Ethan Bellamy: Value in MLP Tax Structure
Source: Brian Sylvester of
The Energy Report
09/07/2010
http://www.theenergyreport.com/cs/user/print/na/7291
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Wunderlich Securities Senior Analyst Ethan Bellamy is another
success story in a considerable line of exceptional MLP analysts.
He focuses on about 15 MLP names, including a number of closed-end
funds. He believes the tax advantages of the MLP structure will
eventually allow MLPs to become a "stalwart" asset class.
"Ultimately, capital is going to flow where it is best treated," he
says, "MLPs offer pretty significant value propositions for an
investor." In this exclusive interview with
The Energy Report,
Ethan talks about his favorite closed-end funds and some
unprecedented opportunities in the upstream MLP space.
The Energy Report:
Today we're talking with Ethan Bellamy, an analyst with Wunderlich
Securities. Ethan, please tell us about yourself and your coverage
sector.
Ethan Bellamy:
I started out as a junior analyst covering cable and media at
Stifel Nicolaus and Co. Then I got a job covering MLPs before I was
lured to the buy side at Lehman Brothers, which was a shorter-lived
experience than I would've hoped. I've been with Wunderlich for two
years. My coverage list is a gathering of direct MLPs and
closed-end MLP funds. I cover about 15 names, everything from
propane to coal to the closed-end funds to oil and gas production
to pipelines. I've either owned, shorted or written research on
just about every MLP out there.
TER:
That's quite a range of MLP experience. Ethan, we've seen about a
25% increase in dollar volume flowing into MLPs this quarter versus
the same quarter last year. What's driving that increase and what
sort of names are those dollars headed toward?
EB:
Fund flows into MLPs can really be attributed to a bullish "perfect
storm" phenomenon. First, you have the launch of two
de novo
MLP closed-end funds at more than $1 billion each. We also had two
follow on offerings in existing MLP closed-end funds,
Kayne Anderson MLP Investment Company (
KYN
)
and
Fiduciary/Claymore MLP Opportunity Fund (
FMO
)
, which raised another $260 million. All four of those vehicles
have to rapidly put that money to work in order to pay their
distributions. That's been the primary driver of fund flows into
the large- and mid-cap MLPs that we've seen since mid-May. We're
now coming to the end of the three-month window in which those two
big initial public offerings of closed-end funds have been put to
work. I wouldn't be surprised to see a short-term period of MLP
underperformance as that capital deployment subsides.
The "perfect storm" is being further enhanced by the big
macroeconomic trend we're seeing in U.S. Treasuries. The benchmark
10-year T-Bills just hit 2.5%. That means risk-free yields are
really offering very little income, so investors are forced to look
elsewhere.
We're also seeing significant fear of rising personal income tax
rates for 2011 if Congress allows the Bush tax cuts to expire. With
the additional taxes for "Obama Care," most people recognize that
the cash from the "helicopter" stimulus plan we've had has to be
paid by somebody. That somebody is going to be wage earners in the
next two decades through higher taxes. On a relative basis, MLPs
offer a tax-deferred income stream that looks a lot like municipal
bonds; a municipal bond is tax exempt and MLPs are tax deferred
until you sell. That looks pretty attractive to people considering
the likelihood of higher taxes in the future.
TER:
You're basically saying other investment vehicles could see more
taxes, and thus it's better to be in MLPs because they likely won't
be subject to the same taxes as other investments.
EB:
There are taxes on MLPs but they are deferred until the time of
sale; you recapture that depreciation expense upon sale. But in the
interim you're getting an 80%-100% tax-deferred distribution
stream, so your net present value with the investment is a lot
higher.
TER:
Ethan, I'm not sure most investors know the key differences between
the closed-end funds and the open-end funds. Can you explain the
basic differences?
EB:
At the simplest level, closed-end funds are fixed pools of capital
that trade on exchanges. You can have a secondary offering that
will grow the pool of capital; otherwise it's fixed. You buy a
share in that pool that is traded on an exchange. You can have
premiums or discounts to the net asset value (
NAV
) of that closed-end fund based on how the shares are trading. With
an open-end fund, it's a variable pool of capital that grows when
you buy into it and declines when you redeem your shares. That's
typically done daily through the fund manager.
In a closed-end fund you can have a discount of premium to NAV,
while with an open-end vehicle you're buying or redeeming at the
NAV every day. It's just basically two separate types of vehicles,
both of which are popular.
TER:
A couple of other MLP vehicles have launched recently. SteelPath
has launched several MLP mutual funds-
SteelPath MLP Alpha Fund (NYSE:MLPAX)
,
SteelPath MLP Income Fund (NYSE:MLPDX)
,
SteelPath MLP Select 40 Fund (NYSE:MLPFX)
-and the
Alerian MLP ETF (
AMLP
)
launched this week. Do you expect those to draw significant
investment dollars away from closed-end funds?
EB:
I expect less cannibalization of existing funds than new money that
may like the ETF structure better for whatever reason. There's a
reason no one has done an ETF in the MLP sector until now. That
reason is the churn of a product like that with daily liquidity can
add a tax burden.
These funds in the MLP space are different from a lot of other
asset classes because they're structured as taxable investment
companies that do not benefit from the same tax benefits of
registered investment companies. That's intentional so that you get
around the K-1 tax forms. Typically, you get 1099 tax forms by
buying all these products. But you can have a tax burden. With the
open-end funds and with the ETF, there's a chance that they're
going to underperform the underlying index because of a tracking
error created by taxes. I would encourage everyone to go read the
prospectus before they go piling into the ETF thinking it's going
to produce the returns that the index is likely to produce. I think
it's similar to how the
United States Oil Fund L.P. (
USO
)
or the
United States Gasoline Fund, L.P. (
UGA
)
have underperformed the commodities that they're supposed to track,
because there are specific structural features in the fund that may
cause them to underperform. That might not be readily apparent to
the casual observer.
With respect to the SteelPath open-end mutual funds, which are
discrete and separate from the new ETF, I'm told by my industry
sources that those were done on a reverse inquiry rather than on
spec. Hopefully, they'll be predominantly low churn and held by
registered investment advisors who are buying big positions that
they'll hold for the long term. Otherwise that could create some
additional volatility in the market that could be negative. For
example, if there are redemptions that require the selling of a big
position at the market close, that could create some volatility.
Still, I think you have to hand it to
Gabriel Hammond
and Kenny Feng at Alerian and SteelPath for their aggressive
entrepreneurialism in MLP products. They've certainly not been shy
about creating an avenue for investment in the group that was
unavailable to most consumers. Although I'm a fan of the closed-end
funds, there are some people who are never going to be able to get
over the premiums-to-GAAP NAV that some of the closed-end funds
exhibit.
TER:
MLP ownership seems to be transitioning from retail to
institutional investors. What do you think its ultimate result will
be?
EB:
I think and I hope that the ultimate result will be something
similar to what's occurred with Real Estate Income Trusts (REITs),
where as the asset class expanded and became more
institutionalized, more specific management vehicles were set up to
invest in the space and valuations and liquidity improved.
Ultimately, it became a stalwart investment class. I think that's
occurring with MLPs and it's likely to continue on an incremental
basis over time.
The sea change we've seen lately is that the combination of
returns and improved liquidity has made the sector too difficult to
ignore. Ultimately capital is going to flow where it is best
treated. MLPs certainly offer pretty significant value propositions
for an investor. The other benefit is that the bigger and more
entrenched the MLP sector gets, the less likely it is that
something dramatic happens with the MLP tax structure. For example,
no one questions the tax benefits of REITs because they are
globalized, have been around for a while and the structure is in
place.
TER:
You like a number of closed-end MLP funds, but you also like a
number of individual MLPs. Are investors best served by directly
owning MLPs or owning units in a closed-end fund or a combination
thereof? What's a good mix?
EB:
There's something for everybody here. It really depends on whether
you are deploying taxable or non-taxable funds. Meaning, are you
buying in a taxable account or are you buying in an IRA or a 401K
or Keogh Plan? You can buy MLPs directly in an IRA or another
non-taxable account, but at certain thresholds those will generate
unrelated taxable income on the income received, not necessarily on
the distributions received. There is no prohibition against buying
MLPs directly and holding them in an IRA. It just can present some
additional taxes that may not be warranted. The most efficient
thing you can do is buy MLPs directly and receive the benefits in a
taxable account. But if you want to deploy capital in the MLP space
and you don't want to directly track investments, and you're
worried about generating unrelated taxable income, then you might
want to choose a closed-end fund or an exchange-traded note (
ETN
), which produces a 1099 tax form. A closed-end fund basically
gives you a diversified portfolio of MLPs, so you get some
portfolio diversification benefits, as well.
TER:
You have buy ratings on the closed-end funds
Energy Income & Growth Fund (
FEN
)
and
Tortoise North American Energy Corp. (
TYN
)
. Tell us about those.
EB:
Energy Income and Growth Fund is sub-advised by Energy Income
Partners, which is led by a guy named Jim Murchie, whom I consider
the Warren Buffett of MLPs. He's value biased, very conservative.
Jim picked up sub-advisory of the fund before the credit crisis,
reoriented the portfolio toward very conservative investments and
had a very conservative cash flow payout ratio. When the credit
crisis hit and most MLP managers were forced to sell assets to
maintain compliance with leverage limitations, he was forced to
sell less. He was able to maintain his distribution without
trimming it, whereas most of his peers were forced to cut. And FEN
was the first fund to raise distributions since the credit
crisis.
If you're looking for a very conservative way to play MLPs, you
can take advantage of Jim's strategy, which he calls "selling
pickaxes to the miners."
TER:
And TYN?
EB:
I like that name. TYN is a little smaller and has a little more
commodity price sensitivity than some of the other funds. This is
one of four funds now managed by Tortoise Advisors. I like this
name particularly because they've got almost 10% of their capital
allocated to two upstream MLPs I like a lot-
Linn Energy, LLC (
LINE
)
and
EV Energy Partners, L.P. (
EVEP
)
. From time to time these funds trade differently on price to NAV.
We have our own proprietary method for calculating
price-to-adjusted NAV, where we basically adjust the net present
value of deferred tax assets and liabilities to come up with a
better representation of NAV than the nominal NAV that's reported
under GAAP. But generally speaking, this is one that I think has
pretty good distribution growth prospects because of its commodity
price sensitivity.
TER:
You said you like Linn Energy and EV Energy. Why do you like those
names?
EB:
The upstream MLP subsector I think has the single biggest secular
growth story in MLPs. LINE and EVEP are somewhat controversial
vehicles. Many of the traditional MLP asset managers look askance
at them because of the history of the MLP sector. The first MLP was
Apache in 1981. Thereafter many of the first MLPs were oil and gas
entities that were under-hedged and over-levered and ultimately
failed when oil and gas prices stayed low throughout the 1980s.
These new breeds of upstream MLPs, which started with LINN Energy
in 2006, are better because management realized they have to retain
a significant portion of cash flow in order to reinvest it. They've
also hedged strongly and, more importantly, they have a huge
secular growth opportunity. They're the most efficient way in terms
of tax structure to hold producing oil, gas and natural gas liquids
assets that don't have much development upside because you don't
pay corporate entity taxation. That way you avoid the double
taxation of corporate dividends. That's the case with all MLPs but,
specifically, with oil and gas assets that you're basically just
trying to milk over time; it's a very efficient structure. We see
about $250 billion of proved, developed, producing reserves in the
United States potentially flowing into these upstream MLPs over the
next decade. They have the potential to be as big as the rest of
the MLP sector combined.
TER:
What are some other companies that stand to benefit from that
transition of assets?
EB:
LINE, EVEP,
Legacy Reserves, L.P. (
LGCY
)
,
Vanguard Natural Resources, LLC (
VNR
)
and
BreitBurn Energy Partners, L.P. (
BBEP
)
are definitely going to be able to tap into that $250 billion pool
of existing assets that I talked about. The onus is really on these
partnerships not to overpay for the assets. If they can buy them on
the right terms, then the world is their oyster. The one caveat for
investors that I would throw out there is that there is some
lingering uncertainty about the liquidity and cost of commodity
derivatives after the passage of the Dodd-Frank Financial Reform
Bill. There's a nominal exclusion in the legislation for end-users,
but the major swap dealers may still have to collateralize some of
these transactions, which would raise the costs of derivatives. At
this point it's still I think unclear how this is going to shake
out. It's important to point out that MLPs are large users of
derivatives. If something were to come out of the Dodd-Frank
legislation that was draconian with respect to derivatives, it
would definitely impact the MLP sector.
TER:
Let's head back to some other closed-end funds you like.
EB:
The other funds I like include Kayne Anderson MLP Investment,
Tortoise Energy Capital Corp. (
TYY
)
and
Tortoise Energy Infrastructure Corp. (
TYG
)
. Basically, these should perform in line with the
Tortoise MLP Index (TMLP)
. They are generally a good way to access the sector. You're buying
predominantly the large- and mid-cap MLPs via these funds. They
have reasonable expense ratios. They have a reasonable track
record. We look to enter and exit these based on price to NAV.
TER:
What are some individual MLP names you like besides LINE and
EVEP?
EB:
Just to be clear, I don't cover those. Those are owned by TYN. The
two upstream MLPs that I like and follow formally are
Legacy Reserves, L.P. (
LGCY
)
and Vanguard Natural Resources. I've been following Legacy since
its IPO in 2007. I just took a tour of their new properties they
bought in Wyoming. Their roots are in the Permian Basin in West
Texas; they're based in Midland, Texas. They just squeeze as much
blood from the turnip as they can when they get assets. Sometimes
the assets have not been maximized either by a small producer that
maybe couldn't afford an engineer, or they were an afterthought to
a larger producer that had bigger development capital projects to
go after. Legacy will go in and maximize an asset. They are in
there buying things as small as $2 million apiece and up to $100
million plus. Last year was a bit dicey for Legacy when oil prices
cratered and it looked like private equity firm Apollo Management
L.P. might come in and buy them on a discounted basis. Apollo
would've pulled off the best deep value trade of the year if they
were able to buy Legacy. But oil prices recovered and Legacy was
able to walk away from the deal. Since that time they've been able
to produce more distributable cash flow, and continue their
growth-through-acquisition story. I anticipate that they'll be able
to restart distribution growth very soon. We have them growing
their distributions by about 5% in 2011.
TER:
And Vanguard?
EB:
Vanguard, which also went public in 2007, really started out as an
Appalachian gas producer but it has since morphed to 50/50 gas and
liquids. They stood out as robust for a small cap, particularly in
2009, by having a solid hedge book that carried them through a
period of very low commodity prices. You know, in my career I'd
never seen a more obvious invalidation of Efficient Market Theory
given Vanguard's hedge book. I basically stood up in 2009 and said:
"Vanguard is really super cheap for no reason. Go buy it." It
returned more than 300% in 2009 on what I would consider a march
back to fair value. I don't expect to see that kind of mispricing
on an asset again in my lifetime. Now it's tracked to a more
reasonable valuation range. I really like it as a growth story. I
think the stage is set for them to post high single-digit
distribution growth via acquisitions in the next few years. Both
Legacy and VNR, along with some of the other peers I mentioned
earlier, should also be able to take advantage of that $250 billion
shift in assets that I talked about before.
TER:
Vanguard made about a 22% gain above your estimates on commodity
derivatives in the last quarter, correct?
EB:
Well, the main things we look at are margins and distributions.
Vanguard has been tracking pretty closely to where we think cash
flow and distributions are. Although GAAP earnings are certainly
relevant, they're much less relevant for MLP investors because
typically we're looking at non-GAAP distributable cash flow as the
true benchmark for profitability.
TER:
Vanguard produces oil and gas and it's hedged, but to what
extent?
EB:
I believe they're 80% hedged through 2011 on gas and about 50%
hedged on oil through 2013.
TER:
What are they hedged at in gas?
EB:
They're hedged at about $8 through 2011.
TER:
With gas prices around $5 that's not a bad thing. Another thing
that we wanted to talk about is that a number of the MLP indexes
have vastly outperformed the bond market and certainly the S&P
by large margins over the last decade. A $1,000 investment in the
Cushing 30 MLP Index in December 2001 would be worth almost $5,000
now, whereas the same investment in Merrill's High Yield Bond Index
would be worth just under $2,000. Why is the Cushing 30
dramatically outperforming its peers?
EB:
I think the best way to talk about these is to talk about all the
indexes that we watch and how they differ from one another.
The three indexes that I would point investors to would be the
Alerian MLP Index (NYSE:AMZ)
, the Tortoise MLP Index and the
Cushing 30 MLP Index (NYSE:MLPX)
. They will tell you what the large caps are doing via the AMZ;
what a typical portfolio should be doing via the TMLP; and what a
high-beta aggressive growth strategy would be doing via the
MLPX.
The Cushing 30 is equal weighted, so it's going to give you more
pop and more beta when the smaller cap names are performing well.
In an environment where MLPs are going up, you'd expect the high
beta names to be going up a lot more and the MLPX to be
outperforming.
TMLP is more market cap weighted like the AMZ, but it has
position limits on the large caps so it's not dominated by
Kinder Morgan Energy Partners, L.P. (
KMP
)
and
Enterprise Products Partners, L.P. (
EPD
)
the way the Alerian MLP Index is. It looks more like what you would
actually own as an investor. If an investor were to ask: "Hey
what's a proxy for a reasonable MLP portfolio?" I would tell them
to look at the TMLP. You've seen all these indexes move up pretty
rapidly on the strength of the capital deployment from those two
IPOs-north of $1 billion.
TER:
Do you have some parting thoughts on the MLP sector?
EB:
I think in the near term there's some risk that you'll see a
reversion toward the S&P 500, but long term I think it's pretty
easy to be constructive on the MLP space. I think that we're going
to see an inflationary environment essentially created by fiat
money and big budget deficits. I don't think there's a really easy
solution for the Fed to do anything but inflate our way out of the
debt that we've created. In that type of environment, an MLP should
do very well over the long term. Moreover, I think there's no way
around higher personal income taxes. Frankly, most investors should
be buying these for the long term because that's where the real
benefit is, deferring as far out into the future as possible the
taxes that will be due.
Ethan Bellamy specializes in the analysis of Master Limited
Partnerships. Previously, he was the director of research for the
Lehman Brothers MLP Opportunity Fund where he was responsible for
fundamental analysis and due diligence in public, PIPE and
pre-IPO investments in natural resources. Prior to joining Lehman
Brothers, Ethan was a senior analyst covering MLPs at Stifel
Nicolaus where his coverage included oil and natural gas
production, gathering and transportation; propane distribution;
marine shipping; coal mining; and MLP-oriented closed-end funds.
Ethan previously worked as a journalist for various local and
national media and taught writing and journalism at the
University of Colorado at Boulder for two years. He was a
doctoral student focusing on energy policy at the University of
Colorado at Denver, with a focus on energy infrastructure and
renewable energy policy. He holds an MA from the University of
Colorado at Boulder and a BA from Clemson University. Ethan is an
avid snowboarder and telemark skier, and has hiked both the
Pacific Crest and Appalachian National Scenic Trails in their
entirety.
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DISCLOSURE:
1) Brian Sylvester 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
or
The Gold Report:
Vanguard Natural Resources.
3) Ethan Bellamy: 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: Vanguard Natural Resources, Tortoise North American
Energy, Tortoise Energy Capital, Tortoise Energy Infrastructure,
Legacy Reserves, Kayne Anderson and Energy Income & Growth
Fund.
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