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.
This impact will continue for many years to come. Plentiful domestic energy supplies and low relative prices have led to resurgence in U.S. manufacturing and positioned the U.S. to become one of the largest exporters of energy in the world.
The shale revolution 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 will require an investment of $250 billion over the next 20 years. This presents a huge 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.
Mick: We are just as optimistic about the longer-term outlook. Due to advancing technologies and the discovery of more reservoirs of resource-rich shale, a domestic energy revival is dramatically altering the global balance of energy, which has tremendous promise for a host of benefits.
As we look long term and evaluate the impact on the energy value chain, the tremendous supply growth in crude oil, natural gas and natural gas liquids has generated a need for a demand response. In our view, that response is in progress but varies in terms of how quickly it arrives. Growing domestic crude oil production is reducing foreign crude imports.
On the natural gas side of the energy value chain, the continuation of natural gas power generation replacing coal as well as exports in 2016 and beyond will drive demand growth. While on the natural gas liquids front, the petrochemical industry has a significant build-out of facilities planned in the back half of the decade, set to take advantage of growing production and attractive prices relative to global competitors.
We expect midstream MLPs and other pipeline companies will benefit from the growth in production in all these various cases. In fact, in the three years through 2015, we project more than $130 billion in MLP, pipeline and related organic-growth projects. We believe these assets, which are critical to our energy needs, are attractive to investors in periods of both economic growth and uncertainty.
Schuringa: Shale production growth continues to be the driving force in the U.S. energy expansion. Texas alone grew its oil field production by 1.5 million barrels of oil equivalent per day (mm BoE/day) over the past five years—a number larger than the Saudi and Russian growth combined. North Dakota, a new energy frontier, also raised its oil production by 0.67 mm BoE/day, nearly equaling the combined growth of the aforementioned two energy giants.
Going forward, the shale revolution should continue to be the main driver of growth in energy production worldwide. According to a study sponsored by the Department of Energy, 32% of the total estimated natural gas resources are in shale formations, while 10 % of estimated oil reserves are in shale or tight formations. In the U.S. alone, it is estimated there are still 223 billion barrels of crude oil and 2,431 trillion cubic feet of natural gas to be extracted.
For investors in midstream MLPs, this means greater storage and transportation volumes as well as increased demand for processing and fractionation. The net result if increasing volumes will be a stable distribution growth trajectory for pipeline operators and gatherer-processors.
What do you see as the advantage of the midstream MLPs’ toll- road model for investors?
Feng: Investors like toll-road business models, whether it be via midstream MLPs or another asset class, because of the predictability of their cash flows. Interstate liquids pipelines in particular benefit from federally approved tariff increases every July 1, inelastic energy demand, high barriers to entry leading to regional monopolies, and meaningful operating leverage from a high ratio of fixed-to-variable costs.
McCarthy: Midstream assets are the “logistics assets” of the energy sector, used to provide services to the energy industry. They include pipelines, processing plants, storage facilities and terminals.
Characterized by stable cash flows, long-lived assets and fee-based cash flows (i.e. minimal commodity price risk), midstream assets are strategically important to delivering energy to our nation. The fees and tariffs charged by many midstream MLPs are often subject to regulation at the federal and state levels and have tariffs that increase based on the rate of inflation.
Increased production from new areas has put pressure on commodity prices in certain regions of the U.S. as insufficient infrastructure exists to move the production to other markets, thereby increasing the importance of fee-based pricing. Finally, MLPs have averaged 8.5% distribution growth since 2000 and grew distributions at 7.4% in 2013, well in excess of yield alternatives.
Mick: We continue to see stable and predictable cash flows as the primary advantage of the midstream toll-road business model. Midstream companies have the potential to distribute steady cash flows, quarter after quarter, year after year.
The robust production growth made possible by advances in drilling technology is driving a correspondingly robust need for more toll roads in the U.S. In our view, this translates to growing cash distribution potential for midstream investors.
The fee-based nature of pipeline company cash flows and inelastic nature of energy use somewhat safeguards the toll-road model from political uncertainty and economic cycles. This is particularly attractive as our nation continues to grapple with fiscal and economic challenges.
On a larger scale, the toll-road model is good for the U.S. economy in that it provides reliable transportation and distribution of energy across the country.
Schuringa: The advantage of the toll-road model lies in the stability and consistency of distributions by the partnerships to end investors. By engaging in long-term contracts and employing hedging strategies, most midstream MLPs are able to secure future cash flows. The market generally rewards partnerships possessing these characteristics with premium valuations, lower yields and a lower cost of capital.
However, investors must consider that not all midstream MLPs are afforded 100% fee-based revenues. For example, many processing contracts are structured as keep-whole or percent-of-proceeds, leaving some of the commodity price risk with the MLPs themselves.
It is therefore important to understand exactly what you are investing in, and that is where active management comes into play. For those who prefer to play the midstream segment without paying higher fees, we would suggest the Yorkville High Income Infrastructure MLP ETF (YMLI), which we launched in 2013.
What potential risks should midstream MLP investors monitor?
Feng: Access to capital markets is critical for MLPs to take advantage of all the opportunities available to them. MLPs generally pay out 80-95% of their available cash to investors each quarter; so in order to pursue new organic growth projects and acquisitions, they need access to the markets.
Investors should beware of rising acquisition multiples, usually driven by the desire to enter a new basin or the potential for a significant ramp-up in long-term cash flows, both of which introduce execution risk. Labor and equipment markets are also tightening, so executives will also need to be vigilant about keeping projects on time and on budget.
Equity issuances are likely to set new records again in 2014, both through marketed secondary offerings and IPOs, so equity overhang could materialize if new investor inflows fail to match supply. Investors should follow commodity prices, particular crude oil and NGLs, which could weaken if bottlenecks are caused by infrastructure or end-user development delays.
And as with all yield-oriented securities, investors should continue to pay attention to possible shifts in the yield curve caused by comments from the Federal Reserve and/or changes in the pace of the Fed’s tapering program.
McCarthy: We believe that stock selection becomes more important in the face of rising interest rates; winners and losers created by changing transportation flows of crude oil and natural gas; MLP valuations; and the growing complexity of the MLP space.
We believe the MLP sector can generate low double-digit returns in 2014, but the total return expectation is partially mitigated by an expectation of rising interest rates. Rising interest rates could lead to higher yields for MLPs (which would reduce total returns), but we believe this will be a temporary headwind. Ultimately, the sector’s attractive yields and prospects for many years of distribution growth will lead to a continuation of strong returns.
Increased production from new areas (the Bakken Shale and the Marcellus Shale are two good examples) continues to have a material impact on historical transportation patterns. In most cases, this means new midstream assets need to be built to move the oil or gas from production areas to end markets‚Äîbut it can also create challenges as changing transportation patterns put pressure on certain existing midstream assets (which may no longer be needed).
For instance, production from the Bakken Shale in North Dakota has increased over five times in the last five years. The vast majority of that oil is not consumed in North Dakota and must be shipped to refineries elsewhere in the U.S. This has put a strain on the existing midstream infrastructure in the area, but creates tremendous opportunities for midstream companies to develop long-term transportation solutions.
After the financial crisis, most if not all MLPs were undervalued, so no matter which MLP you chose, you were pretty much guaranteed a good return. Today, many MLPs are fully valued, so choosing the right names becomes key.
Finally, the MLP space has become more complex. MLPs used to consist of long-haul, fee-based pipelines, processing plants, and storage facilities. Now we have MLPs involved in refining, fertilizers, chemical processing, frac sand, transmix, compression services, coke-making, methanol and ammonia. Investors face a challenge in understanding these business models, analyzing their economics and selecting the names with the best return potential.
Mick: We don’t consider higher interest rates to be a potential risk over the long term, but we realize that this is an area of concern for many MLP investors. This was evidenced by the spate of short-term market volatility following the approximately 50 basis point rise (from 1.6-2.1%) in the 10-year Treasury rate in May.
While higher rates are inevitable at some point, and may cause some shorter-term volatility, we believe that over the long term, quality growth will prevail. As evidence, one can point to the returns for 2013, when MLPs generated a 30%-plus return despite a 125 basis point rise in the 10-year treasury throughout the course of the year.
Here’s what’s behind our thinking: First, it’s important to remember that MLPs, unlike bonds, can grow their distributions over time. Second, midstream MLPs’ generally conservative debt structure and use of primarily fixed-rate debt support them in a rising-rate environment. Midstream companies generally utilize 70 to 100% fixed-rate debt, so their cash flow growth and longer-term performance is less sensitive to higher rates.
In addition, rising rates generally are caused by either inflation or an improving economy. A strengthening economy helps midstream MLPs, because as an economy improves, aggregate demand increases. And when inflation is the catalyst for higher rates, some MLP and pipeline companies can pass through the rate as it relates to liquids pipelines, which receive tariff escalators that would effectively push up the rate side of the equation.
We believe that either one of these rising-rate catalysts would in turn drive improved cash flow, which could either offset an increase in rising equity yields or allow for equity yields to not have to rise given the offsets. In short, we feel there are mitigating factors that will allow MLPs with solid distribution growth to perform well, even in a rising rate environment.
Schuringa: While all MLP investors need to keep an eye on Washington and the debate surrounding tax status of partnerships, we see regulatory risks as slim in the short- to intermediate-term. Not only have the potential tax revenues from MLPs been estimated at no more than $2 billion to $3 billion, but it looks as though the MLP Parity Act (which would extend partnership eligibility to renewables) has a real shot to go through. We see this as political insurance.
The more pressing concern from a valuation perspective in the short term looks to be a run up in rates. While MLPs have proven to be resilient by producing positive returns over every major rising rate environment since 1993-1994, they are susceptible to rising rates in the very short term. Any pullback would represent more of a buying opportunity than real downside in our opinion.