TWST: Please start with a snapshot of your coverage universe.

Mr. Edwards: We're focused on the energy master limited partnerships. Our coverage is spread around as far as subsectors go, and we have pieces of most of them. We cover a number of gas-processing companies, a number of companies that are involved in oil, gas, refined-product transportation and storage, a couple of companies that are on the upstream side, and one of the propane companies. So it's pretty diversified.

TWST: It may depend on which subsector you're talking about, but what is your overall sentiment on the space right now and why?

Mr. Edwards: The way we value it, we're looking for roughly a 8% to 20% total return over the next 12 months. And the way we get there is we look at what our distribution growth outlook is. We look at a target yield based on what the spread is relative to the U.S. 10-year Treasury issue. And then, using that information, we can sort of back-solve, if you will, and derive where we think the sector is likely to trade, and that gets us to a base case return of between 8% and 20%. Our bias is that it will be more toward the upside of that range, probably in the 10% to 16% range.

TWST: How did the units perform last year compared with what you're expecting this year?

Mr. Edwards: The return last year was just under 14% including distributions, beating the S&P 500 for the 12th year in a row. For this year, again, we're at looking roughly the midteens.

TWST: So you expect 2012 to be a better year?

Mr. Edwards: We are looking for a little stronger distribution growth in 2012, and as we indicated earlier, total return approximately equivalent to what we experienced in 2011. Last year, our target was a 4% to 6% distribution growth range, and again, we were close to the upper end of that range, around 6%. This year, our assumed range is between 5% and 8%, and with a target, if we want to narrow it, of probably in the 6.5% to 7.5% range. So we think things are going to be a little bit better this year than last year.

TWST: What's driving that growth?

Mr. Edwards: What's driving that is more capital investment in the sector. There is a substantial amount of capital deployed, and as those projects come on line, you're going to see growth in distributions. The sector invested around $19 billion last year, and in 2010, about $16 billion. You start putting that kind of capital to work, you're going to start generating some stronger distribution growth.

TWST: What are some of the notable projects or key areas these companies are particularly active in?

Mr. Edwards: This year, what we're really seeing take place is those companies involved in the oilier part of midstream is where there is a real need for capital. And one of the obvious indicators of that is you see right now is the wide differential between the price of Brent crude and the price of WTI, and then you see an even further discount between what WTI is and what crude coming out of North Dakota is selling for. You have somewhere in the neighborhood of a $50 differential between Brent crude, which is in the ballpark of $125 a barrel, and North Dakota crude, which has been in the $75/bbl range. And so that price differential is sending a clear signal of the need for oily type infrastructure.

TWST: So overall, are there better opportunities in the midstream right now?

Mr. Edwards: Yes, though I wouldn't put it as better opportunities. There are substantial opportunities in midstream. One of the ways to think about it is: Where is the midstream infrastructure needed, and what are the kinds of rates of return that the upstream players are making? The average rate of return that upstream players are getting on dry gas is very low. It's averaging something like a 5% rate of return with a range of roughly 0% to 10%. That's one reason why you're seeing a big cutback in the number of gas rigs being deployed.

Whereas the rate of return in natural gas liquids plays around some of these basins like the Anadarko (APC), Eagle Ford, Marcellus, etc., is approximately 50%, and then on oily plays - the Permian, Bakken, Niobrara, etc. - they're also averaging around 50%. So that means you're going to see a demand for infrastructure in these oilier areas as the producers continue to put capital to work drilling in these oilier plays.

TWST: What stood out for you as highlights or themes from the most recent quarterly earnings?

Mr. Edwards: I'd say, most companies did very well. I'd say you had more meets and beats than misses. I'd say that the distribution growth outlook was mostly confirmed, so it's quite strong and so, in essence, I think it confirmed our view that MLPs are poised to have a pretty good year.

TWST: What are your favorite names right now and why?

Mr. Edwards: This is in the context of we've had a very strong run in our sector of late. The yield on the sector is about 6.05%. We're about a 375-basis-point spread to the U.S. 10 year, as the U.S. 10-year yield spiked toward the end of the last week. That's normally a pretty positive environment, with the caveat that one reason why the spread is so wide is action by the Federal Reserve to try to keep the U.S. 10 year low around 2%. Obviously, there's been talk about keeping it around that level to the midpart of 2014. So normally, when the spread is in the 400 bps range, the next 12 months' return would be in the 22%, 23% type total return, and we're not calling for that. We're being more conservative on that because of the concern we have with unsustainable deficit levels in this country, and of course, as we have just seen, we have had a spike in interest rate for the U.S. 10 year, which is now above 2.30%

But from a favorite name standpoint, one of the drivers is you have very strong oil prices relative to natural gas, which means some of the natural gas processers are likely to do very well. Some of the names we really like are the general partner to Targa Resources LP (NGLS), which is Targa Resources Inc. (TRGP) We like Crosstex (XTEX) and MarkWest (MWE). We like one of the upstream players, EV Energy Partners (EVEP), which is a play on monetizing their Utica shale position, so it's not your traditional pipeline type of MLP. We like Targa Resources LP, and we like Kinder Morgan Management (KMR), which is trading at a pretty substantial discount to KMP (KMP). We also like the MLPs involved in oil-related infrastructure such as EEP (EEP), PAA (PAA) and EPD (EPD). So those are some of the names we like right now.

TWST: Are there any names you're especially cautious about?

Mr. Edwards: For the long term, we're very positive on the sector. More near term, there are probably some names that have appreciated pretty significantly, so you don't have as much upside. But one of those subsectors we're cautious on is propane. There are some pretty significant headwinds in that subsector. We've seen it from a weather standpoint. We had a very mild winter. You have elevated propane household prices because of demand in the petrochemical area as well as demand for NGLs exported overseas, and that's putting a squeeze on margins. So I'd say we're cautious in that area.

We're a bit cautious on pure natural gas transportation in the sense that basis is so flat, you're not going to make as much margin in that area. And some of the companies, they've had a substantial runup in value and will need a little bit of catchup as far as distributions go.

But for the longer term, we would still be buyers. If we were more near-term focused, we may not look at it that way. But if you can find the substantial yields that this sector is offering, which it is, then the kind of growth outlook that we're looking at - 5% to 8% for the sector, considerably more than that for most of the names that we cover - we feel pretty good about that as presenting a good opportunity for investors. We're still convinced that we've got a 10-year window, at least, in this sector.

In our system, if you find the broader market is giving you about 10% total return for the year, that normally means you'd want roughly 20% to give you an "outperform" rating. But we feel perfectly content to own these names for the long term. You may see 10% to 15% returns would only earn you a "market perform" rating, but if you're able to get those kinds of returns year in and year out, you'll outperform the broader market over a sustained period of time in a very big way. It's the old magic of compound interest.

TWST: You noted the capital investment in this sector in the past two years. Are these companies growing more by new projects or by acquisition, or a combination of both?

Mr. Edwards: Mostly new projects. In the next couple of years, there will be a tremendous number of new projects in the liquids area, so most of the major investment going on is in things like oil storage, natural gas liquids pipelines, oil pipelines, oil terminals. We've got rail spurs, rail terminals. There is such a shortage of pipeline capacity right now, you're seeing companies ship oil by rail - and that just gives you an idea of the opportunity set that's in front of us.

TWST: Are you expecting much in the way of M&A?

Mr. Edwards: You always expect M&A with the upstream players, because it's an acquire-and-exploit-type business model. We continue to expect bolt-on type acquisitions for the larger infrastructure players; that has been going on for years, and we don't expect this year to be any different. It's going to be coming from the usual suspects.

Oil companies that are trying to focus on their upstream operations - they don't get that much value reflected in their share price by owning midstream assets, but MLPs do. The oil companies get value more on reserves. So sometimes you see some trimming going on with some of the majors or some of the larger independents. That has been going on for years, and as we said earlier, we don't expect this year to be any different.

TWST: The MLPs seem to have ample access to capital to fund growth.

Mr. Edwards: The capital markets, yes, the spigot is very much wide open right now.

TWST: Do you expect this to continue to be the case?

Mr. Edwards: That's a loaded question. All you have to do is look at what has happened in Europe. The spigot was open for some of these peripheral countries - until it wasn't. And I think that's going to be the case in the U.S. The spigot will remain open until it isn't.

The thing we always worry about is, given that we're on an unsustainable spending trajectory from a governmental debt perspective, when does this do significant harm to the capital markets? And the difficulty is we'll know it when it does. The U.S. has already told the world we're insolvent. All you have to do is look at the debt ceiling debate of last year, when effectively, the U.S. told the world, if the debt ceiling isn't increased, the U.S. is going to start defaulting. What's happening this time around is we have very large deficits once again being proposed, and that's going to eventually start to put financial markets and the global economy at risk. Nobody knows when that breaking point is - whether it is two years or 10-plus years.

TWST: In addition to the budget and Fed policy, which you mentioned earlier, what macro issues do you pay most attention to as it relates to these companies?

Mr. Edwards: Fed policy is an issue, the budget issues, the situation in Europe - these are nondiversifiable macro issues. But in industry macro issues, it is the very large increase that we're now seeing in oil and gas production. And I'm glad we've brought that up because you have a variety of forecasts that have been publicly released. I think the EIA is most conservative. They're looking for us to grow from somewhere around 5.6 million barrels of domestic production a day now, to roughly 6.7 million or so by 2020, so in about eight years. But you have some other projections out there that are anywhere from 7.5 million to over 9 million, depending upon which forecast you want to believe, and that could occur over the next five years.

We don't think it's going to be as high as 9 million, but our bias is that we think a seven handle is reasonable, which represents a roughly 30% to 40% increase in oil production over the next five years. You're going to need a tremendous amount of infrastructure to be able to move that product, and that's why we think we have a very bright future in MLP land, especially on the liquids side. Again, as we talked about earlier, the rates of return that the producers are making reflect that liquids versus dry gas, but you're still going to have an increase in dry gas production, because you have associated gas coming with oil and liquids and the NGLs. There's a pretty robust future over the next few years.

TWST: What advice would you offer investors considering MLPs today?

Mr. Edwards: We would advise investors to take a good look at these companies, and we think they ought to be a significant portion of their investment portfolio for diversification reasons, number one, for downside risk protection; and then, number two, for total return outlook. Over the very long term, we think, even with the recent runup as far as valuations go, that there is still a very sustainably positive future for this sector.

TWST: Is there anything else you'd like to discuss?

Mr. Edwards: We should talk about one of the risks we worry about a little bit, and it is one of the things that is an issue in the sector right now, which is there is a bit of a glut on the natural gas liquids side, particularly on ethane. There are a couple of different schools of thought in that regard. The reason we have a bit of an ethane glut at the moment is a significant amount of North American petrochemical capacity, somewhere around 7%, has been down for maintenance, and so that has created a temporary oversupply situation.

Then there is the question of: Where is the supply-and-demand balance going to be in 2014, 2015 and beyond? I think most industry observers believe we'll come back into relative balance in the second half of this year, when the maintenance is completed on the petrochemical side and the fractionation facilities - they'll be down for maintenance in May - will be back on line. So we should be in relative balance for most of this year and next. We probably will be slightly oversupplied in 2014.

And then there will be some restarts and conversions in the petrochemical area, and there are about five new facilities being proposed by major petrochemical companies. The issue is: How many of those are going to be built? We figure at least one or two, and possibly, three. And so we believe we'll be in relative balance going forward, even possibly in a shortage situation in the 2017 or 2018 time frame, though we realize that pet chem crackers are going to make sure they have long-term supply secured before they commit the capital to building a new plant.

Others believe that we'll be in a surplus situation for 2014, 2015, 2016. So there is a bit of that tug of war going on in the marketplace. Our bias is that we're going to be in relative balance, but it's something we need to keep an eye on.

TWST: Thank you. (MN)

Note: Opinions and recommendations are as of 03/20/12.

John D. Edwards, CFA

Senior Vice President & Senior Equity Research Analyst
Morgan Keegan & Company, Inc.
Morgan Keegan Tower

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