Steady Returns for a Wealth of Investment Strategies

We believe commodity MLPs in general are an undervalued and mispriced segment of the asset class. They offer higher current income and faster distribution growth relative to infrastructure MLPs. This disparity implies either greater risk or mispricing. But we completed a study earlier this year dating back to the inception of the MLP universe over 25 years ago that showed the commodity sector exhibited price and distribution volatility in line with the infrastructure sector.

McCarthy: We believe the single most important factor will be asset location and exposure to increasing volumes from unconventional reserves. "Unconventional reserves" is an industry term that refers to oil and natural gas reserves produced using advanced drilling and completion techniques. Examples of unconventional reserves include the Barnett Shale, Haynesville Shale, Woodford Shale, Fayetteville Shale, Eagle Ford Shale, Marcellus Shale and Bakken Shale, as well as developing plays such as the Utica Shale, Niobrara Shale and Tuscaloosa Marine Shale.

Why are unconventional reserves so important? Prior to the large-scale development of unconventional reserves, natural gas production remained flat from 2000 to 2005, despite a 64% increase in the natural gas rig count. 

Since 2006, natural gas production has increased by 24% — most of it coming in the last two years — due to the development of unconventional reserves. Shale gas provided around 28% of the natural gas consumed in the U.S. in 2011, up from 11% in 2008. By 2020, unconventional reserves are expected to provide about 50% of the natural gas consumed in the United States.

Crude oil production has also increased as a result of unconventional reserves. For the first time since the early 1990s, crude oil production has increased in each of the last three years. 

According to Wood MacKenzie, crude oil production is expected to increase by as much as 10% to 15% over the next five to 10 years. In a remarkable turn of events, for the first time since 1949, the U.S. became a net exporter of refined petroleum products in 2011. Some forecasts even have the U.S. becoming the top producer in the world over the next 10 to 20 years.

For all these reasons, we're bullish on unconventional reserves. We believe that the sectors that will benefit the most are large MLPs that are well positioned to transport new volumes over interstate pipelines, as well as smaller gathering and processing MLPs that have direct exposure to specific basins such as the Marcellus or Eagle Ford Shales.

Spears: A key theme for 2012 is the execution on announced infrastructure plans, as well as the exploration of new opportunities with a continued focus on oil and liquids-rich areas. This is playing out with a seemingly constant stream of project announcements.

The infrastructure build out of maturing shale plays (e.g. Eagle Ford and Granite Wash) is well under way with a need for additional infrastructure, and several MLPs already possessing a strong foothold. Areas of opportunity also include the developing shale plays (Bakken, Horizontal Permian and Marcellus) and the emerging shale plays (Utica, Mississippi Lime, Niobrara and Avalon).

Simply put, there is an abundance of areas that require midstream infrastructure, and it seems like talk of new opportunities, like the Brown Dense and the Tuscaloosa Marine Shale, is becoming more frequent. Of course, as investors, what we ultimately care about is how all of this development translates into cash flow and distribution growth.

Several large-cap diversified MLPs with sizable asset footprints continue to capitalize on infrastructure needs and increase their distribution growth rates. To illustrate, the following MLPs have accelerated their distribution growth targets:

•  ONEOK Partners' (OKS) projected distribution growth for 2012 is now 14% (versus 11% forecasted in September 2011); this increases to 15%-20% annually in 2013/2014.
•  Plains All American (PAA) expects distribution growth of 8%-9% in 2012 versus a prior range of 5%-7%.
•  Kinder Morgan Energy Partners (KMP) projected distribution growth of 7% annually for the next several years, up from a prior target of 5%.
•  Magellan Midstream Partners (MMP) increased 2012 distribution guidance to 9% (from 7%) and expects 2013 distribution growth of 8-10%.
•  Enterprise Products Partners (EPD) reported cash flow coverage of approximately 1.5-times in the fourth quarter of 2011, and management stated it is evaluating increasing its distribution rate of growth (which has been 5-6% over the past few years).
•  Williams Partners (WPZ) expects to deliver approximately 8% annual growth in distributions for 2012 and 8-10% annual growth for 2013 and 2014. The general partner, Williams (WMB), also raised its 2012 estimates and now expects its 2012 dividend to be 55% higher than the full-year 2011 dividend. The company announced plans to increase its dividend by 20% in both 2013 and 2014.

Thummel: Tortoise believes that the stage is set for pipeline MLPs to perform strongly over both the immediate and long-term. They are the critical link between energy suppliers and end-users, between producers in North Dakota and refineries along the Gulf Coast.

Coupled with population growth and growing volumes of U.S. and Canadian-produced crude oil, natural gas, and natural gas liquids, there is an increased demand for this energy infrastructure. Even better, these companies have a relatively low amount of risk: The cash flow volatility of pipeline MLPs is mitigated by contracts with producers that are based on volume rather than price. Occasionally, pipeline MLPs eliminate more volume risk by serving as a landlord too — they charge "rent" to large oil and gas producers who access their pipelines.

Wells: For the intermediate-term, we believe the crude oil logistics and NGL logistics businesses have the most compelling growth prospects. New production is overwhelming the capacity of assets already in place, which is not only providing midstream operators strong volume growth on current assets but is also creating opportunities to build new infrastructure to relieve bottlenecks.

We believe the trend of substantial volume growth for both crude oil and natural gas liquids is likely to sustain itself for an extended period, though we prefer to invest in this theme through entities that can benefit from this volume outlook without overexposure to the underlying commodity prices given the potential volatility of those prices.

Natural gas gatherers with substantial exposure to dry gas basins and without offsetting wet gas basin positions, and long-haul natural gas pipelines with near-term contract renewals, may face volume and margin pressures in the short term. Long-term, growth in the use of natural gas for power generation, industrial purposes, fleet transport and as an export commodity to overseas markets will likely improve the pricing outlook for natural gas, as well as the volume and margin prospects for these midstream assets.

Young: I'll mention a structural phenomenon happening in North America: that structural phenomenon is rising crude oil production and rising natural gas production. Much of this "new production" is necessitating a new building cycle of energy infrastructure assets, and that is the business of the MLPs, building, operating and expanding U.S. energy infrastructure assets.

Therefore, the rising British thermal unit (or BTU) production volume is creating investment opportunities both on the crude oil side and on the natural gas side. Some MLPs have a natural gas footprint, while others have more of a crude oil asset base  — and some have both.

At the end of the day, the existing MLP players with established energy infrastructure assets will be the prime beneficiaries of the secular increase in North American BTU production.

Interest still appears to be growing in U.S.-based gas as an energy source. Do you see this trend continuing, and if so, how can investors profit from it?

Cunnane: Yes, we see this trend continuing. We believe that natural gas prices will remain low over the near term, so we prefer MLPs with exposure to crude oil pricing and associated volumes. We also believe that there will be a continued need for natural gas infrastructure build-out to deliver energy product from the growing areas of supply (the shale plays) to customers. Gathering & processing (G&P) MLPs with assets in wet gas plays should benefit from this environment, as this shift to wet gas plays is increasing the level of processing required prior to putting this new supply into the pipeline system.

Hug: Our natural gas is so cheap compared to Europe and Asia that it's going to be a major advantage to the U.S. economy. Shale gas currently represents about 27 to 30% of our natural gas production, and estimates project it could grow to 40 or 50% over the next decade.

The entire MLP market is about $300 billion. We estimate the cost of expanding domestic energy infrastructure to accommodate new discoveries could double the market's size over the coming decades.

Some of that is going to be organic, while some will be outside acquisitions or drop downs. For example, Anadarko's general partner has stated it is going to sell, or drop down, billions of dollars' worth of acquisitions to Western Gas Partners, its MLP. Drop downs make sense, because they are usually accretive to the general partner and to the limited partner as well. On April 30, Energy Transfer Partners announced the acquisition of Sunoco Inc., for $5.3 billion, which will be immediately accretive.

McCarthy: Yes, we see continued interest in U.S. unconventional reserves.  In fact, development of these reserves could be one of the biggest stories as it relates to the long-term impact on the domestic economy.

Significant amounts of capital are being spent to develop these reserves. In fact, major oil companies, foreign oil companies and national oil companies spent approximately $50 billion in 2011 and over $60 billion in 2010 to acquire unconventional reserves, either directly or through joint ventures. After shunning domestic opportunities in favor of international projects for many years, major oil companies are now devoting significant capital and resources to domestic unconventional resources. We believe their technical expertise, capital discipline and financial resources will ensure these reserves are developed in a prudent fashion.

This trend is very important for MLPs, as development of these new reserves will require substantial amounts of new midstream infrastructure. We agree with the study by the Interstate Natural Gas Association of America (INGAA) that concluded that $250 billion will need to be spent building midstream assets over the next two decades to facilitate the development of unconventional reserves. We believe this infrastructure build-out will provide attractive investment opportunities for MLPs and help drive future distribution growth.

Spears: I do see continued growing demand in the United States to utilize natural gas as an energy source. Investors can profit from trends, including the buildout of LNG terminals (and the associated pipeline infrastructure connected to them), the buildout and the construction of natural gas pipelines to connect to new gas fired generation, and other ways.

Thummel: Yes, we expect natural gas consumption to grow and continue to displace coal as an energy source. The United States is potentially the world's largest natural gas field, so there is an ample supply (estimated to be at least 100 years).

Currently, natural gas prices are near decade-lows, creating opportunities for increased demand from multiple sources. That means generating electricity from natural gas-fueled power plants is more profitable than using coal. Also, truck fleets that previously used gasoline are being converted to burn natural gas to affect cost-savings in the transportation industry.

Wells: The prospect of exporting natural gas to international markets certainly seems likely to provide additional demand for the commodity. This demand could help to improve the commodity's price outlook, as well as the volume and margin outlook of natural gas midstream players, generally speaking.

Currently, the investment options to benefit from that trend in a direct way are relatively limited. Others have announced an interest in developing liquefaction capacity, but whether they will be able to obtain the necessary approvals and customer commitments remains to be seen.

Young: There are several angles to the answer. One segment of the MLP industry is the upstream players such as LINN, EV Energy, etc. Their business model is to acquire and develop (A&D) BTUs in the ground, typically mature oil/gas fields.

There is an abundance of gas properties for sale, and this creates acquisition opportunities for the upstream MLPs. That gives them growth and visibility of volumetric growth and, therefore, cash flow growth.

The modus operandi of the upstream guys is to buy and hedge. Even though they are producers of hydrocarbons, in effect by virtue of the hedge portfolio, they have created a steady stream of future cash flows regardless of the volatility of the commodity they're producing, because they're hedged. Typically that hedging takes place at the time of an acquisition, when they lock in a cash flow for the foreseeable future.

The second aspect of the upstream players is that their reserve life averages 18-plus years, which means that you also have visibility of production. The modern day MLP A&D model is very different from the old exploration model.

Upstream MLPs back in the '80s were more focused on the exploration model. Exploration has its risks, namely unsuccessful exploration is very disruptive to the future cash flows. Today's A&D model is in effect the opposite. The [players] already know what's in the ground, given the maturity of the asset, and therefore there is predictability. The A&D model of the upstream MLPs in today's weak natural gas price environment is like being a kid in a candy store with all of the sweet merchandise "on sale."

 Are you concerned about the reputed environmental risks from fracking? If you are, how do you factor that concern into your investment management process?

Cunnane: We recognize that there are real environmental concerns involved with the dramatic increase in domestically sourced energy. We also see a significant number of economic and geopolitical advantages associated with the increase.

Our sense is that regulation surrounding natural gas drilling and infrastructure will increase at a manageable rate. Our process is adjusting to the regulatory environment by emphasizing cleaner sources of energy over dirtier ones such as coal, as well as preferring MLPs operating in energy-friendly areas of the country, such as the Bakken and Eagle Ford Shales, to those operating in less energy friendly environments, such as the Marcellus Shale.

Hug: We're cognizant of the responsibilities exploration & production companies face in order to operate securely, and we're convinced hydraulic fracturing is safe. Fracking has been around for a long time, but the process has been perfected over the last five to 10 years.

The combination of hydraulic fracturing and horizontal drilling has been a boon for the production of energy in this country. We now have a potential game changer that enables us to be less reliant on fossil fuels from unstable parts of the world.

McCarthy: Despite concerns about hydraulic fracturing, we believe that lawmakers, including President Obama, recognize the need for natural gas and have strongly embraced natural gas as an abundant, clean-burning fuel. In his State of the Union address, President Obama explicitly supported natural gas development. 

We believe that Washington recognizes that lower natural gas prices are saving consumers money on electric and heating bills and are spurring manufacturing and industrial growth. With rising gasoline prices, we believe that politicians are very sensitive to anything that might increase energy costs, such as lower natural gas production that could result from a moratorium on hydraulic fracturing.

Regulatory reviews of hydraulic fracturing are underway at both the state and federal levels.  States continue to adopt legislation requiring the disclosure of chemicals used in hydraulic fracturing, and several large E&P companies have embraced such disclosure.  We plan to monitor these developments closely, and if any policy changes are implemented, we will make adjustments as necessary to our investment process.

Spears: No.

Thummel: We follow the various federal and state proposals regarding fracking but believe an accord can be reached that maintains the benefits of fracking while addressing environmental concerns. While midstream MLPs that we currently target do not directly participate in the fracking process, fracking is essential for these midstream customers, as they provide the transportation for what is produced.

Hydraulic fracturing technology has been used by the oil and gas industry for more than 60 years and is constantly being improved. While environmental issues have always been of concern to the oil and gas industry, we believe those concerns will be balanced against the need for energy, and that, over the long-term, companies will continue to find new and improved technologies that are environmentally safe to allow continued production of these resources.

Wells: No one should support a cleaner and/or cheaper source of energy if it endangers the welfare of people in surrounding communities. That being said, we believe that the producers that employ fracking techniques in the production of natural gas and oil, with few exceptions, do it in an environmentally responsible way.

It appears most of the complaints being thrown against fracking really relate simply to the fact that the technique has resulted in an abundance of economic drilling locations, and so drilling is more common in more regions. Whether those operators are employing fracking techniques or not, if they are not following sound and environmentally conscientious practices then they should face stiff and sufficiently deterrent penalties.

Ultimately, however, we believe the environmental risks are and will continue to be sufficiently mitigated to enable the continued use of the practice and facilitate domestic exploration and production growth, generally speaking. Regardless, issues are likely to continue to arise until all stakeholders are convinced the energy industry has addressed their concerns.

It is fair to say that the industry has more work to do on this front. We believe those most likely to bear the brunt of any harshening of regulation related to fracking are the producers themselves. Given our midstream focus, we do not anticipate this potential cost escalation will significantly impact our portfolios. However, if a change in policy were to significantly increase the costs of fracking, or drilling more generally, midstream volumes in marginally economic basins could be impacted as producers would likely rationalize rigs away from those basins.

Young: Fracking regulation, in my view, is more of a headline risk as opposed to a disruptive business model risk. All parties in the drilling process are seeking safe and sound practices.

An important aspect of fracking and drilling regulation is that the rules tend to be set at the state level (due to states' rights). The EPA and other Federal agencies are also trying to be part of the regulatory process. In some cases this has created some turf wars. The bottom line is that all parties are trying to reach workable solutions and continue the effort towards U.S. energy independence.

How do U.S. interest rates factor into your analysis of the investment potential of MLPs? If rates were to rise from current levels, say, 50 to 100 basis points on 10-year debt, how would that affect MLPs and your investment outlook for the asset class?

Cunnane: We have managed MLPs through several periods when interest rates increased 50 to 100 basis points over a short period of time. Our observation is that MLPs don't perform well from an absolute perspective during these periods, but they do tend to outperform lower-growth securities, such as bonds.

The strong MLP performance of the last 20 years was helped by a steady decline in interest rates. We expect the next 20 years to be an environment of rising rates. Our long term expectation is that MLPs will generate 6-10% returns for investors, as a high yield and solid growth is somewhat impacted by the higher interest rate environment.

Hug: The 10-year Treasury-to-average MLP yield spread usually runs around 290 basis points. It's wider than that now at about 370 basis points, which suggests MLPs are undervalued. But current income is only half the appeal of MLPs, and this analysis fails to account for distribution growth.

MLP distribution growth rates in the first quarter of 2012 were 10% year over year, with commodity sector MLP distributions growing by 19.4% and infrastructure by 6.7%. Such significant growth is a natural hedge against rising rates.

Look historically, and you'll see that MLPs performed very well last time rates rose. Investors witnessed MLPs appreciate by 40% during the last rate tightening cycle from 2004 through 2006. The ability to grow their distributions makes MLPs a great inflation hedge, so they make a lot of sense if investors seek attractive income in a rising rate environment.

McCarthy: One thing we often look at is the yield spread between MLPs and the 10-year U.S. Treasury. For the five years prior to the financial crisis, the average spread was 219 basis points (where 100 basis points equals one percentage point). Today, as of April 19, 2012, the spread is 418 basis points, which is almost double the historical average. 

One reason the spread is so high is that interest rates are unusually low today. If the rate on the 10-year Treasury were to go up 50 or 100 basis points, the yield spread would probably narrow, but we can't predict by how much. However, it's possible that the large cushion we have right now could absorb part or all of a 50 to 100 basis point increase in Treasury rates, thereby moderating the impact on MLP valuations.

Spears: If the rate increases are immediate and not anticipated by the market, then we would expect it to have a negative impact on the MLP sector. If the rate increases are anticipated and rise over a longer time period, we believe that you would simply see a tightening of the spread between MLP yields and the 10-year Treasury.

Thummel: Some investors view MLPs like fixed-income securities, implying that a rise in interest rates could negatively impact the unit price of MLPs. However, unlike other fixed-income securities, MLPs have historically grown their distributions. That means the potential impact of rising interest rates can be greatly reduced. If you look back to 1992 at time periods when interest rates rose by more than 50 basis points, bond returns were negative while MLPs on average still generated positive returns.

Wells: Though long-term correlations to the 10-year Treasury are low, experience informs us that unexpected interest rate spikes do have an impact on short-term price performance. This exposure, in fact, pertains really to all yielding equities and even to the broader equity markets.

However, in general, MLP trading has been agnostic to gradual rate increases. Further, we believe the growth prospects within the midstream sector provide participants attractive distribution growth potential, which may help prices recover from interest rate related weakness.

Young: There's a multi-prong answer to this question. The first answer is it depends upon the rapidity and whether or not it is a surprise move in interest rates.

Rising interest rates as a generalization tend to be a depressant on asset prices, because you have a higher discount rate to future cash flows. The unique thing about the MLP industry and the business model is the fact that MLP have rising distributions or what we call "unfixed" income. The rising unfixed income nature, over time, overcomes rising interest rates. Bonds, on the other hand, will typically go down in price in a rising rate environment, because bond coupons (interest income) are fixed for the life of the bond.

Secondly, if you have the ability to raise your "rents," the underlying value of the assets generating rising income can appreciate. It's more valuable to a potential buyer. An analogy would be a well-located apartment complex with credit-worthy tenants and the ability to raise rents. The resale value of that apartment complex will tend rise over time.

MLP assets are like the well-located apartment complex; MLPs have credit-worthy customers, and MLP assets can support rising rents. If in fact MLP cash flows are rising, even in a rising interest rate environment, the underlying asset value of those MLPs will rise. There may be some short-term hiccups, but over time the MLPs can overcome the rising interest rate environment you've described.