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Low Oil Prices Unlikely to Hurt Some Energy Investments

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So long as the federal government smiles upon tax-favored energy infrastructure projects, market participants say, not much can stand in their way as a growth and yield investment—not even low gas and oil prices, such as those caused on Monday by Saudi Arabia’s decision to cut prices on the oil it sells to the U.S.

Master limited partnerships in energy pipelines are increasingly popular with tax-conscious investors who are hungry for income in the current low-interest-rate environment, said Leonard Weiss, senior VP of investments with the Weiss Wealth Management Group of Raymond James in Farmington Hills, Michigan.

At the same time, MLPs protect investors from commodity price swings because pipelines simply act as a “toll road” that carries upstream products in distant locations to downstream refiners, Weiss said.

“Midstream pipeline carriers don’t own oil or gas, so the price of oil or gas is irrelevant to them. What’s relevant is that pipeline capacity is rented at a pre-negotiated fee to oil companies for many years at a time,” he said.

MLPs are a growth market because a game-changing U.S. energy renaissance is under way, Weiss said, asserting that the nation’s large shale-rock fields, including the Bakken, Eagle Ford and Marcellus fields, hold more oil reserves than Iran and Saudi Arabia combined and doubled.

Annual cash distributions on MLPs range from 4% to 12%, Weiss said. He added that MLPs are a good play for investors because the investor captures cash distribution growth by statute.

“A publicly held company’s dividend goes up because of the benevolence of the board of directors. A pipeline MLP raises its distribution to stay in compliance with tax laws,” Weiss said.

The Alerian MLP Index has outperformed both the S&P 500 and Dow Jones Industrial Average indexes for the last 10 years, Weiss said, but added that the number of MLPs has proliferated so investors must be careful about where they put their money.

Weiss named Enterprise Product Partners (EPD) as a major player in the space, with a $60 billion market cap that makes it larger than General Motors, Ford and Comerica Bank combined. EPD has raised its cash distribution every quarter for the last 41 consecutive quarters, he said. 

Renaissance Results 

Improved shale-rock extraction technologies have led to the renaissance-level rise in U.S. oil and natural gas production, with domestic shale fields pumping a record 1.1 million barrels a day of output so far in 2014, according to the U.S. Energy Information Administration.

But this embarrassment of riches had led to a problem for energy investors: companies are pumping out oil and gas at such a fast clip that demand can’t keep up with supply. As a result, prices are going down.

Will Riley, co-manager of Guinness Atkinson Global Energy Fund (GAGEX), said that oil prices for benchmark West Texas Intermediate crude currently stand at approximately $80 per barrel versus $100 per barrel six months ago. Similarly, the price of a barrel of global benchmark Brent crude oil has dropped to approximately $86 from $100 in the same period, Riley said.

“There’s been a slowdown in global oil demand growth, and that’s been coupled with an acceleration in supply forecasts,” Riley said. “The amount of oil produced is rising faster than demand is rising. If you ask why oil is rising more quickly, you would firstly see the growth in shale oil production in the U.S., and secondly, there’s been a recovery in supply in Libya.”

However, Riley expects to see a rising average oil price over time, with a barrel of Brent ranging between $130 and $150 by the end of the decade. That would be a positive for energy infrastructure MLPs, he said.

“If U.S. oil and gas production grows strongly, there’s a corresponding need for energy infrastructure to grow in order to take the production from the well head to market,” Riley said.

He warned that the principal risk to oil prices and midstream MLPs would be continued acceleration of U.S. shale oil production.

“If there’s too much supply, then that would depress the price for oil. Correspondingly, if the price falls, it’s likely that the demand for energy infrastructure also declines,” Riley said. 

Tax Situation 

Since 1987, the U.S. tax code has authorized the formation of MLPs by oil and gas companies, with ownership interests, or units, traded on the market like corporate stock, according to the National Association of Publicly Traded Partnerships.

Libby Toudouze, president at Dallas-based Cushing Asset Management, which sells midstream MLPs and mutual funds, reports that 120 of the 150 energy infrastructure companies now traded on exchanges have an MLP structure.

The annual cash distributions that investors get is tax-advantaged, Toudouze said, adding that investors who put their money into MLPs must be prepared to file K-1 tax forms. Those who prefer to file 1099 forms may prefer to invest in energy infrastructure mutual funds or exchange traded funds, she said.

(Toudouze and Cushing Asset Management were named an SMA Manager of the Year for 2014 in the Specialty category by Investment Advisor magazine and Envestnet.)

Jason Stevens, director of energy equity research at Morningstar, agreed that the tax implications of MLPs might scare off individual investors.

“But some high-net-worth investors and advisors may like MLPs because of their tax implications,” he said. The MLP sector has seen cash flow and market cap increase by a factor of 12 times in the last decade as the U.S. has cracked the code on shale gas and tight oil, Stevens said. Income-oriented investors have been the key stockholder group for midstream MLP groups as annual distribution rates over the last 10 years have increased by 6% to 8% per year, he said.

“So long as there’s continued growth in production, there’s a lot of runway for midstream energy firms to invest,” he said. “It’s been a strongly outperforming asset class. Funds don’t get quite the same performance as the MLP units because of expense ratios.”

Asked if low oil prices will hurt the asset class, Stevens gave a “yes and no” answer.

“MLPs derive their cash flows from longer-term contracted fee-based revenues, so there’s not a lot of commodity price sensitivity,” he said. “However, if these commodity prices were to go lower for a long time, then production would begin to slow or decline, and the need for new infrastructure would diminish. But I see no evidence that drilling has slowed materially.”

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