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Income Investing Through MLPs
Master limited partnerships are giving income-oriented investors an opportunity to take part in the nation’s energy revolution and earn steady returns, say MLP experts:
Rob Chisholm, Portfolio Manager of Center Coast Capital
Chris Eades, Managing Director, Portfolio Manager of ClearBridge Investments
John Tysseland, Analyst, Partner of Energy Income Partners
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00:55:41
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MLP masterclass 9 17 14
Evan Cooper: [0:00] Welcome, I'm Evan Cooper. In today's Masterclass, we'll be discussing master limited partnerships.
[0:05] 2014 has been good to MLP investors with year to date gains of around 14 percent for the major MLP indices, almost twice the 7.4 percent gain of the S&P 500. Will the good times continue? We'll find out from our experts, Rob Chisholm of Center Coast Capital, Chris Eaves of ClearBridge Investments, and John Tysseland of Energy Income Partners.
[0:26] Rob, tell us a little bit about where master limited partnerships are now.
Rob Chisholm: [0:30] Absolutely. Master limited partnerships are an asset class. They're primarily energy infrastructure, which are connecting supply centers to demand centers with the growing hydrocarbon supplies, whether it be natural gas, crude oil, or natural gas liquids.
[0:46] Historically, the master limited partnerships have been a high form of current income, but they've morphed into more of a hybrid where it's high income, high growth, which offers an attractive total return for investors. So the asset class is attracting a lot of new investors. It's traditionally a retail investor base, but we're seeing more and more institutional investors come into the space to take advantage of a very attractive total return potential.
Evan: [1:16] Chris, give us your view.
Chris Eaves: [1:18] I would agree with everything Rob said. I think the other thing I'd highlight is just the explosive growth that we've seen; and this growth is being driven by two things.
Five 5 or 10 years ago most of the growth that MLPs were experiencing was largely a function of acquisitions, dropping assets from C corps down into MLPs. But what we've seen over the last five years is a very strong and likely sustainable organic growth story. Oil production is growing, as Rob mentioned, as are natural gas and natural gas liquids.
[1:43] As that production continues to grow — and it's growing high single digit percentage points currently and likely will going forward — you simply have to have infrastructure to facilitate moving those growing production volumes from the well head to the end user, and it's the MLP companies that all three of us are investing in that are at the forefront of building out all that infrastructure.
Evan: [2:02] John, give us your view.
John Tysseland: [2:05] We are certainly are seeing a lot more publicly traded master limited partnerships. The market cap and number of these entities has grown dramatically over the last several years.
[2:16] One thing that I think investors need to pay attention to is that a master limited partnership is really just one way that a company can finance its business. There are a lot of different ways you can a finance business, and master limited partnerships just so happen to have some tax advantages. But with those tax advantages you are paying out most of your capital. Most of your cash flow is going to investors. We would argue that paying out all your cash flow to investors is a pretty high hurdle to meet. Promising growth on top of that is an even higher hurdle.
[2:49] We see a lot of different businesses choosing the MLP structure. While non cyclical businesses seemed to be the most common several years ago, more cyclical businesses are choosing to finance themselves as MLPs more recently. Despite the rapid growth of the structure, we do not believe all the assets or businesses that are forming MLPs have the ability to meet both of those hurdles that include paying out available cash and delivering growth to investors through a variety of economic or commodity cycles. We just see MLPs as one way of financing a business, but being able to achieve a high payout ratio and growth, in our opinion, is only suitable for assets that generate very stable non-cyclical cash flows.
Evan: [3:26] We'll get to the issue of how you select the master limited partnerships that are in your fund, but let me touch on one point about the energy boom that's going on. Obviously, the revolution is talked about constantly. North Dakota is the boom frontier.
[3:43] But there also seems to be cracks in the story. There are reports of production coming down or growth not increasing to the degree that it has been. Tell us about that —about the current state of energy production and exploration, and whether we’re reaching a plateau in all these new energy sources that are coming up.
Chris: [4:01] I'm going to argue no. We'll see what the other two say. There've been plenty of articles. I seemingly get an email once a month with some article saying that shale is a fraud, or that energy production is about to roll over.
[4:14] The reality is that these wells have high decline rates. That's true. A lot of these wells decline in terms of production and about 80 percent in the first year. But after that, it's a fairly flat plateau that lasts a long time thereafter. As the percentage of wells that are older instead of new increases, which by definition as we drill more and more wells is going to be true, offsetting natural production declines is not an insurmountable task.
[4:39] I think you need to look no further than the reality that the rig count in the United States — the number of rigs drilling for oil and for natural gas — has been effectively flat for the last couple years. Yet oil and natural gas production and natural gas liquids production continues to clip along at an 8, 9, 10 percent growth rate, and that's likely in my opinion going to continue going forward.
Rob: [4:58] I think that if you look at it as a whole, the United States is the largest hydrocarbon producer in the world today. We've surpassed Russia and Saudi Arabia. Russia and Saudi Arabia's supply growth or supply curves are relatively flat, while ours are increasing. If you break it down by each of the underlying hydrocarbons - natural gas we're the largest natural gas producer in the world. Production is up 30 percent since 2005. Now, unless we start exporting, it will match demand in terms of the supply growth.
[5:27] But if you look at crude oil production levels, they’re near where we were in 1989. We're on track to be at record supplies of crude oil production in the US by 2016. We are the largest refined product exporter in the world.
[5:50] Then you have the natural gas liquids where, supplies are up 30 percent since 2010, and now we represent 50 percent of the LPG worldwide market.
[6:02] So, we're growing. Supplies continue to increase. Some of the decline curves in the early years, yes, they are a hyperbolic decline, but they are leveling off and we're seeing three to five percent on decline thereafter. I think growth is really turning from exploration to manufacturing and production. We feel that there are a tremendous amount of legs underneath this growth, or a tremendous amount of runway left to keep growing these supplies.
Evan: [6:36] John.
John: [6:37] No question there is a well established trend of growing production, exports, and all of the above. While we view this as a positive trend, we do not believe it is absolutely required to generate an attractive return in the space. It provides some opportunities, but it's not the sole factor that we believe will drive returns.
[7:03] We think there are infrastructure investments in both the US and Canada that will do well over the next several years, whether production is growing or not. That's the idea of trying to generate returns in non cyclical assets. So whether production goes up, down or sideways, hopefully if you make the right investments, that won't matter.
Evan: [7:26] Chris, one of the biggest developments recently has been the Kinder Morgan event. Tell us what happened and why it's important and what the meaning of it will be going forward.
Chris: [7:38] I'll start. It was a very large transition. It was actually the largest energy transaction that we've seen since Exxon merged with Mobil. I think the timing of it perhaps caught the market a little off guard. Perhaps the magnitude of it caught us off guard. But the fact that Kinder did something I don't think surprised any of the three of us.
[7:56] Kinder was in a position where they needed to make a transaction, and the key issues was because they...
Evan: [8:01] Tell us again, what actually happened?
Chris: [8:02] I'm sorry, good point. Kinder Morgan is four publicly traded entities. You have a general partner — KMI — and then you have MLP companies: KMP, KMR and EPB. Basically, KMI is absorbing all the master limited partnerships, and everything will be domiciled at the KMI entity, which is a corporation, not a partnership.
[8:27] Kinder did this because their cost of equity financing as a function of how much cash they had to pay to their general partner had become onerous. Their cost of equity capital was in excess of 12 percent. If you look at the overall space, most people have a cost of equity of capital between 5 and 6 percent, and that left the company at a competitive disadvantage, for two reasons.
[8:48] One was acquisitions, obviously. But two, it left them at a disadvantage in terms of returns on their own internal growth opportunity set. I think most of us, and certainly I expected that the MLPs would buy the general partner — actually the inverse of the transaction that was announced. But the fact that they made a transaction, I don't think that was a surprise.
[9:09] Right after the deal — a huge transaction that effectively absorbs three MLPs and puts them in a corporation — I was immediately asked, "Does that mean that MLPs are dead?"
[9:21] I would argue this is a one off. This was specific to Kinder Morgan. This was not an offensive move at first. It was a defensive move to fix their cost of equity capital, and it wouldn't surprise me at all to see at some point down the road that some assets in the Kinder family ultimately migrate their way back towards an MLP.
Evan: [9:38] Rob, what's your view?
Rob: [9:39] Absolutely. I would agree with all those points. If Kinder had been in the 50 percent IDR splits or the incentive distribution right splits...
Evan: [9:50] Explain what that is.
Rob: [9:51] As the LP, or a master limited partnership’s LP distribution increases, the GP [general partner] gets a greater take. Typically, a split starts at 2 percent, then 15, then 25, then 50 percent. For every new dollar created, 50 percent goes to the GP and 50 percent goes to the LP. That increases the cost of capital at the LP level.
[10:13] To further complicate things, there were some business lines inside the KMP business model that a lot of investors were not terribly enthused about, primarily the CO2 crude oil production, and there was some debate whether maintenance and growth capex was being treated fairly inside that one sector of KMP.
[10:38] We all thought that maybe they would split the MLP into four separately traded MLPs, with the CO2 crude oil production trading in line with its peers, which is closer to 10 times the price of distributable cash flow, which translates into about a nine percent distribution rate, and then having a refined product, a crude oil and a natural gas. If you line those up against their comps, you could get to a sum of-the-parts for KMP at 90, 95 pretty easily-compared to where it was trading at 75 bucks.
[11:06] Now that with the tax lawyers, and the step up, and creating a large depreciation shield up at KMI, they're able to roll up all the entities under KMI and provide a high cash flow business with not a lot of tax drag at the C-corp level.
[11:27] I agree, it was more of a defensive move versus an offensive move. I think it caught the market by surprise because it rolled LPs up into the C corp, and I think another question people ask is, "Is Rich out in front of something that the market doesn't see?" meaning, "Are they getting out in front of some tax changes perhaps?"
[11:46] We don’t think he was getting out in front of tax changes. I think he had to solve his cost of capital issue, which based upon market response he’s done a good job of improving his overall cost of capital. Time will tell in that regard. But again, it was reacting to unique circumstances in the Kinder complex in solving some of their issues and not necessarily getting out in front of potential tax changes moving forward.
John: [12:16] If you look at a lot of the things that led up to the transaction, it was somewhat foreshadowed. For example, the success of the yieldco structure. These are full payout structures that are corporate entities, but have large tax shields and do not pay a lot of cash taxes. The IPOs of these entities had strong investor appetite despite being structured as corporations as cash generated at the asset can be efficiently pass on to investors without significant entity level taxes.
[12:39] Then there was the Williams transaction where they bought the remaining 50 percent ownership interest in the GP of ACMP. In connection with this transaction they also bought a lot of ACMP LP units. These LP units provided WMB with a large tax shield that reduced the company’s cash taxes. So we viewed the Kinder Morgan transaction as a natural extension of the market willing to reward a corporate entity with a full payout structure that also buys LP units to reduce its overall cash taxes.
[13:27] That's everything that Kinder Morgan is doing. They will create a large tax shield by buying the LP units of KMP and EPB. Once this transaction closes it will actually reduce the company’s overall cash taxes and increase the amount of cash that can be distributed to all stakeholders. Said another way: Prior to the transaction, management expected to pay cash taxes in 2014 of about $550 million on around $5 billion of distributable cash flow. Once they consummate the transaction, most of that $550 million of cash taxes will be shielded by DD&A and can be distributed to stakeholders or directed toward growth projects.
[14:15] Overall, yes, it does reduce Kinder Morgan’s cost of capital and should benefit investors over time. It seems to be a good decision by management and that is one thing we focus on, good management teams, and they certainly are one of those.
Evan: [14:32] How does it affect the shareholders who had those in their partnership interests?
Rob: [14:38] The main impact is going to be at the KMP holder. For long term KMP holders, it's going to create a large tax bill for them at the end of the year or upon the consummation of the transaction. The KMR unit holders are seeing the benefit the most, as the C corp/C corp swap is a non taxable transaction for the KMR unit holders. Now, they will have, depending on how long you've owned the KMR unit, a very low cost basis in KMI, but it will not trigger a tax bill this year.
[15:14] The EPB, or the El Paso unitholders, again, it's a function of timing - how long you've owned the unit, what the cost basis is determines on what your tax bill is going to be, but I think most of the push back, or what we expected the push back to come from, was the long term KMP unit holders because it's a taxable event, and they're being stepped up, and they're going to have a large tax bill coming at the end of this year.
[15:41] I think a lot of people, they were using KMP, the long term unit holders, as estate planning, where upon death, it would be stepped up and there would be no tax event. They're being forced into that taxable event now.
[15:56] For the KMP unitholder, vote, I think it's interesting to note that the KMR unitholders get to vote in the KMP proxy, so when you do a unitholder count, you can get there pretty quickly because most of the KMR unitholders, which are predominantly institutional, investor based, are going to go along with the transaction.
[16:16] We feel that the deal certainty or deal close is fairly certain when you layer that in.
Evan: [16:23] How big a piece of each of your funds was this?
Chris: [16:26] It was a big chunk of ours. I run five different strategies and it was anywhere between 8 and 14 percent across the entire Kinder complex. It was a meaningful event for us.
Rob: [16:35] We were in a similar boat. We had a meaningful KMR, but we also had exposure to EPB and KMI, and so collectively we are in a 15 percent type exposure.
Evan: [16:46] John?
John: [16:47] Similar. We had, throughout all structures, about 10 to 12 percent in KMI, KMR, EPB, and KMP. It was a positive event for us.
Evan: [17:02] Have you gotten any response from the advisors and indirectly from shareowners, saying, "Maybe we should steer clear of this now because who knows what's going to happen and I don't want to get stuck with a tax bill"?
Chris: [17:14] I've gotten those calls. I've had a couple advisors reach out to me, and they're not happy about the tax bill, but as I remind them, they've had a big step up in the price of the stock. You're now left with an entity that is fixed from a cost of capital perspective, we're now poised for growth again, and if you look at expectations, or at least my expectations for distribution growth or dividend growth from the succeeding KMI, it's going to be greater than it was for KMP.
[17:40] Yes, you may face a tax bill, but you also had a stock that gapped up enormously on the heels of the announcement, and with a little bit of patience and a little bit longer term viewpoints instead of a shorter term viewpoint, I think those shareholders are going to be just fine.
John: [17:54] At the end of the day the yield for investors at KMP, KMR, and EPB are going down a little bit, but not as much as what people might expect because investors are getting cash back in the transaction. So on a net yield basis KMP investors will only go from a 6.9 percent yield to a 6.3 percent yield. Note that this yield calculation assumes no tax paid and assumes the cash portion is reinvested.
[18:12]So while KMP and EPB investors face a tax bill, they will be investing along with the general partner as units are converted into KMI shares. As a result, there won't be any misalignment of incentives when it comes to investing capital and issuing equity. At KMP, management was guiding toward five percent growth, while at EPB management was guiding toward no real growth over the course of the next couple of years. On a fully consolidated, management is guiding all investors to annual dividend growth of 10 percent, which still trades with a 5 percent yield. In our opinion, investors are probably on a better trajectory to earn a higher return over time, and enjoyed an immediate step-up in valuation. The tax can pose a problem for some investors, but where we had the most exposure was through KMR and luckily that is a non-taxable event for investors of KMR.
Evan: [19:13] If this is a hiccup in the MLP world, where are the long term opportunities in MLPs generally?
Chris: [19:30] In my view, it sounds like John and I may have a slightly different view of it. I believe growth is being driven by production. So long as production continues to grow, we're going to have to have more infrastructure. To me, it's that simple.
[19:41] Obviously, it matters where your infrastructure is, what basins you're exposed to, how your balance sheet looks, what your cost of capital is. But when you factor all those things together, as a sector, putting individual stocks aside for the moment, I still think we're poised for a sustainable growth.
[19:55] I don't think is a one or two year story. I've said many times I think it's going to be a multi decade growth story as we continue to see US production grow, and with it the infrastructure that's needed.
Evan: [20:06] Give an estimate. How much infrastructure is needed; how much are we talking about?
Chris: [20:09] Just look at what we're doing right now. This year, we'll probably build out close to $40 billion of infrastructure in the United States. If we'd had this conversation back in 2011, it was around $10 billion. We've had a four hold increase in the amount of infrastructure spending in three very short years, and my view is that we're going to need to continue building out roughly $40 50 billion of infrastructure on an annual basis forward.
John: [20:35] Look. I think a good example would be a company like Plains All American. Good assets, exceptional management team. They generated 20 percent total returns for investors prior to 2006 when oil production was going down three percent a year.
[20:54] After that, oil production has been going up eight percent a year. They're still generating 20 percent returns for investors. That's the type of company we're obviously looking for. Whether that be structured as an MLP or not.
[21:10] We're only 60 percent invested in MLPs. The other 40 percent is in utilities, yieldcos, or Canadian infrastructure companies that used to be royalty trusts but obviously aren't anymore. That's what we're looking for.
[21:29] There's no question that the need for new infrastructure is going to create interesting opportunities for a whole host of companies and management teams.
[21:42] But I would argue that this strong environment allows the high cost provider or the smaller entity to survive, whereas in a down market that might not be the case. We'd rather stay with large scale backbone type infrastructure that might be growing a little bit slower, but in a down cycle will still perform very well.
Evan: [22:11] What kinds of things are those?
John: [22:13] We invest specifically in assets such as long haul pipelines, terminals, and other fixed assets that have long asset lives and utility type cash flows. We tend to stay away from E&P type assets in general just because they don't fit our investment strategy. Not because we don't think they're good business, but those businesses financed with perpetual equity with a high payout ratio just don’t fit with our philosophy.
[22:39] From our perspective, long haul electric transmission is interesting. Local distribution companies on the gas side are interesting. We also believe certain infrastructure assets in Canada are interesting. In some respects Canadian development of liquid rich natural gas are behind the US in terms of their ability to grow things like NGL production. Similar to the US we see good management teams and high quality infrastructure assets in Canada that have the ability to provide low-cost transportation or storage to growing supplies over the next several years.
Evan: [23:15] Rob.
Rob: [23:50] I think that, to piggyback or to reiterate some of the thoughts that have just been discussed is we're amidst this unprecedented supply growth which is driving a tremendous amount of demand for new infrastructure. Whether it be $40 billion this year, there's numerous different estimates out there ranging from $500 billion to a trillion dollars of new infrastructure demand over the next decade.
[23:45] But it's not just the organic growth that's driving the growth of the MLP. In what we refer to as financial engineering and/or drop down, there are a number of different entities out there, whether publicly traded or private equity, that have assets that fit the midstream or energy infrastructure master limited partnership structure, and they are bringing those assets to the market.
Whether it's exploration and production companies — such as Western Gas or Devon — that want to monetize the midstream assets they have into the MLP structure, or the refining companies - whether it's Marathon, Philips, Valero or Western Refining that have midstream assets that are not being reflected in the C corp's value - they're spinning those assets out into LPs so they can get full valuation of the parent company for those assets.
[24:48] That's driving growth and I think with Shell having filed for their IPO — the first by a major, if you consider them a major, coming into the space — it's definitely going to drive growth.
[25:00] So, it's two fold: organic growth being driven by the supply growth and demand for new energy infrastructure, and new entities with existing assets that are migrating into the structure. These are driving long term growth and really strong return potential for investors.
Chris: [25:19] Just look at the number of publicly traded MLPs. Back in 2010 when we launched our first fund there were 70. Today, there's around 120, and we're probably going to continue to see 10 to 10 IPOs a year. That's only going to increase trading liquidity, only increase investment options for us as portfolio managers. It just makes our life a lot easier.
Evan: [25:38] What in the midstream do you find interesting or attractive and what do you stay away from?
Chris: [25:43] At ClearBridge, we think the biggest benefit of the asset class as a whole, MLPs broadly, are stable and predictable cash flows. Asset that are backed up by long term contracts, government regulated returns. Very stable and predictable cash flows, literally for years. Sometimes 10, 15, 20, 30 year contracts backing up these assets.
[26:02] The minute you introduce assets that have cash flow volatility, whether as John mentioned E&P companies, or refining assets, fertilizer plants, whatever the case may be. To me, that limits, if not eliminates, the biggest benefit of the asset class, which is stable and predictable cash flows.
[26:20] We, like John, stay away from E&P. We stay away from anything that would loosely be described as a variable payout rate MLP, and we stick to boring assets, to be honest with you. These are pipelines. These are storage tanks. These are terminal assets.
[26:35] While they may be boring, they're not much fun to go look at, they generate an enormous amount of cash flow with an enormous amount of predictability. That allows us to deliver to our investors what we put forward to them that we would give them, which is a relatively high level of income and then growth on top of that in time.
Evan: [26:52] When a pipeline company decides to build a pipeline from point X to point Y, do they start out with a contract that says, "We're not going to build it unless we get a commitment from somebody to say, "OK, I'm ship this much stuff through it?"
Chris: [27:01] Yes. These are multibillion dollar projects very often, and to get that sort of a project financed you have to have commitments to get that kind of a project financed, if not permanent, from the governments.
Rob: [27:13] I would say that on average typically what they're going to look for in firm commitments, and these are contracts that are going to be 5 to 10 years, it's going to be about 60 to 70 percent of the capacity contracted by the shippers. Typically, that's going to result in a mid teen type return on equity, which is a base case for moving forward for these MLPs.
[27:38] I think we're seeing a lot of new pipelines announced. The shipper mix is changing over time as well. I think back in 2005 to 2010, especially if you look at natural gas pipelines, you had a lot of marketers that were taking out capacities on these pipelines. As the volatility in natural gas dried up, those contracts were not renewed, and if they were renewed they were renewed at much lower rates.
[28:09] Today, we're seeing producers as well as utilities primarily taking out capacities on these pipelines, whether it be natural gas, and then obviously on the crude oil, whether it be the producers or the refiners as well taking out capacity.
[28:25] Those are more permanent type users of those pipelines versus the marketing, which was trying to take advantage of volatility in the space and might not have been counted on to renew all those contracts. But again, I think you're going to have 60 to 70 percent of the capacity on a pipeline at minimum in order for it to proceed with construction.
John: [28:47] At the end of the day, it's a management call. While we start at the asset level and do a lot of research on that, we also put a lot of responsibility on management and try to invest along with high quality management teams. They are the ones that are putting the capital to work and securing contracts with customers.
[29:12] There's no regulation that says, "You need 70, 80, 90 percent of a new pipeline secured with long term contracts before it can be built." Who would determine the length of the contracts? All of that is up to the management team to decide the right combination of risk/reward for any given project.
[29:33] While there might be an opportunity for a pipeline, if you have a management team that is willing to only get 50 percent under long term contract before committing the capital to build it, that's a company we are probably not interested in owning. We try to own assets that meet our rather narrow investment criteria, but this also includes a lot of trust in the management that runs those assets. That's really important to us.
Evan: [29:57] Let's talk about the inherent demand for these facilities over the near term and medium term, even the long term, given the country's voracious energy needs. What are the risks? The risks of, for example, changes in the tax code, A? Or B, changes in interest rates and interest rates going up?
[30:17] How would that affect things? We'll take any one you want to start with, let's say changes in the tax code, making master limited partnership less favorable for individual investors?
John: [30:28] I would just say that all three of us can sit here and rationalize why the MLP structure should survive any kind of overall change to the corporate tax code. But to predict it and assume that it's never going to happen I think is a little disingenuous.
[30:50] I think the way investors should really approach it is to say, "How much of your overall portfolio do you want invested in the MLP structure and when, or if, they lose their pass-through tax status what would you do about it?" The way we address this question is to balance the portfolio with other investments that are not MLPs but have similar characteristics that we are looking for such as utilities, LDCs, and yieldcos. MLPs make up approximately 60 percent of our overall portfolio.
[31:09] If MLPs lost their tax advantages and pass through status, most likely they would go down and we would look at that as a tremendous opportunity to increase our weightings in the MLPs that we own with high quality asset. Very similar to what happened when Canadian royalty trusts lost their beneficial tax status.
Evan: [31:33] Fill us in just briefly. What happened in Canada?
John: [31:35] In Canada, you had a very similar kind of structure where publicly traded companies could structure themselves as royalty trusts, which allowed them to distribute operating cash flow to shareholders tax-efficiently. It was very similar to the MLP structure here in the US with the exception that there was no limitation on the types of assets that could go into Canadian royalty trusts.
[32:00] In the US, a business has to generate 90 percent of their income from qualified sources, which means there are more restrictions on the types of businesses that can finance themselves with MLP capital.
[32:15] The point being is that when Canadian royalty trusts lost these tax advantages and traded down there were still a few that owned and operated well positioned assets that were interesting to own long term with good fundamentals that also did not depend on the structure to survive.
[32:36] Surprisingly, some of the old Canadian royalty trusts with pipeline assets, such as Keyera, Inter Pipeline, and Pembina, have outperformed MLPs over the last ten years even while enduring the loss of these tax advantages. Other Canadian royalty trusts went private, got acquired, or went out of business when they lost their tax advantage because they depended on a cheaper cost of capital to survive.
[32:54] That's the overall goal. It is not to say it can't happen. It might happen. Who knows? But do you own the right types of assets that can withstand losing a tax advantage? What do you do about it if it happens? If MLPs are not a hundred percent of your portfolio and they lose their tax advantage you can always increase your allocation as long as the assets in the MLP have the ability to generate attractive returns on an after tax basis.
Chris: [33:15] I agree with John completely, but at the risk of being disingenuous, I will argue that it's unlikely that we have any sort of near or medium term change in the overall structure. I think the reasons for that are rather simple.
[33:28] This is the number one job creating sector in the entire US economy, and the government has had a mantra of trying to reduce the amount of imported oil since the Arab embargos back in the '70s. We're actually doing that now.
[33:38] Then the other thing to consider is, what would happen for the government if we actually eliminated the structure and all these things were taxed like C corps? It's not that big of a revenue generator for the government.
[33:47] The last study I saw estimated that it would be about $3 billion a year of incremental tax revenue to the US government. That in the context of a $500 or $600 billion a year deficit doesn't do much to fix our fiscal woes. So, while it's not likely, it is possible, but I do agree with John that having a hundred percent of your eggs in MLPs is probably not the right way to go. Whether you're an individual investor or whether you're a large institutional investor, either.
Rob: [34:14] I would agree. If you looked at the Canadian royalty trusts, there was no ring fence around what qualified. The Dr. Pepper bottling company in Canada was filed to go as a royalty trust. The largest telecom in Canada was filing for a royalty trust. Something had to be done in Canada.
[34:30] There was a reaction to that, and especially if you look at investment in western Alberta, it dried up after the tax changes. It created a lot of investment opportunities as well because of the fallouts.
[34:52] But looking here, we are ring fenced. Ninety percent of your income has to be generated from qualifying income, be it derived from natural resource production or transportation, and so on and so forth.
[35:03] But the 1986 tax reform act, the reason they enacted the MLP was to incentivize investment in US energy infrastructure and US energy independence, and that is exactly what it is doing. To cut the knees out of the vehicle that's raising the capital, creating the jobs and building the infrastructure for a small pittance of tax revenue just doesn't make sense.
[35:29] Right now, there is a suspension of private PLRs, or private letter rulings, as they look at the overall process of how they issue the PLRs. The same thing happened in REITs last year, and they went back out with no real reform for the REITs.
[35:46] I think at the MLP right now, they're actually looking at, instead of relying on the PLRs having more the definition of what qualified as being more hard coded, if you will, so there's not some ambiguity to what really gets into the space.
[36:02] You can't just stick your head in the sand and pretend like nothing's ever going to happen. We have tax reform overall coming our way, and MLPs will be caught up in that over time. We think the vehicle is doing exactly what it was designed to do.
Evan: [36:17] Of course, given the chaos in the Middle East and with Russia and Ukraine, it seems like having domestic production is probably a good idea.
Rob: [36:23] Absolutely.
Evan: [36:25] But let me get back to the point you were making, Chris, about eggs in a basket. Even though you're experts in MLPs and not necessarily what advisors do in terms of setting up portfolios for individuals, what kind of advice might you give to an advisor as to what is the right amount of MLPs to have in an individual's portfolio, and for what reason?
[36:44] Why should they have MLPs and to what degree? Aside from the fact that you’d love to sell more MLPs. But what's the right amount?
Chris: [36:50] I think the reasons are clear. It's a yield starved world. We are offering investors securities that have a relatively high level of income. There's tax advantages to it. Most importantly, there's growth to that. Those are the big selling points for MLPs.
[37:05] I personally think it gets dangerous when you start generalizing on how much exposure an investor should have to MLPs, because obviously that's going to depend greatly on every investor's age, income levels, desires, risk tolerances, et cetera. I'm going to shy away from that, but the underlying reasons why you would want to own some, irrespective of how much, I think are very clear.
John: [37:27] I would just argue that if your MLP investments go down 25 percent, 30 percent and you don't have the wherewithal to add to that position, then you own too much. If they go down 25 percent, 30 percent and the assets still have the same attributes as when you made the initial investment, then you should be willing to increase your overall allocation in your portfolio. If you can't do that then you own too much.
Evan: [37:58] Rob.
Rob: [37:59] I'd agree. It's hard to determine, because it really depends upon the risk tolerance of the investor. But talking to a lot of financial advisors where do we put this, where does it belong in a portfolio, is it qualified as a real asset, is it a fixed income hybrid, is it an alternative, and really, where does it fit?
[38:23] I can't exactly say where it belongs in a portfolio, but acting as a fixed income surrogate, I do not believe. If you look at the standard deviation and the volatility, it is an equity, and so it's not a fixed income surrogate. It fits really well in a real asset or alternative and equity sleeve of a portfolio.
[38:42] But the attributes of a high form of current income are going to attract investors, but they need to be aware of the volatility. But once you factor in the growth, it really turns into a very total return type equity. Where that fits in a portfolio, it can go into a number of different buckets. But I think the main point is not to turn a blind eye to the volatility that can come in this space.
Chris: [39:05] I think actually that's a great segue into the interest rate question. How do these things behave in different interest rate environments? MLPs are inversely correlated to 10 year Treasuries. That's true over a 5 year, 10 year, whatever window you want to look at, and the reasons for that are very simple.
[39:20] As Rob mentioned, they're not fixed income securities. They increase their payouts to investors year in, year out without exception. Even during the financial crisis we saw MLPs, albeit modestly, increase their distributions to investors.
[39:34] These are assets that have not historically — and I'm going to argue should not be looking forward — traded with the overall interest cycle over time. Can that happen on a one day basis, on a one week basis, or even a one month basis, can they trade with interest rates? Certainly they can. But if you look over longer periods of time, they have not traded like bonds, and there's a reason for that, which is why they offer investors a high level of portfolio diversification.
[39:58] Just to throw some stats out to make my point, 10 year Treasuries bottomed in July of 2012; 1.38 percent I think was the bottom. We actually ended 2013 at more than 3 percent, just a little bit above 3 percent.
[40:12] If you are vary of rising interest rates you would have gotten crushed in that kind of environment, and in fact they were actually up 22 percent. Other income oriented securities like REITs were up I think 7 percent, utilities were up 5 percent, and bonds were down 2 percent looking at the index.
[40:30] Again, I think it depends on what your time horizon is. If it's a short term discussion, maybe there's more validity to arguing that interest rates are going to directly influence MLPs. But over time, I don't think that's going to hold true. It gets back to that growth and income part of the story that I think is so vital to why investors should own these stocks.
Evan: [40:49] In terms of the contracts that the pipelines for example have, it's not a function of the price of oil or gas, is it, or is it? Does what they charge go up if there's an increase in the price of oil or gas?
Rob: [41:02] It depends upon the underlying contract structure, but the underlying answer is no. There are regulated returns or some regulated assets that are inflation based adjustments or PPI plus 2.65, primarily on the refined products side.
[41:19] On the natural gas side of the world, typically you're allowed to earn a return on your equity that is regulated anywhere from 12 to 20 percent. If you're under earning, you can adjust the tariffs. But if interest rates rise, it's not going to necessarily affect what you can charge for transporting that barrel of crude or a mmbtu of gas.
[41:42] But I think what's important and what we can do and, again, non correlation historically to the interest rates, what's going to happen when interest rates rise, so on and so forth?
[41:54] Well, all we can do as an asset manager is look at our balance sheets. How much of our balance sheets are fixed versus float. Because rising interest rates on a floating rate balance is going to increase my interest expense and add less cash that I can pay out to my investor.
[42:09] Looking for the fixed balance sheets and not companies that are living on a revolver, that will be impacted by rising rates is one thing to do.
[42:19] The other thing I think that needs to be looked at is the midstream provider historically looking at the different interest rates environments and impacts on overall cost of capital. Well, if I have a higher form of cost of capital, if I'm building a new pipeline, well, I'm either going to pass that on to my shipper because it is a regulated pass through, or I'm going to charge a higher tariff in order to meet my cost of capital on the investment.
[42:48] On an acquisition, if I have a higher cost of capital, it means I'm going to pay less than I would have been prior to an increase in interest rates. Again, as an asset manager and a portfolio manager aspect it’s OK, how can we insulate our portfolio from it? Look for the fixed versus the floating balance sheets.
[43:06] Then I think of translating what's going to happen to the growth moving forward. I think historically, we've been able to see the midstream provider pass through to the shipper or whoever is utilizing that asset.
Evan: [43:19] Were many other companies able to refinance when the interest rates were really very low?
Chris: [43:24] There was a tremendous amount of refinancing that was done. Actually, it wasn't refinancing. It was actually paying off revolvers and terming out their debt long term. I don't have any stats, I don't know if you guys do.
John: [43:33] You're still seeing it happen. Even in today's environment, management teams are looking at issuing a combination of anything from 5 to 30 year bonds. It's not just to help finance infrastructure. That's happening whether it be an MLP, utility, E&P company, it doesn't matter.
Chris: [43:59] Or just broadly the US economy.
Rob: [44:02] I think if you look at, we look at the terms and the maturities of the debt instruments, I think we have two to three more years of tailwinds on refinancing where we have investment grade paper that historically is 6.5, 7.5 that's being refinanced at 3.5 to 4.5 percent. I think the refinancing risk is really 2020 to 2024 where you have this 10 year paper that's been put on really cheap levels and where that's going to be refinanced. No one really knows.
[44:39] But again, that goes back to quality balance sheet, quality management teams that are proactive and try to eliminate that. But I don't think that refinancing risk is an MLP asset class specific, I think that's broader equities that are going to have that or face that risk as well.
Evan: [44:55] Aside from interest rates, what are other potential risks for MLP investors? What should they be watching for?
John: [45:07] I think a big risk factor that has developed over the last 10 years is two thirds of the new MLPs that have been taken public operate cyclical businesses. You've really changed the risk profile of the average MLP or the group as a whole. Not only are the number of MLPs increasing along with the overall market cap, but the types of businesses that are structured as MLPs is also changing and growing. This means MLPs now have a higher degree of exposure to things like production going down, crude prices going down, or various other things happening from a cyclical perspective.
[45:51] I view that as a risk factor because a lot of investors have been attracted to the MLP structure because it has been marketed to them as an investment with non-cyclical characteristics yet many of the newer MLPs are involved in cyclical businesses and will go up or down on based on that cycle. On the way up these MLPs might experience great growth and strong margins as they benefit from increasing volumes and high commodity prices, but that works the other way too.
[46:13] I think the overall risk factor is that you have more cyclical assets being introduced into the MLP structure yet investors are still being pitched MLPs as investments that have stable cash flow characteristics. It is important to understand that this is changing as the group expands into new businesses.
Chris: [46:30] I agree with all that completely. I would one just small twist to that. While we're certainly seeing where cyclical classes come into the asset class, the contracting structures have changed over the last 5 to 10 years as well.
[46:41] Most contracts that we're seeing right now are fixed fee, cost of service, whatever the case may be versus maybe 5 or 10 years ago, these management teams might have been willing to take on more of the commodity or more of the volume risk than investors such as all three of us are willing to take on today.
Evan: [46:57] Rob.
Rob: [46:58] I would agree. When we launched Center Coast back in 2007, I think the primary risk which surfaced in 2008 and 2009 was the commodity sensitivity of the underlying assets. Even in the pipeline industry, most people thought that they were pipelines and I'm receiving a fee.
[47:18] In reality, there was a tremendous amount of commodity exposure, primarily in the gathering and processing sector, not necessarily in the long haul. But there was a tremendous amount of commodity exposure and what people thought were these pipeline and/or fee based MLPs, in reality that wasn't the case.
[47:36] Historically, it really was commodity exposure and M&A, management teams overpaying for assets. At that time, they were overpaying for commodity sensitive assets.
[47:45] Fast forward to today. I do think that you have a bit more volumetric risk in some of the MLPs, primarily closer to the wellhead that you get. But I think one of the...
Evan: [47:56] What does that mean? Explain that.
Rob: [47:59] Primarily in the gathering and processing, it's a tough business. You're spending a lot of capital and you can have a high decline rate at the wellhead. If the supply growth or production decreases, the closer you are to the wellhead, the more sensitive you're going to be to that. It's a volumetric risk.
[48:19] But we've also seen a number of drop-down MLPs. That's when the parent is dropping additional assets into the MLP, and one of the risks I think has emerged that people aren't really paying attention to is what is the true inventory of assets available for drop-down?
[48:38] I think a number of, not a number of MLPs, but there are certain cases that they're overstating the amount of assets and/or EBITDA that will be available to the master limited partnership below, and so you're getting a little ahead of yourself on valuation below. Those are some of the risks that we're monitoring.
John: [48:55] Just a quick stat. From 1997 to 2007 you only saw 4 distribution cuts.
Evan: [49:13] That’s LPs that cut what they paid?
John: [49:15] Right, from 1997 to 2007. Then if you fast forward from 2008 to today you've seen 17 distribution cuts. Clearly something is happening. You're seeing more cyclical assets being put into the MLP structure that is leading to distribution cuts. When I say cyclical...
Evan: [49:37] Yes, explain that.
John: [49:38] When I say cyclical, I'm saying that investors are taking on exposure to commodity prices or significant volume risk such as gathering and processing that are pipelines close to the well-head that depend on drilling activity for volumes and cash flow. That's going to be a cyclical type of asset.
[50:04] It's not to say that we think all cyclical assets or all assets that have exposure to volumes are bad. For example, we do own a coal MLP that is a low cost producer of coal out of the Illinois basin. So despite how bad the coal environment is right now, they've continued to grow, generate good returns on invested capital, and increase the distribution.
[50:33] While they're in a cyclical business, they are a low cost producer with long term contracts that minimizes their cash flow variability.
Evan: [50:42] We're reaching the top of the hour, so I'd like to go around and get some takeaways. What should advisors and their clients come away with from our session on master limited partnerships? What should they know and what should they come away thinking about? Rob, let's start.
Rob: [50:55] I think a lot of times I get the question, it seems like I've been answering this since the middle of 2010. It's looking at valuations, have I missed the boat? What I'd like to say is that, over time, there are going to be better entry points than others. Trying to perfectly time the market to enter the MLP asset class from an investment standpoint is very difficult to do, and typically the best times are very volatile times and you have to have a firefighter's approach and be able to run in when everybody else is running out. That's difficult to do with investors over time.
However, if you really want to look at the asset class, look at the high form of their current income. Look at the growth potential of the asset class. Compound that on an annualized basis. It's really difficult to find an investment out there that has similar return attributes.
[51:47] I think, given the backdrop of energy renaissance and the amount of infrastructure needed, that there are a lot of legs in the asset class and it will continue to provide attractive returns for investors moving forward.
Chris: [52:00] The thing I want to add to that is, if you have a downdraft in these stocks, and there are stocks, there's going to be volatility, investors need to step back and ask, "What's changed?" If the underlying thesis for why you own these assets and the underlying cash flow generation of the assets has not changed, that volatility needs to be exploited.
[52:18] Now, if something changes dramatically, whether it's tax code or fundamentals of the underlying market that we're all investing in, that's a different story. But the volatility that we've seen in the past and will very likely see going forward, more often than not, so long as the fundamental thesis is intact, should be something to exploit, to buy into, rather than panicking and selling it just because these stocks have moved down.
Evan: [52:37] And they move down typically now for what reason?
Chris: [52:42] Look at what's just happened over the last couple of weeks. Rates have gone up a little bit and stocks have gone down. They've made a very nice move. They've substantially outperformed the broader market. They pulled in, what, five percent or six percent? It was hardly a horrific correction, but it was a little bit of a correction.
[52:58] Certainly, when that happens, my phone lights up. And people are getting jittery. "What's going on? Am I missing something?" Again, step back, look at the fundamentals. Try to disengage yourself from the emotions and understand what it is you are investing in and understand that these are long life assets.
[53:13] My personal view is that MLPs are not really appropriate from a trading strategy perspective given the longevity of the assets we're investing in. So, when I analyze a company, I'm looking not one quarter down the road, not one year down the road, but literally multiple years down the road, given the kinds of assets that we're all investing in.
John: [53:32] I would just say that most people have been inundated with how good the MLP space is and well it has performed. The thing that I think the individual investor needs to understand is that it's just a structure. It does not tell you the types of businesses that are financed around that structure. By just buying any old MLP is not likely going to achieve your investment objective.
[54:05] You really have to look at the assets that the MLP is structured around in addition to the management team. Both of those things are very important when it comes to, not only investing in MLPs, but also investing in general. Know your assets. Know your management team.
[54:25] What we are trying to achieve is a tax efficient total return from non cyclical energy assets. That's the idea, but it's not as easy as it sounds. By just going out there and buying an index, you are probably not going to end up with what you think you bought.
Evan: [54:46] So you guys are the watchdogs, and you're looking at those managements and those companies?
John: [54:50] That's the idea.
Chris: [54:52] Absolutely.
Rob: [54:52] Definitely.
Evan: [54:53] Rob, Chris, and John, thanks so much for sharing those thoughts with us and the insights on the master limited partnership area. Thank you all for joining us. For Asset TV, this is Evan Cooper.
This video transcript is solely the property and responsibility of asset.tv. Energy Income Partners, LLC ("Energy Income Partners") does not warranty the accuracy of any information provided in this video transcript. The views of John Tysseland and/or Energy Income Partners relating to any security and/or asset class may change without notice. The views expressed by Mr. Tysseland regarding any company or security should not be construed as: (1) a recommendation to purchase or sell any security; or (2) as representing the performance of any investment held by any client of Energy Income Partners.
None of the views expressed by John Tysseland should be construed as tax advice. Please see a qualified tax professional for information regarding the tax consequences of investing in MLPs or in any other securities.
Suggested Disclosures for the Asset.TV Interview Transcript
This video transcript is solely the property and responsibility of asset.tv. Energy Income Partners, LLC ("Energy Income Partners") does not warranty the accuracy of any information provided in this video transcript. The views of John Tysseland and/or Energy Income Partners relating to any security and/or asset class may change without notice. The views expressed by Mr. Tysseland regarding any company or security should not be construed as: (1) a recommendation to purchase or sell any security; or (2) as representing the performance of any investment held by any client of Energy Income Partners.
None of the views expressed by John Tysseland should be construed as tax advice. Please see a qualified tax professional for information regarding the tax consequences of investing in MLPs or in any other securities.
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MASTERCLASS: MLPs September 2014
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