Mlp Plays In Energy Infrastructure
TWST: Please set the stage for our readers with a snapshot of your coverage.
Mr. Siegel: At the moment we follow primarily energy-related master limited partnerships, ranging from pipeline entities to gathering and processing MLPs, as well as several C-Corps that at the moment include Kinder Morgan, Inc. (KMI), CenterPoint (CNP) and NiSource (NI). For the most part our investment theme is looking at entities that are benefiting from the burgeoning drilling activity and required infrastructure around the shale plays in the U.S.
TWST: How would you characterize that market overall right now?
Mr. Siegel: I think what investors, or a lot of folks, lose sight of is that billions of dollars need to be invested in U.S. energy infrastructure, and the entities that are doing the heavy lifting are, for the most part, MLPs. And the reason being is that the MLPs, as pass-through entities, are efficient financing vehicles in which to get the capital required to build out the U.S. infrastructure. Back in the mid-2000s we saw interstate pipelines getting built, billions of dollars spent to do that. Now we're sort of filling in, and the industry needs midstream assets - and that includes pipelines, but also gathering, processing, fractionation, storage assets - to be built, and the MLPs are doing that.
One of the things that we like about the MLPs is we think that the structure is very transparent - just follow the cash. The bottom line is that the MLP model is to pay out all of your cash flow, after whatever you need to maintain your assets, in the form of distributions. And you grow by accessing the external market, both debt and equity. So you need to pay a lot of attention to make sure that your return on investments exceeds your cost of capital, because the model will not work if you're not good stewards of capital. You can't keep going back to investors and saying, "Hey guys, give me more money so that I can destroy the capital." It just won't work, and you won't be able to raise additional capital.
Through the life of the MLPs - I've been following the MLPs for more than 20 years - by and large, they've done a pretty good job of being able to grow the businesses and make investments that exceed the cost of capital. And that's why you see an ever-increasing distribution. In fact, going out the next three to five years, we think, on average, the MLP group should be able to grow distributions around 5%. Some might be a little bit slower and some will be faster than that. And then you tie that in with a 6% yield, and it's a nice value proposition - 6% yield and 5% distribution growth gives you a double-digit type of total return. And what's neat is that most of the distribution is tax deferred. So I'm still very positive on the investment merits of the MLPs.
TWST: How did they fare during the downturn and how are they are doing now that we're in a recovery, albeit a slow one?
Mr. Siegel: From a fundamental perspective there were a couple of MLPs that did get themselves in trouble. They made a couple of investments that were at the peak of the market and had commodity exposure. They got overlevered, and they had to cut the distributions. What's interesting is even those two MLPs that I'm thinking of were able to recover from that. But if you look at the MLPs as a whole, they were able to navigate through the downturn extraordinarily well because of the fact that they primarily generate fee-based and stable income, they generally provide nondiscretionary services, and whatever commodity price exposure they have they tend to hedge. They are very cognizant of maintaining their cash flow stream.
When you look at what happened in 2008, the MLPs fell precipitously with the drop in the market, and that I would ascribe more to technical factors as opposed to fundamental factors. The way that we think about MLPs and the way we think investors should look at MLPs is to look at the cash flow stream. If you do that, when you have these periods of volatility like we saw in 2008, if you just held your ground, you would have come through exceedingly well. The MLPs, even putting in the downturn in 2008, if you go back to 1996 and you look at the Alerian MLP Index, they've generated total returns on average of about 20% throughout that period. So they've proved to be very, very good investments.
TWST: So commodity exposure and the volatility in commodity prices are not a significant factor for most of the names in the space.
Mr. Siegel: I think that's true. You do have upstream MLPs. Those are E&P companies, and they generally hedge most of their commodity exposure. But I think as a general statement, the MLPs have done a good job of being able to mitigate the commodity price risk. Like anything else the devil is in the details, so before you invest you have to make sure that you understand how the commodity swings may impact the MLP that you are interested in. But I don't think it is a major detriment.
TWST: What do you watch that could impact them? Would it be supply and demand trends, macroeconomic issues or market dynamics? What could have a positive or negative impact?
Mr. Siegel: The mantra for the MLPs - and frankly, it should be for companies as a whole - is the dividend. Or in the case of the MLPs the distribution should be viewed as being sacrosanct. You do not want to ever have to cut your distribution. The business model is such that you need to be very cognizant that whatever distribution rate you set, it's sustainable, because invariably you will have market downturns that you need to navigate through. What could go wrong looking out into the future? The economy is a driver of energy demand, and if you are in a severe recession, we saw gasoline demand drop - and for the guys that transport refined petroleum products, their throughput volumes dropped. That was largely offset by being diversified and having other assets that enabled the cash flow stream to be fairly resilient. But a severe economic downturn clearly would have an impact on energy demand. When you think about MLPs, they handle energy. Physically they move gas and oil and natural gas liquids around, and if there is less demand and there is less product to move, that would impact them. But on the margin energy demand is fairly inelastic, so it's not that dramatic, but it is something to be mindful of.
Petchem demand would also be negatively impacted if you had another severe economic downturn. Petchem is supporting a lot of natural gas liquids infrastructure right now because natural gas liquids, especially ethane, are used as a feedstock. So to the extent that petchem demand drops and utilization of petchem plants drop, you will have lower demand for ethane, and that would impact certain MLPs that are tied to the natural gas liquids value chain. And taking it full circle, if you had a severe economic downturn - notwithstanding the global, the geopolitical issues that are driving up oil prices right now - and if you had a significant downturn in oil prices, drilling activity would slow down. What we're seeing now is drilling activity remains robust. Even though natural gas prices are low, crude prices are high. And when you drill for oil you also have associated natural gas, and that natural gas typically is very rich, and there are natural gas liquids that need to be processed. If oil prices were to drop precipitously because of an economic downturn and less demand, then presumably there would be less drilling activity. If there was less drilling activity, there would be less need for infrastructure and that would slow down the growth of the MLPs. But I think you need to see a precipitous drop for that to be an issue.
Then finally, you always, always have the headline risk that when you have a new administration - and I'm thinking 2012 - somebody is going to say, "We have to start attacking the deficit." When you attack the deficit, do you raise taxes, do you try to close loopholes? From time to time somebody looks at the MLPs and asks, "Does it makes sense for the structure to exist as a pass-through entity where taxes are deferred?" By and large, every time somebody raises that issue it goes for naught, because at the end of the day, number one, it's not a big revenue generator in taxes. Taxes eventually get paid when folks sell their MLPs in the stock market. And number two, the way we started the conversation, MLPs are doing the heavy lifting in terms of building the infrastructure in the U.S. That is really, really vital. It's vital for a viable energy policy, and the by-product of that is that the MLPs are supporting a lot of jobs as well. So I can pretty much argue why you would not see any substantive change on how the MLPs are treated, but we would be less than forthright if we didn't bring that up as a topic that comes up from time to time.
TWST: Regarding the shale plays, are there any new or especially promising areas, and thus, particular MLPs that stand to benefit the most from them?
Mr. Siegel: Enterprise Products Partners (EPD) just had an analyst meeting, and they are investing $3.4 billion this year. Most of that is around the shale plays, and most of that is developing infrastructure around the Eagle Ford shale in south Texas. The stuff they're building includes pipeline, fractionation and processing facilities. The Eagle Ford is just a burgeoning gas and oil play that's requiring a lot of capital to be invested. Enterprise is not alone. You also have Kinder Morgan (KMP) that is in the Eagle Ford, and you have Copano (CPNO), which for small MLPs is investing a lot of dollars in the Eagle Ford. So that's one area that has a lot of promise.
Then folks also like the Haynesville - which is in Texas and Louisiana, primarily Louisiana - and you're seeing investment around that, primarily gathering and pipeline assets are getting built. Enterprise is participating in that buildout as well. You have the Marcellus shale play up in the New England/Northeast area, and there you have MarkWest Energy (MWE), which is pretty prominent as an MLP that is building infrastructure in that play. The Bakken shale, which is primarily oil, you have a company called ONEOK Partners (OKS) that is spending around $2 billion building processing facilities, as well as pipeline facilities to both process the natural gas and transport the natural gas liquids. So it's not hard to see billions of dollars getting invested in a relatively short time frame to take care of all of the natural gas and crude and natural gas liquids that will be coming out of the ground because of the shale plays.
TWST: Has Enterprise Products Partners grown through acquisitions in the last year or so?
Mr. Siegel: Enterprise has grown fairly dramatically. A couple of years ago they bought Teppco. They recently acquired their general partner. They took that inside the MLP. And now they are in the process of reacquiring Duncan Energy Partners (DEP), which was a carveout, and that entity was in a JV with Enterprise building the Haynesville pipeline. They have been active on restructuring. Really I think what it amounts to is to be more efficient and lower their cost of capital by doing these things, primarily by bringing in the general partner and bringing Duncan Energy Partners back into the fold.
TWST: Do you expect to see more of that kind of activity and more M&A activity in general?
Mr. Siegel: Yes, recently there has been a spate of MLPs that have bought in their general partners. You had Enterprise do that. Penn Virginia (PVR) recently acquired their general partner. Inergy (NRGY) acquired their general partner. Buckeye (BPL) acquired their general partner. It's interesting, you've seen a handful of MLPs acquire their general partner, and you've also seen a couple of companies, such as Targa (NGLS) and Kinder Morgan, actually take their general partner public and sort of reversing the flow, if you will.
TWST: Do you see one versus the other being more of a positive for the unit holders?
Mr. Siegel: I think as it relates to unit holders, by buying in the general partner, as long as you don't overpay and it's a fair transaction, limited partners will benefit. Because you are effectively reducing the cost of capital of the partnership, and the reason that you are reducing the cost of capital is because the general partner is structured in a way that they are sharing in the cash flow of the partnership, and they share disproportionately in the growth of the partnership through what's known as incentive distribution rights. By eliminating the incentive distribution rights and buying in the general partner, you've effectively reduced the amount of cash leakage that would go to the general partner, and now that cash can basically be distributed to the limited partners.
The other question you had was in terms of M&A. What we're seeing is the MLPs have been acquisitive in buying discrete assets, less so in consolidation of one MLP with another MLP. Historically it has happened. We just mentioned that Enterprise acquired Teppco. I suspect it will happen again in the future, but right now there is so much growth opportunity around the shale plays. And the capital markets, both debt and equity, are very, very accessible to the MLPs that it sort of eliminates any need to merge at the moment.
TWST: What are some of your top investment picks right now and why?
Mr. Siegel: You shouldn't be surprised that Enterprise is one of them. We also like Plains All American (PAA). Plains is also participating on some of the shale plays. They have reasonable exposure to the Bakken, and they are also looking at the Eagle Ford. We pay a lot of attention to management teams, and I would suggest that both Plains and Enterprise have very, very strong management teams. My colleague, Elvira Scotto, just initiated coverage this morning of a company called DCP Midstream (DPM). That's a smaller MLP, and they also are more on the gathering and processing side, and they also fit the theme of shale plays. I think those would be the three top picks that we have at the moment. We're restricted on a couple of stocks that I can't mention because of recent transactions.
TWST: What interest level do you see in this space among investors? Is it still considered an alternative or is it becoming more mainstream? Are institutions investing in this space?
Mr. Siegel: The answer is yes, yes and yes. The retail investor is still very much in want of yield, and 6% yield that's tax deferred, plus growth is very attractive to retail investors. What we're seeing on the institutional side is the endowments and pension funds are finding that equation also very enticing.
The other point is that I really think that folks have become a bit more risk averse and that expectations for the overall stock market have to be reigned in a little bit. The thought that equities can deliver 9%, 10% or 11% type of total returns, I think that's in the rearview mirror. I think expectations for the overall stock market have to be lowered, and I think 5% to 7% might be more reasonable expectations going forward over the next several years. So if you can invest in a subgroup, that the yield alone pretty much will get you that kind of total return. And then you layer in growth on top of that, I think that's an attractive value proposition.
The other thing too is I think demographics will lend themselves to the MLP demand, because as folks are aging there is less tolerance to take on risk, because you have less time to recoup any losses that you might have. So I think people are getting more conservative, looking for income, and that all should lead people to think about MLPs.
TWST: Is there anything else you'd like to add?
Mr. Siegel: I would like to re-emphasize that I think the MLPs should be viewed almost like an annuity that has some growth tied to it, and that you always have to look at the individual securities before you invest. But I think where folks make a mistake is that near-term volatility drives decisions, and if you are really investing as opposed to trading, then you should have a time frame of three to five years. Within that context, I think, the MLPs should do really well.
One thing that we get asked a lot is, "What happens if interest rates go up, what happens if inflation were to rear its ugly head again, how would that impact the MLPs?" I should touch on that quickly. Number one, on the inflation side MLPs historically have been able to raise distributions at a clip that exceeds inflation, and part of that is you have an indexing methodology on the crude and refined petroleum products pipeline side, plus typically as you have contracts roll over they tend to roll over at higher rates. So as an inflation hedge MLPs seem to have worked out pretty well. As it relates to interest rates, the major concern that I have there is if interest rates were to rise quickly, MLPs would take it on the chin because the distribution growth wouldn't be strong enough to offset the impact of a quick rise in interest rates. However, if interest rates were to gradually move higher, then again, the growth in distributions should largely be able to mitigate the impact of higher interest rates.
TWST: Thank you. (MN)
Note: Opinions and recommendations are as of 04/01/11.
Yves Siegel, CFA
1 Madison Ave.
New York, NY 10010
(212) 325-6665 - FAX