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Kenny Feng: What Are MLPs and Why Are They Outperforming?
Source: Zig Lambo of The Energy Report (11/8/11)
Increasing U.S. energy demand has spawned a similarly growing investment space in Master Limited Partnerships (MLPs). These partnerships provide investors with the opportunity to share in the income generated mainly through the transportation, distribution and storage of oil and natural gas. In this exclusive interview with The Energy Report, Kenny Feng, president and CEO of Alerian, which maintains the Alerian MLP Index, gives us the ins and outs of the MLP business, highlighting the unique benefits and risks associated with these income-generating investment vehicles.
Kenny Feng: First, Alerian creates and maintains four indices that track the energy MLP space. Just as someone would use the S&P 500 to gauge the performance of the broader U.S. economy, people use the Alerian MLP Index (AMZ:NYSE) to gauge the performance of the energy MLP space.
Secondly, we license our indices to investment banks and third-party exchange-traded fund (ETF) distributors to create investment products, which facilitate access to this asset class. These currently include JP Morgan, UBS, ALPS Fund Services Inc. and CIBC in Canada.
Thirdly, we are an information provider for the MLP space. As a sort of "Wikipedia" of MLPs, we are the first-pass information source for investors just finding out about the asset class through a CNBC spot or an article in Barron's or through word of mouth. People are looking for sources of higher-income returns and learning that MLPs have historically provided them.
TER: Can you define an MLP for people who aren't that familiar with the structure?
KF: Master Limited Partnerships are involved in four basic businesses at a very high level: transportation, storage, processing and exploration, and production of minerals and natural resources. By confining themselves to these specific activities, MLPs are not subject to entity-level taxation. They are, however, subject to the same reporting requirements as any other publicly-traded corporation. Approximately two-thirds of these names trade on the New York Stock Exchange, with most of the others trading on the NASDAQ.
TER: How did you get into the business of creating these indices?
KF: We actually kind of stumbled into it. In 2004, Alerian was launched as an asset manager for the MLP space. Being a pretty small fish in this pond we thought, "What can we do from a marketing standpoint?" Reading the different analysts' research reports and talking to different MLP investor relation (IR) teams, we realized there wasn't a third-party index capturing and benchmarking MLP performance. Everyone was calculating their own composite for the sector with different methodologies. We thought this would be great opportunity for us to launch an index that would be really helpful for all the different stakeholders. The Alerian MLP Index was launched on June 1, 2006.
Our methodology largely mirrors the construction of the S&P 500, which is a float-adjusted, market capitalization-weighted index. We were fortunate to have first-mover advantage and to be able to have the different stakeholders of the sector adopt it as the benchmark. Today you see the MLPs themselves using it in their corporate presentations. The media has adopted it, including CNBC, Barron's and other publications.
In 2006-2007, people said to us, "We love your index, but I'm really more interested in traditional pipeline and storage." They were looking to track what are called toll-road business models. So we launched the Alerian MLP Infrastructure Index (AMZI:NYSE) for those who are more focused on that midstream energy infrastructure component. Then, as the gas shale plays started to emerge in full force in the U.S., we decided to launch a gas infrastructure index—the Alerian Natural Gas MLP Index (ANGI:NYSE).
TER: Why did MLPs lack their own index for a full 20 years since their 1986 inception and before Alerian launched its index?
KF: That's a great question. This asset class is still pretty small—about $250 billion (B) spread among just over 70 securities. That's two-thirds the size of Exxon Mobil Corp.'s (XOM:NYSE) market cap, which is in the $375B range by itself. This hasn't been an asset class that has historically interested a lot of institutions, and as a result has largely been held in retail hands. As oil prices have fluctuated over the past eight years between $30–150 per barrel, the pipeline and storage MLPs have not been directly exposed to those commodity-price fluctuations. It's a stable business with very predictable growth in earnings and cash flow. This may not be exciting for a lot of people, but it generates stable cash flow, allowing MLPs to pay out consistent distributions over time.
TER: How does an energy infrastructure asset compare to other types of assets?
KF: What makes the energy infrastructure asset unique is the underlying business type, a toll-road business model. Those stable cash flows and the fact that you can predict it with a greater degree of certainty than, let's say, the advertising revenue of Google in any given quarter. It's attractive to a lot of people.
The MLP revenue equation is very simple. It's just price multiplied by volume. On the price side, you have a tariff on all interstate liquids pipelines that grows by PPI (Producer Price Index) plus 2.65%, federally mandated every single July. There is federally-mandated stability. On the volume side, you have energy demand growth in the U.S. averaging roughly 1% per year over the past 30 years.
TER: You touched on this earlier, but maybe you could go into a little more detail on how MLPs are valued compared to utilities and Real Estate Investment Trusts (REITs).
KF: MLPs are similar to utilities in that they are similarly exposed to inelastic energy demand. The difference is in how they are regulated. If a utility wants to implement something that will provide cost savings, the regulator will say, "It's a great idea, and now I want 50% of your cost savings for my consumers." With MLPs, the Federal Energy Regulatory Commission oversees all interstate pipeline activity. They have shown themselves to be constructive and efficient in their oversight.
MLPs are similar to REITs in that they own hard assets with permanent storage value. But REITs are much more exposed to economic cycles than MLPs and REIT distributions are consequently much more volatile. MLPs have raised their distributions on average by 3–6% each year through the 2008–2010 economic crisis, and they're on pace to do the same this year.
TER: So it's a good, solid, entrenched business that's not going to change much.
TER: Are there unique tax considerations investors need to make for MLPs?
KF: Absolutely. MLPs are partnerships. Instead of receiving the 1099 tax form you would get if IBM or Google paid a dividend, you're going to get a Schedule K-1 form, which is essentially your allocation of deductions and income that come from the MLP itself. I always tell people that if you don't find a Schedule K-1 to be burdensome, you should invest in MLPs directly, because MLP distributions are actually tax-deferred return of capital. When IBM or Google pays you a dividend, you're going to be taxed at the qualified dividend rate. With MLPs, because of various deductions, the return of your distribution is actually a tax-deferred return of capital.
Roughly 70–100% of MLP distributions will be tax deferred. The balance is going to be taxed at your ordinary income rate. So if I receive a distribution of $1 and 80% of that is going to be tax deferred, then I'm only taxable for that remaining $0.20 at a 35% rate. So it's $0.07 on a $1 distribution in the current year. Your cost basis will be adjusted downward accordingly. There will be a recapture upon the sale of MLP units, and that's when the tax deferral catches up. There's a recapture for that component, but certainly it does create a dynamic where, if you believe in the business and the asset, then certainly it's going to defer that income all the way out until you sell. So it's a great income tool, and also a great way to defer your taxes.
TER: How has the performance of MLPs compared to similar alternatives?
KF: Over the past 10 years, MLPs have returned approximately 17% annualized—obviously very strong. If you break down the actual performance, roughly 8% of that is a function of distribution growth. Another 6–7% of that is from yield, and the balance, that 3% or so, is really from valuation compression. So what's been driving that? Part of that is just that the asset class has grown through acquisitions and organic growth projects. Ten years ago, it was 20 securities, $20B and today there are 70-plus securities and $250B. The other part is the tariff escalators that we talked about earlier.
TER: How do we know that this growth will continue?
KF: The Interstate Natural Gas Association of America (INGAA) estimates that there's roughly $10B of new natural gas infrastructure that needs to go into the ground each year for the next 20 years. So you're looking at a roughly $200B investment through 2030. When you compare that to a market cap in the space today of $250B, it's pretty significant. What's driving the spending is the changing supply-demand dynamics caused by the gas shale plays. Ten years ago, we didn't know that some of these reserves were economically recoverable. As a result of changes in drilling technique and technology, those reserves are now recoverable at a much lower gas price.
On the acquisitions side, which is the other component of the growth, companies such as Exxon Mobil, BP Plc. (BP:NYSE; BP:LSE) and Chevron Corporation (CVX:NYSE) have midstream assets that they're not really getting credit for. They have an incentive to sell these assets (which they effectively operate as cost centers) down to the MLPs and redeploy that capital into a drilling budget. The MLPs, obviously, have an incentive to operate these assets more efficiently. Because of their pass-through tax status, they're able to pay a little bit more than the traditional corporation and still have the acquisition be accretive. The synergies with their existing assets create an opportunity to continue allowing their distribution to grow as a result of these acquisitions.
So the two components of growth are organic growth and acquisitions. That's going to allow the trajectory of this asset class to continue going forward. We wouldn't tell you 17% is anything to expect on a going-forward basis but if you do some basic math, research analysts expect 3-5% distribution growth, combined with a current yield of 6-6.5%, which gives a 9-12% total return. On a cash flow-volatility basis, the risk-reward would generate what we think compares pretty favorably to other asset classes.
TER: Is there anything on the negative side that could change the economics of this business?
KF: Investors with a long-term commitment to the asset class are going to be better rewarded over the long run just because there will be volatility in the shorter term. Let's talk about a couple of the risks.
The first is interest-rate risk. These are yield-sensitive instruments, to a certain degree. In times of gradual or slow interest rate rises, MLPs have shown to be largely protected due to their distribution growth component. So it's not a completely fixed-income security. If you do see a spike in interest rates, such as in 1994, for that short period of time MLPs suffered just like any other yield-oriented equity class. If you expect yields to double over the next year on 10-year treasuries, then you should really be careful with this asset class because they do pay a distribution, and the yield component is going to be an issue.
Another side of it is just a broader equity risk. MLPs, historically, have been largely uncorrelated to the broader S&P 500 at about 0.3-0.4%. The asset class has become more well-known and everything has been more correlated in recent years. With more volatility in the broader markets, you are going to have broader equity risk that people might not have thought about, historically, because of their cash-flow business.
Another component is that MLPs are an emerging asset class. About 60% of the $250B market cap is in public hands. The balance is held by sponsors. So there's really only $150B of MLP equity out there. Some of these securities are going to be fairly illiquid. Investors need to know how much volume is trading on a given day and whether there are any large blocks that may unlock at some point to create an overhang on the stock itself.
Beyond that, you have environmental risk around hydraulic fracturing (fracking). The U.S. Environmental Protection Agency is going to release a study at some point next year detailing its perspective on fracking, which could make it more tightly regulated than it is today. So, environmental legislation would be a risk because it would reduce some of those growth opportunities that currently exist.
Finally, there is tax reform legislation, and MLPs could get swept up in that. We don't believe they will, because Congress does understand that these assets are critical to U.S. energy security as well as being thought of like other infrastructure assets, such as airports, toll roads, hospitals and schools.
TER: What key points should people bear in mind when considering MLP investments?
KF: MLPs present an opportunity to invest in the long-term build-out of U.S. energy infrastructure. The key elements that make this asset class attractive are: (1) stable cash flow, which is anchored by what are effectively regional monopoly-type business models; (2) benign overarching federal regulation, which has been very supportive over the long term, and (3) this tremendous resource in U.S. gas shales, which represents an opportunity for the infrastructure companies that need to move this gas from these new supply centers to new demand centers.
From an investment-opportunity standpoint, if you're looking for a stable source of cash income, I think MLPs are certainly worthy of consideration. With a 6–7% yield and a 3–5% conservative distribution growth on a going-forward basis, you're still looking at low-teens returns with a fairly stable cash-flow profile for the pipeline and storage MLPs, in particular.
If you're looking for a total return proposition, with an opportunity to build out these assets over the next 5 to 20 years, there's a return potential that could be even greater than that, as shown by some of these individual partnerships over the past 10 years.
TER: It looks like MLPs are kind of a win-win for everybody involved.
KF: We certainly think so.
TER: Thanks for joining us and providing these valuable insights.
Kenny Feng, CFA, is the president and CEO at Alerian, an independent provider of objective indices, data sets, and analytics for the Master Limited Partnership (MLP) sector. Over $5 billion is directly tied to Alerian's indices, including the leading benchmark of MLP equities: the Alerian MLP Index. Mr. Feng is a former managing director and portfolio manager at SteelPath Capital Management LLC, a Dallas-based MLP investment manager. Prior to his experience at SteelPath, Mr. Feng covered MLPs, electric and gas utilities and diversified gas companies at Goldman, Sachs & Co., in the firm's Global Investment Research Division. Mr. Feng graduated summa cum laude with a Bachelor of Science in economics from the Wharton School and a Bachelor of Arts in international studies from the University of Pennsylvania. He also serves on the advisory board of Midstream Business, a monthly publication addressing the need for business market intelligence on North American midstream energy infrastructure.
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1) Zig Lambo of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None.
3) Kenny Feng: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None.