make the switch by 2016, saving 500,000 barrels of diesel fuel per day.

We also expect a continued resurgence in the U.S. petrochemical industry. More than $110 billion of new petrochemical plants and manufacturing facilities are currently planned or under construction in the United States. These projects will create high-paying construction and manufacturing jobs. Naturally, the gathering & processing MLPs will benefit the most from the growing production of natural gas.

Feng: The outlook for LNG exports ultimately lies in the hands of the Department of Energy (DOE). Currently, U.S. exports of LNG are only allowed to be sent to Free Trade Agreement (FTA) countries. However, the majority of countries that desire LNG exports from the United States are non-FTA countries.

In December 2012, the NERA Economic Consulting group, which was commissioned by the DOE, concluded in an independent study that despite higher natural gas prices, overall the U.S. economy would be stronger if LNG exports were permitted. This is due to higher GDP from increased production, export revenues/tariffs and more job creation domestically.

Growth in LNG exports would be an overall positive for the MLP sector, because the increased production would drive the need for pipelines to be expanded to support export facilities, more storage to satisfy peak demand and more processing plants to separate the natural gas stream.

Kiley: If large-scale LNG exports do come to fruition, that demand may cause differentials—variances in gas prices between two geographically distinct pricing points—to increase, which could positively impact the long-haul natural gas pipeline sector. That being said, with significant natural gas reserves in relatively close proximity to potential export locales, the impact may be somewhat muted over the long term.

McCarthy: We agree with other industry observers that 6 billion to 8 billion cubic feet (Bcf) per day of LNG export capacity will be built in the U.S., primarily along the Gulf Coast. Currently, the Cheniere project (roughly 2 Bcf per day) is the only one permitted to export to non-FTA (Free Trade Agreement) countries, and construction is already underway. The Department of Energy (DOE) recently announced that Freeport LNG has received conditional approval to export up to 1.4 Bcf per day to non-FTA countries. Other projects are waiting on approval by the DOE for export to non-FTA countries or are planning to export only to countries where the U.S. has a free trade agreement.

If LNG exports reach expected levels, producers are likely to increase domestic production of natural gas, which is good for MLPs with gathering assets. LNG export facilities—once they are built and have long-term contracts—are suitable assets for MLPs. Because each project will cost billions of dollars, we believe that only the largest MLPs will be able to own these types of assets.

Sallee: We are seeing an increase in both production and LNG exports and in the potential for supportive regulation. On a positive note, the Department of Energy recently completed a third-party study that concluded the U.S. would gain net economic benefits from allowing LNG exports. LNG operators must obtain authorization from the DOE to export LNG to non-free trade countries (as deemed by the World Trade Organization), such as Japan and China. LNG operators also must receive authorization to build liquefaction terminals from the Federal Energy Regulatory Commission, which prepares environmental assessments or impact statements for all proposed LNG facilities.

There currently are 23 U.S. LNG export projects pending or proposed to support export capacity of approximately 32 Bcf per day, and we expect a portion of this to be approved. While this activity is obviously good for upstream producers, we also see opportunity for additional MLP pipeline and related infrastructure build-out to support transportation from areas of supply to these export terminals and even own the terminals themselves.

Swank: With the recent approval of Freeport LNG’s application by the U.S. Department of Energy, there are now two facilities (Cheniere Energy being the other) that have been approved to export LNG to countries without free-trade agreements with the U.S. We anticipate over the next year or two that there will be an additional four to six projects that receive similar approval, although there is some uncertainty around the timing and political landscape.

With respect to the near-term, we believe it will be another 18 to 24 months before we see the first of these facilities come online, but in the interim these initiatives are supporting the need for additional infrastructure. Taking a longer-term perspective of our country’s LNG export business, we acknowledge that it will likely support natural gas prices to an extent, but producers have become very efficient with their ability to raise production in a relatively short period of time.

The fact that natural gas production has turned into a precision manufacturing process leads us to believe that the country’s abundant and growing supply will outpace the ability to bring exporting capabilities on-line, thus keeping the domestic price advantage relative to most other countries fairly sustainable. MLPs that will benefit from the LNG opportunity will be those with projects to build LNG export facilities and those with natural gas pipeline systems that feed those facilities.

What new developments could push petroleum-focused MLPs in new directions and/or produce new results for these petroleum-focused MLPs?

Chiaro: The need for crude oil pipelines and terminals has increased significantly over the last few years as crude oil production in the Eagle Ford shale, Permian Basin, and Bakken shale (to name a few) has increased dramatically. Pipeline construction has lagged production growth resulting in large basis differentials (i.e., the price of crude is materially different from region to region), since there is not sufficient pipeline capacity to transport the crude from producing regions to refinery centers.

MLPs are addressing the pipeline shortfall two ways: (1) They are constructing pipelines to transport the crude to the refinery centers, and (2) They are converting or reversing existing pipelines that are currently underutilized to transport crude.

While returns on new construction have generally been in line with historical averages, providing the MLP with an accretive project, returns on converted or reversed pipelines have typically been much higher. This is due to the fact that the cost associated with such a conversion is materially lower than new construction costs, the regulatory burden is generally easier, and the time to get a project into service is generally quicker.

We tend to invest in MLPs that have this type of opportunities, as current valuation usually undervalues growth associated with pipeline conversions. Often, an owner of crude oil pipelines also owns refined-product pipelines and terminals, and a growing opportunity for this segment is gasoline blending. Most gasolines are required to contain a specific, or minimum, percentage of ethanol, and at certain times of the year can be blended with butane.

Gasoline blending is usually completed at the refined-product terminal, an asset type most often owned by MLPs. Since the price of butane is now below the gasoline price and is expected to stay that way for an extended period due to the increased production levels of natural gas liquids, while ethanol blending is driven by governmental mandates, blending operations have become a source of material incremental cash flow with minimal incremental investment.

Edelstein: The development of tight oil is as significant as shale natural gas. This part of the U.S. energy growth story is being largely overlooked. The U.S. has grown its domestic daily oil production by 2 million barrels per day over the past two years. This growth alone is close to two-thirds of the total daily output of Iran, Iraq or Kuwait, which each produce 3 million barrels per day. North Dakota has gone from a non-producing energy state to the second-largest energy-producing state in less than five years.

We expect to see more tight oil development in non-traditional energy producing states. The approval of the much delayed and anticipated Keystone XL Pipeline will provide a substantial boost to exports of petroleum and its derivatives, creating a greater world dependency on U.S. energy, fueling additional demand and opportunity.

Feng: On the crude oil front, increased production from areas such as the Bakken, Permian and Canada are pushing MLPs to grow their asset base in the immediate future, particularly through rail and repurposing pipelines. Over 50% of crude travels out of North Dakota via rail, and MLPs are participating in this movement by expanding rail facilities and terminals along rail routes.

The rail trend is expected to continue, as the shorter nature of contracts and multiple rail points gives producers more flexibility to access various end markets. In order to provide more takeaway capacity of Canadian and Bakken crude to various markets, MLPs have begun converting existing natural gas pipelines to transport crude oil or reversing the directional flow of current crude pipelines to reach more efficient markets.

For refined petroleum products, growth in overall volumes has been fairly muted, particularly as higher fuel efficiency requirements for cars place an invisible cap on total domestic demand. That said, there is still cash-flow growth on the refined-product side for MLPs due to inflation-indexed tariffs and international terminal projects, particularly around the Caribbean islands serving major export and cruise ports.

The amount of domestic refined-product opportunities tends to be less than crude oil opportunities. As such, many MLPs that used to be more of a refined product pure-play, such as Magellan Midstream, NuStar Energy, and Sunoco Logistics have actively grown their crude oil logistics businesses these past few years. We expect this trend to continue, as well.

Kiley: We think we are already seeing dynamic shifts in the oil infrastructure sector. Public attention is focused on the Keystone XL Pipeline, but there are several billions of dollars in capital expansions already on going all across North America. Crude oil MLPs valuations reflect this activity, as the market has paid up for those entities exposed to the most attractive projects.

McCarthy: Crude oil infrastructure has been one of the most active areas for MLPs and other midstream companies over the past year. The rapid increase in domestic production has created numerous bottlenecks and dislocations between producing areas and the refiners that consume the crude oil. The most notable bottleneck is at Cushing, Okla., the pricing point for the domestic benchmark West Texas Intermediate (WTI) crude.

Increasing supplies in the mid-continent (most notably from the Bakken Shale in North Dakota) and constraints in transporting the crude to Gulf Coast refiners have resulted in a steep discount in the price of WTI relative to Brent, which is the international benchmark. This “differential” in prices has fluctuated over the last two years, but has been much higher than historical norms.

We expect that differentials will remain abnormally wide in the near-term and will narrow over time as new pipelines relieve the logistical constraints at Cushing. As a result of wide price differentials in the U.S., MLPs have begun focusing on regional crude oil infrastructure.

Some are using railroads to move crude oil out of the Bakken Shale and the Permian Basin in West Texas. Others are building new pipelines or “repurposing” existing natural gas or refined-product pipelines to transport crude oil to market centers. Midstream MLPs with the capability to move the regionally oversupplied crude to higher-value markets have been very profitable over the last couple of years, and we expect that trend to continue for the next few years.

Sallee: There are several scenarios we are watching. We continue to see a bright horizon for petroleum-infrastructure MLPs. As an example, driven by additional build-out, the bottleneck at Cushing, Okla., which has pushed U.S. crude inventories to near-record highs, will see some relief.

The Seaway Pipeline at Cushing, which went online in 2012, is ramping up capacity and is expected to move 850,000 barrels per day from Cushing to the Gulf Coast by mid-2014. Additionally, the southern leg of the Keystone will provide relief starting later this year, delivering a greater supply of cheap domestic crude to Gulf Coast refiners.

Over the long term, this should help narrow the spread between the price of West Texas Intermediate and Brent crude oil to the cost of pipeline transportation. Interestingly, there is also talk of swapping U.S. light sweet crude with Mexico, because its refineries can accommodate it, in exchange for Mexican heavy crude, which is what many U.S. facilities are built to refine. This would require government approval, and we are by no means banking on this. But if it gets the green light, we anticipate the resulting environment would be opportunistic.

Swank: First and foremost is the continued increase in our domestic production of crude oil from new or underdeveloped basins from an infrastructure standpoint. This changing dynamic is creating a myriad of opportunities for those MLP companies that have significant and/or focused operations in the transportation and logistics of crude oil and refined products.

To highlight a couple of the interesting dynamics driving activities and opportunities in this space, I would point to: (1) the bottlenecks that exist from Cushing, Okla., down to the Gulf Coast’s refining complex, and (2) the lack of infrastructure that exists to allow East and West Coast refiners to participate in the country’s burgeoning lower cost domestic crude oil production.

We’re seeing some growth in the number of “non-traditional” MLPs from companies that provide refining, fertilizers, chemical processing and frac sand, for example. What is your investment outlook on these MLPs? And how should investors evaluate the prospects for these MLPs? Do you expect there to be more non-traditional MLPs in the years ahead, and why?

Chiaro: We typically do not invest on these types of  non-traditional MLPs. Our view is that investors often under-appreciate the cash flow volatility and subsequent risk that the MLP is able to sustain a fixed distribution level. This risk can result in stock price volatility that is well above the traditional pipeline MLP. However, since these types of MLPs often trade at a higher yield, they have become attractive to investors more focused on current income.

Edelstein: For the appropriate investors—and even for the more risk-averse investors as modest additions to their core portfolios—we are quite positive. That being said, business models need to be evaluated on a case-by-case basis and positions need to be monitored closely due to market factors and the cyclicality of their businesses.

Feng: Non-traditional MLPs are a relatively new use of the MLP structure. In order to be an MLP, a company must generate at least 90% of its income from qualifying sources as defined by the IRS. Originally, those sources were only the transportation, processing, and storage of natural resources and minerals.

If a company thinks a form of income may qualify, it can apply to the IRS for a Private Letter Ruling (PLR) to clarify the law according to the specific situation. In the past 10 years, 58 PLRs have been issued, but 18 of those came in 2012. These clarifications and expansions are shaping the scope of the MLP space and driving the growth of the non-traditional MLP.

Recently, we’ve seen a great deal of growth related to those activities related to hydraulic fracturing and the shale plays. The IRS has been interpreting the law to include assisting in the fracking process as qualifying income. The IRS is very clear that the services necessary to support fracking, as well as broader exploration and production, are considered qualifying income.

Kiley: We have not been buyers of these non-traditional MLPs in a meaningful way. Many have variable payouts that make the yields unpredictable, which is unsuitable for many of our clients. For that reason, we don’t see these entities becoming a big part of our portfolios, although we do expect more of these assets to come public in the future.

McCarthy: In our opinion, the MLP structure is best suited for businesses that generate stable cash flows and provide a critical service for its customers. Volatile businesses are generally not as well suited for the MLP structure, because most MLP investors can’t assess what will happen to the earnings power of these MLPs as they return to more “normal” operating conditions.

Despite these caveats, we have invested in some of these non-traditional MLPs. We’ve been opportunistic and have relied on our broader understanding of the energy markets to buy equities that we believed were being mispriced by the market. We think it’s extremely important for investors to value these companies based on mid-cycle economics, which is not an easy task.

Sallee: Over the past five years, more than 40 MLPs have launched—some quite successfully, some not so much. Today, there are more than 115 MLPs, with 20 in non-energy related businesses. Within energy, the assets can vary widely, and investors who are interested in non-traditional MLPs have many from which to choose.

Additionally, more non-traditional energy related companies are now going public. In 2012 and 2013 year to date, seven non-traditional energy MLPs have raised more than $2 billion in initial public offerings. In that same time frame, nine non-pipeline energy MLPs have also raised more than $2.4 billion in initial public offerings.

Swank: I think it is fair to say that we have a cautious but constructive view of the non-traditional MLP structure as a whole. To further clarify, we do not have a philosophical opposition to the inclusion of these tangent business lines into the MLP qualifying definition. In fact, we believe that it speaks to the validity of the MLP structure as a way to encourage private capital into expanding the build-out of our nation’s energy “renaissance.”

That being said, and like with any expanding frontier or business adaptation, we believe investors should proceed with caution. Similar to an evaluation of traditional, time-tested MLPs, investors should (or require their managers to) focus on bottom-up fundamental research and thoroughly understand the dynamics of both the industry and company-specific economics, along with their associated risks.

Are there any trends in MLP investing or in a particular MLP sector that you would like to highlight?

Chiaro: One of the biggest changes we have seen in MLP investing over the past several years has been the emergence of MLP closed-end funds. These closed-end funds have raised billions of dollars, largely from smaller retail investors unwilling to deal with the K-1s or from institutional investors concerned about UBTI. These funds have been very beneficial to the MLPs, allowing them to raise a tremendous amount of capital at very attractive prices to fund the construction of assets supporting the production increases in the US.

We do not believe that MLPs would have been able to raise nearly as much capital over the last two to three years to fund these projects if it were not for the emergence of the closed-end funds. However, many of these funds have been less beneficial to the investors themselves. Due to a variety of issues related to tax and the restrictions placed on the management of mutual funds, most closed-end funds add an additional layer of tax at the fund level, a tax that an investor would not incur had it owned the MLP securities directly. We will be monitoring the continued growth of these funds to help determine the availability of capital for MLPs for their continued investment.

Edelstein: In last year’s Research MLP Roundtable, we mentioned that we own several general partners (GPs). In our opinion, these partnerships still represent excellent value because of the higher growth rates that they ­offer and because of their Incentive Distribution Rights (or IDRs). While investors in MLPs are interested in yield, those wishing to forgo some current income in exchange for additional capital appreciation will find that GPs are an excellent addition to a portfolio.

MLPs are an asset class in growth mode. In our quarterly MLP update, we discussed the significant growth opportunities and growth in distributions in the asset class. In the first quarter of 2013, distributions for constituents of the Yorkville MLP Universe Index grew by an average of 7.8% quarter-over-quarter annualized, which is above historical averages. Using the MLP total return formula (current income plus income growth and price appreciation equals total return) implies a forecast total return of 13.7% for the asset class.

When considering MLPs may be entering a trend in yield compression as institutional flows pick up to capture distribution growth rates, price appreciation may even outpace distribution growth. Total returns above the mid-teen levels in a 12-month timeframe could be easily surpassed.

Feng: There have been so many access products for MLPs launched in the past several years. With 61 access products investing in 102 MLPs (as of May 15, 2013), we may soon see more access products than operating companies. Obviously, we’re joking, but the numbers do indicate that the MLP investor market is much more heterogeneous than has been previously believed. There are closed-end funds, mutual funds, ETFs, and exchange-traded notes (ETNs). In a list of the top 10 products ranked by assets under management, each one of these products is represented.

There is no one best or most appropriate way to invest in the MLP space. For instance, for a U.S. taxable investor, comfortable building his or her own portfolios and taking on the single-security risk and filing K-1s, a direct investment in MLPs will always be the most efficient way to access the MLP market. Those circumstances do not fit everyone, however.

When investing in the MLP space, investors should begin by considering: Will the investment be in a tax-advantaged account; whether they’re interested in active or passive management; if they are comfortable with a fund using leverage and, if so, how much; if they are comfortable with single-source credit risk and from which sources; and what their capital market expectations are—specifically, do they think the return from MLPs will come primarily from price appreciation or are they looking for after tax yield?

The learning curve for MLP investing has always been rather steeper than that of other sectors. Even with the amount of available access products, it behooves investors to continue to do their homework.

Kiley: There has been a significant increase in the flow of funds into MLP exchange-traded products over the last two years, especially into index-based vehicles. As a result, an MLP being added to an index that these products follow has been a significant boost for that MLP’s valuation. It wouldn’t surprise me to see some of the smaller MLPs that have seen huge price appreciation in recent quarters suffer a meaningful correction when flows slow down or reverse.

McCarthy: The MLP success story is well documented and well understood by market participants. What a difference 13 years makes! Today there are approximately 100 MLPs with an aggregate market capitalization of close to $400 billion. In 2000, there were only 20 MLPs with an aggregate market cap of $16 billion.

MLPs are now seen as a distinct asset class and as a “must have” for yield-oriented investors. Given what is happening in the domestic energy market, we are very excited about how the sector will develop over the next 10 years.

Sallee: As new and different players come into the fold, we believe it is increasingly important to understand and assess their differences—they are not all created equal. A rising tide may lift all boats, but market cycles will separate quality MLPs from those with weaker business models. We believe this will play out as the MLP market evolves and business cycles ensue. This thinking forms the basis of Tortoise’s investment philosophy: Steady wins.

Swank: We believe the shale revolution in natural gas and crude oil is changing the energy infrastructure in the U.S. as never before, creating massive opportunities for MLPs, but also disrupting long-standing infrastructure economics. Nowhere is this demonstrated so vividly as with the long-haul natural gas transmission businesses.

Historically, pipelines that take natural gas from the Gulf Coast to the Midwest and both the East and West Coasts were secured by attractive long-term, firm commitments from investment-grade utility customers. With the rapid growth of the Marcellus Shale (2007-present), which is now the largest natural gas field in the U.S. (producing over 9 bcf/day out of 70 bcf/day of total U.S. supply), much of this Gulf Coast natural gas now needs to find a new home.

This development and other factors have driven lower volumes/earnings and discounted (or altogether lapsed) contractual commitments for these once “gold-plated” lines. To their credit, though, many of the natural gas transportation & storage MLPs are aggressively doing what they can to at least mitigate their sector challenges, including M&A, converting legacy natural gas pipelines to other product services (like crude oil or NGLs), finding new outlets for their gas such as various growing power and industrial markets, or other optimization strategies like backhaul service (particularly heading away from the Marcellus).