Kenny Feng: What Are MLPs and Why Are They
Outperforming?
Source: Zig Lambo of
The
Energy Report
(11/8/11)
http://www.theenergyreport.com/pub/na/11558
Increasing U.S. energy demand has spawned a similarly growing
investment space in Master Limited Partnerships (MLPs). These
partnerships provide investors with the opportunity to share in the
income generated mainly through the transportation, distribution
and storage of oil and natural gas. In this exclusive interview
with
The Energy Report,
Kenny Feng, president and CEO of Alerian, which maintains the
Alerian MLP Index (AMZ:NYSE), gives us the ins and outs of the MLP
business, highlighting the unique benefits and risks associated
with these income-generating investment vehicles.
COMPANIES MENTIONED
: ALERIAN MLP INDEX - ALERIAN MLP INFRASTRUCTURE INDEX - ALERIAN
NATURAL GAS MLP INDEX - BP PLC. - CHEVRON CORPORATION - EXXON MOBIL
CORP.
The Energy Report:
Alerian is an independent provider of objective indices and
underlying data for Master Limited Partnership investments. Can you
explain what your company does?
Kenny Feng:
First, Alerian creates and maintains four indices that track the
energy MLP space. Just as someone would use the S&P 500 to
gauge the performance of the broader U.S. economy, people use
the
Alerian MLP Index (AMZ:NYSE)
to gauge the performance of the energy MLP space.
Secondly, we license our indices to investment banks and
third-party exchange-traded fund (
ETF
) distributors to create investment products, which facilitate
access to this asset class. These currently include JP Morgan, UBS,
ALPS Fund Services Inc. and CIBC in Canada.
Thirdly, we are an information provider for the MLP space. As a
sort of "Wikipedia" of MLPs, we are the first-pass information
source for investors just finding out about the asset class through
a CNBC spot or an article in
Barron's
or through word of mouth. People are looking for sources of
higher-income returns and learning that MLPs have historically
provided them.
TER:
Can you define an MLP for people who aren't that familiar
with the structure?
KF:
Master Limited Partnerships are involved in four basic
businesses at a very high level: transportation, storage,
processing and exploration, and production of minerals and natural
resources. By confining themselves to these specific activities,
MLPs are not subject to entity-level taxation. They are, however,
subject to the same reporting requirements as any other
publicly-traded corporation. Approximately two-thirds of these
names trade on the New York Stock Exchange, with most of the others
trading on the NASDAQ.
TER:
How did you get into the business of creating these
indices?
KF:
We actually kind of stumbled into it. In 2004, Alerian was
launched as an asset manager for the MLP space. Being a pretty
small fish in this pond we thought, "What can we do from a
marketing standpoint?" Reading the different analysts' research
reports and talking to different MLP investor relation (
IR
) teams, we realized there wasn't a third-party index capturing and
benchmarking MLP performance. Everyone was calculating their own
composite for the sector with different methodologies. We thought
this would be great opportunity for us to launch an index that
would be really helpful for all the different stakeholders. The
Alerian MLP Index was launched on June 1, 2006.
Our methodology largely mirrors the construction of the S&P
500, which is a float-adjusted, market capitalization-weighted
index. We were fortunate to have first-mover advantage and to be
able to have the different stakeholders of the sector adopt it as
the benchmark. Today you see the MLPs themselves using it in their
corporate presentations. The media has adopted it, including
CNBC,
Barron's
and other publications.
In 2006-2007, people said to us, "We love your index, but I'm
really more interested in traditional pipeline and storage." They
were looking to track what are called toll-road business models. So
we launched the
Alerian MLP Infrastructure Index (AMZI:NYSE)
for those who are more focused on that midstream energy
infrastructure component. Then, as the gas shale plays started to
emerge in full force in the U.S., we decided to launch a gas
infrastructure index-the
Alerian Natural Gas MLP Index (ANGI:NYSE)
.
TER:
Why did MLPs lack their own index for a full 20 years since
their 1986 inception and before Alerian launched its
index?
KF:
That's a great question. This asset class is still pretty
small-about $250 billion (
B
) spread among just over 70 securities. That's two-thirds the size
of
Exxon Mobil Corp.'s (XOM:NYSE)
market cap, which is in the $375B range by itself. This
hasn't been an asset class that has historically interested a lot
of institutions, and as a result has largely been held in retail
hands. As oil prices have fluctuated over the past eight years
between $30-150 per barrel, the pipeline and storage MLPs have not
been directly exposed to those commodity-price fluctuations. It's a
stable business with very predictable growth in earnings and cash
flow. This may not be exciting for a lot of people, but it
generates stable cash flow, allowing MLPs to pay out consistent
distributions over time.
TER:
How does an energy infrastructure asset compare to other
types of assets?
KF:
What makes the energy infrastructure asset unique is the
underlying business type, a toll-road business model. Those stable
cash flows and the fact that you can predict it with a greater
degree of certainty than, let's say, the advertising revenue of
Google in any given quarter. It's attractive to a lot of
people.
The MLP revenue equation is very simple. It's just price
multiplied by volume. On the price side, you have a tariff on all
interstate liquids pipelines that grows by PPI (Producer Price
Index) plus 2.65%, federally mandated every single July. There is
federally-mandated stability. On the volume side, you have energy
demand growth in the U.S. averaging roughly 1% per year over the
past 30 years.
TER:
You touched on this earlier, but maybe you could go into a
little more detail on how MLPs are valued compared to utilities and
Real Estate Investment Trusts (REITs).
KF:
MLPs are similar to utilities in that they are similarly
exposed to inelastic energy demand. The difference is in how they
are regulated. If a utility wants to implement something that will
provide cost savings, the regulator will say, "It's a great idea,
and now I want 50% of your cost savings for my consumers." With
MLPs, the Federal Energy Regulatory Commission oversees all
interstate pipeline activity. They have shown themselves to be
constructive and efficient in their oversight.
MLPs are similar to REITs in that they own hard assets with
permanent storage value. But REITs are much more exposed to
economic cycles than MLPs and REIT distributions are consequently
much more volatile. MLPs have raised their distributions on average
by 3-6% each year through the 2008-2010 economic crisis, and
they're on pace to do the same this year.
TER:
So it's a good, solid, entrenched business that's not going
to change much.
KF:
Exactly.
TER:
Are there unique tax considerations investors need to make
for MLPs?
KF:
Absolutely. MLPs are partnerships. Instead of receiving the
1099 tax form you would get if IBM or Google paid a dividend,
you're going to get a Schedule K-1 form, which is essentially your
allocation of deductions and income that come from the MLP itself.
I always tell people that if you don't find a Schedule K-1 to be
burdensome, you should invest in MLPs directly, because MLP
distributions are actually tax-deferred return of capital. When IBM
or Google pays you a dividend, you're going to be taxed at the
qualified dividend rate. With MLPs, because of various deductions,
the return of your distribution is actually a tax-deferred return
of capital.
Roughly 70-100% of MLP distributions will be tax deferred. The
balance is going to be taxed at your ordinary income rate. So if I
receive a distribution of $1 and 80% of that is going to be tax
deferred, then I'm only taxable for that remaining $0.20 at a 35%
rate. So it's $0.07 on a $1 distribution in the current year. Your
cost basis will be adjusted downward accordingly. There will be a
recapture upon the sale of MLP units, and that's when the tax
deferral catches up. There's a recapture for that component, but
certainly it does create a dynamic where, if you believe in the
business and the asset, then certainly it's going to defer that
income all the way out until you sell. So it's a great income tool,
and also a great way to defer your taxes.
TER:
How has the performance of MLPs compared to similar
alternatives?
KF:
Over the past 10 years, MLPs have returned approximately 17%
annualized-obviously very strong. If you break down the actual
performance, roughly 8% of that is a function of distribution
growth. Another 6-7% of that is from yield, and the balance, that
3% or so, is really from valuation compression. So what's been
driving that? Part of that is just that the asset class has grown
through acquisitions and organic growth projects. Ten years ago, it
was 20 securities, $20B and today there are 70-plus securities and
$250B. The other part is the tariff escalators that we talked about
earlier.
TER:
How do we know that this growth will continue?
KF:
The
Interstate Natural
Gas Association of America
(INGAA) estimates that there's roughly $10B of new natural
gas infrastructure that needs to go into the ground each year for
the next 20 years. So you're looking at a roughly $200B investment
through 2030. When you compare that to a market cap in the space
today of $250B, it's pretty significant. What's driving the
spending is the changing supply-demand dynamics caused by the gas
shale plays. Ten years ago, we didn't know that some of these
reserves were economically recoverable. As a result of changes in
drilling technique and technology, those reserves are now
recoverable at a much lower gas price.
On the acquisitions side, which is the other component of the
growth, companies such as Exxon Mobil,
BP Plc. (BP:NYSE; BP:LSE)
and
Chevron Corporation (CVX:NYSE)
have midstream assets that they're not really getting credit
for. They have an incentive to sell these assets (which they
effectively operate as cost centers) down to the MLPs and redeploy
that capital into a drilling budget. The MLPs, obviously, have an
incentive to operate these assets more efficiently. Because of
their pass-through tax status, they're able to pay a little bit
more than the traditional corporation and still have the
acquisition be accretive. The synergies with their existing assets
create an opportunity to continue allowing their distribution to
grow as a result of these acquisitions.
So the two components of growth are organic growth and
acquisitions. That's going to allow the trajectory of this asset
class to continue going forward. We wouldn't tell you 17% is
anything to expect on a going-forward basis but if you do some
basic math, research analysts expect 3-5% distribution growth,
combined with a current yield of 6-6.5%, which gives a 9-12% total
return. On a cash flow-volatility basis, the risk-reward would
generate what we think compares pretty favorably to other asset
classes.
TER:
Is there anything on the negative side that could change the
economics of this business?
KF:
Investors with a long-term commitment to the asset class are
going to be better rewarded over the long run just because there
will be volatility in the shorter term. Let's talk about a couple
of the risks.
The first is interest-rate risk. These are yield-sensitive
instruments, to a certain degree. In times of gradual or slow
interest rate rises, MLPs have shown to be largely protected due to
their distribution growth component. So it's not a completely
fixed-income security. If you do see a spike in interest rates,
such as in 1994, for that short period of time MLPs suffered just
like any other yield-oriented equity class. If you expect yields to
double over the next year on 10-year treasuries, then you should
really be careful with this asset class because they do pay a
distribution, and the yield component is going to be an issue.
Another side of it is just a broader equity risk. MLPs,
historically, have been largely uncorrelated to the broader S&P
500 at about 0.3-0.4%. The asset class has become more well-known
and everything has been more correlated in recent years. With more
volatility in the broader markets, you are going to have broader
equity risk that people might not have thought about, historically,
because of their cash-flow business.
Another component is that MLPs are an emerging asset class.
About 60% of the $250B market cap is in public hands. The balance
is held by sponsors. So there's really only $150B of MLP equity out
there. Some of these securities are going to be fairly illiquid.
Investors need to know how much volume is trading on a given day
and whether there are any large blocks that may unlock at some
point to create an overhang on the stock itself.
Beyond that, you have environmental risk around hydraulic
fracturing (fracking). The U.S. Environmental Protection Agency is
going to release a study at some point next year detailing its
perspective on fracking, which could make it more tightly regulated
than it is today. So, environmental legislation would be a risk
because it would reduce some of those growth opportunities that
currently exist.
Finally, there is tax reform legislation, and MLPs could get
swept up in that. We don't believe they will, because Congress does
understand that these assets are critical to U.S. energy security
as well as being thought of like other infrastructure assets, such
as airports, toll roads, hospitals and schools.
TER:
What key points should people bear in mind when considering
MLP investments?
KF:
MLPs present an opportunity to invest in the long-term
build-out of U.S. energy infrastructure. The key elements that make
this asset class attractive are: (1) stable cash flow, which is
anchored by what are effectively regional monopoly-type business
models; (2) benign overarching federal regulation, which has been
very supportive over the long term, and (3) this tremendous
resource in U.S. gas shales, which represents an opportunity for
the infrastructure companies that need to move this gas from these
new supply centers to new demand centers.
From an investment-opportunity standpoint, if you're looking for
a stable source of cash income, I think MLPs are certainly worthy
of consideration. With a 6-7% yield and a 3-5% conservative
distribution growth on a going-forward basis, you're still looking
at low-teens returns with a fairly stable cash-flow profile for the
pipeline and storage MLPs, in particular.
If you're looking for a total return proposition, with an
opportunity to build out these assets over the next 5 to 20 years,
there's a return potential that could be even greater than that, as
shown by some of these individual partnerships over the past 10
years.
TER:
It looks like MLPs are kind of a win-win for everybody
involved.
KF:
We certainly think so.
TER:
Thanks for joining us and providing these valuable
insights.
Kenny Feng
, CFA, is the president and CEO at Alerian, an independent
provider of objective indices, data sets, and analytics for the
Master Limited Partnership (
MLP
) sector. Over $5 billion is directly tied to Alerian's indices,
including the leading benchmark of MLP equities: the Alerian MLP
Index. Mr. Feng is a former managing director and portfolio
manager at SteelPath Capital Management LLC, a Dallas-based MLP
investment manager. Prior to his experience at SteelPath, Mr.
Feng covered MLPs, electric and gas utilities and diversified gas
companies at Goldman, Sachs & Co., in the firm's Global
Investment Research Division. Mr. Feng graduated summa cum laude
with a Bachelor of Science in economics from the Wharton School
and a Bachelor of Arts in international studies from the
University of Pennsylvania. He also serves on the advisory board
of Midstream Business, a monthly publication addressing the need
for business market intelligence on North American midstream
energy infrastructure.
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DISCLOSURE:
1) Zig Lambo 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:
None.
3) Kenny Feng: 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: None.
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