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16816
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54f9e25f140ba0f3078b45b5
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MLPs continue to satisfy the need for yield
Master Limited Partnership have very distinct advantages and offer a unique diversification opportunity. Watch as four experts discuss how investors can take advantage of MLPs in the current environment.
Diego Kuschnir - Portfolio Manager & Managing Director at Tudor, Pickering, Holt & Co.
Jeff Jorgensen - Senior Vice Presidnet, Director of Research at Center Coast Capital Advisors, LP
Michael Clarfeld CFA - Managing Director, Portfolio Manager at ClearBridge Investments
John Tysseland - Partner at Energy Income Partners
Duration:
00:56:25
Transcript:
Courtney: Welcome to Asset TV’s Master Limited Partnership Masterclass. Joining us today in our New York studios are: Diego Kuschnir, Portfolio Manager, TPH Asset Management; Jeff Jorgensen, Director of Research, Center Coast Capital; Mike Clarfeld, Managing Director and Portfolio Manager, ClearBridge Investments; John Tysseland, Partner, Energy Income Partners. As investors search for income in a low rate environment, MLPs have emerged into a viable allocation to satisfy that need. Will this continue amid the headwinds of a strong dollar, low oil and rising rates on the horizon? Well, that’s what we’re about to find out. Gentlemen, welcome to our MLP Masterclass. I want to start out with the name, Master Limited Partnership, it alludes to the legal structure, but other than that it’s kind of ambiguous for an investment vehicle which has pretty distinct characteristics. John, what’s an MLP?
John: [00:00:52] An MLP is predominantly just a way of financing business, you know, it’s unique just because it has some tax advantages, predominantly the fact that it’s a single taxed entity where all the taxes are done at the investor level rather than at the corporate level. And then, you know the dividends or cash flows from that entity to the investors not having to be taxed as dividends. So predominantly all the tax accounting is done at the investor level. So yeah, the single tax entity versus a double tax entity. The entities or the businesses that can actually qualify for an MLP would have to generate 90% of their income from qualified sources. Those qualified sources typically are in the natural resource business. What an MLP doesn’t do and I think this is somewhat confused by investors a lot is it doesn’t tell you the types of cash flow these businesses generate. It doesn’t tell you how cyclical those businesses are, how stable those businesses are. And I think that point has been confused a lot. But generally speaking think of it as a business that is financed with its equity capital, financed around a natural resource business, whether it be E&P upstream oil and gas production or pipelines or terminals.
Courtney: [00:02:06] Okay. So it has good tax benefits, liquidity, Diego, why else are these attractive to investors?
Diego: [00:02:12] Well, you know, I think to John’s point, I think there’s a difference between what an MLP is and what a lot of people sometimes think of midstream companies. So the usual benefits for companies in this space is that most of them have a toll road model where they collect fixed fees and it’s a very attractive and stable source of income for these companies and, you know, in turn for their investors. As the industry has developed obviously there’s been a lot bigger differentiation in the type of companies that consist, you know, that make up the MLP world. And that differentiation comes into play especially moments like this. So there’s different points in time where maybe different business models are more attractive than others. And clearly today we think the less commodity exposed, more toll road basis is clearly in favor in today’s environment.
Mike: [00:03:03] And I think if I can just add, I think one of the things that most individual investors find attractive about MLPs in addition to what these two gentlemen have said is just taking it a step further, on the investment side is it’s a powerful combination of upfront cash flow. So everybody’s looking for income and today MLPs offer an attractive income but they also offer growth. So over the last 10 years MLPs have been growing their dividends or in distributions at probably a 5/6/7% rate. So it’s a nice combination of both upfront yield, today it’s about 6% for this space, and combining that with growth. So because of the tax of assets investing in these stable fee based energy infrastructure assets, combined with the benefits of the advantage tax status that was discussed it enables a cash flow stream that’s very attractive for individuals.
Jeff: [00:03:50] And I think because there’s yield and growth or distribution rate and growth, I think it’s important. It’s not necessarily a fixed income surrogate 100% of the time. It’s not necessarily an equity. It’s a little bit of a hybrid of the MLPs around asset class, a very attractive one.
Courtney: [00:04:05] And when you look at other tax advantage vehicles that investors might be wanting to look at, on a relative yield basis how do MLPs stack up, Mike?
Mike: [00:04:15] Yeah. So I think MLPs stack up pretty well today, particularly against … specifically against some of the other tax advantage assets, but even more broadly. So I think when I think of other sort of tax advantage assets coupled with [unclear 00:04:15] REITs, which is sort of a similar structure but for real estate, and REITs today I think yield a little less than 4%. And then municipal bonds has obviously historically been a very attractive a tax advantaged way of fixed income. But like most bonds today is really very little yield there. So particularly with the pullback that we’ve seen in the MLP space in the last six months because of the correction or the decline in oil prices, MLPs today yielding, you know, 6 or just north of 6%, stand out as being really relatively attractive compared to most every other asset class, whether tax advantaged or not.
Courtney: [00:05:02] And Diego mentioned midstream, so we hear upstream, midstream, downstream, Jeff, can you explain what these mean?
Jeff: [00:05:10] Sure, certainly. So upstream is effectively drilling a well, you know, poking a hole in the ground and extracting hydrocarbons. Downstream is effectively getting closer to the end user, whether it’s a refinery in crude oil, whether it’s a chemical plant using, you know, NGL products or whether it’s an end user on the power side or something for natural gas, or maybe a retail station for gasoline even further downstream. And in the middle you have the supply side on the upstream, you know, the downstream demand center, in midstream are the pipes, the toll roads that are connecting those two, it’s simply put, processing, storage, transporting, that hydrocarbon from supply to demand.
Mike: [00:05:46] And I think the reason people talk so much about midstream in MLPs is the upstream, the E&PPs is very exposed to the commodity price. So you know, the driller is … when oil prices are high they make a lot of money and when they go down they’re very closely tied to that. The midstream pieces, as we keep talking about the toll roads are really very utility like and so relatively insulated from the moves in the commodity. And so that’s what’s so attractive for the MLP space is, as MLP investors, everybody likes the predictability and stability of cash flows. And that midstream piece in the middle is really insulated probably speaking from the commodity flows and commodity price moves and so is a good vehicle or a good asset for the MLPs.
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John: [00:06:27] I mean I’ll just say it’s important to kind of note that there’s a difference between, you know, midstream MLPs, upstream MLPs and even downstream MLPs. And what actually … and midstream, kind of what people categorize as midstream is not always toll roads. You know, a lot of times you can have some commodity set price sensitivity and cyclicality and these midstream names. So it kind of goes back to my initial comment saying, you know, just because it’s an MLP it doesn’t tell you the kind of the cash flows that are coming out of that business or that asset. There are MLPs that have highly cyclical cash flows, have high relative yields but, you know, when you’re paying out all your cash, the way we kind of think about it is, if you pay out all your cash to your equity holders, you obviously are paying cash to your debt holders, you’re almost a fully levered entity. And so the types of businesses that really can be able to pay a steady distribution and income to investors on a recurring basis need to have long asset lives and very stable cash flows. So there tends to be a mismatch in some cases where you have short lived assets, highly cyclical assets in the MLP structure that is trying to promise a distribution, because over time as the cycle goes, those are the ones that are going to have problems paying their distribution and keeping that promise to investors of being able to pay that distribution or grow that distribution. We’ve seen a number of distribution cuts, a lot of those have come into the ones that have cyclical assets and E&P type of businesses as in the MLP structure.
Courtney: [00:08:03] But the E&P is upstream?
John: [00:08:05] E&P is upstream, they produce oil and gas and they generate revenues based upon what their production is and what oil and gas revenues … oil and gas prices are. They can hedge that to some degree but that’s limited.
Courtney: [00:08:18] And what’s driving this demand, Diego, for MLPs right now?
Diego: [00:08:21] I think to, you know, to the point that you made before, it’s clearly one of the few areas, you know, likely in the US economy and certainly on a global scale as we see in the US position versus others, where you do have the combination of some of the most attractive growth out there. It’s one of the sectors, oil spaces in the US economy which has grown the fastest over the last … since the 2008 financial crisis. So you do have this growth component that has been very meaningful and very attractive for investors that are wishing to be levered to growth. The second part of the attractiveness clearly is the income side, that the income play which especially in the 2% 10 year yield environment, makes it all that more interesting. So the combination of those two we think makes for a very compelling argument for the industry as a whole. I think as we’ve all discussed, and we’re learning more today than maybe a year ago, there is a big differentiation that perhaps within this space that people just bunched everything together. But as a sector as a whole it clearly offers those two components that make it very attractive.
Courtney: [00:09:28] So it is pretty nuanced but what were you going to say, Jeff?
Jeff: [00:09:30] Well, I was going to say, I mean everyone wants to get behind this North American unconventional oil and gas revolution, but no one wants commodity exposure. And if you’re investing in the right MLPs the great way to get behind what truly is a worldwide game changing event in the development of shale oil and gas resources in the lower 48, and it’s a great way to play that without taking on too much risk. So we’ve seen the risk play out in some of the upstream names, and you know, it’s pretty great.
Courtney: [00:09:57] And with everything that’s going on how are you, Mike, able to navigate everything that’s going on with, you know, the energy market kind of having a tough time in 2014?
Mike: [00:10:05] Yeah. So I think it comes back to, you know, the work you do on the way in and the types of companies you’re focused on investing in. And so we’ve talked a little about the midstream versus the upstream versus the downstream and there’s a very … you can see very clearly amongst some of those sectors the big differences. So the upstream we talked about you’re really very exposed to the commodity price. And I think when everything was going well, maybe some investors were tempted to move into upstream MLPs and think that they were well hedged or that it was, you know, they were well positioned. And I think what we’ve seen is when the downturn as oil has come off a bit, upstream MLPs have performed very poorly. I think at ClearBridge and I actually suspect from most everybody on the panel we’ve always stayed away from the upstream MLPs and really focused on the midstream. And I think, so the way we’re able to navigate it is on the way in, in terms of the investments we make in the companies we’re choosing to invest in, focusing on those with really sort of truly fee based businesses, businesses and revenue streams that are long term contracts often have take or pay provisions meaning whether or not the pipe even gets used they get paid the same. So truly by focusing on companies that really have those fee based highly stable business models, you choose those on the way in, they’ve weathered it a lot better and I think are well positioned actually to play off in this environment.
Diego: [00:11:26] Yeah, I mean to add to that I would say, you know, I think us as investors, you know, what you’re trying to do is you’re trying to buy a 100 cents for 80 cents, right. That’s the game we try to play. And it clearly is a lot easier of analysis to do when you have significantly more visibility towards the type of contracts and the assets that you’re buying into, right. So upstream MLPs, you might be able to buy it at a discount at different points in time, but there’s clearly significantly greater uncertainty as to what exactly those cash flows will end up being. And I think that’s why a lot of us tend to gravitate towards the more [unclear 00:12:01] at the midstream side of this space, yeah.
Courtney: [00:12:03] Is that accurate for everyone on the panel here?
Jeff: [00:12:06] Absolutely. And really it depends on an investor’s objectives. And I think the MLP asset class, many investors enter into MLPs to collect stable distributions. And I think that’s why we keep harping on midstream as the preferred, you know, piece of the energy puzzle for MLPs. That’s our strategy, that’s where we focus. And it’s proven to be very attractive.
Mike: [00:12:26] Yeah. And just to explain that a little further, you know, if you think about it, there’s nothing wrong with the E&P business, it’s, the challenge is when you put the E&P business inside of the MLP wrapper and for an MLP investor base. So most MLPs pay out the vast majority of their cash flows which is … and then when they need to finance growth projects they go to the market and raise equity and debt. The problem with being an upstream E&P who pays out most of your cash flows is, you know, in a good year you may be able to pay out a dollar 50 a share. And in a bad year, I’m just making sums up, it may good down to 50 cents a share. And investors don’t like that kind of volatility. And so just for yield oriented investors it’s much better we think to have stable predictable distributions as opposed to more volatile ones. And the E&P probably fits better in a C corp structure than in the MLP structure.
Courtney: [00:13:14] And, John, your thoughts on this?
John: [00:13:15] I would just say that that’s, you know, we look at things as whether the business actually matches the structure in which the business resides and how they finance themselves. And so there’s just a mismatch between upstream E&P business and the MLP structure where you’re paying out all your cash flow. But I’d also say that this goes, you know, even broader than just when you look at just the individual companies because when you talk about indexes, when you talk about the Alerian MLP index, which is kind of a very widely used benchmark, and you use things like averages, average 6% yield, 6% growth, hey, it looks like it’s 12% total return. However, when you look at that average yield of 6%, you’re taking into consideration a lot of upstream MLP yields that have higher yields than 6% and then a lot of pipeline MLP yields, they have much lower yields than 6%. And so if an investor comes in and says, “Hey, I want a 6% yield like in the Alerian MLP index.” What you have to understand as an investor is that you are requiring or handcuffing the manager and saying, “I want asset quality that is very, very broad that includes E&P, MLPs that might have 12% yields and these pipeline MLPs that might have 4, 3, 4 or 5% yields.” You know, when we look at, you know, our portfolios, our yield tends to be a lot lower than what the averages are. But we tend to outperform … the portfolio tends to outperform during things like the fourth quarter.
You know, the Alerian MLP index was down 12% if not more in the fourth quarter, it was up not even 5% for the year. Where you look at our portfolios we were down only 1% and up 17% net of fees for the year. So there’s a huge difference in terms of, you know, what that average yield is and what that growth is. And when you have cyclicality or you have commodity prices falling dramatically, how those different, you know, indexes perform, how the different securities perform and my point is, is that you really as an investor, need to be cautious about buying an index that has a high yield, buying any security that has a high yield just because you’re attracted to that. Because the asset quality within that can vary greatly, and that’s what can drive really big divergence in performance like we saw in the fourth quarter.
Courtney: [00:15:38] These are all really interesting points. But I want to pivotal it a little bit, what’s your sense, Jeff, of the supply demand dynamic right now in the energy complex?
Jeff: [00:15:46] Well, we obviously have a tremendous amount of supply. And you know, the way that I … this is obviously causing a price crash globally, because we’ve flooded the world with crude. On the demand side it’s a very difficult equation. You know, I think a lot of the demand side for crude is driven by the BRIC nations, you know, China specifically. But I think on the natural gas side you have some nice tailwinds domestically, it’s a domestic product and so we get oil energy plants up and running. You have some tailwinds there. But really we’ve flooded the world with supply and that is what has caused a price crash. The good news for midstream investors, if someone’s got to move the supply around and get it to demand centers and that is why the midstream companies have performed very well. You know, if you take a look at fourth quarter cash flows over third quarter, that’s something that we look at just to prove kind of the fee based nature of those midstream businesses and how all that supply has benefitted them. From our portfolio’s perspective our DCF or EBITDA grew at 6% and 10% whereas commodity prices declined about 40% in our third quarter over fourth quarter, fourth quarter over third quarter. So you have a tremendous amount of supply and it’s going to keep coming in my opinion because we’re getting and better extracting, you know, shale gas and oil from the rock.
Courtney: [00:17:08] Alright. And this is kind of an interesting point, I don’t know, maybe you guys can weigh in. But I’ve heard that there is so much supply that companies are actually leasing oil tankers just to park their product, is that a typical scenario or is this kind of just new with this excess supply, Mike?
Mike: [00:17:24] Well, I mean, yeah, there’s a lot of parking of your product right now because you’re in a container market, right. So you’re going to want to contain, meaning that the forward price in the future is greater than the price today. And so that often happens in times of tremendous supply. So you’d rather sit and sell it later and just park your product as opposed to selling it today.
Mike: [00:17:42] Yeah. And that’s definitely something that people pick up on in a time like this when the market is correcting so significantly. It’s not new to this point in the cycle. It’s not like that’s never happened before, this is something you sort of regularly see when there is again this contango structure in the market where you see ships being, you know, floating offshore just full of oil waiting for … to sell in the future. The big talk these days is what’s going to happen with the storage at Cushing. So Cushing is a big storage hub in the United States and people are very focused on the fact that the storage there is filling up because people are similarly taking advantage of the contango structure to buy their oil today and you can sell it forward and lock in a spread and make money. So this is not unique to this market cycle, this is something you always see at this point in the cycle.
Diego: [00:18:27] And I think one of the consequence of this and I happen to be of the view that, you know, medium to long term buy yield, we don’t seem to … at the firm we don’t seem to believe that the $50 oil is really sustainable for the large projects, right. We think that shale works to, you know, much lower … much lower numbers than the usual 80 or 90 that we have seen for a long time. But on a global scale as depletion start coming online in two, three, four years down the line the numbers are pretty significant, you know, 92 million barrels a day of global demand, four million barrels of shale supply. So it’s a big component which has made a big impact on the short term demand supply and balance but longer term we don’t think that that’s really a sustainable number. I do think that in the near term for those that expect a pretty quick recovery, this topic that we were just discussing is going to act as somewhat of a lid on prices, right, because as prices start recovering, all this storage that has been building up clearly will start, you know, flooding the market or coming back into the market and that has a lid in the near term as well.
Jeff: [00:19:31] Yeah. And I think, you know, since the prices have crashed, since, you know, OPEC, you know, gave us a very happy Thanksgiving and, you know, refused to cut production, prices crashed. And since that time you’ve seen a 30% reduction in rig counts. Well, if prices creep back up in any quick way, you know, these three market producers in the US can accelerate right back up 30% and drill yourself back down into, you know, a certain environment, and the decline curves are steep, you know, you’ve got a lot of demand and we’re not that far in balance right now. And so medium to long term, I think, you know, you do see a recovery, but shale production I think longer term will keep a lid on going back to triple digit oil prices.
Courtney: [00:20:10] Yeah. And I think just to bring us kind of together, if the investor is looking to invest in MLPs they might be thinking, okay, $50 barrel oil, strong dollar, bad for commodities. You know, there’s all these kind of headwinds, but I think it’s either a perception or a misperception that that is going to affect MLPs. So I’d like to get your take on that, Mike.
Mike: [00:20:31] So, I think you’ve heard us talking about toll roads and sort of fee based businesses. And I think that it’s important to understand that that is broadly true. And that we think for most of the MLPs that we invest in, the bulk of their revenues are relatively well insulated particularly over the short term. And most of the … and it differs a little by commodity. So on the natural gas side, long-long natural gas pipes are actually, it’s called take or pay. You get paid whether the pipeline’s used or not. On oil pipelines it’s different, you get paid a volumetric fee, so per barrel you move. And it doesn’t matter whether that barrel is $50 or $100. Where price comes into play is about what it means for production volumes. So if prices were to stay very low for, you know, for many, many years, then that starts to impact MLPs in the out years because you’re going to see E&P companies do less drilling in 2015/2016 because they can’t make a sufficient profit from drilling at those oil prices. But I think what we’ve been talking about here is that I think most people who follow the industry think that the current prices aren’t sustainable because if you look at where we’re at today with about a $50 [unclear 00:21:42], $60 on a global basis, about half of all the production in the United … in the world rather, wouldn’t be economic at that level, which means you wouldn’t drill a new well today based on $60 oil. And what people have to remember is that oil production is sort of in constant steady decline, right.
So you know, on a global basis oil production decline’s on a steady state to go up 7/8/9% a year, meaning if you don’t drill new wells, next year you’re going to have, you know, 80/90% less production than you did this year, because the wells are just getting older. All of which is to say that there should be a self-correcting mechanism that brings prices back up, which is a longwinded answer of saying that we think in the relatively short term MLPs should be pretty insulated from these dynamics. And we expect that oil prices will largely correct within a reasonable enough timeframe then MLPs do okay. If somehow oil prices were to stay theoretically at $50 for the next five years then I think in the out years you’d start to see more meaningful impacts on what that means for MLP cash flows.
Diego: [00:22:44] The one thing I would add to that and I think it’s very important for midstream MLP investors to remember is that what we like to say, it can’t be both ways, right. So a big part, this is not a demand destruction exercise, right. So we’re not talking about 2008/2009 financial crisis where, you know, demand … there was a significant possibility for demand destruction. Now it’s maybe demand isn’t growing as fast as it, you know, as we want it to be or as we need it to be but it’s certainly still either flat or growing, and in fact it has been growing at predictions as it will continue to do so. So the whole reason why we are … or a big part of the reason why we do have crude markets at 50, WTI over 60, brand, is because of the tremendous amount of supply. So from a midstream MLP investor, our point, you know, would be you can’t have it both ways. It cannot be continued supply growth which is clearly good for this space and the low price, right. So if prices go, you know, stay at 50, because we continue producing a lot and we continue supplying a lot, that’s good for this space. If we start slowing production that likely is going to translate to the price out of the equation pretty quickly as well, right. So we don’t expect that you can have the two negatives to this space.
Courtney: [00:23:58] Right. So it’s pretty nuanced, Jeff?
Jeff: [00:24:00] Yeah. And I want to put it a little bit into historical context because a lot of focus, certainly from investors when we chat with them is all on crude production, crude prices, crude oil production. But MLPs are a lot more than just crude oil production and new crude oil production in the US. From 2000, 2010 actually the flat crude oil production in the US, we developed, you know, we figured out how to crack the curve on conventional tight oil, shale, shale oil and gas, and all of a sudden we had tremendous supply growth in oil, which was great for midstream MLPs. But from 2000 and 2010 only at flat crude production midstream MLPs grew their distributions at a 7% rate annualized. So, what were they doing? They were buying companies that were putting more assets into BMLB, natural gas pipelines or a big part of it, refined product pipelines. And you have greater refined product demand, you know, when you have low crude prices. So we hear a lot more than just transport crude around although that seems to be obviously everyone wants to talk about it. We can grow our distributions without, you know, strong crude production.
Courtney: [00:25:02] And like we said, I mean, everybody talks about crude but natural gas is really an important part of the equation and it kind of gets overshadowed sometimes I think in the narrative. But I want to talk about interest rates, when people think MLPs interest rates, either they’re correlated, not correlated, I want to get your take on that, John.
John: [00:25:20] To hit that and then also kind of hit these macro themes that we’re talking about. Let’s detach the macro thematic versus stock price performance and total return to investors. You know, interest rates very similar to crude production, are these macro themes that everyone likes to talk about, strategists that you see on news organizations time and time again. But you know, how often does that actually mean you’re earning a good return on your investments from a stock perspective? And so what I mean by that is for example, when you look at … and it’s understandable because if you look at oil and gas prices and oil and gas companies, corporate entities that produce oil and gas it’s relatively decently correlated, meaning that as oil and gas prices go up, a lot of times you see [unclear 00:26:04], their equities go up and down. But that doesn’t necessarily mean that’s the case for all equities. So you know, the interest rate example is another … is a good one where, you know, let’s look at the long term correlation of MLPs utilities even, you know. I think the one thing that, you know, you’ve seen a lot of is you know, individuals talking about MLPs being not correlated to interest rates because they have growth. Well, that’s true. But the long term trend has certainly been that MLP yields today are much lower than they were 10/15 years ago.
So in that overall declining interest rate environment MLPs have benefitted from a lower yield environment whereas like utilities for example, this has been kind of a sector where they look at it and say, “Oh my God, if interest rates go up, utilities are going to get killed.” Well, what’s the correlation to that? The correlation is actually relative … it’s very, very low. And if you look at the overall benefit on a long term basis over the last 15 years, utilities have continued to trade between 3½ and 4½% yields and still trade today in that same range. So we don’t think MLPs are that as very correlated to interest rates from a total return perspective, but neither are utilities. And you just have to look at the data to actually get that, similarly certainly on individual stocks on … we’re talking about crude production, [00:27:23] American is, that’s their core business is crude logistics, getting crude from the well head to the refiner. You know, this entity was generating 20% returns and crude production was going down 2.7% a year, generating 20% returns when crude production from 2006 to 2014 when crude production was going up 6% a year. So does it really matter that crude production was going down versus up on this company, every year was on average generating a 20% return? So again it’s a good question because it gives us the opportunity to dispel, I think, some common thoughts in terms of how these yield securities react in our rising interest rate environment. And there is a big difference between what’s happening in the macro and what happens on the stock level.
Diego: [00:28:12] Yeah, I mean I’ll add to that just and you know, we’ve done some of the same similar analyses in both the utilities and MLPs using the indices, the main indices and through the last nine periods of higher interest rates they increased 150 basis points or more in the last 15 or 18 years. And the data would suggest that they usually outperform markets instead of underperforming. And the reverse I would say also applies. The last … the two worst years for the Alerian index if you want to use it as a metric in the last 15 years, taking away 2008, were the two years where the 10 year interest averaged the lowest it ever has and those were the two worst performing years. So I think it speaks to both sides of the fence, the correlation really isn’t there. But again it really does go on a company by company basis and the business models and, you know, why you’re investing in that company.
Courtney: [00:29:06] Okay. And the last one is how sensitive are MLPs to economic cycles, Mike?
Mike: [00:29:11] Yeah. I think MLPs are relatively well positioned for even slow economic cycles. So I think, look, as pretty much every sector of the economy, always more wealth is better. But I think when you think about what the key demand drivers are for MLPs, right, so MLPs are moving natural gas, crude oil. Natural gas is used to heat homes or generate electricity. Crude oil is used generally to, you know, refine and to, you know, gasoline for driving, jet fuel, what have you. The end demand driver is whether it’s miles driven in the country overall or how much people are heating their homes or electricity, those are relatively stable uncyclical things. And so I think when you compare MLP sensitivity, their sensitivity to sort of broader economic cycles, they’re more defensive than almost any … most other sectors out there, very utility like in that regard broadly speaking. There are of course, you know, whether if you looked at upstream MLPs that have significant commodity exposure, you can look at certain gathering and [unclear 00:30:10] MLPs, again may take more commodity exposure, those may be more sensitive. But sort of when you think about the backbone of the energy infrastructure in the United States, the long-haul natural gas, crude oil, refined products, pipes and storage, those kind of assets, they’re relatively defensive.
Courtney: [00:30:26] And I think to that point, you know, in the 2008/9 recession, gasoline prices only declined 3% on a year over year basis. So that kind of speaks to your point.
Jeff: [00:30:35] It’s not a luxury good, you know, it’s a very inelastic product, you know, you’re going to heat your home.
Mike: [00:30:40] And you’re going to drive to work.
Jeff: [00:30:41] You’re going to drive to work.
Mike: [00:30:43] Right. So, you know, and it’s interesting because that actually cuts both ways, right, I mean, which means that when the economy’s, you know, really going gung ho, you know, MLPs actually their growth, you know, on an organic basis sort of the industry and the volumes, you know, absent what’s going on, and the commodity perhaps is a big absent but you know, are pretty stable. So it’s very defensive.
Courtney: [00:31:03] And I want to shift gears a little bit. We have an exciting new feature for our masterclasses, we love to get our viewers’ feedback. So we actually have Stephen Schork of the Schork Report here with us today. He has a question for you all.
Stephen: [00:31:16] Thanks. It’s great to be here and I appreciate the opportunity to ask a couple of questions.
Courtney: [00:31:21] Alright, thanks, Stephen, go ahead.
Stephen: [00:31:24] Now, the Alerian MLP index has lost 20% [unclear 00:31:28] value since [unclear 00:31:29] 5% of that loss. Now, the upstream [unclear 00:31:35] MLPs have certainly fired the worst, [unclear 00:31:38] pipeline, the so called [unclear 00:31:40] and in each type have [unclear 00:31:43]. So the question now is crude oil at this level is [unclear 00:31:48] eventually, therefore the valuation on upstream look to be giving good value at this point. So if I’m looking to [unclear 00:31:57] potential, how do I enter this market? And what time horizon should I have? And if I’m wrong how do I protect myself?
Courtney: [00:32:06] Okay. So that was a few questions in there but, Jeff, would you like to take a stab of that?
Jeff: [00:32:12] Yeah. The Alerian is often, as John alluded to, it has a large component of upstream MLPs in the Alerian and that has, you know, hurt the Alerian more than it’s hurt the toll takers as Stephen pointed out and as we’ve been talking about all day. If you want to play off fence and bet on commodity prices going up, certainly you wouldn’t invest in our fund because we are not going to change our strategy to bet on crude prices going up in any, you know, any time soon. Our investors are looking for stable cash. And you know, I really think that you, if you are going to jump into the upstream MLPs today, I do think that there’s risk, not of further distribution cuts, but you’re not going to get necessarily the total return proposition that we’re seeing in some of the midstream names. They’re still, even though they’ve had great relative performance relative to upstream MLPs, I still think the total return proposition for 11 midstream names that are the toll takers of the defensive pipelines still looks really attractive, especially if you’ve got some dropdown MLPs, they’re projecting 20/30/40% growth year over year and they’re yielding 1%, you’re not taking them for income, you’re taking them for that growth. So I don’t think you need to go into upstream and take that risk to play off fence here, even at these levels.
Courtney: [00:33:24] Mike, your thoughts on this?
Mike: [00:33:26] Somewhat similarly, I mean I think I’d come back to the main reason I think that people look to MLPs is for that stable cash flow and growth. And so, well, there’s nothing wrong with trying to make an investment based on a thesis that oil prices are going to recover. I’m not sure that MLPs are actually the best way to do it. And I would say, you know, if you look at the universe of upstream MLPs, there’s really just a handful, whereas if you wanted to play commodity prices you could just go buy regular E&P companies, it’s a much bigger universe so there’s a lot more ways to play it, you know, again, I don’t think you really want to use MLPs broadly speaking. I think most people are looking at them for stability and growth, not for really sort of a highly charged or highly levered way to play the commodity.
Courtney: [00:34:12] Okay. And, Diego, what do you think about this?
Diego: [00:34:13] So you know, we think that the midstream MLP space offers very interesting attractive opportunity, entry points today. You know, the dislocation was clearly pretty significant in the last few months. But I would say that despite the fact that, you know, Stephen points out, you know, E&P MLPs got hurt more than some of the more traditional business models that we talk about. I would say that the dislocation perhaps has been bigger on the traditional business sides than … in the business models than the E&P companies, right. So if you think about commodity prices down 50 plus percent, I would be of the view and certainly and what we do on a daily basis, that many companies whether it be E&P MLPs or just traditional energy companies aren’t really pricing 50 crude oil. They’re pricing already some recovery. I think many companies would struggle and on an ongoing basis at these prices. So I don’t know that there’s a dislocation happened completely on that side as it perhaps might. But I’d say you’re bounded on the recovery to some degree. And yet on some of what we talk about we believe that there’s some components, whether it would be the general partners of the MLPs or some places where you really are levered to both the growth component as well as the beta recovery in crude prices. So we think you can capture a big component of that without having to make a total bet on the recovery of the commodity.
Courtney: [00:35:44] Okay. And, John, what do you think?
John: [00:35:45] Yeah. We’re not going to change our strategy in terms of where we invest our capital just because one asset class appears cheap. We kind of tend to think of ourselves as not, you know, not value investors. I mean we’ll buy blue chip companies that have good stable cash flows and high quality management teams and a history of success. You know, we’re not going to chase performance just because an asset class like E&P MLPs underperformed, not to mention the fact that we think there’s a fundamental mismatch in terms of what their business is and the payout structures that they have. And I think, you know, it’s not dissimilar to what you saw in the financial crisis with banks, right. I mean you have an issue where, you know, these are very levered entities have, you know, promised to pay out all their cash, they have very little cushion. You know if commodity prices stay where they are or, you know, go lower, these companies are going to be forced to issue equity and sell assets at the bottom of the cycle. And so what you thought was going to be a bounce, all of a sudden doesn’t even come close to it because you are selling assets and issuing equity at a very bad time because you have to.
Courtney: [00:36:52] Okay. And this is so interesting because it really brings us to, after our next question with Lydia, we’re going to talk about the valuation process, how your portfolio construction and all your methodologies. But we actually have here Lydia Sheckels of Westcott Financial Advisory Group. They actually just were ranked the number one financial advisor in the state of Pennsylvania by Barron’s two weeks ago. So congratulations to you, Lydia.
Lydia: [00:37:16] Hello, Courtney. Thank you for having me today.
Courtney: [00:37:18] Okay, go ahead, Lydia, thank you.
Lydia: [00:37:20] E&Ps or MLPs with a potential for future dropdown of assets from the parent, and how does your valuation of them differ?
Courtney: [00:37:31] Jeff, you touched on this earlier, but…
Jeff: [00:37:33] I like dropdowns, I think it’s a nice embedded way of growing your company. And for the benefit of those that don’t know, dropdowns are asset sales from a parent sponsor that owns the incentive distribution rights and most of the times more than 50% of the limited partner units of an MLP, an asset sale of MLP qualifying assets into the MLP itself at an accreted multiple. Thereby, you know, generating distribution growth, accretion and it’s good for everybody, especially that sponsor who owns a lot of it. So we like align sponsors that have a lot of LP and they have the incentive to grow those distributions. And they’ve got a suite of assets that can aid them in doing that. What we like … but not all dropdowns are created equally. And I think the backlog of dropdown opportunities is tremendously important because what you want is … certainly you don’t want those dropdowns to dry up. You know, there have been some MLPs in the past that dropped down all their assets and then they were stuck because they weren’t necessarily real midstream companies positioned to grow in an organic manner as well. So we like to see dropdown companies are focused on the transition, either their transition isn’t in sight because they have so many assets or they’re focused on the transition in the sense that in 2018 when the dropdowns are done they’re ready to spread their wings and fly as a standalone company that can by themselves grow distributions organically [unclear 00:38:55].
Courtney: [00:38:55] So not all dropdowns are created equally. Mike, what’s your take on this?
Mike: [00:38:58] Yeah. So I think dropdowns are an area that investors have favored very much because of the predictable low risk growth profile. And certainly we like them and it’s an area that we’ve invested in significantly. It’s also an area though where we see multiples are often very high for these companies. Part of that makes sense because there is this very long lived or can be very, you know, long lived highly predictable future growth. But I think it’s something to keep in mind that investors … and this is something we see not just in MLPs, but you see broadly across sort of all segments of the economy and all asset classes. People are at this point in this economic cycle and market cycle are paying big premiums for highly certain cash flows and growth and we do see that there. So it’s definitely an asset class we like, but we think we want to be careful about valuations because I think at some point I think there could be, particularly when interest rates start to rise, you could have more risk in some of these because they have pretty low current yields.
Courtney: [00:39:57] Diego, are you seeing this as well?
Diego: [00:39:59] Yeah, I mean, absolutely see that, I think to Jeff’s point before, I think it’s extremely important to differentiate, you know, between, you know, and we get the question sometimes, “Should I put money in, you know, dropdown names or, you know, a certain subsector?” And you know, and to John’s point before, I think it’s, you know, important to keep, you know, the important part here is companies are very different within the same subsectors and certainly within different subsectors, I think that even more anyway, even more so. I think one of the attractive parts of … thinking back again on Jeff’s point, I think one of the attractive parts of some of the dropdown names today is that if you find the right dropdown that has obviously a long lived asset base at the parent and they are positioning themselves properly for either organic or third party acquisitions as well, I think this could be a very attractive timeframe, because in a highly dislocated market, these companies that have very attractive cost of capital advantages, they can benefit not only from the continued dropdown strategy, but they really … it could enhance their profile because they can take advantage of, you know, the added access to liquidity and the very attractive cost of capital. So it really could enhance their growth long term.
Courtney: [00:41:10] So they can be very attractive but you just have to pick the right one?
Diego: [00:41:12] That is correct.
John: [00:41:14] And yeah, I mean I think, you know, when you look at the dropdown strategy, what you’re really trying to do is arbitrage between cost capital, between the parent entity and the MLP. What ends up being the most important is return on capital, stability of assets and the longevity of the assets that are getting transferred from the corporate entity down to the MLP. So you know, look at the offshore drilling rigs, you know, these were set up to where you’re passing, you know, rigs with long term contracts down to the MLP. But at the end of the day these things are very, very highly cyclical businesses. So you have to be very cautious in terms of what the parent entity does, what are the returns on capital? What are the businesses, what are the assets that they have and the contracts that they have. And just because you have dropdowns doesn’t necessarily mean you’re kind of checking the box in all the things that you need in order to promise a steady distribution to investors in the MLP structure. So again, buyer beware, dropdowns aren’t all the same, not a shock, and you know, it’s something that we look at. I mean it’s not something that we necessarily favor over another. It’s something that we look at, and combined with between midstream regulated pipelines, LDCs – Local Distribution Companies, utilities, it’s just part of one of the … one of the things we look at for investment opportunities.
Courtney: [00:42:34] And I want to pivot a little bit. If you’re an advisor watching this which is primarily our audience, you’re thinking … and I know we touched on it, but what are the risks of investing in MLP and what is my upside, Mike, what would you say to that?
Mike: [00:42:46] Yeah. So the risks would be … I mean I guess there’d be several risks, like as in any investment. There’s company specific risks, you know, whether the company maybe has too much debt on the balance sheet and they ran into financial trouble or the growth goes away or maybe they have more commodity exposure and they have declining cash flows in the future, so sort of commodity specific risk. I think the big theoretical risk that people need to be aware of with MLPs, and it’s sort of always you know, the big one would be MLPs were created as part of the US tax code, as being a tax advantaged asset class as we’ve talked about. If the government were ever to take away that favorable tax status that would a material negative for the whole group. I don’t think … we don’t think that’s likely though any time soon and we don’t think they’re talking about that in Washington.
Courtney: [00:43:30] And it was [unclear 00:43:32] in 1987, so they’re in their third decade almost, yeah.
Mike: [00:43:34] It’s been around for a long time, yeah. And there’s other asset classes like this, right, REITs are somewhat similar, so there’s precedent. So this is … but it’s something people should be aware of theoretically that would be a risk. You know, and then I think, you know, be aware of just capital markets risks, I mean you know, MLPs are not immune to, you know, broader markets even though, you know, if the stock market were to, you know, have a meaningful selloff, MLPs are likely to probably participate in the selloff, even though their businesses are relatively defensive.
Courtney: [00:43:58] And, Jeff.
Jeff: [00:43:58] I was going to say, to distribute all their cash they have to externally finance, and so I think that adds to the, you know, capital markets exposure, because if I am forced to equity finance into a bad market, obviously that’s not a very efficient use of my capital.
Courtney: [00:44:10] But overall they have a fairly low correlation if you’re looking at your overall asset allocation, they’re pretty low correlation to everything else, would you agree with that, Diego?
Diego: [00:44:19] Yeah. I mean, yeah, I think a lot of what we described today makes it such that the characteristics over the medium term do tend to have a life of their own, if you want, right, because of the stability of the cash flows in many, you know, in many cases. The income component, obviously the shale revolution that we are, you know, undergoing and clearly shows no signs of abating any time soon. So it’s one of those industries where, you know, you tend to be protected in really bad environments and it attracts capital in a defensive manner. But it also has been able to participate to the growth and to the upside of different cycles. So it’s got a very unique investing base. So all those components I think make it somewhat uncorrelated. You know, in the near term and I think we’ve witnessed this, you know, a lot of things do tend to correlate to one. But from a fundamental perspective, they do exhibit significant differences from many other different asset classes.
John: [00:45:18] I think the biggest risk to investors that are investing in MLPs is really categorically just assuming that all MLPs are the same. You know, this has been … they … they’re talked about as a kind of a single asset class when in fact they’re just a bunch of different businesses. You know, they’ve grown so quickly over the last 20 years, in 1995 you only had 10 MLPs, four billion dollars of market cap. Now you have over, you know, 130 MLPs with close to, if not more than 500 billion dollars of market cap. So that staggering amount of growth in a space or in an equity structure, you know, you just need to be careful. And I think when you look at kind of our portfolio and by the numbers, if there are 130 MLPs out there, 86% of those we do not invest in. So we only look at 14% of the MLPs and think that they have the right assets and management teams that meet the things that we want to have and hold an invest in long term. So once again, I mean I think it’s just more or less you have to look at the MLPs and the businesses that they own, the assets that they have, the longevity of those assets and the stability of the cash flows.
Courtney: [00:46:27] So I think this is interesting because it brings us to really the portfolio construction process and what is your process for picking individual MLPs which, you know, an investor could go out and buy them but there’s a lot of ways that you can get exposure through exchange traded funds or closing funds or open ended funds. And so I’d like to hear your take on this, Jeff, what is your process for this?
Jeff: [00:46:49] Well, a lot goes into it but we first eliminate commodity exposure, weather sensitivity, you know, businesses with low barriers to entry. And effectively what you get to is these midstream MLPs. And once you’re left with the midstream MLPs, we look at a lot of things, primarily being fundamentals and valuation. And I’m looking on the fundamental side. I’m looking across a variety of spectrums. I’m looking at your cost capital. I’m looking at your historical capital efficiency. I’m looking at your management team. You know, we know these management teams really well, all of us on this panel, and it’s important that they’re MLP friendly, that they know how to run a business and they’re interested in the long term value proposition to the investors. And then you also look at valuation. From a valuation perspective, I think you were going to ask about valuation. But we want to make sure that we’re not investing at values where we have too much downside protection based on historical levels or based on the intrinsic value of the cash flow based on, you know, conservative assumptions on discount rates and required returns. So you know we’re looking at fundamentals. We’re looking at valuation and then the final step would be liquidity.
You know, a lot of MLPs are small. And a lot of them don’t have the liquidity you need to make sure you can prudently enter and exit in a timeframe that would be, you know, responsible from an investment perspective in our view. So you weight them accordingly and that’s, you know, kind of our process. What you end up with is there’s no magic sources, you know, I’m looking for this much natural gas transportation, this much crude, you know, after you blend it all together you end up with a nice balanced portfolio from a commodity perspective and from a sizing perspective. And you end up with what we think are the 20/25 best MLPs.
Courtney: [00:48:23] Great. And, Mike, what’s your process?
Mike: [00:48:24] Yeah. So similarly taking a bunch of different factors into consideration, I think the things somewhat similar to what others have said. You know, focus on companies with strong balance sheets. So relatively low debt metrics, strong cash flow and good access to the markets, both debt and equity are financed themselves, looking at the type of business that they’re in. So are they transporting oil, gas, really focus, and I think this is really important is what basins they’re focused in. So understanding, particularly as the oil prices change, understanding that some basins in the United States are going to continue to be more productive than others and focusing on MLPs who are tied to those more productive and basins with better outlooks. And then combining that with valuation, so our primary valuation metric is distributable cash flow yield, also look at generally like an enterprise value to cash flow, and when we’re looking at valuation, we’re combining, you know, it’s a combination of probably a few things. But it’s upfront yield, what’s the current income, what’s our projected growth of that income and then how much risk is, you know, what’s the chance that we think that it doesn’t meet our forecast. And then liquidity is a key consideration as Jeff mentioned. Some MLPs actually have pretty good liquidity these days, the larger ones, the smaller ones don’t, so taking that into consideration. And then building a portfolio that we think is relatively balanced in terms of you know various different risk factors.
Courtney: [00:49:47] And, Diego, your thoughts on portfolio construction and valuation? Thank you for bringing that up, Jeff.
Diego: [00:49:52] Yeah. You know, I think our approach perhaps on a company by company basis is not unique, but certainly different than many in this space. We employ what we think is a somewhat of a private equity type of approach and analyzing companies, right. So we try to get very, very deep and very granular. One of the benefits of this space is that it’s highly data intensive. So we have, you know, we have a team of data gathering people just to be able to collect a lot of the pipeline by pipeline, individual data on, you know, we’re talking about companies with more or less commodity exposure, trying to analyze percentage of contracts on the gathering and processing side, which might be fixed fee versus percentage of proceeds versus [unclear 00:50:35] in different bases. So we really try to get very, very granular on a company by company basis. And obviously we think that’s very valuable, especially in at certain times and giving us greater visibility. From a portfolio construction, we don’t put all our eggs into the best names, because what we’ve learned I think in the energy space is things not only can happen but they do happen. So we certainly have a risk management approach which makes us be fairly well diversified across some of the components that we talked about, whether it be subsectors, or basins or regulatory risk, fuel exposure. So we try to have a fairly diversified approach so that we’re not making only company bets but also subsector bets. So we try to be pretty well diversified across that process.
Courtney: [00:51:21] Interesting. And, John, your portfolio construction and valuation process.
John: [00:51:24] I should say we start, you know, we start at the asset level. We don’t really care if it’s an MLP or not, it just so happens that 60% of the portfolio is in MLPs. But that’s just because that’s where the quality assets are and the quality management teams. But 20% is in utilities and the other 20% is in pipeline, C corps and yield curves. So really we start from an overall, you know, energy capital markets being about, or total capital being about 5.4 trillion, whittle that down, we don’t invest in debt. So now you’re left with about 4 trillion. You know, look at the right types of assets being pipelines, transmission, and pipelines terminals and then also regulated utilities and transmission wires and then looking at how it did in payout ratios. Because we think that really drives management to be … to pick the best projects, high return on invested capital, very disciplined with their capital. And so we kind of cross reference the types of assets that we want to own, the management teams and also the high payout structures being MLPs, yield curves in utilities because we think that drives capital discipline. And so that’s kind of how we select and kind of narrow it down from there.
Courtney: [00:52:41] Interesting. So a lot of similarities here but I liked hearing everybody’s viewpoint. And we are just about out of time, so I just want to get everybody’s final 30 second takeaways starting with you, Jeff.
Jeff: [00:52:50] I just want to say, you know, in all the talk about all the risk factors and commodity price and everything, let’s not forget what we just went through in the US. We found unconventional oil and gas reserves, we thought we were at peak oil, we were going to re-gas fire and important natural gas. And all of a sudden, you know, three market producers figured out how to crack the code on a tremendous, tremendous resource. A great way to play that is through MLPs. And a great way to play that is through the midstream MLPs that are moving all the supply around for a fixed fee.
Courtney: [00:53:19] Mike, your takeaways.
Mike: [00:53:20] Yeah. I think that MLPs are attractive long term investments, or can be attractive long term investments because of the combination of upfront yield and growth and the fact that they can do it in a relatively low risk manner. And I think that they can be a part of portfolios for all different types of clients. I think young clients who we generally think of as less income oriented, but because of the combination of growth, and older people who need income to support themselves in retirement. So I think MLPs can have a place in a lot of peoples’ portfolio, you know, as in any sort of portfolio construction and, you know, that’s sized appropriately. But I think it can be a suitable investment for a lot of people who have an appropriately long horizon and are able to understand that even though the general fundamentals of MLPs are relatively not that volatile in a market like we’re in today, stocks can continue to experience volatility as the commodity does. So you have to be able to be patient and be long term. But if you are it can be an attractive candidate.
Courtney: [00:54:12] Interesting. And, Diego, your final takeaways.
Diego: [00:54:15] Absolutely, yeah, I’m not going to echo what they said although I agree with both gentlemen to my right. I think the one thing I would add is we believe that this dislocation in the energy market presents perhaps a fairly unique entry point and a way to enter early the energy space without having to make a full on bet on the recovery, both the path and the timeline of that recovery of the commodity. So we think it’s a very attractive dislocated market at the moment.
Courtney: [00:54:42] Interesting. And last but not least, your final takeaways, John.
John: [00:54:44] I would just say, you know, when you are looking at this space or picking a manager in general, you know, we’ve talked about a lot of qualitative things up here. I would just say, you know, hold them to that and do your homework. I mean who generated good returns in the fourth quarter, despite the volatility of cash flows. If we’re talking about investing in stable cash flow generating entities, you know, how did they do in the fourth quarter? And you know what do