Need for New Midstream Energy Infrastructure Remains Strong
The Polar Vortex
Blasts of cold air swept over North America in the first few months of 2014 that froze cities, snarled travel, created numerous business, school, and road closures and introduced the phrase “polar vortex” into the lexicon. This year will rank as one of the coldest on record for North America; many cities and regions recorded record low temperatures and an extended winter season. Early January in particular saw historic low temperatures set across the U.S. with even parts of Georgia recording temperatures below zero. Heavy snowfall east of the Rockies was coupled with a record drought west of the Rockies. Climatologists cited a “sudden stratospheric warming” which led to a breakdown in the regular “polar vortex” which altered the jet stream to send cold winds from the Arctic much further south than usual.
This record cold spell also had a cooling effect on the economy in the first quarter. Economists revised down their GDP growth estimates for the U.S. as factories shut down, construction slowed, and consumers could not get to the malls to shop. Employment growth slowed significantly as the monthly new jobs report showed significant drops in the pace of job creation. Housing starts and sales dropped meaningfully and car sales slowed. But bad news for the economy as a whole was good news for energy producers. Demand for heating boosted the consumption of natural gas and heating fuels like propane. Natural gas prices rose to their highest level since 2011 and gas reserves are exiting the winter at one of their lowest levels in years. Producers will have a big job to refill gas storage to normal levels this summer in time for next year’s heating season. If not for the increased production of hydrocarbons that North America has experienced in recent years, the rise in energy prices we experienced this winter could have been much more dramatic.
The Pause that Refreshes
After a torrid pace of equity offerings and IPOs that has continued almost without pause for two years now, the first quarter marked a refreshing break from this pattern. We estimate that less than $3 billion was raised in secondary and follow-on offerings last quarter, down from over $5 billion in the fourth quarter of 2013. In addition, we saw only a single, relatively small MLP IPO in the first quarter versus seven in the fourth quarter of last year. The need for capital has not abated; estimates are that capital spending by MLPs in 2014 should equal or surpass last year’s $30 billion total. However, there has been a shift in the way that MLPs raise capital.
One notable development has been the emergence of ATM or “at the market” offerings. In an ATM, a company will raise new equity by selling shares steadily and continuously in the public markets subject to SEC guidelines. This method of raising capital allows issuers to avoid the sharp price drops that often accompany large follow-on offerings and also save on underwriting fees charged by investment banks. Bad news for investment bankers means good news for MLP shareholders as the cost of raising money in the ATM programs can be cheaper than other alternatives. Wells Fargo estimates that while ATM offerings amounted to only 8.4% of equity raised in the MLP sector in 2012, it had risen to over 30% in the fourth quarter of 2013. Since the end of 2013, five more MLPs have announced ATM programs suggesting that this upward trend could continue. Extrapolating these trends implies that the diminished use of traditional follow-on offerings seen in the first quarter could have been totally balanced by increased use of the ATM avenue to raise capital.
One concern raised by this development is that the negative one time price impacts of MLPs issuing secondary offerings might have been replaced by a general downward pressure on the sector from the steady issuance of new equity supply. However, a benefit of the use of ATMs might be decreased volatility of individual names as companies can increase issuance when prices spike upwards and decrease issuance when prices fall. The modest 1.8% appreciation of MLPs over the first quarter with less volatility in the overall index than the S&P 500 seems consistent with this hypothesis. Unfortunately, one consequence of the increased use of ATM programs is that we do not really know how much equity MLPs raise until SEC filings are made after the quarter is over. Right now our statements on this are mainly conjecture.
What is not subject to debate is that MLP dedicated investment vehicles continue to funnel funds into the MLP asset class. The past quarter saw two new closed-end funds go public that should enable nearly $900 million in new capital to be invested in the sector. MLP dedicated open-end funds, ETNs and ETFs also continue to grow significantly and this past quarter was no exception. Many retail and institutional investors, which were inhibited from direct investing in MLPs due to their tax structure, have taken advantage of the greater convenience and ease of tax filing that these new investment vehicles offer. Open-end mutual funds focusing on MLPs are the newest and fastest growing source of funds to the sector, with over $18 billion invested in these new vehicles at the end of the quarter. Eagle is experiencing this growth first hand as our Eagle MLP Strategy Fund saw net new inflows in the first quarter amount to a 21% increase in assets. It is worth pointing out that while the growth in MLP 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.
Underlying this need for capital is the requirement for infrastructure to develop new hydrocarbon basins. This past quarter, the INGAA, an industry association, updated its forecast for energy infrastructure needs in the coming decades to accommodate the dramatic increase in hydrocarbon production forecast for North America. They now forecast that the U.S. will need to spend $641 billion on new midstream infrastructure through 2035, up sharply from its prior forecast of $261 billion made in 2011. The primary reason for the increase in expected capital spending is the dramatic increase in North American crude oil and natural gas liquids production that is now expected; to accommodate this new production, the INGAA increased by seven times (from $48 billion to $328 billion) its forecast for the amount of new infrastructure needed to process, store, and transport these liquids. Increased expectations for natural gas production prompted the INGAA to increase their expected capital spending for this sector by 50% to $313 billion. The American Petroleum Institute also published forecasts of significant midstream and downstream infrastructure needs in the quarter. What the future actually holds is yet to be seen, but these forecasts confirm the current needs for new midstream infrastructure and suggest that this pace of capital spending may not abate for decades.
A number of MLPs announced material new capital investments. Kinder Morgan announced it would invest $1 billion to expand its CO2 operation to support enhanced recovery projects in the Permian basin. It also announced $700 million additional investing to drill oil wells and build field gathering, treatment, and compression facilities at the St. Johns field. At its analyst day in March, Enterprise Products highlighted a vast array of midstream growth opportunities that should materially add to its current backlog of $8 billion in projects. Since Enterprise is so large and diversified, it benefits from nearly all of the growth in new hydrocarbon production in North America; however, it highlighted particularly the opportunities that will arise from increased exports of NGLs and bottlenecks in the development of the new shale hydrocarbon basins. DPM, the MLP jointly controlled by Phillips 66 and Spectra, announced a $1.15 billion purchase of interests in pipelines and processing facilities from its privately owned parent.
Politics Promotes Gridlock - Again
We continue to believe that a major change in the tax status of MLPs is not likely to occur any time soon. The greatest threat to the MLP tax status has always been a general tax reform that rewrites the corporate tax code and in the process impacts the MLP structure. We wrote last quarter that this prospect was severely damaged by the retirement of the Chairman of the Senate Finance Committee Max Baucus. What little possibility for general tax reform that still existed was further reduced by the March announcement of the retirement of Dave Camp, the Chair of the House Ways and Means committee, at the end of this term. Chairman Camp had created some excitement that tax reform might progress by releasing a detailed tax reform plan earlier last quarter. While that plan had created concern that certain tax preferences might be reduced, it is notable that the MLP tax structure was not addressed in his plan. However all speculation regarding this is moot since he has announced his retirement. The new Chair of the House Ways and Means Committee will be Paul Ryan and it is not expected that a novice Chair will advance the politically complicated general tax reform early in his term.
Long Term Outlook: Positive
As we look into the future, we continue to believe that over the next five years the MLP market should generate real annual returns through a combination of yield and price appreciation. We believe valuations, while not as attractive as they were a year ago, are still attractive relative to most other asset classes. The average MLP yield is about 5.8%, down from about 6.6% at the beginning of 2013 but still fairly high. While spreads of MLP yields versus Treasuries, REITS, corporate bonds, and high yield bonds have compressed from unusually high levels a year ago, they remain above long-term averages. 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 last year, our outlook for attractive total returns for the next twelve months remains intact.
Rates on competing yield sectors like fixed income, REITs, and utilities generally fell in the quarter, and they are generally low from an absolute, relative and historic context. While MLP yields are also lower than before, they are generally above alternative yield investments and we feel 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 will result in a wider investor base seeking out the income generation of the MLP asset class. In our opinion, the growth in the distribution that MLPs and midstream energy infrastructure companies offer is a further attraction to those wishing to stay ahead of inflation and earn positive real returns as well as a buffer to rising rates in the long term.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Eagle MLP Strategy Fund. This and other important information about the Fund is contained in the prospectus, which can be obtained by calling 1-888-868-9501 or visiting www.eaglemlpfund.com. The prospectus should be read carefully before investing. The Eagle MLP Strategy Fund is distributed by Northern Lights Distributors, LLC member FINRA. This is an actively managed dynamic portfolio. There is no guarantee that any investment (or this investment) will achieve its objectives, goals, generate positive returns, or avoid losses. The information provided should not be considered tax advice. Please consult your tax advisor for further information. Eagle Global Advisors, Princeton Fund Advisors, LLC and Northern Lights Distributors, LLC are not affiliated.
A master limited partnership (MLP) is a limited partnership that is publicly traded on a securities exchange. It combines the tax benefits of a limited partnership with the liquidity of publicly traded securities. To qualify for MLP status, a partnership must generate at least 90 percent of its income from what the Internal Revenue Service (IRS) deems "qualifying" sources, generally relating to the production, processing or transportation of natural resources, such as oil and natural gas.
The Alerian MLP Index is a composite of the 50 most prominent energy master limited partnerships calculated by Standard & Poor's using a float-adjusted market capitalization methodology.
A real estate investment trust (REIT) is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors a regular distribution, as well as a highly liquid method of investing in real estate.
Credit Risk: There is a risk that note issuers will not make payments on securities held by the Fund, resulting in losses to the Fund. In addition, the credit quality of securities held by the Fund may be lowered if an issuer’s financial condition changes.
Distribution Policy Risk: The Fund’s distribution policy is not designed to guarantee distributions that equal a fixed percentage of the Fund’s current net asset value per share. Shareholders receiving periodic payments from the Fund may be under the impression that they are receiving net profits. However, all or a portion of a distribution may consist of a return of capital (i.e. from your original investment). Shareholders should not assume that the source of a distribution from the Fund is net profit. Shareholders should note that return of capital will reduce the tax basis of their shares and potentially increase the taxable gain, if any, upon disposition of their shares.
ETN Risk: ETNs are subject to administrative and other expenses, which will be indirectly paid by the Fund. Each ETN is subject to specific risks, depending on the nature of the ETN. ETNs are subject to default risks. Foreign Investment Risk: Investing in notes of foreign issuers involves risks not typically associated with U.S. investments, including adverse political, social and economic developments, less liquidity, greater volatility, less developed or less efficient trading markets, political instability and differing auditing and legal standards.
Interest Rate Risk: Typically, a rise in interest rates can cause a decline in the value of notes and MLPs owned by the Fund.
Liquidity Risk: Liquidity risk exists when particular investments of the Fund would be difficult to purchase or sell, possibly preventing the Fund from selling such illiquid securities at an advantageous time or price, or possibly requiring the Fund to dispose of other investments at unfavorable times or prices in order to satisfy its obligations.
Management Risk: Eagle’s judgments about the attractiveness, value and potential appreciation of particular asset classes and securities in which the Fund invests may prove to be incorrect and may not produce the desired results. Additionally, Princeton’s judgments about the potential performance of the Fund’s investment portfolio, within the Fund’s investment policies and risk parameters, may prove incorrect and may not produce the desired results.
Market Risk: Overall securities market risks may affect the value of individual instruments in which the Fund invests. Factors such as domestic and foreign economic growth and market conditions, interest rate levels, and political events affect the securities markets.
MLP Risk: Investments in MLPs involve risks different from those of investing in common stock including risks related to limited control and limited rights to vote on matters affecting the MLP, risks related to potential conflicts of interest between the MLP and the MLP’s general partner, cash flow risks, dilution risks and risks related to the general partner’s limited call right. MLPs are generally considered interest-rate sensitive investments. During periods of interest rate volatility, these investments may not provide attractive returns. Depending on the state of interest rates in general, the use of MLPs could enhance or harm the overall performance of the Fund.
MLP Tax Risk: MLPs, typically, do not pay U.S. federal income tax at the partnership level. Instead, each partner is allocated a share of the partnership’s income, gains, losses, deductions and expenses. A change in current tax law or in the underlying business mix of a given MLP could result in an MLP being treated as a corporation for U.S. federal income tax purposes, which would result in such MLP being required to pay U.S. federal income tax on its taxable income. The classification of an MLP as a corporation for U.S. federal income tax purposes would have the effect of reducing the amount of cash available for distribution by the MLP. Thus, if any of the MLPs owned by the Fund were treated as corporations for U.S. federal income tax purposes, it could result in a reduction of the value of your investment in the Fund and lower income, as compared to an MLP that is not taxed as a corporation.
Energy Related Risk: The Fund focuses its investments in the energy infrastructure sector, through MLP securities. Because of its focus in this sector, the performance of the Fund is tied closely to and affected by developments in the energy sector, such as the possibility that government regulation will negatively impact companies in this sector. Energy infrastructure entities are subject to the risks specific to the industry they serve including, but not limited to, the following: Fluctuations in commodity prices; Reduced volumes of natural gas or other energy commodities available for transporting, processing, storing or distributing; New construction risk and acquisition risk which can limit potential growth; A sustained reduced demand for crude oil, natural gas and refined petroleum products resulting from a recession or an increase in market price or higher taxes; Depletion of the natural gas reserves or other commodities if not replaced; Changes in the regulatory environment; Extreme weather; Rising interest rates which could result in a higher cost of capital and drive investors into other investment opportunities; and Threats of attack by terrorists.
Non-Diversification Risk: As a non-diversified fund, the Fund may invest more than 5% of its total assets in the securities of one or more issuers. Small and Medium Capitalization Company Risk: The value of a small or medium capitalization company securities may be subject to more abrupt or erratic market movements than those of larger, more established companies or the market averages in general. Structured Note Risk: MLP–related structured notes involve tracking risk, issuer default risk and may involve leverage risk. Mutual Funds involve risk including possible loss of principal.