Volatility Returns to the Financial Markets
The financial markets in the U.S. have enjoyed a very rare period of stability in the past number of years. Starting from the beginning of 2012, there has not been a correction, usually defined as a 10% decline from peak to trough, in the U.S. stock market, a remarkable period of stability that has seen the financial indices rise fairly steadily over this time period. This has been especially true for the MLP sector which has seen a very strong period of returns. The worst sell-off for MLPs in this period was about 8% during the “taper tantrum” in May and June of 2013 after remarks by then Fed Chair Ben Bernanke sparked fears interest rates would rise sooner than anticipated. Since then the markets have been unusually well behaved.
This quarter, however, volatility returned to the MLP market. After a very strong start to the year, returns for investors in MLPs were volatile in the quarter. Interestingly, oil prices as measured by the West Texas Intermediate benchmark fell over 10% during the quarter, leading to declines in the stock prices of many energy companies. We have always maintained that fee-based midstream energy companies like the ones we focus on in our portfolio are not beholden to the price of oil, but they are in the energy industry and, from time-to-time, can trade in sympathy of other more commodity-sensitive companies.
We continue to see evidence that underpins our long term positive outlook on MLPs and midstream energy infrastructure companies. The need for new midstream infrastructure remains significant and announcements of large projects continue to be made. New export markets for U.S. hydrocarbons continue to develop and offer new profit opportunities for MLPs. Furthermore, the MLP model continues to expand into new areas of infrastructure; this quarter saw the first IPO of a company with primarily international midstream assets in an MLP-like high payout structure with visible growth opportunities. Investor interest continues to expand with a broadened interest in the sector among generalist mutual funds, pensions and endowments, and foreign-domiciled accounts. We continue to believe that the future of MLPs and midstream energy infrastructure companies is bright and that over time they should offer higher returns compared to assets of equal risk.
Rich Kinder Continues to Surprise
The MLP world was rocked in August when Rich Kinder announced that Kinder Morgan Inc. (KMI) would acquire its listed subsidiaries Kinder Morgan Partners (KMP), Kinder Morgan Management (KMR), and El Paso Partners (EPB) for a combination of cash and stock. Including the debt assumed in the mergers, this transaction is valued at over $70 billion and will make Kinder Morgan Inc. the fourth largest energy company in the U.S. One factor behind this transaction is that Kinder Morgan was hampered in using its subsidiary MLPs for mergers and acquisitions due to the uniquely high general partner take of the cash flows of the subsidiaries. After these transactions are closed, KMI will be well situated to acquire and consolidate portions of the U.S midstream infrastructure that complement its current footprint. We would not be surprised to eventually see KMI have a new subsidiary MLP that it could use in such consolidation efforts.
The issue of larger MLPs consolidating smaller MLPs was highlighted by the purchase of Oiltanking Partners LP by Enterprise Products Partners (EPD) just after quarter end in early October. EPD will pay Oiltanking Holding Americas $4.6 billion in cash and common units for its general partner stake, incentive distribution rights and 66% equity interest in Oiltanking Partners. EPD has been investing in infrastructure to serve new export markets for U.S. hydrocarbon products. Recently they announced they were going forward with a $1 billion investment in facilities to export ethane, and the purchase of the Oiltanking assets will complement those investments and facilitate further expansion of export infrastructure.
Another significant acquisition during the quarter was Buckeye Partners’ purchase of an 80% interest in Trafigura AG’s Corpus Christi and Eagle Ford assets. The $860 million deal is transformative to Buckeye as it not only adds a new geographic footprint in South Texas marine and terminaling, but also creates exposure to new segments of the midstream value chain including condensate splitting and crude gathering. The associated contracts are 100% fee-based take-or-pay and range from 7 to 10 years, making the deal well suited for the MLP structure. Furthermore, there may be additional growth opportunities with Trafigura in the South Texas/Eagle Ford area or within Buckeye’s existing assets, ultimately resulting in upside to management’s estimate of $250 million in additional capital investment.
This quarter saw a number of new projects being announced in addition to the EPD expansion of its export facilities. A number of open seasons were announced for pipelines to take hydrocarbons from the Niobrara formation in the Rockies as producers start to ramp up production. Magellan Midstream Partners, NGL Energy Partners, Semgroup Corp., and Tallgrass Energy Partners are trying to compete for a share of the market; NuStar Energy is also a potential entrant. Regency Energy Partners, a subsidiary MLP of Energy Transfer Equity, announced a large pipeline project joint venture with the producer American Energy Utica to increase the takeaway capacity for the new gas production from the Utica formation. Regency’s portion of the investment will be $350 million with the possibility of a higher amount if conditions warrant. Additionally, MLP management teams indicate that numerous unannounced infrastructure projects are at various stages of consideration throughout the U.S. While a number of studies have projected major needs for new midstream infrastructure for decades to come, some MLP investors have questioned how long the current pace of investment can be maintained. Announcements from this past quarter imply that the investment trends in the sector are still very healthy.
A number of companies made significant announcements regarding dropdowns to enhance growth in various MLPs. Enbridge Energy proposed dropping down its interest in the Alberta Clipper Pipeline into its associated MLP for $900 million. After capping its incentive distribution rights last quarter, this is further tangible evidence that Enbridge intends to accelerate the pace of drop downs to its associated MLP. Energy Transfer Partners announced a larger than expected injection of retail assets into Susser Petroleum after buying Susser’s general partner. Teekay Corporation, the parent of Teekay Offshore and Teekay LNG Partners announced at its investor day in September its intention to accelerate its asset disposals to its associated partnerships and become more of a pure play general partner. Another shipper, GasLog Ltd., dropped down two LNG carriers to its associated MLP GasLog Partners in a transaction that was also larger and sooner than most analysts expected. Also, activist investor Third Point Capital announced a campaign to get TransCanada Corp. to boost its sales of midstream assets to its U.S. MLP TC Pipelines, LP. While TransCanada publicly rebuffed Third Point, it did announce it would sell to TC Pipelines its remaining interest in the Bison Pipeline and re-emphasized its strategy to grow the MLP via dropdowns of its U.S. natural gas assets.
New areas of energy infrastructure development continue to be attracted to the MLP model. Last quarter we commented that utility “YieldCos” with investments in renewable and conventional energy generation assets had come to market. This quarter saw SunEdison sell a new “YieldCo” TerraForm Power Inc. in July, and they have announced plans to IPO emerging market renewable power assets in a similar structure soon. This quarter saw the first IPO of a midstream infrastructure vehicle to finance purely international assets. VITOL, a Netherlands-based energy trading and logistics company, brought Vitol Energy Partners, a company with oil storage assets around the world, to market in September. We believe this is the first of a number of listings of international midstream assets to come. While we did not invest in any YieldCos or new non-standard MLPs this quarter, we are monitoring these securities as possible investments. We also view these securities as an example of how the MLP universe continues to expand.
All of the above developments contributed to another active quarter of capital raising in the MLP sector this quarter. We estimate that more than $6 billion was raised in IPO, secondary, and follow-on offerings by MLPs last quarter; if one includes associated C-corps, the total rises to over $9 billion. In addition, we saw 5 MLP IPOs raise about $1.7 billion in the second quarter, bringing the total number of new MLPs to 12 for the year. Also as noted earlier, there were two non-standard MLP IPOs in the quarter. In addition to the very visible equity offerings, MLPs continue to use the less visible ATM (“At the Market”) method to raise capital that we highlighted in last quarter’s commentary. The need for capital has not abated; estimates are that capital spending by MLPs in 2014 should surpass last year’s $30 billion total.
MLP dedicated investment vehicles continue to funnel funds into the MLP asset class. The past quarter saw a very large closed-end fund go public that should enable nearly $1.8 billion 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. 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.
One development that has prompted some concern has been the moratorium on new “private letter rulings” for MLPs by the IRS. This past spring the agency announced that it would take a pause of undetermined length in issuing new private letter rulings that some MLPs seek when they wish to go public with an asset that has not previously been included in a publicly listed MLP. MLPs rely on the “natural resource exception” in the Tax Reform Act of 1986 that limits the assets to be included in a publicly traded partnership to be investments in non-renewable resources or the assets used to process, transfer, or store these resources. While there is no question that traditional assets like pipelines, storage tanks, gas processing or fractionation facilities are allowed in MLPs, over time management teams have pushed the boundaries of what types of assets might be allowed.
In recent years, companies have asked for and received assurances from the IRS that assets such as frac sands, ethylene crackers, some rail facilities and other non-standard investments would qualify for inclusion in MLPs. Recently oilfield service companies, refineries, Jones Act tankers, and containerboard plants have been proposed as potentially qualifying assets for MLPs. The IRS has stated that it will review the current guidelines to make sure they are being consistent with their prior rulings and see if there is a way to give the industry broader guidance they can use going forward. While this has delayed some MLPs which need a private letter ruling from going public, this has not hampered MLPs with standard assets from issuing IPOs. We expect that the IRS will resume private letter rulings later this year or early next year, but take a bit more conservative approach to granting new assets the MLP qualifying treatment.
Long Term Outlook: Positive
As we look into the future, we continue to believe that over the next five years the MLP/midstream energy infrastructure market should generate attractive annual returns through a combination of yield and price appreciation. Valuations may not be as attractive as they were a year ago, but we firmly believe that they appear attractive relative to most other asset classes. The average MLP yield was about 5.2% at the end of September, down from about 6.6% at the beginning of 2013 but still fairly high. Spreads of MLP yields versus other assets such as Treasuries and corporate bonds have compressed from unusually high levels a year ago. However, the outlook for distribution growth has improved over that time frame, driven by accretive capital projects and the availability of asset acquisitions. Our outlook for attractive annual returns over the next few years remains intact.
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. The growth in the distribution that MLPs 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.
David Chiaro is Co-Head of MLP Strategy for Eagle Global Advisors, LLC,
Co-Portfolio Manager of the Eagle MLP Strategy Fund
Eagle Global Advisors, LLC
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/SIPC. 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.