Investing in Energy Infrastructure through MLPs
TWST: Would you introduce us to SteelPath and then the products and services you offer?
Mr. Watson: SteelPath is a money manager with a complete focus on energy infrastructure, primarily by investing through master limited partnerships. We run a family of mutual funds, as well as privately available products. In total, we have about $2.2 billion of AUM.
TWST: When you say primarily through MLPs, what other investment vehicles do you use?
Mr. Watson: We look at the corporate holders of those assets as well, when it makes sense. The majority of pure-play energy infrastructure opportunities are MLPs, but we will look outside of those if the value proposition is there.
TWST: How and why did you get into the MLP space? I understand you first started offering funds in 2010.
Mr. Watson: The mutual funds were launched in 2010. The firm was launched in 2004. The story behind the firm is that our founder, Gabriel Hammond, was covering MLPs for Goldman Sachs and realized that there was an opportunity here to build a business and not just write about it. So he went out and launched the firm - originally under the name Alerian - managing private investments in the MLP space. Really, the big picture there is that, starting in 2004 and earlier, it became clear that the MLP structure was going to be to energy infrastructure what the REIT structure is to real estate. So as those assets migrated into the structure, it presented a really interesting opportunity, and that opportunity continues today.
TWST: Give us a sense of MLPs as an asset class and why you see them as such a good investment vehicle.
Mr. Watson: One, it is important to be careful with the term asset class, because obviously to say something is an MLP is just to describe a structure. It doesn't describe its underlying businesses. What we are really focused on are those that use the structure to hold their energy infrastructure assets; that's really what we find so attractive. Essentially if you stick to that core group, you've got pipelines, terminals, and it's a bunch of assets that are absolutely necessary for the transportation and working of the United States' energy infrastructure. They're critical links in the system. They charge a fee for providing their services. They are almost the definition of cash cow in that they're low risk, and they spin off this nice amount of cash, but for a number of reasons they're growing, on entity level, at pretty attractive rates. That growth is primarily coming from acquiring assets that are still on the corporate balance sheets, and building new assets to meet new needs, primarily associated with crude oil sales, natural gas development and the production of natural gas liquids.
TWST: What kind of MLPs are you staying away from, if you will?
Mr. Watson: The main thing is trying to avoid exposure to commodity pricing or other volatile markets. A good thing about MLPs for investors is this group has a habit of paying out almost all of its free cash flow in the form of distributions. So obviously investors get a very nice yield through that, but it also instills, we think, a healthy amount of diligence in the management teams. Anything that they do has to be cash flow accretive. They can't manipulate earnings. It's got to be cash-on-cash accretion. We think that drives pretty good investment decisions. But the downside of it is, if one of these MLPs were ever really forced to cut its distribution, the price reaction can be really dramatic and asymmetric. And so, we just think it's an awkward structure to try to take on businesses with volatile margins, like those with commodity price exposure and others. If you are right and the commodity goes straight up, you probably would have made more money owning the same commodity exposure in a traditional C-Corp. But if you are wrong and the commodity price goes against you and the MLP is forced to cut its distribution because of that, you'll lose much more than you would have in your traditional C-Corp. So we think the structure is best suited to these fee-based earners, these more stable margin earners.
TWST: Tell us about the three funds you offer.
Mr. Watson: On the mutual fund side, we offer a fund called the Select 40; we internally dub that the "thinking man's index." It's 40 names, and the highest weighting is capped at 5%. It is a broad sampling of the sector, although we weight them consciously to our favorite names, so it's index like, but we think about it consciously and attempt to do our best. The Alpha Fund really goes after the value proposition present in the sector, related to the growth opportunities. We've limited that fund to 20 names. We think by having a more concentrated portfolio, we can really focus on those names that are essentially growing their distributions at an above-par rate. We think through focusing on those names will give us a high total return.
The Income Fund really is the flip side of that. Again, we've limited the holdings to 20 names. But this is an effort to focus on those with higher yields. For those that are drawn to the sector because of the yield, that's probably a pretty good option. Those drawn to this sector for the growth prospects, Alpha Fund is a good option, and for those who just want kind of a broader exposure to this sector, the Select 40 is a good option. On January 12, SteelPath Advisors announced the launch of two more funds, the SteelPath MLP & Infrastructure Debt Fund and the SteelPath MLP Alpha Plus Fund. The first is the industry's first debt-focused MLP mutual fund and invests in debt securities of approximately 15 to 20 MLP and energy infrastructure companies. The Alpha Plus Fund is a concentrated portfolio of approximately 20 MLP equity securities, and also employs leverage.
TWST: The Alerian MLP Index has a yield of more than 6%. You touched on this. Why are the dividends so high on the MLPs? And secondly, in general what sort of a yield can investors expect when they are looking at your funds?
Mr. Watson: The yields are high because of the notion that they don't hold back cash flow. When they make growth capital expenditures, that's usually financed with new money, so free cash flow usually gets distributed. Unlike a lot of other sectors, there is not much needed in the way of maintenance capex. When these guys calculate what they can distribute, they do hold back the amount of cash needed to reinvest in assets to maintain them. But pipelines and terminals don't need a whole lot of cash to maintain them. They generate a lot of free cash flow just by the business model, and of course, they pay that out by and large. Yields are historically pretty much in line. If you look at the past five years or seven years, excluding the financial crisis, yields are slightly below where they were during that period, but not materially so. So it's really just the nature of the industry.
TWST: How have MLPs in general performed relatively over the last few years to the last few months? Have there been some hiccups over the back half of 2011?
Mr. Watson: Yes, the last few years, they've done really well. They bounced back incredibly strongly from the financial crisis. The basic story is that most of these guys, if you look at their income statements over the financial crisis, you wouldn't have known anything bad happened. So when the market settled, they went trading back to the same levels and have really rebounded nicely. 2011 wasn't too dissimilar from the broader market, really. They started off the year pretty strongly, and then oil prices went down, and then the broader economy. They really traded pretty sloppily through most of the summer. They ended the year on a high note. They rallied November, December and ended up beating the broader market by a little bit.
If you look at the S&P, it was essentially flat and MLPs were up maybe 6.5%. So they outperformed the broader space a little bit, and then you throw in the distributions that investors were able to accumulate, and it was even a better total return in comparison.
TWST: We talked about the type of MLPs that you tend to focus on. Would you give us a better idea of your investing philosophy within that space and how you choose MLPs?
Mr. Watson: Our first task really is to try to define the MLP as mainly energy infrastructure or not. Has it taken on too much commodity price exposure, essentially, to be a potential core holding? To do that isn't all that easy. If you look at the sell-side research, they broadly categorize MLPs as refined products or natural gas or whatever, but the truth is those managers buy whatever they want to buy and they don't care what category they are being put in. You really have to look at the individual assets and make that determination. The way we do it is we model it out to the greatest degree of specificity we can, and then we run a bear case. For instance, if it's a company with lots of natural gas processing, in many cases those processing contracts will expose the owner of the asset to the price of crude oil through the price of natural gas liquids, which tends to track crude oil. Right now, our bear case is $60 oil for two years with a very weak ratio of natural gas liquids to oil. That is obviously not many people's expectations. But we felt like for a bear case, if something happens that really causes trouble, that's a reasonable thing that could happen. Plus, one of the reasons why people go to these energy infrastructure names is that in that down case, that recessionary case, they expect energy infrastructure to hold up well, at least on a fundamental basis. That's why we run it that way. Essentially, if a company can experience that kind of scenario and not violate any debt covenants, not be forced to cut its distribution, we consider that name as having an asset base that has retained that energy infrastructure-like makeup. So that's our first step.
From there, our goal is to capture value as best we can. We look at our bottom-up NAVs. We will take those same models and try to figure out what that entity value should be on a private equity basis, on a roll-up basis. We look at the typical things that we know the sector typically trades on. We know that stocks are most likely to move on the next press release or a change in investor perception on distribution growth rates and those kinds of things. We try to capture names that are in transition. The perfect name for us would be one that's grown slowly historically, and so it has a cheap value on our NAV perhaps, but we can look at its prospects and realize that it's going to be able to surprise the market over the next year or two by increasing that growth rate. Then we can look forward not only to buy the name that we think is attractively valued but also might have some multiples expansion.
TWST: What are some of your key holdings or some of your favorite stories at the moment?
Mr. Watson: Our biggest holding across the funds right now might be Buckeye Pipeline Partners (BPL). Buckeye is a refined products transporter primarily - moving gasoline, diesel and jet fuel from refining centers to consuming centers. It's a very attractive base business that benefits from annual tariff escalators and things like that. It's a very secure low-risk business with some growth to it. They bought, last year, the BORCO facility in the Gulf. It's a very large products terminal. They bought it for, I think, about 10.5 times, which is kind of a high multiple, but they were able to quickly find a number of expansion opportunities and margin growth opportunities that they can exploit. Over the next year or two, they should get that multiple down to the seven times range. We think if that happens, it would really change the market's perception of its ability to grow its distribution. So that's one of those names that we are looking for. It trades attractively on a valuation basis, and we think it's got an opportunity to have some multiples expansion as we go forward.
TWST: What's the biggest holding in the MLP income fund?
Mr. Watson: A firm called Regency Energy Partners (RGP). It's kind of a similar name, actually. It started its life as a processing company and has transitioned, to this point, to a longer-haul, fee-based gas-pipeline company. They are spending a pretty good amount of money right now on a natural gas liquids private company, and they are expanding natural gas liquid services to West Texas. It's a pretty large investment for them. As that goes into fruition, we think it has the opportunity to change investors' perception of its ability to grow. Very similar theme; it just offers a higher yield with an average, so it's a candidate for the income fund.
TWST: When you look at the holdings over the funds, are there certain trends within the energy infrastructure space that you're focused on this year than in the past?
Mr. Watson: I think generally speaking, as I mentioned for both of those entities, the primary growth prospects in the space are crude related, products related or natural gas liquids related. The world of natural gas probably offers a pretty steady volume growth for a number of years, but the ability to capture new business is a little bit less than it was a couple of years ago. So really it's the handling, the logistics related to crude oil and natural gas liquids that are really providing the growth opportunities today for most entities, and that's where we are focused.
TWST: The MLPs you like on that theme are not really tied into the price of natural gas?
Mr. Watson: Right. They're taking a fee for moving it. So if the price is really low, that's potentially good for demand. It might certainly make volume growth be better than people expect, and that could benefit them. The trick is, with this truly revolutionary change in natural gas dynamics and the fact that we are now in such a low-price environment has made it challenging for certain guys, so you've got to be careful. Those who are storage operators, particularly those who've built storage and leased it to marketers - whose whole job in life is to go out and buy natural gas on the spot market, lock in a profit on the futures market, normally during the winter months, and then have that storage there to physically back the trade - are facing not much margin in doing that any longer, because of the huge decrease in natural gas pricing. So there are certain storage operators who are providing that storage for those marketers that are not making very much money any more. You've got to be careful with names like that. There are pipelines that we're servicing moving natural gas from a production basin to a city gate that, when they built the pipeline, probably was a great motive. Today there are a handful of pipelines we think that maybe aren't going to be able to recontract at a very good rate. So those are names you've got to really watch when that contract expires. More so than the world of natural liquids and crude oil, the natural gas world and some of those assets require you to do a little bit more homework.
TWST: Some people in the MLP world point to tax advantages and to using these as an inflation hedge. Is that a selling point for you?
Mr. Watson: There's certainly an argument for the inflation-hedge aspect, simply because a lot of these pipelines that are moving petroleum products - crude oil or refined products - across state lines are regulated by the Federal Energy Regulatory Commission, and FERC does allow a Producer Price Index-tied annual tariff increase. So there is a good swath of these assets for whom, if PPI were to increase more aggressively, they'd be able to raise their tariffs in accordance with that. That's a fairly direct inflationary offset. Less directly is just the fact that the sector, generally speaking, has been able to grow its distributions at a pretty nice clip, and we think that continues. So if one wants to buy the sector for the yield, at least you can find a yielding product that is likely going to grow its distribution, and that should help offset inflation. I think it's a fair statement and particularly today, with fixed income rates of return seemingly lower and lower, this is a sector they can go to where investors can find a higher yield - and hopefully have a little distribution growth, too. I think it's a fair argument that the MLP structure itself is tax efficient, because there are no corporate-level taxes, and certainly that's probably why they're able to reinvest in new assets and distribute so much to their holders. We are more interested in the fact that they own these assets than we are their structure, but certainly it's an efficient form of organization. I think it's helped them perform over the years. But the primary reason is the assets they own.
TWST: What are some broad risks within this space? How do you folks go about managing risk or minimizing risk?
Mr. Watson: If you look at the MLP sector as a whole, I think one of the broad risks is the number of names with commodity-pricing exposure. Obviously, we talked about how we try to address that. Outside of that, these are entities that own dozens of different assets across the country, so it's kind of hard to find any one risk. I think if you look at the trading of the units, we know that like other yielding securities, a spike in interest rates will tend to beat up the trading of the units. That's not really a fundamental problem for the group. That usually is a trading pattern that they'll experience; though as I described earlier in the performance for the year, they tend to have a lower beta than maybe the oil and gas sector to the broader markets. A down day for the S&P might also be down for MLPs, but it'll be down less so. Of course, they still do trade to broader markets, and so you have to know that they are not completely disconnected. Long-term correlation to the broader market is pretty low, but short-term correlation, particularly during times of stress, goes up. These are still equities. They still trade on the NYSE, and they will be volatile like any other equity. Over time, they've shown themselves to be more resilient, but daily trading will have the same volatility.
FERC, as I mentioned earlier, is a regulator that most influences the sector. FERC has always been a very good regulator. I think FERC has appropriately focused on making sure there aren't bottlenecks in the system and things like that, and been less concerned with picking on every penny earned. So if FERC were to change its tune, I think that would be something to watch out for. We don't see that happening, but obviously it's a regulator that spans this space. So if you're looking at systemic risks, that is a potential systemic risk - if they were to change their mode of behavior. I guess you have your real Black Swan events, where world crude oil supply is disrupted as in the 1970s, and U.S. refineries literally can't get the crude to produce gasoline. Obviously, that would have a volume impact across this space, a systemic impact. We think that's pretty unlikely, but that's the kind of thing you'll have to look for if you're looking for something that really impacts the whole space, simply because you're really taking about just hundreds and hundreds of disparate assets spread around. It's kind of hard to find things that would really disrupt all of them across the whole sector.
TWST: What are the two or three best reasons for a long-term investor interested in MLPs to look closely at SteelPath versus other providers?
Mr. Watson: It really depends on what the investor is looking for. Obviously, we are really focused on the risk side of things and capturing what's considered a more boring, but we think reliable, return profile, and that is owning these fee-based guys that can grow sustainably over the years. There are MLPs that take lots of commodity price risk, and if crude oil goes straight up, given we are trying to avoid the exposure, that may helps others more than us. Our M.O. is different than some. We think that's what's so unique about this space. But investors may want to be more aggressive and go after commodity price exposure; that's really up to the investor. I think there are probably a number of good managers out there. I think we probably focus on risk more than others, but just generally speaking, I think this sector offers a pretty interesting profile right now. We've had declining crude oil, declining natural gas, declining natural gas liquids production in the U.S. for a generation practically, and now it's actually reversed; you've got increasing crude production, increasing natural gas production, increasing natural gas liquids production. I think that seismic shift, which maybe hasn't totally been recognized by most of the market, creates a really interesting opportunity set for these infrastructure providers. I think that generally speaking, this sector has the wind in its back. Whether someone chooses us or someone else I think is worth a look.
TWST: Is there anything else you wanted to cover? Anything else investors should know about SteelPath?
Mr. Watson: We offer the mutual funds, as well as some private products for those who would have interest. We try to offer the product that the investor needs and target those three main portfolios, but a number of different products to suit investors' needs.
TWST: You have separately managed accounts as well, right?
Mr. Watson: That's right. We have separately managed accounts, a private LP and other one-off products for investors.
TWST: Thank you. (MJW)
Director of Research
SteelPath Fund Advisors
2100 McKinney Ave.
Dallas, TX 75201