|
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 Oil Corp. (MRO: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.
Want to
read more exclusive Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new
articles have been published. To see a list of recent interviews with
industry analysts and commentators, visit our Exclusive
Interviews page.
DISCLOSURE:
1) George S. Mack of The Energy Report conducted this interview. He
personally and/or his family own shares of the following companies mentioned
in this interview: None.
2) The following companies mentioned in the interview are sponsors of The
Energy Report: None.
3) Kenny Feng: I personally and/or my family own shares of the following
companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this
interview: None. I was not paid by Streetwise Reports for participating in
this interview.
|
