Planet of the Apes?
“They did it! They blew it up!” shouts Charlton Heston in the iconic ending scene of the film Planet of the Apes when he finds out he has been living on a post-nuclear war planet Earth. Americans are probably having some of the same feelings about our current world resulting from the ongoing political “nuclear war” raging in our nation’s capital.
Beyond the drama in Washington D.C., ordinary life goes on and in particular, the economy marches slowly forward. So far the financial markets have shrugged off the shenanigans going on in the Congress. Repeated crises this year that have been averted by last minute compromises may have made investors blasé about the budget and debt ceiling fracas. The stock market rose while MLPs, as measured by the Alerian MLP Index, were basically flat in the past quarter before this latest crisis. Despite the tax bill uncertainty at the beginning of the year, the sequestration budget cuts that went into effect this past spring, and the rise in interest rates since May, the Alerian MLP Index has risen 21.2% this year through September.
Nevertheless, concern about the future direction of the financial markets and MLPs is high given the disturbing political backdrop. A negative outcome from the Congressional standoff, or a further rise in interest rates, or some other unforecastable event, could negatively impact MLPs in the short run. Unfortunately these short run perturbations are inevitable and we endeavor to not overreact to them. While we remain vigilant to the risks to our portfolio in the short run, we continue to be guided by our assessment of individual company long-term total returns. We believe that the long-term prospects of MLPs and midstream energy infrastructure companies remain attractive, especially in an environment where numerous growth projects offer visible paths to potential distribution increases.
Plentiful Potential Investment Opportunities Fuel MLP Capital Raising
During the quarter, MLP management teams announced a number of new investments. The year 2013 appears to be on track to be a record year for capital raising, fueled by IPOs, acquisitions, and new organic capital projects. So far, 13 companies have completed initial public offerings this year, raising over $3.5 billion. The fourth quarter promises to also be busy as the visible backlog of companies filing to go public remains robust. The third quarter saw $7.3 billion in MLP equity raised bringing total MLP equity issuance to nearly $24 billion this year, including private placements to general partners. MLPs also raised a significant amount of bonds as both investment-grade and non-investment grade MLPs continued to take advantage of record low interest rates to lock in long term financing at favorable terms. Companies issued low cost debt mainly to fund construction projects and to refinance higher cost debt, both of which could increase the available cash flow for distribution going forward.
The MLP sector has been able to raise equity capital at such a brisk pace at least partly due to the expansion of MLP-focused funds and other investment vehicles. These new investment vehicles have made it easier for investors to overcome some of the impediments to investing in MLPs and have widened the universe of potential investors. In addition to closed-end funds, which have been a major source of new investor capital into the MLP space for many years, open-end funds, ETNs and ETFs have become a significant source of new investor capital in the past two years, and this past quarter was no exception. Open-end mutual funds focusing on midstream energy infrastructure are the newest and fastest growing source of funds to the sector, with now over $9 billion invested in these new vehicles alone. While the growth in MLP-focused open-ended funds is dramatic, many of these new investment vehicles are relatively young and are still a small fraction of the total sector market capitalization. Recently it was estimated that investment products linked to MLPs represent approximately 7% of the total MLP market capitalization; by comparison, it is estimated that REIT investment products represent approximately 27% of the REIT universe. It appears that these new investment vehicles are still in the early innings of raising investor funds.
Furthermore we continue to see MLPs gain acceptance with institutional investors like pension and retirement plans. The market capitalization of the sector continues to expand which we believe is critical in attracting these larger pools of assets. By some estimates the pure MLP market capitalization (not counting the MLPs structured as C corporations) is over $450 billion. Shareholder databases indicate that the typical institutional ownership level of MLPs is 50% of the level of institutional ownership of REITs or Utilities. We believe the trend of institutions continuing to raise their exposure to MLPs has many years to go.
Underlying this increased need for capital is the requirement for infrastructure to develop new hydrocarbon basins. As we have noted previously, dramatic increases in the production of oil, gas, and natural gas liquids from North America have been unleashed by new technologies improving recoveries from previously uneconomic shale formations. In July, the U.S. Energy Information Administration announced that the U.S. is on track to surpass Russia as the largest producer of oil and gas in the world this year. The US EIA projects that the U.S. will produce 22 million barrels a day of oil, natural gas, and related fuels, which is slightly above their estimate for Russia’s production this year. (Saudi Arabia is the world’s largest oil producer, but not a major player in gas unlike the U.S. and Russia.) While Saudi Arabia and Russia still top the U.S. in oil output, recent gains in natural gas production have vaulted the U.S. to being the top hydrocarbon producer in the world. In our opinion, the current abundance of new hydrocarbons from different geographies has created many potential investment opportunities from which to choose by MLPs and MLP-related companies.
Announcements of large potential projects just keep coming. TransCanada announced that it will move forward with its $12 billion Energy East project to convert its existing natural gas pipeline to crude oil service. Also Spectra Energy Partners and NextEra Energy Inc. plan to construct a $3 billion interstate natural gas pipeline to supply power generation needs in Florida. Enbridge announced a $1.3 billion extension of its Woodland Pipeline to expand oil transportation capacity from the oil sands of western Alberta. Williams and Boardwalk continue to increase the scope of their Bluegrass joint venture, with the latest announcement of an LPG export terminal added to the $1.5+ billion project. El Paso Partners announced they received sufficient interest from shippers to go forward with expansions of their natural gas pipelines in the Southeast, and numerous other projects were announced.
The acquisition market was particularly active this summer. The biggest deal was the announcement by Spectra Energy Partners to acquire the remaining U.S. transmission, storage, and liquids assets of its parent Spectra Energy for $11 billion. The assets included most notably the Texas Eastern Transmission Pipeline system. This follows the announcement that Spectra Energy Partners would acquire its parent’s interest in the Express-Platte system in June; after these transformative transactions, Spectra Energy Partners will hold all of the U.S. pipeline assets formerly held by its parent. The parent will now hold the general partner and limited partner interests of Spectra Energy Partners in addition to its Canadian assets and 50% of DCP Midstream LLC. Another notable transaction was the announcement by Oneok Inc. that it will spin off its regulated natural gas distribution utility holdings into a new security called One Gas. After the spin-off, Oneok Inc. will also be primarily a holding company for the General Partner of its associated MLP, Oneok Partners. This transaction is expected to be completed in the first quarter of 2014. Also in the quarter, Plains All American Pipeline LP announced an offer to acquire all of the publicly held units of its associate PAA Natural Gas Storage in a deal valued at about $1.4 billion. A number of smaller acquisitions were also announced in the quarter, which coupled with the larger acquisitions noted above and the deals already announced earlier this year could make for a record year of MLP acquisitions in 2013.
Political Update: Gridlock as Usual
At the beginning of this year there were fears that Congress would restructure the tax code in a way that might alter the tax status of MLPs. Now given the extreme dysfunction between the parties that has led to the recent government shutdown and debt ceiling impasse, it is hard to imagine the parties could agree on a tax reform package. With the shenanigans going on in Washington D.C. today we are reminded of the Mark Twain quote: “Suppose you were an idiot, and suppose you were a member of Congress. But I repeat myself.” We continue to believe that a major change in the tax status of MLPs is not likely to occur any time soon. More and more it appears that a general tax reform would have to be undertaken after a national discussion during a Presidential campaign since the sides are so far apart. Nonetheless, the merry-go-round of Washington politics is a never ending puzzle and we continue to closely monitor the administration and Congress for signs that MLPs could be affected by some of the various tax proposals being discussed; however, we have not seen any specific developments of concern.
Our Long-Term Outlook: Positive
As we look towards the future, we continue to believe that over the next five years the midstream energy infrastructure markets should generate positive annual returns through a combination of yield and price appreciation. Valuations, while not as attractive as they were at the beginning of the year, we believe are still attractive relative to most other asset classes. Given the rise of interest rates in the past quarter, spreads of MLP yields versus Treasuries, REITS, corporate bonds, and high yield bonds have compressed from unusually high levels but still remain above the long-term average. We think the outlook for distribution growth is also very healthy, driven by accretive capital projects and the availability of asset acquisitions. So despite the sharp run up this year, our outlook for attractive total returns for the next twelve months remains intact.
While rates on fixed income, REITs, and utility securities rose in the quarter, they are still absolutely low in a relative and historic context. In contrast, while MLP yields are lower than before, we believe they still appear attractive to the yield oriented investor. We believe that the demographic trend of an aging population retiring and expecting to live off their investments may result in a wider investor base seeking out the income generation of the MLP asset class. We also believe that the growth in the distribution that MLPs and MLP-related companies may offer is a further attraction to those seeking to stay ahead of inflation and potentially earn positive real returns as well as seeking a buffer to rising rates in the long term.
David Chiaro is Co-Head of MLP Strategy for Eagle Global Advisors, LLC,
Co-Portfolio Manager of the Eagle MLP Strategy Fund
This report was prepared by Eagle Global Advisors, LLC and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Eagle Global Advisors, LLC makes no representation regarding the advisability of investing in the products herein. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice and is not intended as an endorsement of any specific investment. The information contained herein is general in nature and is provided solely for educational and informational purposes. The information provided does not constitute legal, financial or tax advice. You should obtain advice specific to your circumstances from your own legal, financial and tax advisors. As with any investment, past performance is no guarantee of future performance.
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