By The Energy Report, on November 11th, 2011
 Fertilizer companies have felt the pain of global monetary chaos, but as indicators lag, some potash equities are positioned ahead of the curve for big gains. Dundee Capital Markets Vice President and Senior Financial Analyst Richard Kelertas believes investors need to be sharpening their pencils and establishing positions. In this exclusive interview with The Energy Report, Kelertas shares his best names.
The Energy Report: There’s been damage done to potash stocks over the past six months. Why?
Richard Kelertas: Macro issues have hurt all commodities. When the world is worried about its next breath, all these stocks get hit very hard. We’ve had the Euro crisis and then the Greek debt crisis since these stocks peaked in summer. Also, I think there were expectations that North America and Europe would emerge from the last serious recession with half-decent growth going forward, and that recovery would be moderate, measured and continual from 2010 all the way up to 2013–2014. That’s now been interrupted by macro events, and the odds that they will be quickly resolved is almost nil. We are going to have to deal with slower economic growth worldwide, not just in the eurozone and North America, but also in China and all of Asia because it’s all interdependent.
We will also have to expect that the consumer will be drawn back a bit, both in Western societies where food is a necessity and a luxury, and in developing economies where it is a necessity. So, high-end food values, high-end organics and food stocks that are higher priced will be under pressure. That means lower requirements for meats, which means that the farmer may be cutting back on his crop output.
TER: Can you make a case for growth in potash consumption?
RK: For the next six months, I expect flat growth. Prices and volumes have retreated slightly. Inventories dropped in October. That’s good news. I expect prices will be flat to down.
However, if Europe’s debt crisis and low North American growth are resolved in the next 6–12 months, we could then see Asian export nations gear up again. That means that their diets will improve again, and crop prices and speculation in crop price increases going forward will pick up. That will happen sooner than six months in the futures market, but at the same time my expectation is that the next six months are going to be slow.
Within the next year, we should see some growth return. That will be composed of three components: Farmers will use potash at normal levels and growth will be reflected in shipments and prices. Lands that will be brought back into production will expand demand. This is fallow or abandoned agricultural land throughout the world, especially in Africa, that has been bought up by either investment pools or sovereign wealth funds or specialty farm land managers. In the grand scheme of things that doesn’t seem to be a lot in terms of the total farmland area throughout the world; however, potash application rates will be much higher than normal because you are bringing it from infertility to fertility levels. So, we could see a substantial push and it will show up in perhaps a 0.5–0.75% increase in potash demand worldwide.
TER: Are you able to venture a forecast on the price of potash?
RK: My international price forecast, the Vancouver export price, is about $450–465 per ton (/t) right now. For 2012 we expect an average price of $505/t and then moving to $520/t average price in 2013. The peak price in 2013 should be around $650/t, maybe $625/t. But, it won’t be as high as the $700-725/t that I thought may take place when I made that forecast a year ago.
TER: Are fertilizer prices leading or lagging economic indicators?
RK: They are lagging indicators. We need to see economic activity pickup first. The mood of farmers is always pretty gloomy, and getting them to change their view on world markets requires crop prices to move. But, crop prices won’t move really unless you see economic activity pickup.
TER: Is potash still low-hanging fruit? Or is it getting much more difficult to mine?
RK: That’s a good question. We just put on a seminar and heard from ERCOSPLAN, the German exploration consulting firm that has provided a lot of NI 43-101s for potash projects throughout the world. If you’re doing deep shaft, it is very expensive and time consuming, and there are long lead times. I would say that most of the best sites, except in Saskatchewan and Russia, are deep-shaft mines. There may be one or two open-pit opportunities in Ethiopia or in Utah where you’ve got very shallow deposits. Solution mining, though, provides you with the opportunity to get several large sites into production in a relatively short period of time.
But the limiting factor right now is financing, and that’s because you’re dealing with $800 million (M)–1 billion (B) for a 1–1.5 billion tons per year (tpa) equivalent of potash, even for a solution mine. The second limiting factor is cash balances. If we are going to have a long, drawn-out economic downturn here, which is quite possible, then very few of these projects will come to fruition and get into production. They will run out of cash before they can either get taken out or get the financing. So, there are only a couple of strong plays that have plenty of cash and, where cash-burn rates are low, can survive this downturn and lack of liquidity in the marketplace. The third thing is that we could possibly see some deep-shaft mines flood over the next 6, 12, or 24 months like we had in Russia with Sil’vinit (acquired by Uralkali OAO (URKA:RTS; URKA:MICEX; URKA:LSE). We could see something possibly happen in Saskatchewan or in other areas. And I don’t think it’s a question of “if”; I think it’s a question of “when”. Many deep-shaft mines are 2,200 meters down. A lot of money is being spent pumping out water, and you could see some production disruptions. If that’s the case then the market could get tighter very quickly.
TER: Limited access to financing could be a major problem for small companies, couldn’t it?
RK: Yes, absolutely. I think about 100 worldwide projects are being considered in potash, both public and private. I would say 10–15% of them have a hope of getting financing, and of that, I think perhaps three or four might actually get financing.
TER: From everything you’ve just said it sounds like margins are going to have to contract or that prices are going to have to go up. Where does this put the potash producers?
RK: Well, at the current pricing their margins are pretty good. For instance Potash Corp. (POT:TSX; POT:NYSE; Not Rated) is the most visible, and its operating margin, not gross margin, so we’re talking before interest, is about 40%–45%. Terra Nitrogen Co., L.P. (TNH:NYSE; Not Rated) is 65%. CF Industries Holdings Inc. (CF:NYSE; Not Rated) is 60%. Now CF is urea, and it’s a different kettle of fish, but Potash Corp. is about 40%. So, prices can come off quite a bit before they’re going to have any issues. However, I can tell you that any projects that are not in progress will be put on the back burner. You need to have potash pricing power. For instance, BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK; Not Rated) Jansen Project in Saskatchewan needs average long-term potash prices of about $500–550/t really to make a go of it, and from my work the long-term international price is about $410–425/t.
But to answer your question, in a lot of cases their cost inputs have gone up too. So, if they have the combination of prices falling while their cost inputs remain high for let’s say two, three or four quarters, their margins are going to get squeezed quite substantially. But there is no doubt about Q112 and Q212, so If this economic crisis settles down, they’re going to push for higher prices.
TER: The large-cap companies have so many advantages. It seems like there’s so much risk in the small-cap potash equities.
RK: Right: That’s why they’ve been hit very hard. The juniors are the most at risk.
TER: What regions are the most favorable for companies right now?
RK: I would say the best places are Saskatchewan, Utah, Arizona and Ethiopia in Africa.
TER: What specific companies are you telling your clients to invest in?
RK: We’ve been very consistent in the stocks we like since the economic crisis of 2008. On the large-cap side, Agrium Inc. (AGU:NYSE; Buy) has probably had the lowest margins of the big-cap names, but it tends to have the most diversity in its product mix. It has a wholesale nutrient division, a retail division and a specialty fertilizer division, which includes distribution. In a tough economic environment, we opt for diversification. In a very strong commodity market, it makes sense to go to single commodities or pure nutrient plays like Potash Corp., CF Industries, Terra, The Mosaic Company (MOS:NYSE; Not Rated) or Intrepid Potash Inc. (IPI:NYSE; Not Rated). Because we expected the economic recovery to be very difficult, we liked Agrium the best in the large-cap space, and we still feel that way. Until we see commodities fundamentals suggesting a speeding up of economic recovery, we’ll stick with Agrium on the large-cap side.
TER: What about small caps?
RK: On the small cap side our top picks continue to be Allana Potash Corp. (AAA:TSX; ALLRF:OTCQX; Buy) and Karnalyte Resources Inc. (KRN:TSX; Buy). They have the most cash, the lowest burn rate and they are the closest to production and financing. They have all the components in place, including their NI 43-101 resource estimates. But they both have different advantages and disadvantages. Allana has the possibility of being an open-pit mine, or open-pit/solution mine combination, or just a solution mine, which would be low cost because of the solar evaporation in Ethiopia.
Karnalyte is a solution mine, but it’s a gigantic deposit and will probably only need one cavern for 10 years. It does not have to do a lot of drilling. But if it does, the drilling will be horizontal. The key thing with Karnalyte is that it has boron-free magnesium chloride. That is attached to the potassium salt, KCL. The magnesium chloride comes out with the potassium. Thus, its extraction costs are not any different. Refining costs are going to be a little bit more expensive to separate the magnesium chloride, but that’s an extra revenue source.
TER: So, Allana is getting the magnesium chloride practically for free?
RK: That’s correct. Allana has not only the opportunity for MOP (muriate of potash), which is the standard potash, but also SOP (sulfate of potash), which sells at a premium. When the first million tons is fully operational, Allana will be able to produce 20–30% SOP.
TER: Karnalyte is up 31% over the past 12 weeks, and it’s the only one I see with its head above water over that period. Most others are the mirror image of that, down anywhere from 20–40%. Why such high relative strength?
RK: I think there are a few things: One, it has been getting its story out aggressively. Number two, it has been very close to getting the feasibility portion of its magnesium chloride production, and that will be ready by the end of November. I think that’s the most important thing, and it is just now starting to be understood by the market, which has been quite anticipatory of that. Three, there’s been some talk on the street that Karnalyte has worked a 30% contingency into its production costs, which is a lot higher than what it will actually work out to be. That means that its return on the project is much higher, we think, than what the company has been telling the street.
TER: How much per ton is the magnesium chloride right now?
RK: Well, it sells anywhere from $450–700/t depending on the end-product use and the purity levels. It will almost be a one for one. I think that Karnalyte will be able to get 600,000 tpa of magnesium product that they’ll be able to take out of the ground. That’s not factored into its numbers, but my NAV reflects that expectation to a small extent. So, it could be double the size in terms of profitability and revenue than the consensus on the street.
TER: Your target price on Allana is $3.05, which is an implied return of about 200% from current levels. I’m wondering about its preliminary economic assessment (PEA) due out before year-end. What is that going to tell investors?
RK: Well, I think it is going to solidify the resource in terms of measured/inferred. And of course, you’ll get a good idea of whether Allana can go to an open-pit or solution or both. More than everything else it’ll firm up the opex and capex. It will be quite clear that the area will support not just a million tons per year (Mtpa), but 2–2.5 Mtpa.
TER: If it is a solution mine, how much advantage will the solar heat evaporation be?
RK: If it’s open-pit, opex will be $40–50/t. If it is a solution mine it’ll be $65–70. A typical solution mine with natural gas or coal evaporation costs would be close to $90–100/t.
TER: What other companies are you talking to investors about?
RK: Well, at our conference we had nine presenters. Of course Allana and Karnalyte were there. We also had Passport Potash Inc. (PPI:TSX.V; PPRTF:OTCQX; Restricted). There were others at the conference that we have put on our watch list, and we are bringing them forward to investors as items of interest. We are looking at the resource and numbers on each one. They include Western Potash Corp. (WPX:TSX.V; Neutral), which just came out with a further update on its NI 43-101 and firmed up its resource estimate and capex/opex. We had IC Potash Corp. (ICP:TSX.V; ICPTF:OTCQX; Buy). We had Encanto Potash Corp. (EPO:TSX.V; Buy) and we also had ENP Minerals, which is hoping to get going in Utah. We had Rio Verde Minerals Development Corp. (RVD:TSX; Neutral), Epm Mining Ventures Inc. (EPK:TSX.V; Neutral) and Verde Potash (NPK:TSX.V; Neutral). So, we’re talking about those and getting up to speed as well on the numbers and the resource for each one of those companies. We’ve issued research on them and put them on our watch list, but we don’t have firm numbers or target prices for them yet. We will continue to speak with those companies.
TER: Western Potash CEO John Costigan noted that his company has the largest resource base of current junior potash explorers and developers. What does that mean to you?
RK: Well, there’s the old adage: It’s not necessarily how big it is but how low-cost it gets. To me, quality or concentration of the resource is number one. You have to take a lot of brine out before you get a half-decent concentration of potash. So, it is going to be all about costs. It seems to have fairly low opex costs, but I have to check into that and do more work on it. On the surface, costs seem to be a bit low compared with comparable projects. The initial capex of $2.5B to get it started sounds reasonable for a 2 Mta mine. I think it’s going to be a question of distance to market and ease of getting the mine up and running.
TER: Encanto was one of the presenters at your conference. How much can it expand its resource?
RK: From the information we have, we think the resource could be expanded quite significantly. With all the agreements Encanto has with native groups in Saskatchewan and its proximity to the Esterhazy deposit where Potash Corp., Agrium and Mosiac all operate, I think it has a good chance of expanding its resource anywhere from 25–50%. That is quite possible. But, again, before we make any pronouncements on it, we’re going to be speaking with management and talking with the engineers and geologists.
TER: Were there any other companies you wanted to mention?
RK: Not at this stage. We haven’t done enough work on, for instance, Ethiopian Potash Corp. (FED:TSX.V; FED.WT:TSX.V; Not Rated). We haven’t done enough work on IC Potash or EPM Minerals. So, we’ll reserve judgment on those for the time being.
TER: Richard, it was a great pleasure speaking with you once again.
RK: No problem, my pleasure as well.
Richard Kelertas has 25 years experience as a research analyst covering the forest products sector. He has been one of the top-ranked analysts in the sector over the years consistently, and was most recently ranked No. 1 by Brendan Woods. Kelertas has worked for a number of well-known brokerage firms, including ScotiaMcLeod, Deutsche Morgan Grenfell, UBS Warburg, and Desjardins Securities. He has a bachelor’s degree in forestry and a master’s degree in forestry and economics from the University of Toronto. Richard is also a Registered Professional Forester.
By Christopher Briem, on November 11th, 2011
By Simon Grey, on November 11th, 2011
As I mentioned before, I’m currently enrolled in a microeconomics course that makes use of Mankiw’s textbook. I haven’t read much of the book, save for the assigned homework questions and his chapter on oligopolies. He begins with a discussion of monopolies, and asserts that Microsoft is an example of a market monopoly. This claim struck me as quite hilarious for two reasons.
First, Mankiw uses a very narrow definition of market to prove his point. Instead of placing Microsoft in a software market, he claims that Microsoft has a natural market monopoly on Microsoft software, since one can only acquire Microsoft software through Microsoft.*
What Mankiw should say, in order to be precise, is that one can only legally acquire Microsoft software from Microsoft. But this would undermine his point, because what enables Microsoft’s monopoly power is not the natural mechanisms of the market but rather the government, via intellectual property laws. Therefore, Mankiw’s narrow definition fails because it Microsoft’s monopoly power is the result of governmental favoritism and is not a natural market monopoly.
The second thing that makes Mankiw’s claim laughable is that he ignores the broader market of software. There are plenty of alternatives to Microsoft software. Mac, Linux, and Unix are all alternatives to Windows; OpenOffice is an alternative to Microsoft Office; Wii and PS3 consoles and games are alternatives to the Xbox console and games; etc. Mankiw, if he were being honest, would say that Microsoft cannot force anyone to buy any of their software, and is therefore not a monopoly in the sense of being able to make prices.
Of course, if Mankiw were concerned with honesty, he would have to say that Microsoft, though not a true monopoly, does have a limited form of monopoly power via government regulation. Saying this would be heretical to mainstream economics because the natural conclusion of this assertion is that improving market function would require less government, not more, and we can’t have that.
* Of course, this latter claim is patently false as one can easily acquire Microsoft software on a variety of torrent sites.
By B.P.T., on November 11th, 2011
At 9:55 AM EDT, Consumer Sentiment for the first half of November will be announced. The consensus is that the index will be at 61.5, which would be an increase of 0.6 points from the level reported in the second half of last month.
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By Simon Grey, on November 10th, 2011
The largest burden of corporate taxes is borne by workers.We discover that by asking a simple question, such as: Which workers on a road construction project earn the higher pay, those employed moving dirt with shovels and wheelbarrows or those doing the same atop giant earth movers? You’d guess the guys operating the earth movers, but why? It’s not because they’re unionized or because construction contractors have a fondness for earth mover operators. It’s because those workers have more capital (tools) to work with and are thereby more productive. Higher productivity translates into higher wages.
Tax policies that raise the cost of capital formation –such as capital gains taxes, low depreciation allowances and corporate taxes –reduce capital formation. As a result, workers have less capital, lower productivity and lower wage growth. In 1980, Joseph Stiglitz, now a Nobel laureate, said that workers share the highest corporate tax burden in the form of lower wages. A number of economic studies, including that of the Congressional Budget Office, show that workers bear anywhere from 45 to 75percent of the corporate tax burden. Adding to the burden is the fact that capital has the kind of mobility that labor doesn’t. Corporate capital can flee to other countries easily, but workers cannot.
I’ve hammered on this before, but it bears repeating: Only people pay taxes. Corporations are nothing more than legal fiction and, at the end of the day, an actual human being has to pay taxes.
What’s intriguing is how workers end up paying more in taxes than consumers. It does make sense, though, since the current legal and political system in the United States encourages consumption and discourages capital accumulation. At any rate, it should be clear that it takes a significant amount of ignorance to talk about taxing corporations. This cannot, and will not ever be done; only people can be taxed, and so it would be more constructive talk about how best to go about taxing people.
By The Gold Report, on November 10th, 2011
 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, gives us the ins and outs of the MLP business, highlighting the unique benefits and risks associated with these income-generating investment vehicles.
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.
By Ajay Shah, on November 10th, 2011
We know a lot about price controls from the field of exchange rates. Here’s an argument from way back, in 1998:
When change comes to a stabilised currency, as it must, that change is painful. Change in the long term is inevitable. The random walk doles out a little change every day, which is less painful than sudden large changes.
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Currencies which are random walks yield a deeper sort of stability. The steady pace of small changes every day generates realistic expectations about currency risk and continual realignment in production processes in the economy. It avoids sudden changes, and keeps the currency out of the domain of politics. The random walk regime is sustainable without incurring serious distortions in the economy.
In the field of exchange rates, India understood these arguments, and moved to a floating exchange rate. In March 2007, the INR/USD volatility moved up to roughly 9% and from early 2009 onwards, RBI stopped trading in the currency market. This was the biggest achievement of the UPA in economic reforms: In the 2007-2009 period, we got to a market determined rate on the most important price of the economy.
These same ideas are useful in thinking about the price of petrol. A large jump of Rs.1.8 per litre attracts attention. It is far better to let the price fluctuate every day. Ultimately, the price has to adjust. We suffer a lower political cost by letting it adjust every day (through the depoliticised market process). If we bottle up the small changes, then we have to make large changes. These are a bad use of political capital.
By Simon Grey, on November 10th, 2011
Recently, I’ve been thinking a lot about how pointless economic models are. A good portion of this is probably due to being in a college microeconomics class (which uses Mankiw’s book, which Vox picks apart here.). What passes for mainstream economics is nothing more than gussied-up tautologies and pretty models that don’t actually prove anything. What irks me most is how the proponents of the mainstream view—in this case my professor and Mankiw’s textbook—act so certain about everything they assert.
For example, Mankiw devotes a chapter to the actions of a monopoly in the free market, complete with very precise mathematical models. Yet, this entire chapter is utter B.S. because all the models in the world don’t change the fact that said models are based entirely on assumptions and tautologies, and stupid tautologies at that. The models, then, only say what the programmer thereof tells them to say. This isn’t science; it’s an appeal to personal authority, writ large.
In the same vein, an economic prediction is only going to be as accurate as the assumptions upon which it is based. The reason why so many mainstream pundits missed the housing bubble is not because they lacked computational power with which to build their macroeconomic models; it’s because their assumptions about the housing market and banking industry were wrong. They thought housing growth could be sustained forever, or that the current housing growth was organic instead of government-subsidized, or that the government would be able to subsidize housing forever, etc.
Trying to build on assumptions of arbitrarily-defined variables being correlated to one another is a recipe for failure, as is evidenced by decades of repeatedly doing so. The time has come to put away the pretentious belief in the need for mathematically precise models; this isn’t physics, after all. Ultimately, the foundation of economics must be built on understanding Man as an economic actor. This paradigm shift cannot come soon enough.
By B.P.T., on November 10th, 2011
At 8:30 AM Eastern time, the U.S. government will release its weekly Jobless Claims report. The consensus is that there were 400,000 new jobless claims last week, which would would be 3,000 more than the previous week.
Also at 8:30 AM Eastern time, the International Trade report for September will be released. The consensus is a deficit of $46.3 billion, which would be $0.7 billion more than the previous month.
Also at 8:30 AM Eastern time, the Import and Export Prices index for October will be released, providing some data that can be used to monitor the threat of inflation.
At 9:45 AM Eastern time, the weekly Bloomberg Consumer Comfort Index will be released, providing an update on Americans’ views of the U.S. economy, their personal finances and the buying climate.
At 10:30 AM Eastern time, the weekly Energy Information Administration Natural Gas Report will be released, giving an update on natural gas inventories in the United States.
At 2:00 PM Eastern time, the Treasury budget for October will be released, providing an account of the federal government’s budget surplus or deficit for that month.
At 4:30 PM Eastern time, the Federal Reserve will release its Money Supply report, showing the amount of liquidity available in the U.S. economy.
Also at 4:30 PM Eastern time, the Federal Reserve will release its Balance Sheet report, showing the amount of liquidity the Fed has injected into the economy by adding or removing reserves.
By Ajay Shah, on November 9th, 2011
In continuation of my previous post on piped natural gas, I found that Mahanagar Gas charges Rs.33/m^3 for natural gas. The energy content is 8500 kcal/m^3 or 35.56 MJ/m^3. This corresponds to 10 kwhr i.e. 10 units. In the units of electricity pricing, then, this gas is priced at Rs.3.3 per unit (i.e. $0.066 per unit). This is slightly cheaper than electricity but not by much. I’d have expected gas to be cheaper than this. This isn’t a pricepoint at which one can obtain a big shift from electricity to NG. It is more convenient than shipping bottles around, but that’s about it.
For a comparison, in Los Angeles, the price of gas works out to $0.036 per kwhr while the price of electricity is $0.132 per kwhr. That is, piped electricity is 3.667 times costlier than piped gas. It makes you wonder about what we’re doing wrong with natural gas in India. 
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