Riding the U.S. Energy Boom

This impact will continue for many years to come. Plentiful domestic energy supplies and low relative prices have led to resurgence in U.S. manufacturing and positioned the U.S. to become one of the largest exporters of energy in the world.

The shale revolution is creating demand for midstream assets that transport natural gas and crude oil to end markets. The build-out of new pipelines, processing plants and storage facilities will require an investment of $250 billion over the next 20 years. This presents a huge growth opportunity for midstream MLPs and midstream C-corps. In fact, we believe the outlook for growth is as good as it has ever been for the midstream sector.

Mick: We are just as optimistic about the longer-term outlook. Due to advancing technologies and the discovery of more reservoirs of resource-rich shale, a domestic energy revival is dramatically altering the global balance of energy, which has tremendous promise for a host of benefits.

As we look long term and evaluate the impact on the energy value chain, the tremendous supply growth in crude oil, natural gas and natural gas liquids has generated a need for a demand response. In our view, that response is in progress but varies in terms of how quickly it arrives. Growing domestic crude oil production is reducing foreign crude imports.

On the natural gas side of the energy value chain, the continuation of natural gas power generation replacing coal as well as exports in 2016 and beyond will drive demand growth. While on the natural gas liquids front, the petrochemical industry has a significant build-out of facilities planned in the back half of the decade, set to take advantage of growing production and attractive prices relative to global competitors.

We expect midstream MLPs and other pipeline companies will benefit from the growth in production in all these various cases. In fact, in the three years through 2015, we project more than $130 billion in MLP, pipeline and related organic-growth projects. We believe these assets, which are critical to our energy needs, are attractive to investors in periods of both economic growth and uncertainty.

Schuringa: Shale production growth continues to be the driving force in the U.S. energy expansion. Texas alone grew its oil field production by 1.5 million barrels of oil equivalent per day (mm BoE/day) over the past five years—a number larger than the Saudi and Russian growth combined. North Dakota, a new energy frontier, also raised its oil production by 0.67 mm BoE/day, nearly equaling the combined growth of the aforementioned two energy giants.

Going forward, the shale revolution should continue to be the main driver of growth in energy production worldwide. According to a study sponsored by the Department of Energy, 32% of the total estimated natural gas resources are in shale formations, while 10 % of estimated oil reserves are in shale or tight formations. In the U.S. alone, it is estimated there are still 223 billion barrels of crude oil and 2,431 trillion cubic feet of natural gas to be extracted.

For investors in midstream MLPs, this means greater storage and transportation volumes as well as increased demand for processing and fractionation. The net result if increasing volumes will be a stable distribution growth trajectory for pipeline operators and gatherer-processors.

What do you see as the advantage of the midstream MLPs' toll- road model for investors?

Feng: Investors like toll-road business models, whether it be via midstream MLPs or another asset class, because of the predictability of their cash flows. Interstate liquids pipelines in particular benefit from federally approved tariff increases every July 1, inelastic energy demand, high barriers to entry leading to regional monopolies, and meaningful operating leverage from a high ratio of fixed-to-variable costs.

McCarthy: Midstream assets are the "logistics assets" of the energy sector, used to provide services to the energy industry. They include pipelines, processing plants, storage facilities and terminals.

Characterized by stable cash flows, long-lived assets and fee-based cash flows (i.e. minimal commodity price risk), midstream assets are strategically important to delivering energy to our nation. The fees and tariffs charged by many midstream MLPs are often subject to regulation at the federal and state levels and have tariffs that increase based on the rate of inflation.

Increased production from new areas has put pressure on commodity prices in certain regions of the U.S. as insufficient infrastructure exists to move the production to other markets, thereby increasing the importance of fee-based pricing. Finally, MLPs have averaged 8.5% distribution growth since 2000 and grew distributions at 7.4% in 2013, well in excess of yield alternatives.

Mick: We continue to see stable and predictable cash flows as the primary advantage of the midstream toll-road business model. Midstream companies have the potential to distribute steady cash flows, quarter after quarter, year after year.

The robust production growth made possible by advances in drilling technology is driving a correspondingly robust need for more toll roads in the U.S. In our view, this translates to growing cash distribution potential for midstream investors.

The fee-based nature of pipeline company cash flows and inelastic nature of energy use somewhat safeguards the toll-road model from political uncertainty and economic cycles. This is particularly attractive as our nation continues to grapple with fiscal and economic challenges.

On a larger scale, the toll-road model is good for the U.S. economy in that it provides reliable transportation and distribution of energy across the country.

Schuringa: The advantage of the toll-road model lies in the stability and consistency of distributions by the partnerships to end investors. By engaging in long-term contracts and employing hedging strategies, most midstream MLPs are able to secure future cash flows. The market generally rewards partnerships possessing these characteristics with premium valuations, lower yields and a lower cost of capital.

However, investors must consider that not all midstream MLPs are afforded 100% fee-based revenues. For example, many processing contracts are structured as keep-whole or percent-of-proceeds, leaving some of the commodity price risk with the MLPs themselves.

It is therefore important to understand exactly what you are investing in, and that is where active management comes into play. For those who prefer to play the midstream segment without paying higher fees, we would suggest the Yorkville High Income Infrastructure MLP ETF (YMLI), which we launched in 2013.

What potential risks should midstream MLP investors monitor?

Feng: Access to capital markets is critical for MLPs to take advantage of all the opportunities available to them. MLPs generally pay out 80-95% of their available cash to investors each quarter; so in order to pursue new organic growth projects and acquisitions, they need access to the markets.

Investors should beware of rising acquisition multiples, usually driven by the desire to enter a new basin or the potential for a significant ramp-up in long-term cash flows, both of which introduce execution risk. Labor and equipment markets are also tightening, so executives will also need to be vigilant about keeping projects on time and on budget.

Equity issuances are likely to set new records again in 2014, both through marketed secondary offerings and IPOs, so equity overhang could materialize if new investor inflows fail to match supply. Investors should follow commodity prices, particular crude oil and NGLs, which could weaken if bottlenecks are caused by infrastructure or end-user development delays.

And as with all yield-oriented securities, investors should continue to pay attention to possible shifts in the yield curve caused by comments from the Federal Reserve and/or changes in the pace of the Fed's tapering program.

McCarthy: We believe that stock selection becomes more important in the face of rising interest rates; winners and losers created by changing transportation flows of crude oil and natural gas; MLP valuations; and the growing complexity of the MLP space.

We believe the MLP sector can generate low double-digit returns in 2014, but the total return expectation is partially mitigated by an expectation of rising interest rates. Rising interest rates could lead to higher yields for MLPs (which would reduce total returns), but we believe this will be a temporary headwind. Ultimately, the sector's attractive yields and prospects for many years of distribution growth will lead to a continuation of strong returns.

Increased production from new areas (the Bakken Shale and the Marcellus Shale are two good examples) continues to have a material impact on historical transportation patterns. In most cases, this means new midstream assets need to be built to move the oil or gas from production areas to end markets—but it can also create challenges as changing transportation patterns put pressure on certain existing midstream assets (which may no longer be needed).

For instance, production from the Bakken Shale in North Dakota has increased over five times in the last five years. The vast majority of that oil is not consumed in North Dakota and must be shipped to refineries elsewhere in the U.S. This has put a strain on the existing midstream infrastructure in the area, but creates tremendous opportunities for midstream companies to develop long-term transportation solutions.

After the financial crisis, most if not all MLPs were undervalued, so no matter which MLP you chose, you were pretty much guaranteed a good return. Today, many MLPs are fully valued, so choosing the right names becomes key.

Finally, the MLP space has become more complex. MLPs used to consist of long-haul, fee-based pipelines, processing plants, and storage facilities. Now we have MLPs involved in refining, fertilizers, chemical processing, frac sand, transmix, compression services, coke-making, methanol and ammonia. Investors face a challenge in understanding these business models, analyzing their economics and selecting the names with the best return potential.

Mick: We don't consider higher interest rates to be a potential risk over the long term, but we realize that this is an area of concern for many MLP investors. This was evidenced by the spate of short-term market volatility following the approximately 50 basis point rise (from 1.6-2.1%) in the 10-year Treasury rate in May.

While higher rates are inevitable at some point, and may cause some shorter-term volatility, we believe that over the long term, quality growth will prevail. As evidence, one can point to the returns for 2013, when MLPs generated a 30%-plus return despite a 125 basis point rise in the 10-year treasury throughout the course of the year.

Here's what's behind our thinking: First, it's important to remember that MLPs, unlike bonds, can grow their distributions over time. Second, midstream MLPs' generally conservative debt structure and use of primarily fixed-rate debt support them in a rising-rate environment. Midstream companies generally utilize 70 to 100% fixed-rate debt, so their cash flow growth and longer-term performance is less sensitive to higher rates.

In addition, rising rates generally are caused by either inflation or an improving economy. A strengthening economy helps midstream MLPs, because as an economy improves, aggregate demand increases. And when inflation is the catalyst for higher rates, some MLP and pipeline companies can pass through the rate as it relates to liquids pipelines, which receive tariff escalators that would effectively push up the rate side of the equation.

We believe that either one of these rising-rate catalysts would in turn drive improved cash flow, which could either offset an increase in rising equity yields or allow for equity yields to not have to rise given the offsets. In short, we feel there are mitigating factors that will allow MLPs with solid distribution growth to perform well, even in a rising rate environment.

Schuringa: While all MLP investors need to keep an eye on Washington and the debate surrounding tax status of partnerships, we see regulatory risks as slim in the short- to intermediate-term. Not only have the potential tax revenues from MLPs been estimated at no more than $2 billion to $3 billion, but it looks as though the MLP Parity Act (which would extend partnership eligibility to renewables) has a real shot to go through. We see this as political insurance.

The more pressing concern from a valuation perspective in the short term looks to be a run up in rates. While MLPs have proven to be resilient by producing positive returns over every major rising rate environment since 1993-1994, they are susceptible to rising rates in the very short term. Any pullback would represent more of a buying opportunity than real downside in our opinion.