Double-Digit Appreciation for North American MLPs
TWST: Please start by giving us an overview of Tortoise Capital Advisors.
Mr. Kessens: Tortoise was founded in 2002 by five entrepreneurial investment professionals to provide investment management services to institutions and individuals seeking investments in energy infrastructure and master limited partnerships or MLPs.
We have a dedicated team of 46 professionals. Our specific investment committee is comprised of our five founders and managing directors. On the investment team, we have 14 other members, and they really bring a range of disciplines to the table that include financial, trading and structuring expertise. Our operations team completes our company’s capabilities with in-house specialties, including capital markets, financial reporting, tax, compliance, business development, marketing and investor relations skills. In general, we have a singularity of focus in energy investing, staff breadth and depth, and a commitment really to put our clients first.
A lot of people ask us about our name. As evident in part by our name, we bring a long-term perspective that looks across cycles, not just over the short term. We aim to deliver attractive total returns that typically have a combination of current income and some growth in that income. Above all, we maintain a commitment to high quality in all we do, carefully evaluating risk as well as reward, which is an attribute we believe has served us and our clients very well, particularly in the period since the 2008 financial crisis.
TWST: What types of products do you offer?
Mr. Kessens: We have significant expertise across the energy infrastructure sector. Our primary focus is midstream MLPs. As of June 30 of this year, we managed a total of $7.7 billion in assets, and that included four MLP-focused closed-end funds and two other closed-end funds that are a little bit broader in scope but also infrastructure focused. We also manage separate accounts for our clients that are seeking a more actively managed MLP investment strategy.
TWST: You mentioned MLPs. Would you please educate us on what exactly an MLP is?
Mr. Kessens: Yes. MLP stands for master limited partnership. From a simplistic point of view, an MLP just combines the tax benefits of a limited partnership with the liquidity of publicly traded securities. We focus on energy infrastructure MLPs, which own and operate a network of pipeline and energy-related logistical assets that transport, store, gather and process natural gas, natural gas liquids, crude oil and refined petroleum products. These companies effectively connect areas of energy supply with areas of demand. Midstream MLPs tend to generate a stable high current yield and consistent growth from these long-lived critical assets.
TWST: What makes MLPs so attractive right now?
Mr. Kessens: In our view, MLPs generate sustainable fee-based revenues with attractive growth prospects and controlled risk. We believe this sector will continue to deliver a current yield of approximately 6% with additional upside in the form of distribution growth and price appreciation of 6% to 8% for a total return in the low to mid teens. Because of the relatively stable fee-based nature of MLPs cash flows, the relative inelasticity of demand for the services and the critical nature of the assets they operate, we think MLPs offer a compelling total return opportunity with less risks relative to other industries, and this is evidenced by the fact that MLPs have historically generated substantially higher Sharpe ratios than the broader equity market and other yield oriented equities like REITs and utilities.
TWST: Does the general investor understand MLPs?
Mr. Kessens: Ten years ago no one knew what an MLP was. As the sector has grown to nearly 100 companies today, so has the level of knowledge about MLPs and the attendance at the various MLP conferences throughout the year. However, I still think that MLPs have a long way to go before they become what would be labeled a mainstream investment, equally understood by everyone.
TWST: What are some of the larger trends that you see that are driving the space right now?
Mr. Kessens: The combination of two technologies really, both horizontal drilling and hydraulic fracturing, are changing the entire energy landscape and expectations are that the U.S. and Canada will have tremendous production growth through 2020 in both crude oil and natural gas liquids. This production growth is presenting numerous opportunities for MLPs to construct supporting pipeline, processing and fractionation infrastructure, particularly those that can alleviate congestion in the middle part of the country. We’re seeing an increasing number of pipeline projects being announced supporting this robust production-growth outlook. For example, production in the Bakken area in North Dakota, we expect to double over the next 10 years, which will make North Dakota the second top producing state in the country behind Texas. That’s not the only area we are experiencing this sort of outsized growth. We also expect substantial production growth in the Permian basin in west Texas and the Eagle Ford shale in south Texas. Several MLPs and pipeline companies are building pipeline takeaway capacity to transport production from these areas to markets such as Cushing, Okla., and the Gulf Coast. These projects are primarily fee-based in nature, and they support extended MLP distribution growth over the coming years.
TWST: Please share with us a little bit about your investment philosophy and strategy.
Mr. Kessens: The hallmark of Tortoise’s strategy is an emphasis on high quality, as we focus on investing in long-haul, fee-based, investment-grade pipeline companies. We think this strategy offers the most compelling risk-and-return proposition over the long-term.
Our approach is to understand and follow the entire energy value chain, including upstream, midstream and downstream sectors, and we think this knowledge of all energy sectors provide some of the best insight into the fundamentals of pipeline companies. We also emphasize a credit-driven analysis with identification of the downside along with the potential upside. Our financial models enable us to perform significant and robust stress testing across all phases of the business and capital market cycle, and this analysis is critical to our assessment of risk, which we define as the potential for the permanent loss of capital.
In line with this approach, we own strategic assets critical to the sustainability and growth of economic activity. We like to ask the question, if this asset is gone tomorrow, will anyone miss it? And if the answer is yes, then this asset is probably strategic and something we will potentially include in the portfolio.
We also invest with the more proven, deep-management teams. We routinely meet with company management on a quarterly one-on-one basis, and because of our long history, have a great understanding of what management teams have promised versus what they have delivered. This knowledge, we think, is vital to understanding a company’s track record of investing capital.
Regarding growth, we prefer internal and drop-down growth potential versus a third-party acquisition strategy. We think that internal and drop-downs are just more identifiable, and we believe tend to offer superior returns to other growth strategies. In sum, we believe that companies with these qualities are really ideally suited for the MLP structure and will outperform over the full economic cycle.
TWST: What makes you sell an MLP, and how often do you turn over your holdings?
Mr. Kessens: Relative value is the primary reason that we would sell a security, given our long-term approach. We try to remain almost fully invested. Our turnover is generally relatively low, anywhere between 15% and 25%.
TWST: How do you manage risk in your funds?
Mr. Kessens: We view risk, as I mentioned, as the potential for a permanent loss of capital. In our investment process, we perform a deep analysis of the firm’s assets, management team and cash flow, and we believe the companies with the more strategic assets, the stronger management teams and more stable cash flow carry lower risks. As we manage the portfolio, we emphasize more of these top-tier names relative to other companies that may have a smaller asset footprint, merely adequate management and/or carry a high yield credit rating. We also have an investment committee structure, where any one member vote can result in the sale of a portfolio name versus the equivalent of all members vote required to buy. So it’s hard to get in, easy to get out. These two risk-management tools have served us extremely well over the past decade.
TWST: What are some of the things investors should be careful about when investing in MLPs?
Mr. Kessens: I think it’s a common belief that all MLPs have similar risks. That’s a myth that if believed can potentially cause an investor a great deal of harm. Let’s take a step back and really understand how each subsector generates its revenue.
Long-haul pipeline MLPs and pipeline companies derive their cash flows primarily from long-term fee-based contracts. Liquids pipelines — which are those transporting gasoline, diesel and crude oil — earn a fee per unit of throughput. And natural gas pipelines, they simply earn a fee, whether or not gas actually flows. This contract structure lends itself to stable, predictable cash flows. It’s no surprise then that this cash flow stability translates into lower stock price volatility as measured by downside deviation and beta.
Gathering-and-processing MLPs and upstream MLPs, including both E&P and coal, earn a profit by selling a commodity whose underlying price varies virtually by the minute. This results in more uncertain cash flows and consequently greater stock price volatility. These companies attempt to hedge the commodity price over the short-to-medium term on a portion of their production, but they still remain subject to basis risk and illiquid forward product markets, and then at some point their hedges must roll.
Furthermore, pipeline companies tend to have larger, more strategic asset footprints. Combined with their cash flow stability, they garner investment-grade ratings providing greater access to credit markets and lower debt costs. Upstream and gathering and processing companies do not share the same benefit, encountering higher debt costs and require healthy capital markets to fund new projects.
You really don’t need to look any further than the financial crisis in 2008 to understand the nature of risk between pipelines and commodity-sensitive MLPs. Multiple upstream and processing companies reduced their distributions, while only one long-haul pipeline MLP did. So I just urge investors to think about what type of companies they want in their infrastructure allocation.
TWST: Is the U.S. election going to impact the MLP space? And if so, how?
Mr. Kessens: We do not think that the elections are going to directly impact the MLP sector, as bipartisan support for the structure really remains. The one thing we may see actually is an expansion of the definition of qualifying income for MLPs. There is a group of Senators led by Chris Coons and Jerry Moran that proposed the MLP Parity Act, which effectively proposes to expand the scope of qualifying income for MLPs to include renewable energy projects like solar and wind. So if anything, we think that as a result of the election the definition on qualifying income may actually get bigger.
TWST: Please tell us about your background.
Mr. Kessens: I’m a Senior Investment Analyst with Tortoise Capital Advisors, having joined the firm in 2008. Previously I was a Vice President at Citigroup in their energy investment banking practice from 2004 to 2008. And prior to Citigroup, I earned an MBA from Columbia Business School in New York and served five years in the U.S. Army as a Field Artillery Officer, having graduated from the U.S. Military Academy at West Point.
TWST: Is there anything you would like to add?
Mr. Kessens: While we may continue to experience volatility in the broader economy, one of the key reasons we think pipeline companies should be a component of every portfolio is their sustainability of cash flows and growth across economic cycles. We expect distribution growth in 2012 from midstream MLPs and pipeline companies of 6% to 8%, with a low double-digit-type total-return expectation, something that we think is very compelling in today’s market environment.
TWST: Thank you. (LMR)
Brian Kessens, CFA
Senior Investment Analyst
Tortoise Capital Advisors, LLC
11550 Ash St.
Leawood, KS 66211
(866) 362-9331 — TOLL FREE
(913) 981-1021 — FAX