In the low yield, low growth environment we live in, we believe that owning growing, high quality midstream energy infrastructure investments will prove beneficial to investors’ portfolios. We also believe that the best way to invest in midstream energy infrastructure is via master limited partnerships (MLPs) and the affiliated corporations that serve as the owners of MLPs.
What is an MLP? MLPs are publicly traded partnerships. They have the unique advantage of trading publicly like a large corporation while enjoying pass-through tax status similar to a private partnership.
They must generate the correct form of revenue in order to qualify as an MLP under the tax code. The types of entities that qualify are generally in the energy infrastructure and real estate businesses. Today our team tracks more then 100 MLPs with a market capitalization of $470 billion.
Many MLPs have parent companies that are also publicly traded. The parent companies typically own an economic interest in the affiliated MLP and may own additional energy infrastructure assets. These parent entities are often corporations as opposed to publicly traded partnerships.
A large majority of MLPs own midstream energy infrastructure assets such as pipelines, natural gas processing plants, and storage facilities that have attractive investment characteristics. They are critical to the functioning of the economy, often monopolistic in nature, and generate a strong level of cash flow. Investors in midstream energy infrastructure can expect the following:
Current Yield: MLPs generate a high level of cash flow that is often passed through to investors in the form of a distribution. Current yields average 6.5%, which is a significant premium to commonly held income securities such as corporate bonds and real estate investment trusts.
Growth Potential: MLPs are benefiting from the current boom in U.S. energy production. The associated build out in energy infrastructure provides growth opportunities for MLPs and can fuel growth in future distributions. We expect MLPs to grow their distributions by approximately 7% in 2014 and by 5% per annum over the next 10 years.
Portfolio Diversification: MLPs have a relatively low correlation to the growth in the broader domestic economy. The build out in energy infrastructure will likely continue except in the most extreme of economic scenarios. Historically, MLP investors have benefited from low correlations to traditional asset classes such as equities, fixed income, and commodities.
Tax Advantages: MLPs traditionally have high levels of depreciation which serves to reduce taxable income. MLPs have the additional benefit of being pass-through vehicles from a tax perspective. Investors tend to face a lower overall current tax burden when investing in energy infrastructure compared to traditional asset classes.
MLPs have generated strong returns for investors for the 10-year period ended December 31, 2013. The annualized return for MLPs, including distributions, was 15.0% as measured by the Alerian MLP Index. This compares to 7.4 % for the S&P 500 Index and 4.6% for the Barclays Capital U.S. Aggregate Bond Index.
We believe that strong domestic energy infrastructure fundamentals position MLPs to deliver 6% to 10% total returns over the next 10 years. Importantly, much of this return will be in the form of quarterly distributions. We expect these distributions to grow steadily, enhancing the total return potential.
As in the past we expect these returns to be accompanied by occasional volatility. Historically, rising interest rates and equity market disturbances have hurt MLP performance over short periods of time. We expect that investors who hold MLPs through the next decade will be rewarded with a total return that compares favorably to many traditional asset classes.
U.S. Energy Production Growth
The shale revolution has positioned North America to reach energy independence by 2020, thereafter becoming a net energy exporter. This is an extraordinary turn of events for the United States, a country that suffered from steadily declining oil and gas production during the 1980s and 1990s.
A turning point occurred when the first hydraulically fractured, horizontal well was drilled in Texas‚Äô Barnett Shale in 2002. The event marked the combination of two drilling techniques that led to a remarkable increase in domestic production. Recently updated projections by the U.S. Energy Information Administration estimate that the growth rate of U.S. oil and gas production will double from 1.1% to 2.2% per year from 2012 through 2025.
The Need for Midstream Energy Infrastructure
Rapidly growing U.S. oil and gas production has put a significant strain on the existing U.S. midstream infrastructure complex. There is a need for new infrastructure to get the hydrocarbon products processed and delivered to end users.
According to a mid-2011 report issued by the Interstate Natural Gas Association of America, the natural gas, natural gas liquid and oil midstream sectors will require total capital spending of $10 billion per year through 2035 to accommodate the increasing supply and demand.
Investing in MLPs & Energy Infrastructure
MLPs are an increasingly popular and visible investment class given their strong historical returns. An example of this popularity is the growth of exchange traded funds and notes offering MLP exposure. These index-based products raised nearly $5 billion in 2013, remarkable for a set of products that are less than five years old.
While we understand the appeal and convenience of MLP-dedicated funds, we recommend that investors carefully examine all of the MLP-related investment opportunities to determine the best fit with their needs.