By The Energy Report, on February 8th, 2012
 Despite depressed natural gas prices, investors in master limited partnerships (MLPs) leveraged to natural gas liquids can expect both excellent income and share price appreciation, says Credit Suisse Senior Analyst Yves Siegel. In this exclusive interview with The Energy Report, Siegel discusses his favorite MLPs and their winning formula for double-digit returns.
The Energy Report: Yves, what can investors expect out of MLPs between now and the end of 2013?
Yves Siegel: Steady as she goes. The yields for our group now are around 6%, and we expect distribution growth to be about 7%. If Fed Chairman Ben Bernanke is true to his word, we’ll continue to expect an environment of low interest rates for the next two years. So if you combine the yield and the distribution growth, we think investors could see low double-digit returns.
TER: How do distributions grow?
YS: When contracts roll over on terminal assets, they typically roll over at higher rates because they’re competing with new facilities. In order for companies to get a return on their facilities, they need a certain price. Storage at Cushing, Oklahoma, for example, is relatively expensive to build. When contracts roll over for those existing storage assets, typically those rates can move up to the prevailing rate for new construction. Distribution growth results not only from contract rollover but largely from new builds and investments that come online, either through greenfield projects or through acquisitions. The MLPs as a group have been able to grow distributions by investing capital in excess of the cost of capital. That’s been a winning formula for quite some time.
TER: Do you see real estate partnership investors shifting their attention to energy MLPs?
YS: I would suggest that retail investors who are searching for yield and invested in real estate investment trusts (REITs) are now looking at MLPs. I would also include investors who have historically invested in utilities. I think MLPs have been around long enough now that investors are feeling more comfortable with investing in the security.
TER: Returns on your MLPs coverage universe have been excellent in recent months, some experiencing double-digital total returns. With more demand and buying, do you expect yields to grow in addition to distributions?
YS: No; I think yields will compress. The current average yield is around 6%. I wouldn’t be surprised to see that reduced to 5.5%, the rationale being that stock prices move higher once the market sees healthy returns. Demand for income-oriented securities remains pretty robust. In a low interest rate environment, people continue to look for places where they can safely park cash as opposed to keeping it under their mattresses. I expect a combination of increased distributions and continued higher stock prices. The result would probably be net-net compressed yields.
TER: Do you expect to see initial public offerings (IPOs) for these types of MLPs this year?
YS: Yes, I expect to see new MLPs come to the market.
TER: Everything you’ve covered suggests good health in this sector. What is your investment thesis right now?
YS: The themes have been threefold: One, invest in MLPs that are well situated to participate in burgeoning shale plays, because as producers pursue these plays, they need the infrastructure to support further production.
Two, we think natural gas liquids (NGL) fundamentals are strong and will remain strong for the foreseeable future because NGL prices correlate with crude oil prices. NGLs are a byproduct of a natural gas production, and current low prices for natural gas are part of the cost of producing NGL. But crude oil prices are high, and that determines the revenue stream NGLs will produce. This all speaks to a very favorable margin opportunity. We would suggest that MLPs that have exposure to NGL fundamentals should continue to do well.
Three, we like this notion that MLPs can buy assets from their sponsors at attractive valuations that enable them to grow distributions. These dropdown stories will continue to perform well over the next couple years.
TER: Are extraction products from natural gas the most profitable part of natural gas production?
YS: Yes. As we speak, natural gas prices have fallen below $2.50/thousand cubic feet (Mcf). Natural gas is very depressed, but what’s keeping the economics favorable is the fact that some of these plays, such as the Marcellus shale play, produce NGLs along with the gas. The NGLs triple the actual realization on the commodity because of the liquids content. So that is a very, very powerful thematic right now.
TER: What are your preferred standards for MLP growth and income?
YS: Our approach focuses more on total return. Simplistically, an investor can buy a stock that’s yielding 8% but has 3–4% distribution growth, and he or she would probably have an 11–12% return. Conversely, an investor could buy a stock that’s yielding 5% and is growing 7–8%, and wind up with a 12–13% total return. Balancing total return with calibrated risk is the right approach. Don’t try to capture total return and take undue risk. Overall, the market pays for growth.
MLPs with more growth typically have much lower yields, so it’s not inconsistent for us to recommend Western Gas Partners, L.P. (WES:NYSE), for example, which is yielding below 5% but which we think will have double-digit distribution growth over the next couple of years. At the same time, we could recommend Boardwalk Pipeline Partners, L.P. (BWP:NYSE), which is yielding around 8% and is going to have much more modest distribution growth of 3–4%.
TER: Let’s segue into your top MLP picks.
YS: Well, what we like about Boardwalk Pipeline Partners is that it has a very steady revenue stream tied to its interstate pipelines. With new management in place, we think 2011 was perhaps an inflection point for the company to try to focus more on growth. It has done so by buying storage assets from Enterprise Products Partners, L.P. (EPD:NYSE) and signing a gathering agreement with Southwestern Energy Co. (SWN:NYSE) in the Marcellus. We think there is an opportunity to accelerate the growth in distributions if management is successful. If management falls short of that goal, I think investors would still be happy with the safety of the yield.
The other company that’s within that interstate pipeline business model is El Paso Pipeline Partners, L.P. (EPB:NYSE). That stock came under a little pressure when Kinder Morgan Energy Partners, L.P. (KMP:NYSE) announced that it was buying El Paso Corporation (EP:NYSE) last year. I think El Paso Pipeline Partners was unduly punished because investors felt the distribution growth would slow. It is going to slow, because instead of having all of El Paso’s pipeline assets migrate into the MLP, now some of those assets will be migrating into Kinder Morgan. It’s almost a truism that the growth at El Paso Pipeline Partners is not going to be as robust because those pipelines will be moving into a different entity. However, we still think El Paso Pipeline Partners will be able to grow its distributions at 9%, and in fact, Kinder suggested as much. So we think a 5.5% yield and 9% distribution growth over the next couple of years is a good formula for success and a good formula for total return potential.
When you think about the other theme we spoke about, the strength of the NGLs, Targa Resources Partners, L.P. (NGLS:NYSE) fits into that. We like Targa because of the investment opportunities, the integrated model it’s pursuing within its midstream business and its very good management team.
We also like DCP Midstream Partners, L.P. (DPM:NYSE), which is another NGL story, but it’s also a dropdown story. There is the MLP, DCP Midstream Partners, and its sponsor, DCP Midstream LLC (DPM:NYSE), which is 50% owned by Spectra Energy Corp. (SE:NYSE) and 50% owned by ConocoPhillips (COP:NYSE). DCP Midstream Partners will continue to see assets migrate to it from DCP Midstream, helping to finance its growth while it pursues its own organic growth.
Then, within the dropdown stories and also in the midstream space, it’s hard not to mention Chesapeake Midstream Partners, L.P. (CHKM:NYSE) and Western Gas Partners, which I mentioned earlier. Both of these MLPs are owned by exploration and production (E&P) companies—Chesapeake Energy Corp. (CHK:NYSE) for Chesapeake and Anadarko Petroleum Corp. (APC:NYSE) for Western. The upstream parents are investing millions of dollars on building infrastructure to connect their wells, and the MLPs are helping to finance that via the dropdown. In the case of Western, it is having some good organic growth in the DJ Basin on top of what it can expect to acquire from its parent. We think Western and Chesapeake give investors nice, double-digit growth.
For investors who are looking for more safety, or simply more mature MLPs, Enterprise Products Partners LP probably represents the best in class, being the largest MLP and having a vast footprint within the U.S. spanning NGL, crude oil and refined petroleum products. It covers the whole spectrum, and it has an excellent management team. It has an excellent balance sheet and a great formula for 5% steady distribution growth as far as the eye can see. Enterprise is a real core holding and one that we would like to have in any MLP portfolio.
TER: Over the past 52 weeks Enterprise is up 15%, and it’s up 2% over the past four weeks. With a $43B market cap, what are its growth prospects?
YS: Well, it is investing $3–4B annually in organic growth projects. Let’s not forget that it will cost billions of dollars to build U.S. energy infrastructure that supports shale play development. We think that a majority of that spending is being done by MLPs and Enterprise is a good case in point. That runway is probably pretty long, meaning infrastructure spending should last several years. That bodes well for the MLPs that are investing the capital and should be generating returns that support distribution growth.
It’s not only the size of the company that matters, but the ability to execute projects efficiently and cost effectively, using existing assets in some cases that provide leverage. For example, Enterprise will be using some of its existing pipeline and its right-of-way in order to realize its planned ethane line, stretching from the Marcellus to the Gulf Coast. The joint venture crude pipeline that it is doing with Enbridge Energy Partners, L.P. (EEP:NYSE) from Cushing to the Gulf Coast makes use of an existing pipeline there. It is reversing the Seaway pipeline at an extremely reasonable cost, which speaks to your point that there are not many companies out there that have the infrastructure or the entrepreneurial spirit to go after these projects.
TER: Are there any other companies that exhibit this entrepreneurial spirit?
YS: ONEOK Partners, L.P. (OKS:NYSE) has an excellent management team, and it is also a play on the burgeoning NGL market. I would also mention Magellan Midstream Partners, L.P. (MMP:NYSE), which is focused on crude and refined products pipelines.
TER: Both of those companies have had tremendous runs recently; ONEOK is up 39% over the past 52 weeks, while Magellan is up 21% or so.
YS: Both of those stocks have good growth characteristics and excellent management teams, but investors might want to wait for a better entry point before buying. They’ve certainly had really terrific runs.
Sunoco Logistics Partners, L.P. (SXL:NYSE) is also doing its bit to take advantage of getting ethane out of the Marcellus. It is also helping to de-bottleneck the amount of crude oil that’s trapped at Cushing by moving crude production from the Permian Basin down to the Gulf Coast instead of north to Cushing. I put it in the same sort of category, as it has a good management team, strong balance sheet and very good growth prospects. All those good things are reflected in the stock price, so a better entry point might be worth waiting for.
TER: Sunoco Logistics has pulled back a bit over the past four weeks, but not much.
YS: I’d just like to stress the fact that the companies in the MLP class are very transparent because of cash flow. It’s a very good pass-through structure for getting cash back to shareholders in a tax-efficient manner.
TER: If you had to pick one of these MLPs as a very favorite, what would it be? Or should investors choose a basket of MLPs?
YS: My thought is that investors are best served by diversifying within a basket of MLPs. I don’t think MLPs are mispriced securities, so you’re not necessarily going to have outsized returns, nor do I think investors who are looking at the bond and stock markets could really expect outsized returns. For the equity market, if investors could see a 6–8% type of total return, they should be pretty happy.
TER: Yves, we haven’t seen any large gains in the price of crude over the past six months, and we have certainly seen the price of gas depressed. If energy commodities began to strengthen, what kind of an effect would that have on these MLPs?
YS: It would affect different sectors in different ways. With the gathering and processing companies, most of the contracts are for a percentage of proceeds. The MLPs do a pretty good job of hedging their commodity risk out one to three years. But in a strong NGL- and crude oil-pricing environment, net-net they would benefit. Low natural gas prices are positive for gas processing margins. However, some intrastate pipelines would see diminished volumes if drilling slows down in dry gas areas. If crude and gasoline prices were to get too high and gasoline prices get too high, refined petroleum product pipelines might experience some negative pushback because of declining volumes in their pipelines.
TER: Thank you for sharing your knowledge and time today.
YS: You bet. Thank you.
Yves Siegel joined the Credit Suisse Energy Research Team in June 2009 to cover the MLP and natural gas pipeline sectors. Immediately prior to joining Credit Suisse, Siegel was a senior portfolio manager at a New York hedge fund focused on MLPs. Prior to his buyside experience, Siegel had established a leading sellside MLP franchise, having spent more than 10 years at Wachovia Securities after prior sellside engagements at Smith Barney and Lehman Brothers. He has received both a BA and an MBA from New York University and is a CFA charterholder.
By The Energy Report, on January 11th, 2012
 John Edwards, first vice president covering energy infrastructure master limited partnerships for Morgan Keegan, is bullish for 2012 and well beyond. In this exclusive interview with The Energy Report, Edwards highlights how this sector pairs a low-volatility asset class with stable, secure distributions—a rare combination in today’s markets.
The Energy Report: A year ago, you forecast average returns of 10% with the yield spread between master limited partnerships (MLPs) and 10-year U.S. treasuries at 290 basis points. How accurate did your forecast turn out to be?
John Edwards: It turned out fairly well. The actual performance for MLPs beat our original expectations by about 390 basis points. On the last trading day of 2011, we were looking at 13.9% total return.
We targeted yields on the sector between 6% and 6.5% and it ended near 6.1% at the lower end of our targeted range.
TER: What is the current yield spread?
JE: The current yield spread is approximately 4.2%, 420 basis points.
TER: Do you believe MLPs are valued fairly right now?
JE: We think fair value in the year ahead should be in the 5.75% to 6.25% range, which is where we are. In that regard, MLPs are fairly valued.
If you look at it from the standpoint of spreads against U.S. 10-year Treasuries, you can make the case that MLPs are undervalued. Over the last decade, the average yield spread between MLPs and the U.S. 10-year has been about 324 basis points. Over the last five years, it has been 385. Obviously, that was skewed by the financial crises in 2008 and 2009. The most commonly occurring yield spread is in the range of 200–250 basis points.
We prefer to be a little conservative. With respect to valuation, MLPs have averaged a 7% yield over the last 10 years, and about 7.4% over the last five years. Inevitably, we expect there will be some spread compression, more due to a rise in the yields on the U.S. 10-years than to drops in the yields on MLPs. But overall, looking at the sector’s history, we consider 6% or so to be a very commonly occurring yield.
TER: Will total returns nearing 12.5% in 2012 lead to a flight into MLPs by retail investors? After all, virtually nothing else out there is performing at a consistent level.
JE: On a risk-adjusted basis we think MLPs offer a very compelling opportunity. For 2011 we targeted 6–6.5% yield and a distribution growth of 4–6%. We believe distribution growth ended up at the high end or a bit above. For 2012, we think the growth will be a bit stronger. We recently raised our target to about 100 basis points, or 5–7% growth. We are now thinking it will be even stronger, maybe 6–8% for 2012, in which case, we would be looking at a total return expectation somewhere between 10–22% for 2012. That would put our mid-point expectations in the 15–16% range for 2012.
TER: As of mid-December the Alerian MLP Index, which is basically the industry benchmark, was down half a percent from an all-time high set earlier in December. Did that surprise you?
JE: That did not surprise us too much. The last three months have been surprisingly strong for the sector; it has been at or very near its all-time highs. The Alerian benchmark has recently surpassed its all-time high, set in April 2011 on a price basis, and of course has set an all-time high on a total return basis.
There are not many opportunities for investors where you can find a low-volatility asset class paired with stable, secure distributions. This is a sector with tremendous visibility in terms of growth over the next 20 years. It is very difficult for us to think of other asset classes available to investors that offer what MLPs offer right now.
TER: In 2011, gas processors and MLP general partners were the best-performing MLP subsectors, with total returns at about 18% for gas processors and 17% for general partners. Do you see that trend continuing for 2012?
JE: We do. The opportunity for gas processors remains very strong. A tremendous amount of opportunity remains in shale plays where there is a lack of infrastructure. There is a lot of wet gas out there, which creates demand for the services needed to separate the gas from the liquids.
It is also important to note that fractionation capacity is also in short supply. We expect the capacity of raw liquids pipeline to be much greater than the fractionation capacity additions over the next few years. Consequently, we think companies involved in those businesses should do very well.
The one risk we are always mindful of and that is difficult to diversify away is commodity exposure in gas processing that arises from difficulties in the financial sector. Whenever there is trouble in the financial sector, it tends to create headwinds in gas processing, as natural gas liquids (NGLs) that are produced tend to tie more closely with oil, which in turn could face downside, should we see contagion from the European banking and the financial sector. NGL prices are important to natural gas processing/fractionation margins. We saw this in 2008 and 2009. But assuming the financial sector stays relatively healthy, gas processers should do very well in 2012.
TER: Conversely, it was a rough year for propane and shipping MLPs. Propane MLPs were down around 6%. Do you expect this subsector to rebound?
JE: This was a challenging year for propane MLPs. There is ongoing conservation in that subsector, and as a result, there is no organic volumetric growth at the retail level. Rising propane exports have kept wholesale propane prices relatively strong, which cuts into margins for the propane companies.
We expect the challenges for propane to continue. The subsector is ripe for consolidation. The irony is that, should there be difficulties in the financial area, propane companies would likely do well because wholesale propane prices would probably fall. But barring that scenario, we think propane companies are more likely to lag.
TER: Your recent Morgan Keegan MLP Top 10 list carries the caveat that those names are not necessarily the best fit for all accounts and are not necessarily how you would build an MLP portfolio. How would you build an MLP portfolio?
JE: In building an MLP portfolio our bias is to protect investors’ interests, to protect against downside risk. Thus, although we believe gas processors have perhaps the best upside potential, there also is more downside exposure to difficulties in the financial sector. With that in mind, we tend to overweight the larger-cap MLP names. But we would certainly want to continue to have exposure to that area.
TER: EV Energy Partners, L.P. (EVEP:NASDAQ) holds the top spot in the Morgan Keegan MLP Top Ten, largely due to its exposure to the Utica Shale. Please tell us about that play and how EV Energy is leveraging it.
JE: EV Energy Partners is an unusual MLP, in that it is in the upstream area, meaning it is involved in oil, gas and liquids production. It has a very strong position in the Utica Shale, about 158,000 acres. A number of wells have been drilled there, and it is providing a lot of data points indicative of a play with very strong potential. Some reports liken its geologic characteristics to the Eagle Ford Shale, which has been a very, very strong play.
We need more data, but based on a number of announcements from other players that have signed up for takeaway pipeline capacity out of the Utica Shale, we believe there is tremendous potential, and that it is only a matter of time before EV Energy Partners is able to realize some of that upside. That is why we think it has one of the strongest total return potentials for the coming year. We also see that at current valuation levels investors are effectively valuing the Utica acreage at just $5,000-$7,500/acre compared to recent transactions that effectively valued the acreage at $10,000-$15,000/acre, again supportive of upside potential in the value of EV Energy Partner units, in our view.
TER: It performed remarkably well over 2011. At the beginning of December, its total return for 2011 was close to 80%. Do you expect similar performance in 2012?
JE: Not quite as strong as 80%—somewhere between 27–73%. A good midpoint would be ~50% total return over the next year.
TER: That is still impressive. In January 2011, you named MarkWest Energy Partners, L.P. (MWE:NYSE.A) as one of your top picks. This year it is in your top 10. Why?
JE: MarkWest Energy had a very strong 2011, with a total return exceeding 30%. It has a very well-positioned footprint in the Marcellus Shale. It continues to have very rapid growth, providing midstream assets and services. We also believe it will be very well positioned to take advantage of emerging demand for services in the Utica Shale. We expect MarkWest will be able to invest hundreds of millions of dollars in the Utica and Marcellus Shales each year over the next several years. With that kind of visibility and potential for tremendous distribution growth, we are looking at returns averaging at least in the mid-teens for the next several years, with strong balance sheets and strong distribution coverage. Most portfolios ought to have exposure to MarkWest Energy Partners, in our view.
TER: And, you recently raised your price target to $66.
JE: Yes, as a result of its decision to buy into a joint venture with the Energy & Minerals Group for $1.8 billion (B). The two will be forming a subsequent joint venture to take advantage of the Utica Shale. We expect an announcement in January about additional plans to serve producers in the Utica Shale play.
TER: In a recent description of your investment thesis for the next few months, you included “exposure on liquids and storage” among the attributes you are looking for. Which midsize names in the liquids camp do you favor?
JE: One of the names we believe has very strong potential over the next year is Enbridge Energy Partners, L.P. (EEP/EEQ:NYSE). The partnership itself is based in Houston, but the parent is up in Calgary.
TER: What sort of distribution growth is Enbridge targeting in 2012?
JE: Enbridge’s target is in the 2–5% range, a very conservative target. We believe that given its position, recent performance and opportunities, Enbridge is more likely to be in the 5% range, giving the units some upside potential from a valuation perspective.
TER: Canadian regulators recently approved Enbridge’s Bakken pipeline project to carry oil from the Bakken into Canada, where it would connect with Enbridge’s main line in Manitoba. Is that a significant catalyst?
JE: That is just one project among many. Enbridge has $1–1.2B in projects on the drawing board over the next year. We believe all of those will contribute to Enbridge’s longer-range growth prospects.
We also like Plains All American Pipeline, L.P. (PAA:NYSE) over the next year. It has had a very strong run recently, but we think it is well positioned for the long term.
TER: Plains All American is a large-cap MLP. It made a number of acquisitions last year, including buying BP’s Canadian NGL and liquefied petroleum gas businesses. Which of Plains’ acquisitions are you most excited about?
JE: The one that you just mentioned. We think Plains was able to acquire the BP assets at a very attractive multiple and that it will be immediately accretive. Because the guidance on that contribution was very conservative, the distribution growth rate was raised recently. We anticipate it will be in the 9% range next year. Now a large part of that has been captured recently in its valuation. But, given the conservatism embedded in the guidance, we see a potential for more upside.
TER: You have an outperform rating on LINN Energy LLC (LINE:NASDAQ). Why do you believe Linn will outperform the S&P 500 in 2012?
JE: We think Linn has good distribution growth prospects. We also think it is pretty attractive valuation-wise. We are looking at somewhere in the neighborhood of 6–8% growth and distribution over the next couple of years. You combine that with its ability to make accretive acquisitions and its robust development program, and we think Linn should continue to do well with a roughly 18–20% total return prospect over the next 12 months.
TER: Do you have any parting thoughts for us today?
JE: We continue to be bullish on MLPs for the next several years at least. And we think MLPs should have a place in almost every investor’s overall portfolio.
TER: John, thank you for your time and your insights.
John D. Edwards, CFA, joined Morgan Keegan in October 2006 as a vice president, covering energy infrastructure master limited partnerships. Prior to joining Morgan Keegan, Edwards was a managing partner of Vektor Investment Group, LLC, where he consulted on energy infrastructure projects and real estate development. Edwards also worked with Deutsche Bank Securities as a vice president and senior analyst covering natural gas pipelines and as an associate analyst covering automotive suppliers. Edwards began his career in the energy industry with Edison International where he worked in regulatory finance, M&A, project finance, and business development. He received his Bachelor of Arts from Occidental College in Los Angeles, California and a Masters in Business Administration from California State University, Fullerton, and he holds the Chartered Financial Analyst designation. He is also a member of the Financial Analysts Society of Houston, Texas.
By The Energy Report, on December 28th, 2011
 According to Jim Letourneau, author of the Big Picture Speculator, oil and gas aren’t going away any time soon. Indeed, new technologies offer the industry and investors profitable opportunities. Read more about why Letourneau considers shale gas, shale oil and enhanced oil recovery “game changers” in this exclusive Energy Report interview.
The Energy Report: Jim, in a nutshell what is the big picture in the oil and gas space right now?
Jim Letourneau: Despite a big renewable trend, oil and gas are still critical to world energy markets. We will need both for the foreseeable future, at least the next decade.
TER: You recently wrote about fear paralyzing the market. What effect is fear having on you as a newsletter writer?
JL: When people are scared, they want dividends, U.S. dollars and precious metals. No matter how interesting or exciting the company is, in a really strong bear market it will not matter unless the assets are productive today. People will look at a mine that is in production and has cash flow. A project that involves lots of drilling to build out a deposit is a tougher sell.
Most newsletter writers, myself included, do not like talking about companies whose stocks do not appreciate. Fewer people want to be invested in the stock market because they don’t see why they should be. However, even that can be an opportunity. When people are fearful, sometimes the market can turn and have a really nice run. If we do not have new lows over the next couple of months and the trend changes, we would hypothetically be able to enjoy that for quite some time.
TER: Some oil and gas companies are boosting dividends in an effort to get attention in the market. Do you expect that to continue?
JL: That is a way of showing off, of saying “Look, we are so comfortable with our business model that we can afford to pay out dividends.” If there is a bull market in dividend-paying stocks, there also could be a time when that popularity will end. It could be just a passing phase.
TER: But it does provide a bit of flexibility: A company can increase or decrease its dividend. It is one of the cards a company can play if it has a lot of free cash flow.
JL: Exactly. Some of the major gold producers are increasing their dividends. Everything else being equal, I would rather have a dividend from a gold producer than from a financial institution. Banks will tell you everything is great until the day before they collapse. If people are looking for dividend-paying stocks, at least gold mines or oil and gas companies have productive assets; they produce something of value. That’s where I would concentrate.
TER: That seems to be where the Chinese are concentrating. Sinopec just bought Daylight Energy Ltd. (DAY:TSX) for a little more than $10 a share, more than double the closing price the day before the bid. Do you think China will continue to turn its dollars into hard assets while dollars still have value?
JL: The short answer to your question is yes. China is making acquisitions all over the world every day of anything that is productive.
It tells you something about the state of the market that Canadian investors thought Daylight was worth less than $5/share and China waltzed in and paid $10 without any haggling at all. This was an opportunistic move by Sinopec.
Chinese companies have taken the clever strategy of going for lesser-tier companies. If they go for a bigger one, they will take a minority interest so it is not seen as a takeover.
TER: What did Daylight have that the Chinese wanted?
JL: Daylight has oil, natural gas and high-content natural gas liquids in a few different plays in western Canada. The Chinese are buying companies with the potential for productive assets.
I think China also has a very long-term horizon concerning its energy policies. The country is willing to invest in the long term over a broad portfolio of energy sources. The Chinese know that all the investments may not all work out, but they can afford to do it.
We are still building out the capacity to export natural gas from North America. If that happens, our low-price North American natural gas will be very attractive to China.
TER: At a recent investment conference in Montreal, you told the audience about three “game changers” in the oil and gas space: shale oil, shale gas and enhanced oil recovery (EOR). Can you please give our readers the nuts and bolts of your presentation?
JL: All three of those things involve new technologies that are squeezing more oil out of the ground than we ever thought possible.
In terms of shale oil, the best example is the Bakken in North Dakota and Saskatchewan, and possibly Montana and Southern Alberta. The Bakken really changed the oil and gas landscape in North America to the point of using trains to transport gas from North Dakota to Texas. And there are a lot of other source rocks that have the same characteristics and will be developed over time.
Shale gas was actually the first big game changer. Five years ago we were building natural gas import terminals because we thought we would run out of domestic natural gas. Today, North America has the cheapest natural gas in the world and we are building export terminals. It started in Texas, in the Barnett Shale. For every argument that says shale gas will not work, there are arguments that say it will. A lot of the technical problems that exist today will be solved in the not-too-distant future. That is one of the reasons I am not a huge believer in peak oil; yes, you can extrapolate present-day trends, but you cannot predict what human innovation will come up with to increase supply.
That leads to the third category, which is enhanced oil recovery. Big picture, roughly a third of the oil that has been discovered has been produced. Getting the next third out will take some innovation. There are a lot of interesting technologies in EOR that make it quite likely that the next third will be produced. Recovery factors can move up from 33% to 50% or 60%.
TER: I see your point on shale oil and EOR. But gas prices on the NYMEX are at record lows. Very few companies can make money at that level. The only shale-gas companies seeing an uptick in their share price deal with natural gas storage, and they are running out of places to put it. How can an investor make money in shale gas?
JL: There are two sides to the story. First, abundant, cheap shale gas is good for consumers of natural gas. Second, all commodity bull markets end.
Natural gas is not the best place to invest, but, it does point to the opportunities. The service companies that unlock the shale gas are doing fairly well. I suggest that people look not so much at the producing side but more on natural gas being used as transportation fuel. Some petrochemical industries and the steel industry will benefit from cheap natural gas. So, you have to be a little bit nimble.
TER: Could you give our readers a name or two in the shale-oil space?
JL: I really like Shoal Point Energy Ltd. (SHP:CNSX) because not too many people pay attention to the company. It discovered Green Point, an oil-in-shale play in Port au Port Bay in western Newfoundland. The Green Point shale can be over 2,000m thick, compared to the Bakken, which is typically 30m thick. The extra thickness really changes the amount of oil per section. Shoal Point has an oil-in-place number of at least 100 billion barrels, calculated from volumetrics. Production will be the challenge, but that is just too big a resource to ignore.
TER: The company also has the Ptarmigan oil-in-shale play in Newfoundland and the South Stoney Creek gas play in New Brunswick. How is Green Point progressing?
JL: There was a delay for further testing and Shoal Point had to wait for permits. Investors got a little discouraged because everybody wants results right away, and the share price languished.
Now, the company has the permits and will deepen the well and test it soon.
TER: In other Newfoundland oil projects, the provincial government has wanted a piece of the action. Does the government have a piece of this?
JL: I’m not sure. But, I cannot imagine Newfoundland not having a royalty interest because that is typically how we do things.
TER: Are there other shale oil plays?
JL: There are a lot in the Alberta Bakken, in Montana and southern Alberta, where that play has yet to really ignite and catch on fire. Companies are also looking in the Duvernay in Alberta. That is a deeper, Devonian shale that sourced a lot of the Leduc oil.
TER: Do you have any names in the shale gas space?
JL: Given that the price of that commodity keeps dropping, one way to play shale gas is through service companies. GasFrac Energy Services Inc. (GFS:TSX) has gotten a lot of attention for using gelled propane as the carrier fluid instead of water.
There has been a lot of concern about the use of water in fracking. Very few people realize that most oil and gas production in North America involves about 10% oil and 90% water.
People like GasFrac because it does not use water. But more importantly, in certain types of formations having a liquid hydrocarbon that changes to the gas phase when the pressure drops helps avoid the formation damage and other problems that can happen when you use a massive water-based frack.
TER: In terms of enhanced oil recovery, what names are you following?
JL: There are very few specific companies; usually it is an oil company with a project. One that I have been following for a long time, and worked for, is Wavefront Technology Solutions Inc. (WEE:TSX.V).
All versions of EOR involve injecting a fluid. It could be water, CO2, chemicals or nutrients. The more uniform and evenly distributed those fluids are, the better the process will work. Wavefront has patented an injection process that provides that uniform fluid distribution.
The company is not quite profitable yet, but the growth will come quickly from its Powerwave application for EOR.
TER: Wavefront now has a market cap of around $68 million (M). It would not take long for a major producer to get older assets to market if this technology works as well as you suggest.
JL: The biggest upside for oil companies using the technology is that they can increase their reserves without infill drilling. The oil industry does not just jump and try new technology; it likes to see some proof. Wavefront now has proof. The longest Powerwave installation is over four years old. It has numerous case studies that document how the technology works and how it makes money for the client. It has made the transition from an unproven technology to a proven technology. It is now a commercial technology with a lot of upside.
Wavefront is essentially a technology company that licenses its technology to oil companies. Wavefront will not have a lot of additional expense to sell 100 tools or 150 or 200. The scalability is exciting.
TER: If a major can apply that technology in its old basins, it would not take long to reach perhaps, $70M worth of oil.
JL: Definitely. Of course it depends on the size of its fields, but increasing ultimate production by 5-10% provides some big numbers. More and more people are seeing exactly that. Wavefront could become a takeover target. The company has roughly $24M in cash. It has a lot of staying power.
TER: Jim, what should investors be keen on in the oil and gas space in 2012?
JL: I would still look to oil and gas service companies with the right technology. Shale gas fracking companies are interesting plays to look at.
I would not be too excited about natural gas producers. Those producers who are moving toward liquid rich natural gas are a little more interesting.
Overall in the oil space, the only thing that would move oil prices any higher would be severe geopolitical tension. And I wouldn’t be shocked to see some unpleasant geopolitical tension in 2012. Economic news is creating tension all over the world. When that happens it’s usually pretty bullish for energy prices.
TER: Jim, thank you for your time and insights.
Jim Letourneau is a public speaker, geologist, corporate evangelist, and investor in emerging technologies and discoveries.
By The Energy Report, on September 16th, 2011
There are few places to hide in turbulent markets, but low bond yields and faltering commercial real estate are driving income investors to U.S. royalty trusts and master limited partnerships (MLPs), where high energy prices are generating huge quarterly cash distributions for shareholders. In this exclusive interview with The Energy Report, Raymond James Associate Analyst Kevin Smith discusses his favorite names where investors are reaping both income and growth.
The Energy Report: Could you start by explaining the differences between royalty trusts and master limited partnerships (MLPs)?
Kevin Smith: Absolutely. There are some unique differences between the two. Royalty trusts and the upstream MLPs I cover are both typically focused on oil and gas production, and that is how they generate cash flow. The difference comes down to whether or not the management team wants to be acquisition-oriented.
Upstream MLPs can be great vehicles for acquiring and consolidating mature oil- and gas-producing properties. However, a lot of explorer and producer (E&P) operators are great developers and operators of properties but don’t want to go out and be forced to acquire more assets. The latter category fits much better into a royalty trust because it has a finite life. And because it does have a maturity, as well as its structure, it’s fairly low maintenance. Other public companies are utilizing royalty trusts because they think it’s a great financing vehicle that will allow them to fund growth capital expenditure plans in a balance sheet friendly way.
Both the MLP and the trust are very much yield-oriented vehicles and can represent very attractive opportunities for the retail investor as well as institutional investors to gain exposure to the bullish uptrend in commodity prices.
TER: Would you think of royalty trusts as unmanaged asset portfolios?
KS: By definition, they’re non-operated trusts; however, what we have seen is that trusts do have a limited ability to drill new wells, at least developed trusts. Now we’re seeing more drilling trusts that have a commitment to drill a certain number of wells, but that don’t have the ability to add new properties or drill wells above and beyond what’s originally stipulated. These structured capital spending plans can provide very nice production and distribution growth in the early life of the trust.
TER: How does taxation vary between MLPs and trusts?
KS: Royalty trusts typically generate very, very minimal amounts of unrelated business taxable income (UBTI), if any; therefore, they are typically much friendlier in an IRA versus MLPs. Some royalty trusts are actually 1099 filers, which is similar to C-corporations.
MLPs are a bit more cumbersome. They are generally K-1 filers, so you have to deal with the nuances of that. A few royalty trusts are K-1 filers as well.
TER: What is the first line of due diligence that an investor should perform when looking at an MLP?
KS: You need to understand how the partnership generates its cash flow. Look at the assets first. We want to understand how capital-intensive the asset mix is and how stable and reliable the cash flow is in different commodity price cycles. Once you get a good feel for that, then you can start looking at the corporate structure. But cash-flow generation will tell you how sustainable the distribution is, as well as its potential for growth.
TER: This is not quite as critical in the royalty trusts, is it?
KS: No, it’s absolutely not. The key point of focus with royalty trusts is their termination date. They are very finite-life vehicles. For example, what we have seen recently are 20-year trusts, so investors need to understand how much cash flow they are going to receive over that 20-year period. Investors get into trouble if they assume that the cash flow is in perpetuity, and then overvalue some of the trusts based on those metrics. There are some perpetual trusts out there, but we don’t cover any at this time.
TER: So, generally speaking, the trusts are depreciating assets and investors should understand that they are getting part of their principal back in addition to income.
KS: Exactly.
TER: Clearly, there’s been major damage to all types of equity instruments over the past few months. But investors in MLPs and U.S. royalty trusts have done pretty well growth- and income-wise over the past year. Aren’t investors supposed to be getting yield at the expense of growth?
KS: That’s a good question. Historically that is true, but we think we have entered into a golden era of yields from commodity exposure. Because it seems like every government is running its currency printing press on its maximum setting, we are expecting an inflationary environment at the end of the day. Oil and gas prices, especially oil, have historically done very well in an inflationary price environment. In this very low-interest environment, combined with the unsettling macro news, people are clamoring for yield, and we think these upstream yield-oriented products are going to do well in delivering both growth and yield. We expect these distributions, especially in the upstream MLP space, to continue to grow over the next five years as oil prices continue to strengthen and as we see further consolidation in the upstream space. For royalty trusts, we continue to see high demand from both investors as well as issuers. We cover several royalty trusts that have a yield to maturity of 10%, which is extremely attractive in these uncertain times.
TER: Kevin, with bond yields so low and cap rates low or non-existent in commercial real estate, I’m wondering if a lot of traditional real estate investors may have trickled into the oil and gas MLP and royalty trust space.
KS: We think it’s very attractive for all investors, and a lot of people are looking to hide out in yield names. The S&P has been essentially flat over the past four years, and the Dow is even worse. Some of these investments with 7% and 8% yields and potential distribution growth are very attractive and will do extremely well over the next four to five years compared to the general stock market.
TER: Which seems to perform better in a strong commodity environment—MLPs or royalty trusts?
KS: Very good question. The upstream MLPs typically have a much more stable cash-flow profile because they hedge a higher percentage of their production and have the ability to add on new hedges. Typically, the upstream MLP world is hedged four to five years out, whereas royalty trusts only have the ability to put on hedges at the very beginning of the trust. With no ability to add on new hedges, after four or five years trusts have a high level of commodity price exposure and are very sensitive to oil and gas prices. So in a rising commodity-price environment, royalty trusts will outperform upstream MLPs. But in a very stable price environment, we would expect MLPs to outperform.
TER: You’re currently bullish on oil-related limited partnerships and trusts right now, aren’t you?
KS: Yes, we are. Leading the pack, we like LINN Energy LLC (LINE:NASDAQ), an LLC, and EV Energy Partners, L.P. (EVEP:NASDAQ). EV Energy Partners has a tremendous amount of upside with its undeveloped Utica Shale acreage. I really think that can be a game-changer for the stock. LINN Energy is doing a fantastic job of developing its horizontal Granite Wash acreage. We think it’s going to lead the group in distribution growth this year and will be set up for an even stronger 2012. Both of those names are extremely attractive at their current valuations. On the royalty trust side, our favorite name right now is VOC Energy Trust (VOC:NYSE), with a yield to maturity over 10%. We think those investors are going to do phenomenally well.
TER: You’ve got a target price of $46 on LINN, which would represent pretty good upside from its current price of $37, given that this is an income instrument. It was battered in July along with everything else, but it has recovered quite nicely. Where is this support and growth coming from?
KS: A large portion of the partnership’s growth is its horizontal Granite Wash play. Organically it is growing production roughly 30% on an annual basis, and that is unheard of in the upstream MLP space. Some of these wells are paying out within seven to nine months. So, the partnership is essentially acquiring earnings before interest, taxes, depreciation and amortization (EBITDA) at less than one times EBITDA and trading at roughly nine times EBITDA, which is phenomenally attractive. The thing to point out here is how fast it is growing distribution. Last quarter LINN raised its distribution by almost 5% on a sequential basis, which is very strong growth. We’re forecasting 6% year-over-year distribution growth in 2011, and we think the distribution growth rate will be even higher in 2012. That is very competitive compared to average MLP distribution growth of 4% to 5%.
TER: You’ve got a $90 target on EV Energy Partners, and it’s currently trading around $75. You’ve hiked the price target twice over the past month. Where does this optimism come from? My understanding is that currently there is really no accurate valuation available due to lack of visibility with regard to its Chesapeake Energy Corp. (CHK:NYSE) joint venture. What’s the low end and what’s the high end on this partnership?
KS: EV Energy Partners is a little bit more higher-risk/higher-rate of return investment versus its upstream MLP peer group. I would argue that close to $20 is in the stock price already on its undeveloped Utica Shale acreage, hence the low yield. But we’re seeing fairly good visibility on ranges of what the partnership’s acreage could be worth and very bullish comments coming from the industry.
If the Utica play doesn’t work at all, I think EV Energy Partners is close to a $50 stock. But a lot of acreage value is being derisked by extremely bullish comments we’ve heard about the results from different management teams, namely Chesapeake’s. We expect a lot of derisking as production results come out over the next 60 days or so, as well as potential monetization events for year-end. As that materializes, we expect EVEP to continue to move up.
TER: Your target price on VOC Energy is $27. Currently the price is just under $22. You seem to place a lot of emphasis on the experienced and highly motivated sponsorship.
KS: Yes. This is a management team that participated in MV Oil Trust (MVO:NYSE) and has done a phenomenal job of maintaining production and offsetting declines. And because it’s a relatively new issuer, it still has quite a bit of its production hedged at high prices. VOC Energy has hedged roughly 50% of its oil at a price that’s a little over $100. This brings a lot of stability to its cash flow in the next several years, as well as its current valuation, which is extremely attractive. I think that people are going to be impressed and surprised to see the upside when VOC Energy announces its quarterly distributions.
TER: Two of these three companies that you mentioned, EV Energy and VOC Energy, seem to have very high relative strength, particularly EV Energy, which is up 18% in the last three months, and has doubled in price over the past year. That’s amazing in this kind of environment.
KS: Absolutely. That’s not something you necessarily expect out of the upstream MLP space or a yield-oriented vehicle. It speaks to the nature of how accretive some of these undeveloped acreage properties can be when you’ve only valued the proven, developed and producing assets, but then happen to get some undeveloped acreage upside for free. That’s what EV Energy has essentially done, and it will be able to monetize this acreage and then flip it into proven and producing properties, which are going to have a significant impact on its cash flow. This is not something you can plan on or something that you can predict, but it’s a big upside.
TER: Do you have any other trusts or MLPs you wanted to mention?
KS: We like Legacy Reserves, L.P. (LGCY:NASDAQ) a lot. I would like to mention it because of Legacy’s reliable and disciplined business model of acquiring working interests in the Permian Basin, as well as its Wolfberry drilling results. Legacy had a really strong second quarter, and it was too bad that the greater market turmoil didn’t allow for significant focus on its drilling results. Legacy is expected to deliver 4%–5% distribution growth this year. We think it is in the position to grow its distribution sequentially for the rest of the year, and so we expect strong things out of Legacy.
TER: What about the integrated gas names?
KS: Our favorite in that space is National Fuel Gas Company (NFG:NYSE). It is one of the larger acreage owners in the Marcellus, with 745,000 net acres, the vast majority on which it owns the mineral rights. That acreage position is not yet fully reflected in its stock price. We’re expecting a lot of good things. It’s delivering 40% year-over-year production growth in 2011, and we’re expecting north of 30% next year. As they derisk some of their acreage, the valuation should show up in its stock price.
TER: National Fuel Gas is down about 18% over the past 12 weeks. Do you think of it has a value?
KS: I do. Some of that price decline was based on the fact that National Fuel Gas decided not to bring in a joint-venture partner. Because of that decision, a lot of the fast money moved out of the stock. I expect the same sort of value creation, but it’s going to take a little longer to materialize than if it had brought in a partner to develop some of their acreage.
We also like El Paso Corporation (EP:NYSE). We like what it’s doing with the dropdowns to El Paso Pipeline Partners L.P. (EPB:NYSE). That’s going to be highly accretive and makes for a wonderful financing opportunity. Its E&P assets have improved significantly over the last 24 months, and it has a very strong organic growth base.
TER: You tend to be conservative in your valuations and not build in premium target pricing above net asset value into your models. Is this due to the uncertain market climate?
KS: Yes. We are in uncertain times. It’s not unprecedented, but we’re seeing extreme volatility in oil and gas prices. That lends itself to more conservative valuations. But we try to be realistic about where we expect the stock prices be within the next 12 months.
TER: I’ve enjoyed meeting you. It’s been a pleasure.
KS: Thank you very much.
For the past four years, E&P Associate Analyst Kevin Smith has been with Raymond James & Associates, where he follows upstream master limited partnerships and U.S. royalty trusts. Previously he was with Wells Fargo & Company in its E&P Corporate Lending group in Houston, where he was responsible for credit analysis of mid- and large-cap E&P companies. Kevin was also a power trader at Reliant Resources for three years. He holds a BBA from Baylor University and an MBA from Texas A&M University.
By The Energy Report, on August 5th, 2011
 As long as the investment environment remains “yield-starved and growth-challenged,” MLPs will remain attractive, says Quinn Kiley, Fiduciary Asset Management’s senior portfolio manager. In this exclusive Energy Report interview, Kiley shares his tips for finding the best apples in the NLG basket, where sector is just as important as size.
The Energy Report: Quinn, you forecast total master limited partnerships (MLPs) 2011 returns of 8–12%. Given the negative news throughout the second quarter, how could that forecast possibly hold up?
Quinn Kiley: When we made the forecast at the beginning of the year, we thought that, given the MLPs’ fast recovery from the 2008 sell-off, there was a chance MLPs might underperform the S&P 500, which has not recovered at the same clip. We were looking at the basic fundamentals of MLPs as a source of growth. MLPs are yielding a little over 6%. We thought distribution growth from MLPs would be about 6%. That 6%, plus no change in valuation metrics and an increase in that cash flow of 6%, should give you a 6% higher value, for a total return of about 12%.
In July, we’re at a little less than 4% return and distribution growth is coming along at a clip north of 6%. We think that’s a good portion of the return. The MLPs are going to pay their distributions at higher levels from today and definitely at higher levels than a year ago.
We also think the number and amount of organic capital expenditure opportunities—new builds, new infrastructure—by MLPs will be done at attractive multiples, which should further increase growth.
TER: Almost $30 billion (B) has poured into the MLP sector this year. With that much capital coming in, should investors rest more easily knowing that Wall Street power brokers aren’t about to let the government tax one of its “golden geese,” or is a less favorable tax structure for MLPs inevitable?
QK: You have to take into account that MLPs have a market cap north of $250B. Exxon’s market cap is north of $400B. So, while MLPs are an attractive investment, and certain banks and investors have done well in them, the size and scale of MLPs compared to the broader market is small. I think calling them the “golden geese of Wall Street” is an overstatement.
That being said, MLPs provide an essential service in delivering fuels and commodities around the country. From an energy security standpoint, you could make an argument for preferential treatment for MLPs to ensure that access to capital continues and that our infrastructure is reinvested in and grows to make the economy overall more efficient.
At the very least, if the Bush tax cuts expire at the end of 2012, there will be a marginal change. Given the current discourse in Washington, I think you are going to see ongoing discussion of the tax code, tax policy and tax reform. MLPs will pop up as they do every other year when those topics get raised.
It would appear to me that you are going to see some sort of tax reform in 2013. Given that the goal is higher revenue, something will probably affect MLPs or their investors. However, I don’t think it will negate the overall investment story, which is that energy infrastructure is necessary and growing, and investors are attracted to those characteristics.
TER: When we talked with you in September 2010, you said the total market cap on MLPs was around $190B. You just said that today it is $250B. That is about 32% growth.
QK: There are a couple of reasons for that. First, broadly speaking, MLPs are up over 20% since we last spoke. That’s a significant portion of that 32%. Since then we’ve also seen about $17B in new equity raised. It’s a combination of appreciation, which is the market realizing the benefits of the growth of the MLPs, and MLPs raising capital to fund that growth.
TER: Last September, retail investors made up about 70% of the space. What is that percentage now?
QK: Off the top of my head, I’d say the number is closer to 67% or 68% now. We have seen an uptick in institutional investors; in addition, more traditional investors like pension funds are starting to pay attention to the space.
Most state pension funds are significantly underfunded. As a result, they are looking for diversification and growth-oriented investments. Something growth-oriented with a significant yield, such as MLPs, is attractive and fits into a bucket for certain funds. We have seen several municipalities and states invest in MLPs as a class or conduct searches for the potential of adding them to their portfolio. That said, MLPs remain a predominantly retail-driven investor space.
TER: Do you think we will see the net market cap for the MLP sector eclipse a trillion dollars within the next decade?
QK: We look out five years and we see, on average, about $10B a year of new-build projects. A trillion is a long way between here and there, but if you look at the Real Estate Investment Trust (REIT) asset class as a corollary, U.S. REIT equities are about double MLPs. Getting to a trillion is possible, but probably not likely.
TER: The MLP sector relies heavily on an investment-friendly boomer generation seeking respectable yields in a low-yield investment world. How long can that thesis play out, and what other drivers do you expect to catalyze MLPs over the short to medium term?
QK: Clearly, there is a significant, rising population entering retirement. They will need income. MLPs can play a great role because they provide a significant yield, north of 6% right now. Compare that to Treasuries at 3%, money markets and cash are effectively at 0, and other yielding equities are in the 2% to 4% range. On a relative basis, MLPs provide a high yield, which is really a cash return. Real cash returns are attractive for any investor, especially those facing retirement or who are retired now.
But generally speaking, this is a yield-starved investing environment, regardless of your age or approach to the market. Our view is that if you are in an environment that is both yield-starved and growth-challenged, it’s hard to find attractive returns driven by growth.
Where will the growth come from? In an essential asset like energy infrastructure, there is a need for growth; it has to happen or the economy won’t function. So, you are delivering growth in a market that is probably not going to have significant growth-driven returns. Additionally, if you can get a large percentage of your returns through cash, it becomes very attractive.
As long as you have a low-yield environment, MLPs will look attractive. As long as you have a struggling economy, a growing yield will look attractive. MLPs have a positive, long-term outlook, but short-term it’s anybody’s guess as to what is going to happen. In the current market, it’s going to be a very choppy.
TER: How long do you think it will be before the bond market is competitive with MLPs again?
QK: In the last quarter, it was superior to MLPs. The Barclays Capital U.S. Aggregate Bond Index returned about 2.3% for the quarter, compared to a negative return for MLPs.
There are a couple of tricks to comparing fixed-income investments to MLPs. First is taxes. You have fully taxable income from a bond, but some portion of your MLP distribution is return of capital and not taxed until sale. There is a near-term tax advantage on a comparative basis. The other big difference is that MLP distributions grow over time; bonds do not. Bonds have maturity rollover risk; MLPs are perpetual. Depending on the environment you are in, bonds can be a very attractive investment if they have good, underlying fundamental cash flow supporting them. We like energy infrastructure bonds right now, but we think MLPs have a better long-term outlook.
TER: Is bigger better when it comes to investing in MLPs in volatile markets?
QK: I guess the classic answer is, “It depends.” It’s not just bigger; it’s which big MLPs you own. Over any short-term period, a bias toward large or small cap could be beneficial or detrimental to your portfolio. We tend to invest in names we think are well positioned for growth, well positioned to pay their distributions, and are of a high quality. Size isn’t a metric; we think of the quality of the name. But when investors flee the markets, the more liquid names are better able to deal with forced or indiscriminate selling. Thus, they perform technically better in a volatile market.
In a rebound, the opposite is true; you tend to see large caps lag and small caps gain strength in the market for the same reason. In today’s environment, large-cap MLPs outperform, but over the long term, it’s more important to buy high-quality companies with a growth component that is better than another MLP on a relative basis. If you make that decision regardless of size, you are going to come out on the right side.
Another thing that is important is not just what the prospects look like, but how well supported their distribution is with the cash flow available. Some MLPs may not do as good of a job of harboring cash and marshalling it to grow distributions over time.
TER: What are some big MLP names that continue to boost distributions and are likely to do so for the foreseeable future?
QK: The largest MLP, which is about $35B, is Enterprise Products Partners, L.P. (NYSE:EPD). The company has a great history and a great track record of putting investor capital to work in a way that creates cash flow. It has increased distribution quarter-over-quarter, year-over-year for a sustained period. Given the attractive footprint of both where their assets are geographically and based on what they do, we think the company is well positioned to take advantage of the domestic energy boom resulting from the recent ramp-up of nonconventional oil and gas production. Enterprise is definitely a blue-chip name that has a great outlook for distribution growth.
El Paso Pipeline Partners, L.P. (NYSE:EPB), is about a fifth the size of Enterprise. El Paso just announced a 20% distribution increase over the same period last year. It is a great long-term story at El Paso; the driver is the quality of the assets of the business it is in, not the size.
TER: What areas of the MLP space do you expect to outperform the sector at large this year and into 2012?
QK: If you take market volatility and political uncertainty out of the discussion, several areas of energy infrastructure are going to do really well, especially those tied into natural gas and natural gas liquids (NGLs): ethane, propane—things that occur in, or are associated with, natural gas or oil reserves. When these materials are produced, they have to be removed from the base commodities. For example, natural gas, like that used in our homes, is of similar chemical quality and heat component all the way around the country; it’s called pipeline quality gas. But to get that, you have to remove the chemical impurities. Those impurities have great value associated with them because they are priced off of crude oil.
If you have been following the energy world, you know crude oil is selling at very high levels, in the $90s/barrel (bbl.) range, and that natural gas has been anchored to the $4/Million British Thermal Unit (MMBtu) range for quite a long time. That means there is more value in NGLs than there is in natural gas itself. Anyone who has exposure to that, whether it be on the logistic side by storing, handling, or processing it, or the price side because they benefit from NGL prices, should do very well. I don’t see that apple cart being upset for the remainder of the year.
TER: What are some MLP names with large exposure to NGL plays?
QK: One of the MLPs, in what I’ll refer to as the gathering-and-processing sector, is DCP Midstream Partners, L.P. (NYSE:DPM) which has a significant NGL business. It has some exposure to both the logistics side and the price of NGL, and has a large geographic footprint and a good growth profile.
Other names have more exposure on the logistics side, like Targa Resources Partners, L.P. (NYSE:NGLS), which has exposure to the growing need for NGL infrastructure and transportation. It also has exposure to processing the fractionation, where you break the NGLs into individual components into what in effect becomes petrochemical feed stock.
Targa has been a great story because the proliferation of domestic resources for NGLs has led to a pricing advantage relative to European imports. The chemical industry here has really turned an eye inward and is trying to make sure it has the best access to feed stocks. As a result, you need new infrastructure to deliver that product to the market. Targa, DCP Midstream and ONEOK Partners, L.P. have strong exposure in this area.
TER: What about Energy Transfer Partners, L.P. (NYSE:ETP)? Do they have exposure to NGLs?
QK: Part of Energy Transfer Partners’ business is in NGLs; mostly it moves natural gas around the country through pipelines, including a significant pipeline system in Texas. It’s a quality MLP that pays a recurring yield. However, growth has been a little bit muted; over the last couple of years, distribution has remained flat.
The story there is much more about its general partner, Energy Transfer Equity, L.P. (NYSE:ETE) and its attempts to acquire Southern Union Co. There has been a back and forth battle between ETE and the Williams Company (NYSE:WMB), which is the parent of another MLP, to pick up these assets. In the end, the Southern Union shareholders have been the big winners. It has seen the price of its equities go up significantly.
Southern Union’s assets, combined with the existing assets of either one of those entities, will provide a lot of synergies and optimization that will allow for better profitability and significant cash flow growth regardless of which acquirer you are talking about. The question is, at what point do you pay too much for those assets? Currently, the market doesn’t believe it has paid too much for them, but the story isn’t over and we won’t know who wins until the deal closes.
But Energy Transfer Partners is definitely a growth-oriented MLP. It is always trying to get bigger and better by creating broader exposure to natural gas infrastructure around the country.
TER: Do you have some parting thoughts for us in terms of the MLP sector, any insights into the market?
QK: Our view hasn’t changed substantially over the year. It has been a rocky road, but we believe MLP valuations and returns will be higher going forward. There is a great long-term story of energy infrastructure build-out to deal with the ever-changing supply and demand dynamics of domestic energy. That fundamental strength, regardless of what is going on in the broader world economy, will play out over the next couple of years. Long term, more individuals and institutional investors are allocating some portion of their portfolio to MLPs. We think that will continue as the years go on.
TER: Quinn, thank you for your time and your insights.
Quinn T. Kiley is the senior portfolio manager of FAMCO’s Master Limited Partnerships product and is responsible for portfolio management of the firm’s various energy infrastructure assets. Mr. Kiley serves as portfolio manager for the Fiduciary/Claymore MLP Opportunity Fund, the MLP and Strategic Equity Fund Inc., the Nuveen Energy MLP Total Return Fund, the FAMCO MLP & Energy Income Fund and the FAMCO MLP & Energy Infrastructure Fund. Prior to joining FAMCO in 2005, Mr. Kiley served as VP of Corporate and Investment Banking at Banc of America Securities in New York. He was responsible for executing strategic advisory and financing transactions for clients in the energy and power sectors. Mr. Kiley holds a BS with Honors in geology from Washington and Lee University, an MS in geology from the University of Montana, a Juris Doctorate from Indiana University School of Law and an MBA from the Kelley School of Business at Indiana University. Mr. Kiley has been admitted to the New York State Bar.
By Richard Daughty, on September 29th, 2009
In another episode where the comics page eerily mirrors real life, a recent “Garfield” cartoon has Garfield confronting a resident rat who has been taking cheese, but leaving IOUs, from the “cheese drawer” of the refrigerator. Garfield threateningly says to the rat “Stop with the IOUs” and the rat calmly holds up his hand in protest and says, with a look of utter sincerity on his face, “No, no…I’m good for it”!
Perhaps it is my Refined Mogambo Sense Of Humor (RMSOH), or perhaps it is my equally-refined Mogambo Sense Of Scorn (MSOS), but either way, using a diseased, lying, filthy, corrupt, thieving rat as a metaphor for Congress is the funny-because-it’s-true part! Hahaha!
I remember it because I was reading the comic strip before I fell asleep on the couch, snoring and snorting and having a wonderful time while taking a well-deserved nap after spending the busy morning writing hate mail to the Federal Reserve (“Dear Morons, I hate your guts because you are the weenies who have so little intelligence that you let the foul Alan Greenspan, chairman of the Federal Reserve 1987-2006, create So Damned Much Money (SDMM) and with So Damned Little Oversight (SDLO) that it allowed massive, MASSIVE bubbles in debt that produced bubbles in stocks, bubbles in bonds, bubbles in houses, bubbles in consumer spending, bubbles in derivatives, and huge, backbreaking bubbles in size and cost of government, and now we’re freaking doomed! Sincerely, Anonymous in Florida and fed up with you clowns!”).
I was just in that delicious part of my nap where I usually begin dreaming of wonderful things that might have been, had I only been prescient enough to say, “Marry you? What? Are you freaking crazy or something?” or “Have some kids? What? Are you freaking crazy or something?” but still buying lots of gold, silver and oil with which to get Fabulously, Fabulously Rich (FFR) so that I could tell lots and lots of other beautiful women, “Marry you? What? Are you freaking crazy or something?”
Let’s just say that fantastical things were getting dreamed up pretty good, if you catch my drift, when the kids come running in with a copy of Barron’s in their hands, yelling, “Wake up, daddy! Wake up! You can raise our allowances even if your income is down! There’s a way to do it! Wake up!”
I was lazily rubbing the sleep from my eyes and carefully watching to see if any of them came close enough that I could reach out and smack them for so rudely waking me up, which I feel empowered to do because that is what my wife did to me for doing the same thing just the other day.
I mean, there I was, early in the morning before the sun was even up, nervously looking at our finances and coming to the only conclusion I could; “The kids have got to go!” Before I knew what I was doing, I went running into their rooms, honking an air horn and anxiously yelling, “Get up! Fire! Get up and get out of the house! Emergency! Get out! Get out of the house!” whereupon they all went rushing outside in their pajamas and I locked all the doors so they couldn’t get back in.
It was, I admit, probably my most pathetic, desperate attempt to clutch at the only straw I had left, a move that led to the aforesaid incident of my wife hitting me, and the police watching her do it, yet doing nothing about it, and the kids wailing, “We’re so traumatized! He’s a horrible person who doesn’t give us enough money in our allowances! Boo hoo hoo!”
But they were right about the S&P 500 “paying more while making less”! The companies in the S&P 500 have been paying out $21.45 in dividends, which is whole multiples of the $7.90 that they have been actually earning, probably explaining why the index sells at a price so high (over $1,000), that the price-to-earnings ratio is 128! Hahaha! Unbelievable! Hahaha!
So, as the kids rightfully pointed out, the companies in the S&P 500 are paying more than they are making, and so there must be a way for me to pay them more than I make, too, and the only reason that I don’t give them more money to offset their rising costs is that I am stingy and hateful, which is true but not breaking any new ground, just as it is also true that buying these stocks at the price of the index would take an investor 128 years of getting everything the companies earn just to break even! Hahahaha!
It gets weirder when you realize that the companies would go broke long before that, because they are always paying out more than they make!
So I look at them and say, “And what kind of Stupid Moron Crap (SMC) is that?”
It was heartbreaking to see the disappointment in their eyes and hear it in their tender, young voices as they were telling me how monstrously cruel I am and how much they hate me, but I am still buying gold, silver and oil with every dime I can manage to keep out of the greedy, grubby hands of the kids, wife, family members and bill collectors, and soon they will understand why, and, if they are good, like not ever again waking me up from a nap, grow fabulously wealthy, insanely wealthy, preposterously wealthy along with me and all the other people who are buying gold, silver and oil as a defense against unbelievable government deficit-spending and monstrous amounts of money creation by the Federal Reserve, which is so ridiculously easy that you hear yourself saying, “Whee!”
By Trace Mayer, on July 28th, 2009
“By the pricking of my thumbs, / Something wicked this way comes” is from Act 4, scene 1, lines 40-41 of the Bard’s Macbeth.
A year ago at Cambridge House when asked whether the economy was going to rebound I responded, “That light at the end of the tunnel is just the next train. Get out of the way!” Another commentator on stage responded that things would get better. What happened?
Lehman Brothers, AIG, Fannie Mae, Freddie Mac, Bank of America, Merrill Lynch, Citigroup, the Adjusted Monetary Base exploded from $800B to $1,800B as the Federal Reserve fails with quantitate easing, unemployment began to soar and the DOW crashed from 12,000 to 6,500 or 13.95 gold ounces to 7.
The prehistoric media wails about how no-one saw this crisis coming. Yet they are still praising Obama’s economic policies, heralding an economic recovery and living in denial. Why believe them? Why even read their newspapers or turn to their channels? Many people, coincidentally almost all of the Austrian school of economics, saw this financial and economic crisis coming.
There is another massive crash coming. For those people who do not see this coming crash the issue is not one of subjective or objective opinions. The issue is a personality block where the individual cannot handle the truth. If you see neither were we are nor where we are headed then you have a personality block and need professional therapy.
ASSET LIQUIDITY
Price is what you pay but value is what you get. During the Great Credit Contraction capital is seeking not only the safest assets but also the most liquid.
Market liquidity is a business, economics or investment term that refers to an asset’s ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value.
Famed value investor Warren Buffett managed to see his net worth fluctuate from $62B to $37B over the past year. His paper profit from bailing out Goldman Sachs has already earned about $2B. Despite his ‘massive losses’ there is a lot to learn from Buffett’s annual letter to shareholders. I have read them all. Particularly interesting is his view on market liquidity from 1993:
In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the business employs. He may even prefer not to know the company’s name. What he treasures is the price history of its stock. In contrast, we’ll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company’s business. After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two. We don’t need a daily quote on our 100% position in See’s or H. H. Brown to validate our well-being. Why, then, should we need a quote on our 7% interest in Coke?
NYSE Program Trading (Click here for full size)
At the end of the day, a buyer and a seller agree on a price. Prices in the public markets are always set at the margins. When the transaction is not consensual, such as with robbery, there is no price and such transactions are unsustainable because they are immoral and will eventually always fail.
The quoted price for assets is becoming increasingly illusory because of the fake liquidity which will learn how to vanish. For example, the NYSE reported, “Due to an NYSE system error, Goldman, Sachs & Co. was inadvertently omitted from the chart of most active firms, but the firm’s program activity was included in the total level of programs as a percentage of NYSE volume, which remains unchanged at 48.6 percent.”
Naked short sales or FTDs (failure-to-deliver) that represent about 37.5% of the volume of securities that require delivery. The galavanting SEC has now taking steps against but it is probably a too little too late. Many investors would be flabbergasted to know that the 100 shares of YYY in their brokerage account were really failure-to-deliver IOUs for 100 shares of YYY. Combined with the fake liquidity that can be instantly withdrawn if serious selling starts it will create a very unfavorable marketplace for additional potential sellers.
ASSET VALUATIONS
There are many ways to value assets such as ownership of a company, real estate, etc. Some of the basics include discounted future cash flows, dividend payout ratio, price to earnings multiple, book value, etc. When assessing the health of a company I get a quick snapshot from the current ratio, acid test ratio, return on equity, free cash flow, net income and dividend payout ratio. I like dividends because when cash must be distributed it is much more difficult for management to play accounting games using the new generally accepted fair value lying standards.
The payout ratio is the percentage of earnings paid to investors and is calculated by dividing yearly dividends per share by the price per share and is the opposite of the plowback ratio. Think of cash like blood and dividends like blood donations. Extremely healthy companies can donate lots of blood without hindering their operations and the investor can then deploy the cash elsewhere for a higher return.
The S&P 500 is a value weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. Dividends are an important component of the total return from equities, accounting for a third of the total return of S&P 500 since 1926.
The S&P 500 earnings have collapsed while dividends have declined at a slower rate. As Ian McAvity has demonstrated, the dividend to earning ratio is now above 300%. This means companies are distributing $3 of dividends for every $1 of earnings. This is accomplished by burning through cash reserves, selling off assets, borrowing, etc. This is unsustainable.
One would think that only the New York Times is stupid enough to borrow money to pay dividends while gross revenue and net income decline. Likewise the current price to earnings ratio of the S&P 500 needs a reality check. When body mass is shrinking (declining gross revenue), blood is leaking (lower earnings or losses) the last thing those setting dividend policy should do is pull out another knife and cut themselves deeper to hemorrhage faster.
But perhaps they are listening to the propaganda organs that neither saw the gathering economic storms nor have taken shelter from the browbeating winds and think their earnings are going to recover which will bring the ratios back into normalcy.
UNEMPLOYMENT
This is no ordinary recession. Obama is intentionally exacerbating the greater depression. For the appetizer the American economy has lost over 4 million jobs. 30 June 2008 the Emergency Unemployment Compensation program began. Benefits have been extended twice. Obama may delay the first course of dinner by extending it a third time. The National Employment Law project estimates that, “Around the country, the number of people exhausting their benefits is piling up. By the end of September, more than 500,000 people will exhaust their benefits checks”.
The Great Depression lasted for over two decades and was not a single event. The early years were marked by lost jobs which were not replaced. As top lines evaporated they were not replaced. People and businesses began to deplete their savings before becoming destitute and getting corralled into soup lines.
In the present case, job losses have been piling up like a massive train wreck. The American consumer has slightly scaled back on their purchases because they still have access to liquidity such as unemployment benefits, credit cards, 401Ks (which have become 201Ks), etc. Those sources of liquidity are drying up as credit card limits are slashed, minimum payments are raised, HELOCs are denied, retirement plans collapse and now, in September, unemployment benefits will end.
The numbers on that chart are estimated to go from 50,000 to 1,500,000 by the end of the year or a 3,000% increase. The issue for the American families kicked out of their worthless homes and onto the street is becoming survivalism in the suburbs. People are not going to care about contributing to their retirement plans, buying name brands like Coca Cola, Proctor & Gamble, Wonderbread, etc. They are going to care about generic bread or Top Ramen on the table.
Consequently, gross revenues for the S&P 500, which are down 10% year over year, are going to be under even more pressure. With most of the slack already trimmed earnings are going to be under even greater pressure. To bring PE ratios into historical norms stock prices are going to have to tumble.
COMMERCIAL REAL ESTATE
The value of real estate is a function of the earning capacity of the underlying business base. With collapsing earnings, rapidly rising unemployment and a commercial real estate market ice age the value of commercial real estate is plummeting. Originations of commercial mortgage backed securities is almost non-existent. Financing for new purchases is almost impossible to secure. Being able to find comparables for appraisals is getting increasingly difficult. Real property taxes will likewise decline putting further strain on state budgets which are in chaos like California.
Many outstanding loans are non-performing and the lending banks are failing. From the 6th to the 27th of July another 12 banks have failed. In January 2008 I warned that the FDIC was preparing for massive bank failures. Lately I have warned about how the annual worldwide platinum production is valued at about $7.8B compared to the FDIC’s $12B of reserves to cover$4,831B of insured deposits. The monetary metals are one way to protect yourself from the risk of massive bank failures and a potential bank holiday.
MARKET MANIPULATIONS
Chris Powell of the Gold Anti-Trust Action Committee has observed that “There are no markets anymore, just interventions.” Where would the manipulators get the massive amounts of capital needed? Perhaps Donald Rumsfeld knows.
The United States Constitution provided safeguards against these types of problems. This is one reason the barbarous relic known as the Federal Reserve should be razed. The unfair and immoral monetary system is complete opposition to a Constitutional monetary system. These interventions of manipulating both the supply and cost of currency are failing as is the Federal Reserve’s attempt at quantitative easing.
MONETARY METALS
During The Great Credit Contraction capital will seek the safest and most liquid assets. At all times and in all circumstances gold remains money. Because of the large aboveground stockpiles gold is the world’s primary monetary commodity. Likewise silver and platinum are also risk-free commodity currencies.
Two weeks ago I recommending buying platinum which has since risen $80 per ounce or about 9%. I also recently suggested buying silver around FRN$12.50 which is now over $14 or about a 12% gain.
I have found GoldMoney to be the best alternative to the current failing worldwide monetary system. I recently sold a few copies of The Great Credit Contraction for platinum. A Swedish buyer remarked, “I have now made my first payment in platinum  … I think we may have seen a glimpse of the future. … (And as a gold-bug I think it can be good.) Thanks a Lot!”
Many people may take for granted the liquidity of the financial markets, banking system and other grease for the wheels of commerce. How would your investments be affected if the financial markets closed for 1-2 years? How would your business be impacted if there was a bank holiday for an undetermined period of time?
Having an alternative system, completely independent on the current failing structure, in place and operational is good business sense. Eventually the Information Age alternative to the barbarous relics of central banks and fractional reserve banking become complete substitutes because of the lower costs, ease of use, lower risk and other superior attributes. As the liquidity of the monetary metals increases through their use in ordinary daily transactions, like being used to purchase books, their value will rise.
Additionally, gold’s technicals are looking extremely strong. The 200dma at $880 while the current price is about $955 or 1.08x. The 18 month consolidation above $900 has laid a very strong foundation for the next upleg. The reverse head and shoulders pattern is extremly bullish. Seasonally gold is weak during the summer and strong during the fall but lately it has been trading like power currency.
While massive short positions are being taken by commercials gold will likely easily breach and maintain $1,000 ounce this fall. With unemployment skyrocketing, bailout fever in Washington, earnings declining the FRN$ is going to be under tremendous pressure from ballooning budget deficits which will have to be monetized. All of this is positive for the ancient metal of kings.
CONCLUSION
The Great Credit Contraction, an economic climate change from an inflationary summer to a deflationary ice age, has barely begun. The remaining liquidity in the market is largely illusory. Residential real estate, commercial real estate, the major stock markets and even the banks are almost all zombie institutions anchored to fraudulent financial statements that are preventing the needed healing liquidation. The unemployment situation is escalating out of control and The Greater Depression is wearing on people and psychology is being changed. Earnings are collapsing and dividend to earning payout ratios are unsustainable. Meanwhile the monetary metals appear poised for a significant rise as the FRN$ continues evaporating.
Because there is no intelligible answer for what is a dollar therefore it is an unreliable instrument for performing mental calculations of value. This next crash which appears imminent but could take a while to materialize because of manipulations will likely see the DOW fall from its current 9.5 ounces to about 5 ounces of gold and the S&P 500 sliding from its current 1.3 ounces of gold to about 0.85 ounces.
Additionally, the really good buying opportunities will be enjoyed by those who can settle transactions because their assets are liquid, like with gold coins in a safe or a reputable third-party like GoldMoney, and not frozen in some closed market or holidaying bank. If you want real cash, not illusions like the FRN$, Euro, Yen, Pound, etc. which can evaporate in hyperinflation, then you better learn how to buy gold because it is the safest and most liquid asset. With gold you will always be able to buy something.
Disclosures: Long physical gold, silver and platinum with no positions in the problematic GLD or SLV ETFs, S&P 500, DOW, NYT, GS, Berkshire Hathaway, Coca Cola, Proctor & Gamble, Bank of America or Citigroup.
Copyright © 2008. This article was published on http://www.RunToGold.com by Trace Mayer, J.D. on July 27, 2009. This feed is for personal and non-commercial use only. Applicable legal information and disclosures are available. The use of this feed on other websites may breach copyright. If this content is not in your news reader then it may make the page you are viewing an infringement of the copyright. Please inform us at legal@runtogold.com so we can determine what action, if any, to take. If you are interested in how to buy gold or silver then you may consider GoldMoney.(Digital Fingerprint: 1122aabbLittleBrotherIsWatching3344ccdd)
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By Winton Bates, on May 14th, 2009
There is a standard joke among economists that equity markets have predicted about 10 of the last 5 recessions. As the joke acknowledges, equity prices embody predictions of future earnings and this implies that they also embody predictions of economic growth rates.
So, what is the rate of economic growth implied by current equity prices?
A good way to think about this is to consider why there is a difference between the current average dividend yield (annual dividends per share as a percentage of the current share price) and the real bond yield (bond yield minus expected inflation rate). This difference is required to cover two elements: the equity risk premium and the expected future rate of growth in dividends. If it is reasonable to assume that the expected rate of growth in dividends will be equal to the rate of economic growth over the longer term, the market’s expected rate of economic growth is given by:
y = (r – p) + x – d
where: y = expected real GDP growth rate;
(r – p) = real long term bond yield;
x = the equity risk premium; and
d = dividend yield.
So, it is a simple matter to calculate y if we know r, p, x and d. Unfortunately, however, there are a couple of thorny issues that need to be considered regarding appropriate numbers to use for the real bond yield and the equity risk premium.
When I last looked at this question (about five years ago) I decided that it would be more appropriate to use a long term average real bond yield than a current real bond yield. If the current bond yield is used, the results seem to become unduly sensitive to current monetary policy settings. In my calculations for Australia I used a real bond yield of 4.5 percent.
What rate of equity risk premium is appropriate? The equity risk premium is one of the few topics for which it could actually be reasonable to claim that if you laid all economists end to end, they still would not reach a conclusion. To cut a long story very short, I used the average equity risk premium implied by the relationship between GDP growth rates, average real bond yields and average dividend yields in Australia over the previous 20 years. This implied an equity risk premium of about 3.3 percent. (I am prepared to make available an unpublished paper discussing the methodology to anyone requesting it by email.)
When I did the arithmetic with the dividend yield prevailing in August 2003 (4.3 percent), I came to the conclusion that the expected real GDP growth rate for Australia implied by then current equity prices was 3.5 percent per annum. Since this was only marginally above the average growth rate for the previous 20 years, it did not seem to me to be unduly optimistic.
When I do this arithmetic now, with the current average dividend yield (6.6 percent on 18 November, 2008), it suggests that the expected real GDP growth rate for Australia implied by current equity prices is 1.2 percent per annum. That seems to me to imply that current share prices in Australia embody an unduly pessimistic view of longer term economic growth prospects.
Health warning:
There is a rumour going around among former work colleagues that when I was living off my earnings as an economic consultant I was heard to say, more than once, that free economic advice was not worth much. That rumour is true, but I have since changed my opinion. There is no truth at all in the rumour that I have been heard expressing the view that there are three kinds of economists: those who can count and those who can’t. I tried to say that once, but I ended up saying that I didn’t know whether I should be considered to be in the first or second category.
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