More and more investors are catching on to the steady returns and market resilience that master limited partnerships (MLPs) have historically offered. And when MLP investors evaluate sector performance, they frequently use the Alerian MLP index as their benchmark of choice. Alerian maintains the standard indices for MLPs, and in this Energy Report interview, the company’s president and CEO, Kenny Feng, explores some of the issues vital to income- and growth-seeking investors.
The Energy Report: Kenny, you are a former MLP portfolio manager. You’ve also been an analyst at a bulge-bracket investment bank, Goldman Sachs Group Inc. (GS:NYSE), where you followed the energy and power sector, as well as MLPs. Is Alerian similar to Standard & Poor’s or Russell Investment’s indices?
Kenny Feng: Yes, it’s similar in that we are purely an indexing firm that maintains benchmarks for the MLP sector. But we are also an education provider for the asset class and aspire to be the Wikipedia of MLPs—the first-pass information source for an investor who comes across the sector through an article in Barron’s, a commercial on CNBC, a conversation with a friend or financial advisor, or even through one of these interviews at The Energy Report. So besides the statistics we provide, we also speak at conferences and conduct free teach-ins to educate the investment community about MLPs.
TER: Do you manage any assets?
KF: No, and because we don’t manage any assets, the investment community views Alerian as an unbiased source of information. We field questions for investors across the spectrum—from individuals who have $100 to invest, to the multibillion-dollar institutions that are conducting due diligence on the sector prior to making a percentage allocation to the asset class.
TER: How does Alerian make money?
KF: We license our indices to investment banks and other financial service companies that create investment products, including exchange-traded funds (ETFs), exchange-traded notes (ETNs) and total return swaps (TRS). There are about $10 billion ($10B) in assets that are now linked to our indices.
TER: Your indices include the Alerian MLP Index (AMZ:NYSE), the Alerian MLP Infrastructure Index (AMZI:NYSE), the Alerian Natural Gas MLP Index (ANGI:NYSE) and the Alerian Large Cap MLP Index (ALCI:NYSE). What factors cause you to add or delete a security to or from one of your indices?
KF: We follow a strict, formula-based methodology that is completely transparent and replicable, and all of the information used to construct our indices is publicly available. Regarding criteria, the primary factors are nature of business, distribution policy, float-adjusted market capitalization and liquidity. The latter two criteria are in place to address the sector’s unique nuances. First, more than two-thirds of partnerships have a market capitalization of less than $2B. Second, only 70% of the shares outstanding are held in public hands. And third, daily dollar-trading volume averages less than $900 million ($900M) per day. Our indices are designed not just from the perspective of what makes sense intellectually, but also what is actually investable given the size and liquidity constraints of this particular universe.
Just an additional point on transparency: We believe that those choosing to utilize an index-based approach to investing do so because they value knowing exactly what is in their portfolio at all times as well as exactly what criteria will dictate changes to it.
TER: Back on Oct. 5, you participated in a panel discussion at the second Annual Platts MLP Symposium in Las Vegas. The topic was “Benefits and Challenges for Institutional Investors in MLPs.” What types of institutional investors were present? Were there generalists there? If so, is the MLP idea still something new for many of these people?
KF: At this point, most U.S. investors, both institutional and retail, have at least heard about MLPs, but the extent of their knowledge varies greatly. Some have been invested in the sector for a decade or more and have enjoyed the 18% annualized total return that MLPs have delivered, as measured by the Alerian MLP Index. Other institutions entered the sector as the U.S. economy was recovering from its financial crisis, understanding that a double-digit equity yield in a sector that was maintaining and growing distributions overall was worth solving some of the back-office challenges created by Schedule K-1s and state tax filings. There are still others who are currently doing their initial or final stages of due diligence before making an allocation.
As far as generalists, the institutions that are just beginning to dig their feet into this asset class now tend to be what we call derivative investors. It might be an energy portfolio manager who’s looking for a derivative way to play the U.S. shale boom that she learned about through her investment in exploration and production (E&P) companies. It might be a utility investor who is looking for a derivative way to play the inelastic energy demand theme that he’s loved for years through his investment in utilities. But definitely, there are more and more people coming to know this asset class and doing the homework to understand it better.
TER: What were the key ideas that you presented to the panel and to the audience? I’m sure they wanted to know about tax advantages and yields, but what were the most important points?
KF: First and most importantly, MLPs are an investment in the long-term build-out of domestic energy infrastructure. The Interstate Natural Gas Association of America has estimated that $250B of new natural gas infrastructure needs to be built over the next 25 years. Compared to a current market capitalization for the sector of about $325B, it’s a sizable investment.
Second, the math is compelling. A 6% tax-advantaged yield, plus a conservative 4–5% distribution growth, results in a double-digit annual total return over the long term.
Finally, interstate energy infrastructure assets benefit from generally inelastic energy demand, high barriers to entry and federally mandated, inflation-indexed tariff increases. These are the main factors that draw institutions to this sector.
TER: We’re all familiar with the crash in the commercial real estate market. We drive by these strip malls on an everyday basis, and we see them empty. Many of these malls were managed by limited partnerships and real estate investment trusts (REITs). Could we ever see anything like this in the energy sector?
KF: I’ll give you the counterpoint to real estate, but I’ll also give you a caveat. First, MLPs generally do not build energy infrastructure assets on speculation. Everyone saw that in the real estate boom; it was driven by the if-we-build-it-they-will-come approach. Tenants were not lined up before the building was constructed. It was only when the building was built and available that potential tenants came in and checked out the residential and commercial properties to compare options and costs.
However, on the energy infrastructure side, interstate pipelines line up their customers, meaning the shippers or producers, in advance, through what’s called an open season. The open season gives the pipeline owner an indication of interest in a pipeline at a particular rate. Generally speaking, roughly 70% of the capacity of a pipeline has to be contracted before an MLP will begin the construction process.
I’d also emphasize that energy demand growth has been remarkably stable over time. A huge part of that is a function of the build-out of President Eisenhower’s Interstate Highway System. He created suburbia. Regardless of whether you drive your child to soccer practice or go to the grocery store, you’re contributing to consistent energy demand.
In spite of dramatic improvements in the fuel efficiency of vehicles and the energy efficiency of household appliances, energy demand growth has been very consistent at roughly 1% per annum over the past 30 years.
Here’s my caveat: The U.S. consumer does have a limit. There was a breakdown in the commodity environment a few years ago that was triggered by demand destruction. When gasoline starts to push $4 per gallon, marginal usage is going to be pared back. In other words, the American family road trip to Disneyland is replaced with a staycation.
TER: The economic cycle works.
KF: Exactly—it just won’t be as extreme as you saw with REITs, because for the most part, only discretionary energy demand is impacted.
In comparing energy infrastructure MLPs to real estate, they are both hard assets. Investors like them because steel in the ground and concrete in the sky are both very tangible as are the tariffs and rents, respectively, that come with them. The difference between MLPs and REITs is that MLP cash flows benefit from lower macroeconomic volatility, evidenced by the fact that no constituent of the Alerian MLP Infrastructure Index cut its distribution during the financial crisis. Those companies still were able to maintain or grow their distributions through that period.
TER: Is midstream infrastructure keeping up with demand?
KF: Yes and no. What MLPs do is connect areas of supply (production) to areas of demand (consumption). Because we’ve seen shifts to emerging supply areas like the Bakken and liquids-rich Eagle Ford, along with shifts to new demand centers as the population moves to and grows in the South and Southwest, a lot of new infrastructure needs to be built. As I mentioned earlier, MLPs generally do not build on speculation, so sometimes bottlenecks will occur while that construction takes place. West Texas Intermediate (WTI) crude is currently trading at a meaningful discount to Brent crude due to the lack of pipeline takeaway capacity in Cushing, Oklahoma, where the NYMEX oil contract is settled.
TER: Why do energy companies do drop-downs? Why do they create MLPs?
KF: There are two reasons. Speaking specifically about the drop-down MLPs created by publicly traded energy companies, it often has to do with valuation, and management’s perception that investors are not properly valuing the company’s logistics assets. For example, Marathon Petroleum Corp. (MPC:NYSE) created MPLX LP (MPLX:NYSE) so that its pipelines and storage tanks would be ascribed a higher valuation multiple consistent with the lower business risk profile of those assets as compared to the parent’s refinery operations.
TER: It’s a way of spinning out a portion of the business.
KF: More or less. The drop-down MLP is a little bit different from a spinoff because the parent company usually maintains control over the assets through ownership of what’s called the general partner.
Logistics assets tend to be a bit boring—6% yield and 4–5% distribution growth leading to low double-digit returns. But there is a certain type of investor who is focused on the MLP space for just that reason.
The other reason why a publicly traded energy company might create a drop-down MLP is to finance its future capital spending plans.
TER: We’ve seen some initial public offerings (IPOs) for MLPs over the past year. Could this space become crowded to the detriment of the instruments as a whole?
KF: It certainly could, but investors are becoming more knowledgeable every day, and there is greater differentiation among MLPs. If you look at the investor market in the 1990s or even in the early 2000s, most MLPs were of the same business type and business model. They tended to be pipeline and storage companies that moved petroleum products and natural gas.
Over the past 10 years, many different types of assets have moved into this structure. We regard the MLP sector as more of a structure than an asset class because there are many different types of businesses that are actually in the MLP structure. Now there is greater differentiation among MLPs, not just by asset type but even in terms of investing style. If you invest in a large-cap MLP, it is unlikely that it is going to grow its distribution in excess of 10–15% per year over the long term because it’s so big—it just requires more to move the needle. On the other hand, you probably have more safety in your yield because its businesses are more diversified, and there may be natural hedges across different business lines.
There are also smaller, growth-oriented partnerships, which require less to move the needle. Smaller partnerships, however, also tend to be riskier investments because their assets may be concentrated in fewer geographic areas and business lines.
Variable distribution MLPs are also coming into vogue with the recent IPOs of a handful of nitrogen fertilizer and refining partnerships. The ownership of these securities tends to be much more heavily weighted toward institutions, which are investing in a secular growth trend that they see for this particular type of business. The retail investor generally prefers a steady yield derived from stable and growing cash flows.
TER: Are you seeing any novel ideas emerge in any of these newer issues of MLPs?
KF: We’ve seen a number of IPOs that derive the majority of their cash flow from businesses like upstream, wholesale distribution and the aforementioned nitrogen fertilizer and refining. These businesses are not new to MLP investors, but the fact that more of them are finding their way into the structure means that a market exists for them. A business line that is relatively new to the structure is frac sand, which had its premiere with the IPO of Hi-Crush Partners LP (HCLP:NYSE). Shortly afterward, Natural Resource Partners LP (NRP:NYSE), a royalty MLP that recently celebrated its tenth anniversary as a publicly traded partnership, announced that it had acquired frac sand reserves, which speaks to the acceptance of this asset type into the MLP structure, not just by one esoteric company but potentially others as well in the future.
TER: Are there any other novel MLPs you can mention?
KF: Another interesting story is Northern Tier Energy LP (NTI:NYSE), which is a refiner with a variable distribution policy. When the partnership’s management team and bankers went on their IPO road show, the offering range was $19–21, which is pretty standard for MLPs. But the deal priced at $14, presumably because the bookrunners feared that investors didn’t understand the value of the asset and they didn’t want the units to break their IPO price. Today, a few months later, it’s trading above the high end of that $19–21 range, so we just might see more refining MLPs and variable distribution MLPs—today there are only three and seven, respectively—on the horizon.
TER: I have enjoyed speaking with you very much. Thank you.
KF: Thank you, George, I appreciate it as well.
Kenny Feng, CFA is the president and CEO of Alerian, an independent provider of objective indices, data sets, and analytics for the master limited partnership (MLP) sector. Over $10 billion is directly tied to Alerian’s indices, including the leading benchmark of MLP equities: the Alerian MLP Index. Feng is a former managing director and portfolio manager of SteelPath Capital Management, a Dallas-based MLP investment manager. Prior to his experience at SteelPath, Feng covered MLPs, electric and gas utilities and diversified gas companies at Goldman, Sachs & Co. in the firm’s Global Investment Research Division. Feng graduated summa cum laude with a Bachelor of Science in economics from the Wharton School and a Bachelor of Arts in international studies from the University of Pennsylvania. He also serves on the advisory board of Midstream Business, a monthly publication addressing the need for business market intelligence on North American midstream energy infrastructure.
Best-selling author John Mauldin of Mauldin Economics says the EU is only left with choices that range from bad to disastrous. Meanwhile, Republicans and Democrats will have to hold hands and walk off the cliff together to solve U.S. economic problems. In this exclusive Gold Report interview, Mauldin expands on his comments at the Casey Conference, “Navigating the Politicized Economy.” Read more about the consequences of those choices and necessary compromises—and how he would reform the U.S. tax code.
The Gold Report: Back in January you said the European Union (EU) would have to make serious political decisions with “major economic consequences” in 2012. Is the EU making those decisions and what is your prognosis?
John Mauldin: It is doing its best to avoid making decisions, but is being forced to make them, ad hoc. The EU allowed the European Central Bank (ECB) to print money to monetize debt. The ECB is buying time for governments to achieve structural reform.
Structural reform, not the debt, is the problem. The debt is a symptom of bad policies, of a system set up for failure. The EU translated a theory into fact, and the theory did not work.
TGR: Is that theory the EU itself?
JM: The theory is the monetary union. If the EU had just left the trade union alone without trying to layer the monetary union on, it would have been just fine. But the EU wanted a single currency. It was part of the Europhiles’ dream. The EU thinks the monetary union is the sine qua non and it is not.
Today, computers do not care about lira, pesos, drachmas, pounds, marks or francs. Computers just say, this is what this unit is worth, click, click, done. Exchange rates become pointless in an age when we are moving to an electronic currency.
TGR: What is the structural problem as you see it?
JM: The structural problem is a fundamental difference in the labor markets of northern Europe and southern Europe. There is a 30% differential over the last 10 years in the productivity costs in Germany and the countries in the south of the EU. That creates trade deficits in the southern countries.
“The structural problem is a fundamental difference in the labor markets of northern Europe and southern Europe.”
If you want to balance fiscal government deficits, you have to have a trade surplus. That is the economic rule. Greece cannot balance its government budget until it balances its trade deficit. The Greek trade deficit is running at 10% because it does not produce enough goods to sell to the rest of Europe at reasonable prices. Before the monetary union, Greece could fix that by changing the value of its currency. That avenue is now closed, so it will have to reduce the relative cost of its labor.
Indeed, when you look at the data, the Greeks work longer hours and harder than Germans; they just do not produce as much at the price the Germans do. There are some reasons for that. Germany restructured its labor force early in the last decade to allow for “mini-jobs.” Companies can hire workers without having to keep them on the books. You can hire him at €400/week without paying any benefits. When you no longer need them, you can fire them. Mini-jobs released excess labor; it gave German industry an outlet, and it is part of the German productivity miracle.
Mini-jobs would be politically unfeasible in Spain, Italy or Greece. Those governments believe people should get full wages for their work. Fine, but nobody is going to buy what you are making. There are consequences to solidarity with the workers.
TGR: What strong governmental decisions need to be made?
JM: The southern European countries must restructure their economies. Simply buying their debt and allowing these governments to borrow more money only means more debt owed to European taxpayers, debt that will be defaulted on.
Now, the EU countries are talking about a European banking authority that looks like the Federal Deposit Insurance Corp. The Germans hate the idea of the ECB telling them how to run their landesbanks, their regional banks, because those regional banks are really under water.
TGR: Structurally changing the labor force could take years, no?
JM: It could take years or it could change overnight.
Change can happen overnight when you have a currency. If we went back to the peso or the lira, Spain and Italy could restructure their relative labor costs immediately by dropping their currency 10–20%.
“The choices now are between very bad and disastrous.”
The countries remain productive, trade does not stop. Italians could then buy less because their currency would be worth less and the Germans could buy more Italian goods because their currency is worth more.
TGR: Why is that option not being discussed?
JM: Breaking up the monetary union is horrendously expensive. It’s a major—insert your favorite expletives here—disaster for everyone involved.
TGR: But the Eurozone countries lose even if they continue down the path they are on.
JM: That is the second disaster. You just have to choose which disaster you want.
The choices now are between very bad and disastrous. The northern countries want a true, full-on political union, but only if the rules clearly state that the European central authorities can take over the budgetary rules for what are now sovereign states if the states cannot get their budgets together.
The northern countries want to give Brussels the power to tell Spain, for example, how many government workers to lay off, how much to raise taxes and reduce spending to achieve a balanced budget. And the Spanish would have to sit there and take it because it agreed to those rules.
TGR: Turning to the U.S., in your speech today (Sept. 10) you inferred that politicians’ knowledge that the U.S. will hit the wall unless they do the right thing has become the catalyst to do the right thing. You also said you did not like all the solutions the politicians are proposing. What solutions would you propose?
JM: We all have our own economic fantasy. Mine is more academic than philosophical. When you study the literature, consumption taxes are less damaging to the economy than income taxes. I would like to see a value-added tax created, and I would like to reduce the income tax. This can increase the total amount of taxes collected and reduce the top rates.
“Over the next four to five years, I like dividend plays and income plays, income-producing real estate, farmland if you can get it—including outside the U.S.”
I would eliminate most deductions: mortgage interest, charity, subsidies. If you make $100,000 and the top tax rate is 20–24%, you will pay that rate. I would drop the bottom rate to 7–8%, and I would make the threshold for paying that rate pretty low.
I would like to see the corporate tax rate taken to 15% or 12%, and get rid of every flipping deduction.
TGR: The deductions for mortgage interest, charitable deductions and some subsidies are pretty emotional. What is the probability they will be eliminated?
JM: I think it is pretty high because it is the only way to reach a compromise. The Simpson-Bowles compromise is one of the worst proposals I have read but I would vote for it in a heartbeat because it solves the problem.
That compromise eliminated a lot of deductions and dropped the total top tax rates. Dropping the top marginal rate is actually very bullish for the economy because it allows businesses and entrepreneurs to keep more of what they make.
TGR: Will politicians who vote to eliminate those emotionally charged deductions pay for those votes when they are up for re-election?
JM: A lot of things are emotional. That is why both parties have to hold hands and walk off the cliff together.
TGR: And you are optimistic they will do that.
JM: I think they will be looking into such an abyss that it will be impossible for one party to force the other party to make all the decisions and do all the heavy lifting.
TGR: Would you also change the capital gains tax?
JM: Academically, it is preferable to get rid of the capital gains tax, but I do not think that is politically feasible, so I would leave it where it is.
TGR: Meaning no taxes on capital gains?
JM: I would get rid of capital gains period, if you go out and create something, invest in something and do something.
However, a capital gains tax of 15% will not change anybody’s economic motive for investing. Same thing for a 20% top income tax rate. People will not try to avoid taxes; they will just pay them.
I would have a 12% to 15% rate for corporations, with no deductions. General Electric made $6–8 billion and paid no taxes. I read a list of 20 corporations whose CEOs earned more in compensation than the corporations paid in taxes. This is just wrong.
I would tax foreign earnings at the same rate. Bring the money back, invest it here or do whatever makes sense for the company. This will have the added advantage of making our corporations far more competitive. It will allow us to become an export machine and it will create jobs.
TGR: How do lower corporate tax rates make the U.S. an economic export engine?
JM: By dropping to lower rates we will collect more in taxes from corporations because there would be fewer, or no, deductions. Instead of giving corporations tax deductions for certain investments or for using green technology, let the market sort it out.
By and large, the government has shown itself to be incredibly bad at trying to pick technology winners and losers. The Defense Advanced Research Projects Agency (DARPA) and a few others are the exception, where funding pure research and cutting-edge development makes sense.
TGR: Your remarks today included a warning that your optimism would change to pessimism if a solution were not developed in the first half of 2013.
JM: Very pessimistic; Spain and Greece-type ugly.
TGR: How does your optimistic side look at investment?
JM: On the optimistic side, I think the technological changes Alex Daley talked about in his remarks are real. Gross domestic product is growing at 2–3% and there are companies out there compounding it at 25–30%, in the biotech space for example.
Over the next four to five years, I like dividend plays and income plays, income-producing real estate, farmland if you can get it—including outside the U.S. There is a whole world of potential investments in companies doing cool stuff: traders, hedge funds, alternative funds. Do not limit yourself to buying a few, large-cap index funds and hoping for the best.
It will be a slower-growth economy for a while. Once we get to the other side of this, we will see a fabulous bull market start in the latter part of the decade. It could be a 15- or 20-year run. The last secular bear market is getting long in the tooth. It could be over in four to five years, maybe earlier.
TGR: What does your pessimistic side say?
JM: Investors must become more defensive; more fixed income, putting more money outside the U.S. and in gold. Look for investments that produce an income and a yield no matter what happens.
Investors should still look at technologies, but should be more conservative. You almost have to see how it will unfold.
In a disaster scenario, you have to start looking at what you will do when rates go up and the U.S. has its “bang” moment. No U.S. investor has experienced that so far. We do not know what this road looks like because it is around the curve.
My pessimist side sees more disruptions in the market, more Lehman-type events, bond markets deciding one morning that they want higher interest rates.
TGR: Your pessimistic scenario included buying gold as insurance not as a moneymaking asset. Can gold protect against these disruptions?
JM: Sure. Gold will have buying power in a disruptive society. If we cannot get our collective deficit act together, I will start increasing my gold allocation.
TGR: In a diversified portfolio, what is a healthy percentage of gold in both an optimistic and a pessimistic scenario?
JM: Optimistic scenario, I would say 5% or maybe a little bit more in physical gold. In a pessimistic scenario, I would double that.
TGR: You used a technical term, saying that “yield is a bitch,” and noted that 5–6% is a good number. In which industries or sectors do you find those percentages?
JM: There are companies that will pay 8–10% yields all over the board, all over the world. If you narrow your focus to U.S. companies, you will not find all of them.
Their stock price might have collapsed, even though they are in solid industries such as beer or liquor; very few countries are going to outlaw alcohol and beer. A company will not pay a 10% dividend for very long, because people catch on and buy the stock. Soon, the dividend returns to rates that are more normal. You have to be opportunistic.
TGR: In your pessimistic scenario, is that 5% or 6% yield erased?
JM: Some of it is. You will have to look for more defensive or more bond-type plays.
People reading this who are investing $100K, $500K, $1M, $2M can look at small, viable targets. If you are looking only at where the big boys are investing, you are limiting your world.
TGR: You are already widely published, why did you decide to start a subscription newsletter?
JM: People have been asking me to do it for 10 years, and I finally found the right people to do it with.
I realized that I could not write a newsletter, do the research that I am doing and run a publishing company. I needed a partner who gets the investment process the way I do. David Galland and Olivier Garret are the right people and I am enjoying our relationship.
TGR: How did you choose Yield Shark as your first newsletter?
JM: That is where the demand is, and I have been overwhelmed by the response.
We will launch Bull’s Eye Investor with Grant Williams in a month. Within the next 18 to 24 months, we will have eight or nine different publications.
TGR: I like that kind of optimism.
JM: The newsletters will give me a certain amount of freedom in the way I write and research and structure my life. This will simplify my life a great deal. I am only doing stuff that I want to do.
My Thoughts from the Frontline will always be free. It will always be written on the weekend, with one major change. I will write it on Sunday night so I can have a real weekend.
That may mean the newsletter will show up in readers’ boxes Monday morning instead of Saturday afternoon.
TGR: Getting your weekends back is a good plan, John. Thanks for your time and insights.
Hear the recommendations of all 28 experts at the Casey Research “Navigating the Politicized Economy” Summit with the audio collection.
John Mauldin is chairman of Mauldin Economics, an investment newsletter publisher, and is the author of four New York Times Bestseller books. They include Bull’s Eye Investing: Targeting Real Returns in a Smoke and Mirrors Market, Just One Thing: Twelve of the World’s Best Investors Reveal the One Strategy You Can’t Overlook, and Endgame: The End of the Debt Supercycle and How it Changes Everything. Mauldin’s free e-letter, Thoughts From the Frontline, is sent to over 1 million people every week. He also offers The Mauldin Circle, a free service that connects accredited investors to an exclusive network of money managers and alternative investment opportunities. He is a frequent contributor to publications including The Financial Times and The Daily Reckoning, as well as a regular guest on CNBC, Yahoo Tech Ticker and Bloomberg TV. Mauldin is the president of Millennium Wave Advisors, an investment advisory firm registered with multiple states. He is also a registered representative of Millennium Wave Securities, a FINRA-registered broker-dealer. Mauldin is a spokesman for the Hard Assets Alliance.
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Master limited partnerships (MLPs) have outperformed the markets for 11 of the past 12 years. With more investors catching on to these low-risk, high-income vehicles, can the outstanding returns continue? Manager Darren Schuringa of Yorkville Capital Management says yes. But as Schuringa explains in this exclusive interview with The Energy Report, MLPs are a different animal, and investors in this space will need some specialized metrics in their toolkits. Read on for due diligence tips and some names that pass muster.
The Energy Report: Darren, many investors have considered real estate investment trusts (REITs) as high-yielding alternative investments. Are energy MLPs a natural place for investors in that space to migrate?
Darren Schuringa: Absolutely, for the following reasons: First of all, MLPs pay out greater income than REITs. As of the end of August, MLPs across the universe were yielding 6.3%, versus 3.3% for REITs. That difference amounts to approximately 300 basis points of additional income, nearly 100% more than REITs. Secondly, MLP performance is more consistent, as a study we did demonstrated. Consistency is very important for investors, especially for those who are looking for alternatives to fixed-income instruments.
TER: Since the year 2000, MLPs have beaten the S&P 500 in 11 of 12 years, and they have done this by a remarkable average margin of 19.5%. But is this just too good to go on?
DS: An institutional investor actually said something similar to me recently. He said, “Wouldn’t that level of outperformance generally point to an asset class that has had its run?” His was essentially a question of valuation. What we need to address is the valuation of MLPs and how are they priced on an absolute basis. One of the primary valuation absolute basis metrics that we look at is the spread relative to the 10-year Treasury, which is currently 460 basis points. That spread did get as low as 0.5% or 50 basis points in 2007. Looking back at that 12-year period you’ve just described, the average spread over Treasuries has been 327 basis points or 3.27%, and so MLPs are currently trading a bit above their historical average spread. When the spread’s been near 500 basis points or 5%, MLPs have had tremendous outperformance relative to the market and tremendous absolute performance in the following 12 months, according to a study done by Credit Suisse. So, based on spreads, MLPs do not look expensive.
Also, if you look at total return of MLPs, 50% of it comes from your current income, which is about 6.3% right now. The other half of your total return is the result of distribution growth. Through the first half of the year, we’ve been seeing distribution growth rates of about 6.5% for MLPs. So, if you add a 6.3% current yield to a 6.5% distribution growth rate, you’re really looking at a 13% total return picture in the current environment.
Therefore, in regard to whether MLPs are overvalued right now, I’d say no. I’m not sure what the S&P 500 is going to do, but given their fundamentals, MLPs have the ability to continue to grow their distributions in the mid-single-digit numbers.
TER: Could MLP outperformance be a low interest rate phenomenon?
DS: It’s not even that, and that’s a really interesting point because if you look at it the last time the Fed was in a tightening cycle, 2004 through 2006, MLPs returned 40%. So, it’s almost too good to be true because if you’re looking at them in any environment, in a tightening environment, in a recessionary environment, in the bull markets we’ve experienced over the past 12 years, the MLPs have consistently outperformed the broader market.
TER: What do you look for in an individual MLP?
DS: It comes down to high-quality yield. If you invest in an MLP that cuts its distribution by even a modest amount, you will witness a huge decline in the stock price of the partnership. That’s a tremendous loss of capital. We need to know that the distributions that an MLP is paying are safe; that’s our top priority. Secondly, we’re looking for partnerships that have catalysts. We’re looking for distribution growth. Remember, the total return picture of MLPs is that you get half from your current income and the other half of your return from capital appreciation. We want to make sure that we have good current income, a high yield and growth to enrich the value of our portfolios.
TER: What specific situations do you avoid?
DS: We try to avoid any MLP that has even the slightest probability of cutting its distribution. That is front and center. No need to make it any more complicated than that.
TER: If an investor is chasing high yields in MLPs, does that necessarily mean that he’s assuming higher risk, as an investor does in high-yield bonds?
DS: Not necessarily. A bond is expected to pay fixed distributions. An MLP, however, is an operating business, and you’re picking up both high current income and growth in distributions over time. This is a very different animal.
I’m going to surprise you because you’re on to something here. Our team has been investing in the MLP asset class now since the early nineties, and I tell investors right from the get-go that one of the things that always surprised me is that MLPs have more volatility than you would expect from an income-producing instrument. Generally speaking, high distributions reduce the volatility of the asset. But MLPs really have a risk profile that’s in line with equities, and where you really saw that was in 2008, the one year out of 12 that MLPs underperformed the market. MLPs underperformed by 2.6% that year, which saw the meltdown of the equity markets. MLPs declined pretty much in line with the S&P 500 at that point, but the big difference is that most partnerships didn’t cut distributions. In fact, many increased distributions over that period of time. So, when you had the market dropping by 40%, MLP yields went from mid-single digits to mid-teen levels across the asset class because they maintained their distributions.
So, when investors started to realize this and saw this type of income and consistency of income that the MLPs were producing in the heart of a crisis, you saw MLPs bounce back to their high-water mark within 12 months. We’ve only seen the S&P 500 recently flirt with its previous highs, and we’re four years post-crisis. So, again, you do have volatility in the asset class similar to equities, but you don’t have volatility with distributions, even in turbulent markets, as we experienced in 2008. Warren Buffett said that’s the worst market he’s ever seen in his entire investing career.
TER: Let’s talk about some individual MLPs.
DS: I will. I’m going to start with Linn Energy LLC (LINE:NASDAQ), a commodity MLP. It’s in the exploration and production (E&P) segment under the Yorkville Capital classification. I like Linn because it has hedged 100% of its future oil production through 2017. This means investors have visibility into its future cash flow on its oil properties for the next five years, and the average price is in the high nineties per barrel. So, we can now look with a high degree of confidence into what Linn’s future distribution growth will be. Linn has also completely hedged its natural gas production through 2015 in the low $4 per thousand cubic feet range, and it is going to be rolling out hedges for the next two years. This is helpful to investors, who need to take a very macro view when they’re looking at portfolio allocation in order to preserve the purchasing power of assets.
TER: Tell me a little about your ETF. By the way, that’s a tremendous yield considering that the fund is trading at either NAV or at a slight premium.
DS: Absolutely. Yorkville High-Income MLP ETF (YMLP:NYSE) has no leverage, and pays dividends that are going to be close to a 100% return of capital. From an after-tax perspective, it’s an even more efficient way of producing current income in your portfolio than even owning an underlying partnership directly. A partnership is 80% tax-deferred, and when you sell the partnership there’s a recapture at the end of that income. I’m not going to get too deeply into the tax advantage/liability of MLPs, but because the majority of Yorkville High-Income MLP ETF’s income, if not all, will be return of capital, that lowers your tax basis. So, if you’re getting 8.5% in a year, that is a 100% return of capital, and your after-tax yield is actually greater than 8.5% with no recapture upon sale. You would just pay the capital-gains rate when you decided to sell the fund. Additionally, investors in Yorkville High-Income MLP ETF don’t need to deal with the complexities of a K-1 tax form. Instead, the fund pays 1099 income, making it much easier come tax time.
From a holdings standpoint, Yorkville High-Income MLP ETF invests in a diversified portfolio of MLPs from various sectors including exploration and production, marine transportation, fertilizers and more. The fund utilizes a proprietary ranking methodology in order to select what we consider to be the best partnerships to invest in from a distribution standpoint, both in terms of current levels and future growth.
Given the fundamentals of MLPs and the boom that we’re experiencing here in the U.S. right now with the unconventional shale plays, the forecasts are that we’re going to need another $250 billion (B) of infrastructure to connect these unconventional shale plays. This infrastructure has to hook these new energy-producing areas into the energy backbone of the United States. That will double the size of the MLP asset class, which will result in future growth of distributions.
TER: What other MLPs are looking strong?
DS: Investors should look at Atlas Energy L.P. (ATLS:NYSE). What you find here is an example of an MLP that falls on the infrastructure side. It has reinstated its distribution. It is experiencing multiples of distribution growth, and the company is performing very well for us. It’s a little bit different in the fact that it’s not as high yielding as some, but in this case we gave up yield for distribution growth, because it is the general partner for two other MLPs, Atlas Pipeline Partners L.P. (APL:NYSE) and Atlas Resource Partners (ARP:NYSE).
TER: I see that Atlas Energy L.P. has been a stellar performer. It’s up 63% over the past 12 months, which is triple and even quadruple some of the runners up. The yield is 2.93% currently, but you certainly got great capital appreciation. Is there another one you could talk about?
DS: Yes, I’ve got another one— Terra Nitrogen Co. L.P. (TNH:NYSE). The fertilizer plays were really hurt at the beginning of this year when the U.S. Department of Agriculture forecast bumper yields per acre for 2012. Unfortunately, yields are down significantly this summer with the drought. And, in fact, some farmers that we’ve spoken to have actually already plowed their fields under, and they did this back in July. They threw in the towel, and corn prices have taken off.
Now, farmers are going to have to be planting more acreage because of lack of a harvest this year. That bodes very well for fertilizer stocks. Fertilizer plays are a way to use the MLP asset class in a non-traditional way to gain long-term commodity exposure. Water, food and energy are all global themes you can play. Terra Nitrogen highlights the diversity of the MLP universe.
TER: Darren, can you address Energy Transfer Equity L.P. (ETE:NYSE) and Energy Transfer Partners L.P. (ETP:NYSE)?
DS: Energy Transfer Partners is the general partner. Energy Transfer Equity is the limited partner, and it’s also the general partner of Regency Energy Partners L.P. (RGNC:NASDAQ). The general partner is responsible for the management of the business, and then the limited partner owns the underlying assets of the business. Because of two major acquisitions, Energy Transfer Equity’s purchase of Southern Union Co. and Energy Transfer Partners’ buyout of Sunoco Inc. (SUN:NYSE) (expected to be finalized before year-end), we anticipate that Energy Transfer Partners will begin to increase its distribution in the near future. This will redound to the benefit of Energy Transfer Equity, which serves as a leveraged way to play both Energy Transfer Partners and Regency via its general partner interests.
TER: Darren, thank you very much.
DS: Absolutely, thank you for having me.
Darren Schuringa was previously a partner and senior portfolio manager with Estabrook Capital Management, where he managed over $1B of fund, institutional and individual assets. At Estabrook, Schuringa oversaw separately managed accounts. In addition, he served as co-manager of the Bank of NY Hamilton Large-Cap Value Fund, a Morningstar five-star rated fund, and co-manager of an institutional collective trust from the date of each fund’s inception. Schuringa received a Bachelor of Arts in finance from the University of Western Ontario in Ontario, Canada, and a Master of Business Administration in finance from the Crummer School at Rollins College in Winter Park, FL. He is also a Chartered Financial Analyst (CFA).
The world still needs gold and other natural resources, but we may need a new investment model to sustain them, says Byron King, writer and editor for Agora Financial’s Outstanding Investments and Energy & Scarcity Investor newsletters and contributor to the Daily Resource Hunter. Despite ongoing market volatility, he names several midtier and small-cap gold equities for investors with a “reasonable” tolerance for risk. In this exclusive Gold Report interview, King also shares his perspective on the practical and political future of gold mining in South Africa.
The Gold Report: Among the 14 investments in your Outstanding Investments portfolio of precious metals companies and funds, there are 10 companies and 4 funds. All 10 companies have market caps above $1 billion. How did you select them?
Byron King: Let me answer the question by referring to something that Chuck Noll said when he coached the Pittsburgh Steelers in the 1970s. Every year, during the National Football League draft, people would ask him what position he was going to draft for. Noll’s answer was that he didn’t draft for position; he looked for the best all-around player.
I do the same for the Outstanding Investments list. I don’t pick a particular type of play or method of operations. I look for the best particular company in any given month when I’m making a recommendation. I want a company with long-term potential and portfolio staying power.
TGR: Is it important that all of those companies pay a dividend?
BK: It is. I want paying the shareholders to be part of management’s philosophy. I want paying the shareholders to be as important to management as paying their own salary, or paying the electric bill or anything else.
TGR: Was that important to you before 2008 or is it is a more recent preference?
BK: I’ve always liked dividends, certainly from large companies. Large companies with large cash flow spend money for all sorts of things. Companies pay big bucks for executive salaries, headquarters and corporate jets. Okay, I get it. Still, the company had better have money for its shareholders. Companies need to include shareholders as regular creditors.
TGR: What do the funds add to the portfolio?
BK: Trading flexibility, more than anything else. If you want to own physical metal, then own physical metal. Take delivery. But if you want to be able to trade in and out of metal movements, funds are okay. Also, funds offer investors a way to expose their portfolio to the upside of the gold and silver plays without locking themselves into a particular company.
For example, when Agnico-Eagle Mines Ltd. (AEM:TSX; AEM:NYSE) had a situation where the structure of its mine in Québec became unsafe and had to stop operations, Agnico-Eagle took quite a hit. Whereas, if you own a fund that owns a variety of gold mine companies or precious metals, you don’t suffer the big hit from a one-off disaster at a particular company.
TGR: What is your rationale for recommending the SPDR Gold Shares exchange-traded fund (GLD:NYSE.A)?
BK: I recommend it for trading purposes only. I make a point of saying that SPDR is a play for when you want to trade in and out of the fundamental metal. If you want long-term gold holdings, you should own physical gold or find another way of doing it, not through SPDR.
TGR: There are no major silver producers represented in the portfolio. Tell us about that decision.
BK: I got out of a couple of large silver producers about a year ago because I thought silver was entering a decline, which it did. That does not mean I would not get back in to the silver producers in the months to come.
TGR: Impala Platinum Holdings Ltd. (IMP:JSE) is the only company in the portfolio that does not have a Buy rating. Why not?
BK: Impala is an intriguing company. It has great potential upside, but it’s frustrating. Because it is a South African play, there’s an element of political risk.
Still, I believe platinum has a very strong upside. Impala could benefit from that. I would call Impala a Buy for people with a stronger than usual stomach for risk.
TGR: Of the 10 companies in the Outstanding Investments portfolio, what are a couple that you think offer the most value right now?
BK: For someone with a two- to three-year timeframe and a reasonable tolerance for risk, NovaGold Resources Inc. (NG:TSX; NG:NYSE.A) is finally making good progress up in Donlin Creek, Alaska. Donlin Creek is one of the world’s largest new gold plays with well over 30 million ounces (Moz) Identified. You cannot ignore NovaGold as an important player in the coming years. The question is how it will get from the here-and-now to those years to come. Everything about NovaGold has been slower and more costly than we would like. In another interesting angle, NovaGold spun out a copper play.
TGR: Yes, NovaCopper Inc. (NCQ:TSX.V; NCQ:NYSE.A). Tell us about NovaCopper and how that will work.
BK: Basically, NovaCopper is the Upper Kobuk Mineral Project (UKMP) in northwest Alaska.
For people with a long-term timeframe, the Upper Kobuk project, under the NovaCopper banner, is worth adding to the portfolio. Investors will have to be patient and realize they’ll go through the up-down rollercoaster cycles as the play develops and evolves. But for a long-term resource play, I think NovaCopper has long-term reward.
TGR: NovaGold also has looked into working with third parties for the gas pipeline, the port facility, the oxygen plant and various mining equipment at Donlin Creek. These could potentially reduce its capital needs by about $1 billion, or approximately 20% of its capital expeditures, so it would have to raise less capital to meet its financial commitments to Barrick Gold Corp. (ABX:TSX; ABX:NYSE) to develop Donlin Creek. Will this ever get to production or does Barrick just take it out? [Editor's Note: NovaGold has not engaged in nor undertaken to engage in any leasing agreements at this time.]
BK: I anticipate an eventual takeover by Barrick. If I were Barrick’s management, I would want to add the entire body of that gold resource to my bottom line for my own defensive purposes and to impress the stock market.
TGR: Some of the companies in the Outstanding Investments portfolio have large mines or significant exposure to Africa. South Africa, with its prolific Witwatersrand basin, is still the continent’s largest gold and platinum group metals (PGMs) producing region, but gold production in South Africa went down in 2011 and there are whispers that the ANC wants to nationalize at least a portion of the country’s PGM mines. What is your take on the current state of mining politics in South Africa?
BK: I was just in South Africa, in May. First, South Africans generally are nervous about what’s happening with the euro, the dollar and the Chinese economy. As a major resource-exporting country, those economies are South Africa’s markets. They’re the cash register for South Africa. So with all the issues in Europe, North America and Asia, South Africans feel as if they are being pulled along by events that are far out of their control.
In addition, as the price of gold and other South African commodity exports drops, the South African national income account drops. What’s more, because much of the accounting is done in U.S. dollars, the strengthening dollar is creating cost inflation in the South African mining industry. The country is getting less money for its products, yet it is paying more to operate its mines. That is very troublesome for the political powers and for the industry.
Unfortunately, the way to deal with the immediate situation is to lay people off. In a country where unemployment is as rampant as it is in South Africa—5% officially, and more like 50% when you count underemployment—that becomes a very dicey political issue. Right now, the big issue in South Africa is the day-to-day economics of the mining business.
When you get into the bigger, pie-in-the-sky takeover questions, the South African political structure has to account for the fact that many of the largest mining operations are extremely expensive to operate because the mines are so deep and technically challenging. The future of deep mining in South Africa is not putting people in the ground to do the work; the only way South Africa can remain a large-scale miner, certainly in the Witwatersrand basin, is with robotic mining.
But automation and robots raise all kinds of technical and cultural issues. One miner down below might support 10 people working in the plant on the surface, and those 10 people working on the surface might support 100 people in their local village. So, one mining job underground in South Africa might be the key to 100 people eating or not eating.
TGR: Some of the bigger mines employ 10,000 people. They do not have the mechanized infrastructure of a North American operation.
BK: No, and mechanization is a very contentious issue with the National Union of Mineworkers in South Africa. However, the economics and safety issues are such that many of the large South African mines must move toward more automation or they will have to shut down the mines. The mining companies are already doing the research and development. I know this. I’ve seen some of the futuristic technology.
TGR: Is South Africa a safe place to invest?
BK: I am OK with investing in large, well-known, name-brand companies with liquidity on the markets in Johannesburg, London, the U.S. or Canada. I am nervous about South African politics there in the medium to long term. For the average North American investor who wants an array of mining or energy stocks, owning shares in a few South African companies listed on North American and European exchanges is fine, but keep your eyes open.
TGR: What about other jurisdictions in Africa? Has the recent turmoil in Mali and subsequent selloff created opportunities, or should retail investors stick to safer jurisdictions?
BK: Right now, one of my strongest small-cap or micro-cap recommendations is Reservoir Minerals Inc. (RMC:TSX.V), which is in Serbia. The Serbian angle alone for copper and gold makes Reservoir Minerals a great play, but it also has some very promising acreage in Gabon.
TGR: Is that a gold play?
BK: Yes, at an early stage. It is based on geologic research performed in years past by France’s Bureau of Geological and Mining Research, which identified some very promising pre-Cambrian greenstone plays in Gabon.
TGR: Where are Reservoir’s projects?
BK: East of Belgrade, it has a gold mine at Deli Jovan. This is a mineral district that goes back to the Roman Empire. A gold mine there was blasted through solid gabbro back in the early 1900s and closed just before World War II. The Reservoir people opened it up after 75 years. To my mind, this is a very promising gold-mining district.
Reservoir also owns acreage adjacent to the Bor copper deposit in Northeastern Serbia. At one time, Bor was the largest copper mine in Europe. Reservoir has mineral claims along strike, north and south of the Bor mine, which it is joint venturing with Freeport-McMoRan Copper & Gold Inc (FCX:NYSE).
TGR: Is there one other small-cap or micro-cap name you could leave our readers with?
BK: One of my favorite small gold players is Carlisle Goldfields Ltd. (CGJ:TSX; CGJCF:OTCQX) in Lynn Lake, Manitoba. Carlisle is pursuing the gold mineralization in an existing mining district—an old copper-nickel play from the 1950s and 1960s. The old miners never went after the gold because the price did not support it, way back when. But there is a remarkably large gold-silver resource in the area.
Lynn Lake has railroad access, which lessens infrastructure costs dramatically. There also is an airfield nearby. There is a lot of old mining heritage and mining history there. It’s not that you would really reactivate any of the old works, but in terms of a brownfield development in the midst of the boreal forest of northwest Manitoba, this is a very promising gold-silver play.
TGR: Basically, Carlisle is working on an extension of the Canadian Shield that goes into Manitoba and stretches around Hudson Bay. Does it have a maiden resource yet?
BK: Carlisle has over 2 Moz Identified, and I think there is more to come. It has an aggressive drilling program. It is cashed up with enough money to do what it needs to do. It already spent the money needed for drilling. Moving ahead, it just has to do back-office lab work and paperwork to process the NI 43-101. I expect Carlisle to show stronger and stronger numbers in subsequent iterations of the NI 43-101. I think it’s a strong takeover candidate.
TGR: Who would do that?
BK: I do not want to be overly speculative. An Agnico-Eagle type of company, a strong midtier that needs a nice resource. I expect its 2 Moz will double in the next 6 to 12 months based on data that’s still being crunched, and without much new drilling. I think Carlisle would make a very attractive 3 to 5 Moz addition to a midtier player.
TGR: Are there rosy days ahead or should investors expect continued volatility?
BK: I think we will have to live with volatility for the foreseeable future. The good news is that the world needs resources. There are seven billion people out there. A billion are doing all right, just now, and the other six billion want to get there, too.
The next big issue is whether the world economy supports the investing model we’ve grown up with. The China story is beginning to unravel. The Chinese are pouring less steel, and even rejecting shipments of iron ore. It’s a slowdown that’s been building for a while, and now we have to deal with it.
We have unending problems in Europe. No need to elaborate there, right? Meanwhile, the U.S. is in the middle of a presidential election season. Everything that anyone says for the next six months will be nothing but political propaganda; you have to work really hard to decipher the truth. As the summer wears on, the U.S. will reach its debt limit and we’ll have those arguments and the threat of a U.S. government shutdown all over again. All of these big picture things are weighing down on people’s willingness to invest in the future.
I was at a conference last week at Harvard University. I was in the room with senior executives from high-tech firms, large money managing firms and such. Everyone talked about how nervous they are about the future. One person explained why he’s sitting on a huge wad of cash and not spending. He said, “I can deal with a recession every 10 years, but if we are going to have recessions every two or three years, I am going to accumulate as much cash as I can. I will sit on it and ride things out, good and bad.”
People are nervous about the future, about investing, about whether they will ever see a return on their investments. We’re living in a world of return-free risk. Where’s the future in that?
We have to learn to live with market volatility. That does not mean there are no opportunities out there. It just means that the risk profile of owning for the long term will be much more problematic.
TGR: You said the world needs resources, but does the world really need gold?
BK: Easy question. Yes, the world needs gold. Gold prevents the people who make and run fiat currencies from doing anything too stupid, although I seldom fail to be amazed. The people in charge are really pushing the limits of that stupidity-envelope.
TGR: Thank you for your insights.
Byron King writes for Agora Financial’s Daily Resource Hunter. He edits two newsletters: Energy & Scarcity Investor and Outstanding Investments. He studied geology and graduated with honors from Harvard University, and holds advanced degrees from the University of Pittsburgh School of Law and the U.S. Naval War College. He has advised the U.S. Department of Defense on national energy policy.
Tom MacNeill doesn’t have to go far to find the most unique early-stage energy companies to invest in. The President and CEO of Saskatchewan-based investment firm 49 North Resources, MacNeill is bullish on his own backyard, and says of the province’s resources, “You name it, we’ve got it.” In this exclusive interview with The Energy Report, he explains why Saskatchewan resource plays trump their Alberta or Ontario counterparts.
The Energy Report: Even some of the most successful small-cap resource investors were schooled in 2011. What did you learn from last year’s ups and downs?
Tom MacNeill: We were definitely reminded of the nature of resource investments. Liquidity absolutely vanished in 2008, but by the time it reappeared in 2009 and 2010, investors had decided they wanted to keep their hands on their cash. Oil entered and exited 2011 at roughly the same price, but at times it had been much higher and much lower. That spooked investors. It became evident that most of the investors who were still comfortable with equity investments preferred dividend paying structures. It’s been a very edgy time.
We were reminded that investors were walking on thin ice. The companies that stepped up and started increasing distributions from their oil and gas production were well served. Those that did not, were not. There’s been a bifurcation in the market. The entire capped energy index is down relative to most of the broader indexes for the simple reason that investors were withdrawing money from the sector even though one barrel (bbl) of oil was about $100 throughout the year.
TER: Will the legacy of 2011 be the split between those companies that brought in dividends and those that didn’t?
TM: It’s one of the legacies. A lot of companies die in the aftermath of an event like the 2008 downturn. However, not enough undeserving companies died off because they had just completed financings and had millions of dollars in their treasuries that enabled them to weather the storm. We didn’t have enough of a rout.
Going into 2011, there were still a bunch of these Johnny-come-latelies and investors got wise. They started to watch the burn rate and what management was doing. It was a wakeup call. It was a really bad year in ‘08, it was OK in ‘09 and ‘10, and then ‘11 leveled as investors became objective. I believe that investors are more objective this year than they have been in five years.
TER: Your company doesn’t just invest in resource companies, it also instills management teams and brings in consultants with specific expertise. It’s an investor and a partner.
TM: We’ve had to be a little bit of everything within 49 North. We act as in-house management for developing companies. We provide seed capital and later-stage capital. We’ve got 25-plus of the best geoscientists in Saskatchewan on staff in one of our subsidiary companies, Northrim Exploration Ltd. That enterprise works with most of the senior players working in the province developing potash, oil and gas, and other sedimentary resources and is moving into hard rock mining consultation. We also have substantial connections within the junior resource capital market and investment banking community worldwide.
We had to develop it that way for the simple reason that we had no capital market in Saskatchewan. Where government used to hold business back, it is now very supportive. The resource business is now wide open. It’s a tremendous opportunity for us, and anybody who wants to invest in the province, because it’s like Alberta was in the ’40s and ’50s.
TER: Saskatchewan certainly shares some of the same commodities with Alberta.
TM: We view ourselves as much better off than Alberta from a geological perspective. The Western Canadian Sedimentary Basin overlays almost all of Alberta, meaning there’s really no hard rock mining with the exception of some coal mining and some other assets in the Rockies. Alberta is very much an “energy only” resource province.
Saskatchewan is the opposite. The sedimentary basin covers the southern half, but the northern half is exposed Precambrian shield. We’ve got all of the mining prospectivity and assets that you would find in Ontario and other hard rock jurisdictions, plus all of the oil and gas that you find in Alberta, and a sea of potash and other natural resources. You name it, we’ve got it. The neatest part is that it’s mostly still in the ground. There are 27 active mines in the province, but we should have a multiple of that given our resource base.
TER: How long do you think it will take you to get to that point?
TM: We have just begun, but it is moving fast. There is $15 billion (B) worth of capital committed already to expansion in the potash industry, not including capital commitments from BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK), which is moving into the final feasibility stage of its 8 million tons (Mt) per annum potash mine at Jansen Lake. When mining is combined with our exponential growth in energy development I expect that $15B will double or triple in the next 5-10 years.
One new gold mine just came on-stream this past year. There are three others that are prospective in the Greenstone Belt in northern Saskatchewan. There’s a potential rare earth elements deposit that’s near development. In the next 10 years, at least 10–20 mining operations should reach feasibility in the province.
TER: One commodity that Saskatchewan is well known for is uranium. The Athabasca Basin is one of the richest areas for uranium in the world. In a 2010 interview with The Gold Report, you told us that you had mostly purged uranium from 49 North Resources’ portfolio and wouldn’t get back in until it was “time.” Is it time yet?
TM: The comments I made were based on a couple of observations. There was a physical price spike in 2006 due to uranium speculators. It created a parabolic price chart, so we knew that the price of uranium was going to come off. When that happens, all of the junior explorers get crucified. We took that time to exit our positions.
We’ve been diligently watching the uranium price chart and energy complex in general and view this year as the time to be taking positions. Uranium stocks have been beaten up. That’s the time when we get involved in projects and we’re actively pursuing more than what we have on the books right now.
We’ve got a significant investment in Unity Energy Corp. (UTY:CVE), which is an early-stage explorer in the same area as Hathor Exploration Ltd.’s (HAT:TSX.V) RoughRider deposit and the area were Fission Energy Corp. (FIS:TSX.V; FSSIF:OTCQX) is exploring. Also we have been accumulating a large position in Eagle Plains Resources. They have substantial landholdings in the Athabasca basin in Saskatchewan and recently announced a high-grade uranium discovery on their property near the Rabbit and Cigar lake mines.
TER: Tell us about Unity.
TM: It’s in the early stages of a promising exploration program having done the geophysical work necessary to advance their package of properties. We hold approximately 12% of Unity. Given that initial results have been very encouraging, we will likely be expanding our exposure shortly.
TER: What’s the earliest that Unity would have a resource estimate?
TM: They are at a very early stage in the exploration cycle so the earliest would likely be at least 2-3 years. Investors need to realize uranium exploration takes time, is expensive and if you want good science you can’t rush the process. This is a long-term investment, as all uranium exploration plays are.
TER: What macroeconomic trends are going to continue to drive energy commodities?
TM: Oil acts a lot like gold in that it’s a good parking lot for rampant money printing in the U.S. One thing that can quell inflation in the short term is a high oil price since it slops up many of the newly printed dollar bills in an asset that is used almost immediatly. This seems counter-intuitive, but it takes time for the inflationary effect of high oil prices to bleed into higher asset prices. So in the short term, it actually helps the money printers because all over the world, oil is traded in U.S. currency, thus distributing the new liquidity worldwide. The U.S. is the only country with this advantage, which creates some ironic economic activity that investors should pay attention to. As long as the U.S. keeps printing money, there’s going to be a high oil price. If the liquidity being added actually creates economic development, there will be rampant inflation. Usually that’s a tap that can’t be turned off, which could lead to much higher oil and gold prices. We view the coming five-year period as very interesting and probably very lucrative for resource investors, especially in gold and energy.
TER: What energy commodities are you most bullish on this year?
TM: We’re focusing on heavy oil and coal (for conversion to crude oil), but our backyard is unique. There are 20–40 billion barrels (Bbbl) of heavy oil in place in west central Saskatchewan. There are also staggering quantities of light oil as well in Saskatchewan, but I’m not as interested in that. Everyone knows about the Bakken shale and other tight light oil plays now being developed using modern multi-staged fracturing but very few follow heavy oil development.
My interest is tied to the recycle ratio, which is the net profit/bbl divided by acquisition and development costs/bbl. The ratio for light oil in Saskatchewan averages somewhere around two, meaning if a company puts $1 million (M) into acquiring and developing an average well, it will get $2M out of it. But heavy oil in Saskatchewan can have a recycle ratio as high as five.
That’s not true of everywhere in the world. We have two heavy oil upgraders in Saskatchewan that have been consistently adding capacity so we’ve got a real blessing here in that we can develop our heavy oil fields and achieve higher netbacks than elsewhere because of that very unique refining capacity in our backyard.
TER: What are some of the companies benefiting from that?
TM: Most of the companies that are developing these heavy oil assets that are in production are very large already and beyond our scope, such as Canadian Natural Resources LTD. (CNQ;TSX) and Baytex Energy Corp. (BTE.UN:TSX). We’re sponsoring private companies in this space. However, Baytex is coming up with ingeneous ways to drill multiple lateral wells from one drill pad and get enormous production out of thin-formation, heavy oil projects. They also pay a pretty decent dividend yield as well. That’s the kind of story we’re looking for, but we’re looking for it at a very early stage when a company has a prospective heavy oil development field and is investing its first $1–5M in the project.
TER: Are any of your private oil plays expected to go public?
TM: Probably. Allstar Energy Ltd., in west central Saskatchewan, is a light oil producer that is converting into a heavy oil producer as well. We’ve actually taken that one in-house and made it a subsidiary company. Had the capital markets been a little bit more buoyant over the last nine months, we might have entertained taking that company public sometime last year. At some point, given it’s growth potential, its capital needs will outstrip our ability to supply it and we’ll have to take the training wheels off and take it public. That could be in 2012 or 2013 depending on how development goes.
We also sponsor Admiralty Oil Ltd., a very early-stage light oil development in southeastern Saskatchewan. It will probably go public if it has some success this year.
TER: You said you are bullish on coal. What are some of your holdings in that space?
TM: There are two that we really like, which are both developing coal-to-liquid technology. We view coal as just another long carbon chain that can be converted into a shorter carbon chain to make heavy crude. These two enterprises are going about it in different ways.
NuCoal, a private company in southern Saskatchewan, will use full gasification to convert coal into transportation fuels at the mine site. It’s a multibillion-dollar project. The company has control of one of the largest coal resources in the world and it could possibly go public sometime in the next 12–18 months.
Westcore Energy Ltd. (WTR:TSX.V), which we have an approximate 25% stake in, has a significant thermal coal resource that it’s developing on the Saskatchewan-Manitoba border. It is working with Quantex Energy in Calgary, which has a proprietary technology developed at the University of West Virginia. Quantex tested some of Westcore’s coal and determined that it’s perfectly adequate for converting into heavy or light crude depending on the extent of processing.
Westcore is currently starting its winter drilling exploration program. It already has at least seven defined targets that have hit intersections as thick as 100 meters (m) of coal, which is absolutely enormous. It’s conservative to estimate that those intersections average 50Mt/coal, which could mean that the company has at least 300Mt/coal in one small area. That’s world class. It appears it will cost about $40-50/bbl of oil for the conversion technology. It will probably cost approximately $200M to build an initial 10,000 bbl/day conversion facility. Given that the process appears to convert coal to heavy crude at a ratio of 3-4 bbl crude from each ton of coal, there’s an almost endless potential supply of heavy crude oil for the refiners in Saskatchewan. Now that is an exciting energy story.
TER: It does sound exciting. Is the process by which they turn coal into heavy oil similar to what’s happening in the oil sands where they steam the bitumen to separate the oil from the sand and gravel?
TM: That’s a liberating technique using steam to get the bitumen. Then the bitumen is processed through hydrocracking, which involves heating up the bitumen under pressure with catalysts to separate it by strata into various elements. The lights float to the top of the column and the heavy stuff stays at the bottom, leaving five or six different strata. These synthetic crude products are then piped to refineries for further processing. The NuCoal project is similar to that in that it uses similar full-scale gasification technology but with the intention of the plant refining all the way to the transportation fuel level right on site.
The Westcore/Quantex route involves using a low-temperature direct liquefaction process. It adds some proprietary chemicals to the coal once it’s emulsified and converts it into heavy crude. The beauty is that the process does not leave much of a greenhouse gas footprint at the mine/processing site because most of the carbon dioxide and other problematic gases that would be emitted stay in the heavy crude and go to the refinery. The exciting part about low temperature conversion is its scale-ability with initial capital cost of probably one tenth that of full-scale gasification.
Both companies have viable approaches; they are simply on opposite ends of the development spectrum. One has low capital cost with smaller initial production while the other has large capital requirements at startup and therefore large initial output. At these energy prices we believe both approaches will be robustly economic.
TER: Once it’s converted it goes to the refineries. Where does the oil go from there?
TM: It is channeled into the North American distribution system running from northern Alberta into a hub center near Chicago. It goes directly into the pipeline system that bisects Saskatchewan diagonally. That’s the beauty. We’re infrastructure laden because we’re in between the consumptive market in the eastern U.S. and the production of western Canadian oil sands and conventional producers in the Western Canadian Sedimentary Basin.
TER: Do you have some parting thoughts on the energy space?
TM: I’m curious to see what prices are going to do. We’re comfortable that the price of uranium has bottomed and that it’s likely a very long-term bottom. We got our feet wet last year in some of the early-stage investments we’ve made. We’re going a lot harder this year and repatriating capital back into projects that we like. There are lots of good opportunities out there within companies that have done poorly in this twitchy market but have good projects.
The energy space should be an exciting one. If the governments keep adding liquidity, the resulting competitive devaluation of currencies will be inflationary and good for commodity prices. Or perhaps the world is going to get a little bit better—also good for commodity prices. It’s a bit of a win-win situation over the next five years if investors are patient.
Investors have to make sure that they stick to certain criteria. Look at management first, not the project, because the best project in the world can be screwed up by bad management. A marginal project can be made wonderful by good management.
TER: Thanks, Tom.
Read more of Tom MacNeill’s gold investing ideas.
Tom MacNeill is the founder, president and chief executive officer of 49 North Resources Inc., a Canadian resource investment company headquartered in Saskatchewan. As the first entity of its kind in the province’s history, 49 North is a pioneer in what is rapidly becoming one of the world’s most renowned resource jurisdictions. A graduate of the University of Saskatchewan (economics/geology), MacNeill is also a certified general accountant and holds a chartered financial analyst designation. MacNeill’s extensive knowledge of Canadian capital markets has been gained through experience as a management accountant within the mining industry, investment advisor with a major Canadian brokerage firm and chief financial officer of a Canadian trust corporation. He is a well-respected member of the resource industry and part of a worldwide network of exploration professionals and resource developers which enables him to source and structure projects.
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.
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.
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.
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.
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.
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.