The U.S. energy outlook continues to improve. The International Energy Agency recently forecast that the U.S. would surpass Saudi Arabia as the world’s top oil producer by 2016, while Exxon Mobil’s CEO projects that the U.S. will be energy self-sufficient by 2020.
These trends bode well for master limited partnerships (MLPs) in the energy business. We asked several leading experts for their thoughts on midstream MLPs’ recent performance and their insights on the asset class’s outlook.
This year’s panel includes:
Kenny Feng, CFA, President & CEO, Alerian, Dallas;
Kevin McCarthy, Chairman, CEO & President of Kayne Anderson’s publicly traded closed-end funds
James Mick, CFA, Managing Director & Portfolio Manager, Tortoise Capital Advisors, Leawood, Kan.; and
Darren Schuringa, CFA, Managing Director, Yorkville Capital Management, New York.
How did midstream MLPs perform in 2013?
Kenny Feng, Alerian: The Alerian MLP Infrastructure Index (AMZI), a composite of 25 midstream-focused MLPs, returned 29.5% on a total-return basis in 2013.
Kevin McCarthy, Kayne Anderson: MLPs performed very well in 2013, providing a 27.6% total return, which factors in price appreciation plus distributions. Over the long-term, MLPs have delivered outstanding performance. For the periods ending December 31, 2013, the two-year return was 33.7%; the three-year return was 52.3%; and the five-year return was an outstanding 264.9%!
James Mick, Tortoise Capital Advisors: The energy infrastructure sector enjoyed another solid year in 2013, with midstream MLPs delivering a 33.5% total return (as represented by the Tortoise Midstream MLP Index), significantly outperforming their upstream counterparts, which returned 11.5% (as represented by the Tortoise Upstream MLP Index). Performance was generally steady throughout the year, although there were headwinds in the form of macroeconomic challenges, including geopolitical tension at times in the Middle East and continued partisan gridlock and a partial government shutdown in the third quarter.
Despite these transitory headwinds, however, investors remained upbeat about the domestic energy renewal underway in North America, and for good reason. As an example, crude oil production is up 50% since 2008 and topped 8 million barrels per day at the end of the year.
This tremendous production growth continued to drive project activity for MLPs, and in particular midstream MLPs, which are responding to the critical need for additional infrastructure to carry oil and natural gas from areas of production to end users. Capital markets were supportive of this growth, with MLPs raising more than $75 billion in equity and debt offerings, surpassing the total raised in 2012. Against this vigorous backdrop, MLPs continued to enjoy stable fundamentals and steady underlying distribution growth.
Darren Schuringa, Yorkville Capital Management: At Yorkville, we are focused on 100% of the publicly traded MLP space. That being said, 2013 was a strong year for midstream MLPs across the board, with the Yorkville MLP Infrastructure Index (our midstream MLP benchmark) returning 32.4% on a total return basis.
Digging a bit deeper, some of our top holdings in the General Partner (GP) and Gathering & Processing sectors provided outsized returns. On the GP side, our core positions in Crosstex (XTXI) and Energy Transfer Equity (ETE) shined, gaining 158% and 88%, respectively. Gathering & Processing names such as Access Midstream (ACMP, +76%) and MarkWest Energy (MWE, +37%) were strong as well, as production continues to rapidly expand in shale plays such as the Marcellus in Pennsylvania and Eagle Ford in Texas.
We also continue to do well with some of our midstream offshoot plays such as Cheniere Energy (CQP), which is a play on LNG exports, and Emerge Energy Services (EMES), which produces the sand used in fracking wells throughout the country.
Did those 2013 results differ from your pre-2013 expectations? If they did, what factors caused the unexpected results?
Feng: At the end of 2012, Alerian conservatively estimated that MLPs’ 6% yield, plus a 4-6% distribution growth rate would lead to a total return of 10-12% in 2013. This estimate was based solely on the growth opportunities available to MLPs at the time and assumed no major merger and acquisition (M&A) activity, new investor inflows consistent with historical levels, a pedestrian increase in interest rates, and a continued but slow recovery of the U.S. economy. We were pleasantly surprised.
Of the 17.5% return above the high end of our estimate, we attribute 12.9% (all of January 2013 performance) to the resolution of investor concerns regarding a fiscal cliff and dividend tax reform. Another 2% of outperformance was driven by average distribution growth of 8%, which outpaced our estimates due to additional organic growth projects and acquisitions.
Valuation improvement comprised the remainder of better-than-expected returns, driven by significant inflows of capital via exchanged-traded products ($4.1 billion), five new closed-end funds ($3.7 billion unleveraged), open-end mutual funds, and separately managed accounts for tax-advantaged institutions and foreign investors.
McCarthy: While we expected solid returns in 2013, the 27.6% total return of the Alerian MLP Index was almost double what we projected a year ago. Fueled by a strengthening domestic economy, calendar 2013 will be remembered for its very strong equity markets.
The S&P 500 Index set new all-time highs during 2013 and generated a total return of 32.4%—its strongest gain since 1995. While the MLP market did not quite keep pace, it generated a total return of 27.6%, which is very respectable in our opinion, considering that this was accomplished during a time of rising interest rates.
Among individual MLP sectors, relative performance was consistent with our views. At our flagship fund, Kayne Anderson MLP Investment Company (KYN), we maintained a relatively high allocation in 2013 to Gatherers and Processors (24% at the beginning of fiscal 2013 versus 14% for the AMZ) and a relatively low allocation to E&P MLPs (2% at the beginning of fiscal 2013 versus 7% for the AMZ). We maintained these relative positions during the year and were rewarded: Gathering and Processing was the best-performing sector (up 44.1% for the year), and E&P MLPs were the worst (up only 5.4%).
To gauge our performance, we use a metric called Net Asset Value Return, which is equal to the change in net asset value per share plus the cash distributions paid during the period, assuming reinvestment through our dividend reinvestment program. KYN had a Net Asset Value Return of 35.7% for calendar 2013.
Recall that the AMZ had a return of 27.6% for the same time period. That means we beat the AMZ by 810 basis points! So, looking at our relative portfolio weightings, 2013 results did turn out the way we expected.
Mick: The pace of midstream activity during the year was largely in line with our expectations. We anticipated rising crude oil production, particularly out of the Permian Basin, the Eagle Ford shale and the Bakken formation, and a corresponding decrease in imports, which played out as expected.
We anticipated that petroleum pipelines would benefit from higher crude oil volumes and a higher inflation tariff escalator, which was the case in 2013. We expected that assets would continue to migrate into the MLP structure, a trend that gained momentum as the year progressed.
We also expected to see pipeline companies restructuring to unlock value, with the largest such examples announced during the year being ONEOK (OKS), which is spinning off its utility assets and transitioning to a pure-play general partner, and Spectra Energy Corp. (SE), which dropped down its significant U.S. midstream assets to its MLP.
From a performance perspective, while the 30%-plus returns were a bit beyond our expectations, we did anticipate an above-normal year due to the weaker than expected 2012 returns, which came in around 5% for MLPs. Notably a significant portion of the 2013 return was generated in the first quarter as MLPs rebounded from a weak finish to 2012.
Schuringa: Coming off the weakness MLPs experienced at the tail end of 2012, we expected a strong rebound in 2013. While the 30%-plus returns were on the higher end of our expectations, they weren’t all that surprising with the long-term U.S energy story intact.
Fundamentally, MLPs delivered in 2013, with 100% of midstream-focused MLPs either maintaining or increasing distributions. On a trailing 12-month basis, average distribution growth was a robust 8.4% for Infrastructure MLPs, above historical averages.
What potential upside do you see for midstream MLPs for the next 6 or 12 months, and why?
Feng: We view midstream MLPs as a long-term investment in the build-out of North American energy infrastructure and believe investors are best served by holding a diversified portfolio of midstream MLPs for at least five years. The simple math—a 6% yield plus 4-6% distribution growth—suggests that returns should average 10%-12% per annum over the long run, excluding acquisitions and valuation improvement.
There is greater visibility to the higher end of that distribution growth range over the next few years given already announced capital projects. But the record crude oil, natural gas, and natural gas liquids (NGLs) production growth in the U.S. coming from widespread application of horizontal drilling and hydraulic fracturing is likely to drive infrastructure development opportunities for decades to come.
McCarthy: Our outlook for 2014 is positive. Continued development of unconventional reserves will create plentiful growth opportunities for the sector, and we expect that distribution growth of approximately 7% will lead to low double-digit total returns for the MLP sector.
MLP distribution growth will help moderate the impact of rising interest rates, and we expect some MLPs to see yield compression in the face of higher rates. We also expect an active year for mergers and acquisitions, leading to additional growth in cash flows and distributions. Finally, 2014 should be an active year for MLP IPOs, with successful deals providing upside to performance.
Mick: We continue to see upside potential for midstream companies in 2014, with the key driver being the continued build-out to support the production growth from various plays all over the country. Specifically, petroleum pipeline companies should remain steady in the months ahead, supported by growing production and an attractive tariff escalator expected in 2014. The project backlog for crude oil and liquids pipeline companies continues to build, as well.
Refined products pipelines are expected to be stable with the potential for a marginal uptick in volumes as an improving economy and employment picture helps offset efficiency gains. While we continue to expect a lower short-term growth outlook and continue to monitor re-contracting rates, natural gas pipeline companies should benefit from the build-out in the Marcellus and longer-term expanding demand potential, driven by power generation and natural gas exports.
Schuringa: Assuming yields remain at current levels, we see a reasonable 12-month total return estimate of 11-15% for midstream MLPs. One can back into this estimate by assuming 6-8% distribution growth combined with yields of 5-7%.
If we see a compression in MLP yields, the potential for price appreciation becomes even greater. But with rates poised to increase over the course of 2014, any additional gains from yield compression will likely be modest.
How do you expect the midstream MLPs to perform in the intermediate and long term, and why?
Feng: Our long-term expected return should also prove out specifically in 2014 if the U.S. economy continues to grow, the forward yield curve is free of significant shifts, equity issuances are absorbed by existing and new investor money, and NGL prices continue to recover.
Additional upside versus our projections could come from a lifting of the crude oil export ban, which has been in place since the 1970s; passage of the MLP Parity Act, which would expand the structure to include renewables; and consolidation of small- and mid-cap MLPs seeking to lower their cost of capital and diversify their geographic and product risk. The first two are unlikely to happen prior to the midterm elections in November, and the timing of consolidation is largely unpredictable.
McCarthy: In the intermediate to long term, the “shale revolution” (the development of domestic unconventional resources) continues to be the biggest story for MLPs and a big driver for the domestic economy. Judging by the large number of news articles written during 2013 on the shale plays, hydraulic fracturing and the impact of surging domestic energy production, it is safe to say most people are aware of the impact unconventional resources on the domestic economy.
Job growth related to the energy industry, as well as a result of increased domestic manufacturing activity, continues to be a boon for the U.S. economy.