Despite Hitting an Oil Slick, Evidence Underpins a Positive Outlook on MLPs
MLPs hit an oil slick in the fourth quarter of 2014. The correction in oil prices in the third quarter turned into a rout in the fourth quarter, especially after Saudi Arabia announced that it would not restrict output to support the oil price. The West Texas Intermediate oil benchmark, which ended September at $91, sold off precipitously during the quarter and ended the year at $53, down 42% on the quarter. Natural gas did not fare much better, falling 30% to $2.90 in the same time span.
Needless to say, this torpedoed most energy stocks. The S&P Exploration and Production Company Index was down 30% in the fourth quarter alone. MLPs unit prices, which had posted strong gains through the third quarter, were affected by the negative sentiment that washed over the energy sector in the fourth quarter. The Alerian MLP Index was down 12.3% in the fourth quarter; still, for the year, the index posted a 4.8% total return.
We have always maintained that the fundamentals of fee-based midstream energy companies like the ones we focus on in the Eagle MLP Strategy Fund are not beholden to commodity prices but are more dependent on volume growth. The fall in energy prices has raised concerns that the dramatic hydrocarbon volume growth we have seen from the new shale plays in the U.S. in the past few years is over or might even reverse. We believe these concerns are overblown. We think the current dislocation in the commodity markets is a case of supply temporarily getting ahead of demand. Demand for hydrocarbons continues to grow worldwide. Many countries, including our own, are transitioning much of their electric generation capacity from coal to natural gas, creating multi-decade new sources of demand. The demand for refined products and chemicals continues to grow, especially in the emerging markets. The major midstream infrastructure projects undertaken in the past few years have been planned and contracted in response to long-term supply and demand relationships. We expect continued strong cash flow results from the investments in new infrastructure made by our portfolio companies in the past few years.
We do not know where commodity prices will go in the short term, intermediate term, or long term. But we know we are not seeing the end of the hydrocarbon era, and if anything, lower prices for hydrocarbons should continue to foster demand. While some needs for infrastructure in certain regions may be lessened in this new environment, new opportunities will arise. Opportunities for acquisition of midstream infrastructure assets are certainly improved in this environment for those companies with cost-of-capital advantages, and we may see a shift of emphasis from organic growth projects to acquisitions as a near term driver of growth for MLPs and midstream energy infrastructure companies. The attractiveness of MLPs and midstream energy infrastructure companies relative to other asset classes has improved as bond yields continue to fall and the U.S. equity market hits new highs. Bottom line, we continue to see evidence that underpins our long term positive outlook on midstream energy infrastructure. We believe that the future of MLPs and midstream companies is bright and that over time they should offer higher returns compared to assets of equal risk.
The Majors Join the Party
While commodity prices were center stage during the fourth quarter, capital market activity continued at a steady pace. Notably, Royal Dutch Shell executed the IPO of its midstream MLP, Shell Midstream Partners. The roughly $5 billion market cap, which by no means is small by MLP standards, pales in comparison to the parent’s roughly $200 billion market cap. However, Shell’s management team is focused on raising their returns on capital and saw the MLP as a way to lower their cost of capital for their midstream investments while allowing them to recycle capital into other parts of the business. In this new environment of lower energy prices, we believe this logic will attract other large producers to follow Shell’s lead. Although it is not on the same scale of Royal Dutch Shell, Hess Corporation is also considering a midstream MLP IPO in 2015. While the MLP asset class has enjoyed steady growth, Shell and Hess are good examples of the magnitude of qualifying assets that currently exist outside the MLP structure. As more companies decide to move these cash flows into the structure, this could be another leg to the MLP asset class growth story. Stay tuned.
There were a number of other IPOs that took place in the fourth quarter. Two of the larger deals were Antero Midstream Partners and Dominion Midstream Partners. Following in the footsteps of other E&P producers, Antero Resources completed its IPO of midstream assets to support its drilling activity in the Marcellus and Utica. Dominion Midstream Partners owns the Cove Point Liquefied Natural Gas (“LNG”) facility and associated pipeline and storage assets in Maryland. Cove Point is currently a LNG regasification terminal that will be converted to a liquefaction terminal and is estimated to be operational by late 2017.
As we talked about last quarter, Rich Kinder completed in the fourth quarter the consolidation of Kinder Morgan Partners, Kinder Morgan Management, and El Paso Pipeline partners into one company Kinder Morgan Inc., creating one of the largest energy companies in the U.S. Kinder Morgan eliminated the General Partner structure putting its cost of capital on a more competitive basis with other large MLPs which have also eliminated the General Partner incentive like Enterprise Products and Magellan Midstream. Kinder Morgan has historically been a major consolidator of MLP assets, and this restructuring is quite timely as the new MLP environment makes the acquisition of MLP assets more attractive. We would not be surprised to see Rich Kinder make some significant consolidation moves in the MLP space sooner rather than later.
There was other significant acquisition activity in the quarter as well. In a large, complex transaction seeing two general partners merge along with their associated limited partners, Targa Resources announced its intention to acquire Atlas Pipeline Partners along with Targa Inc. acquiring Atlas Energy. This merger involves $7.7 billion of assets at the time of announcement, and is contingent on Atlas Energy’s spin-off of its non-midstream assets. In October, Oneok Partners agreed to purchase Chevron’s natural gas liquids assets in the Permian Basin for about $800 million. Also in the quarter, Western Gas bought a private midstream company Nuevo Energy with gathering and processing assets in the Permian Basin for $1.5 billion.
A number of companies have announced investments in infrastructure used to export hydrocarbons and this trend continued during the quarter. Nustar Energy and PMI, an affiliate of Pemex, announced a letter of intent to jointly build midstream assets to support liquids and refined product volumes from the U.S. into Mexico. The size and scope of the joint venture are still to be determined but highlights another factor in the changing landscape of infrastructure investment by MLPs. Mexico’s recently enacted energy reforms could support another avenue of growth for North American infrastructure companies. Early in the quarter, Enterprise Products announced their acquisition of Oiltanking Partners primarily to allow for expansion of their investments in export infrastructure on some of Oiltanking’s well situated facilities on the Texas Gulf coast.
All Parents Love their Children
This quarter we saw a number of examples where MLP sponsors acted to the benefit of their underlying MLPs. TransCanada announced they would drop-down the remaining 30% interest in the GTN pipeline to TransCanada Partners by Q1 2015 at an attractive price. They also stated their intention to sell their remaining U.S. pipeline assets to the MLP over time, representing what could amount to upwards of $4 billion of assets. Enbridge Inc. outlined a restructuring plan that will consider transferring all of its directly held U.S. liquids pipelines, amounting to upwards of $10 billion of assets, to their associated MLP Enbridge Energy Partners over time. Specifically, they announced the sale of their remaining interest in the Alberta Clipper Pipeline for $900 million to Enbridge Energy Partners. Additionally GasLog, the parent of shipping MLP GasLog Partners, announced in early December their intentions to significantly grow their fleet of LNG tankers. This will materially increase the assets available to drop down into the associated MLP. As a first step in this plan, GasLog acquired two LNG vessels from BG (formerly known as British Gas) in late December for $460 million. Both vessels have long-dated contracts with the BG group and would be eligible for drop-downs into the partnership.
The absolute number of companies active in raising capital this quarter was low by historical standards; however, thanks to some very large capital raises, dollar value was still in excess of $8.5 billion. This was comprised of follow-ons, secondary offerings, and IPOs, with IPOs making up about $3.2 billion. For the year, we saw a total of 19 IPOs comprising about $7.4 billion of capital raised. In addition to the very visible equity offerings, MLPs continue to use the less visible ATM (“At the Market”) programs to raise capital that we highlighted in last quarter’s commentary. Even with commodity prices trading lower, MLP capital budgets for 2015 still look robust and should continue to contribute to healthy capital market activity in 2015.
2014 MLP fund flows measured by open-end mutual fund, close-end fund, and ETF/ETN new creations are estimated to be $20.6 billion compared to $18.6 billion in 2013. Despite the equity price volatility and falling commodity prices during the quarter, we estimate that fund flows were still positive to the tune of $3.7 billion. We did not see any closed-end funds price in Q4. For the year, MLP dedicated closed-end funds accounted for $3.0 billion of inflows vs. $4.9B last year during 2013. ETF/ETN new creations were flat year over year at roughly $4.8 billion of inflows during the year. Open-end funds saw a large year over year uptick at $12.8 billion vs. $8.8 billion of inflows in 2013. Even in the face of a very difficult environment for energy equities in Q4, investors still remained positive on the toll-road model and longer-term benefits of the MLP/midstream energy infrastructure sector as was evidenced by the fund flows.
New Congress: More of the Same
January of 2015 will see both the House and the Senate under the control of the Republicans for the first time in eight years. The new Republican Senate Majority Leader Mitch McConnell has said that the first bill the new Senate will take up will be the approval of the Keystone XL Pipeline. If passed by the Senate, where it will need some Democrats to cross the aisle to beat a filibuster, it should also be passed by the House. The President, however, has already said that he would veto the bill. (Interestingly his statement leaves open the door that he may approve it once the Nebraska Supreme Court has decided on its final route.) We see this as a template for the next two years at least. More gridlock. Overall we view this as positive for MLPs. We continue to see comprehensive tax reform as the biggest political threat to the tax preference that MLPs enjoy. While the government is arranged in the state of gridlock, we do not see such a controversial measure as comprehensive tax reform making much headway.
More important for MLPs in the near term will be the regulatory developments emanating from the state, local, and federal bureaucracy. We have written about the IRS moratorium on new Private Letter Rulings (“PLRs”) that companies have sought in recent years to expand the scope of qualifying MLP assets. We expect that the moratorium will be lifted sometime this year and this could create some interesting opportunities for new MLPs depending on the outcome. Increased safety regulation of oil transportation by rail, environmental regulation of oil and gas producers, and the perennial debates about fracking on a local and regional level are areas that we continue to monitor.
Long Term Outlook: Positive
We continue to be positive on the outlook for total returns for MLPs and midstream energy infrastructure companies. Valuations, after the fourth quarter sell off, are more attractive absolutely and relative to other asset classes. The average MLP yield is now close to 6.1%. Spreads of MLP yields versus Treasuries, REITS, corporate bonds, and high yield bonds have widened out to historically large levels. While we would not be surprised to see companies be more conservative with their payouts next year and reduce their distribution growth rates, we would still expect high single digit growth from our portfolio of companies. Combined with current distribution yields, MLPs should still have, in our opinion, the potential for attractive total returns.
Confounding all the pundits, bond yields continue to drop, and the 10 year U.S. Treasury bond is yielding below 2.0% as of this writing. This continues to fuel a demand for yield in the markets, and other yield oriented investments like REITs, utilities, and most types of bonds are hitting new highs. In our opinion, MLPs and midstream energy infrastructure companies continue to offer an attractive tax-advantaged yield with growth, and we believe these attributes will continue to attract favor with investors. This demand is long-term as we believe that the demographic trend of an aging population will result in a wider investor base seeking out the income generation of the asset class. When inflation returns, the ability of MLPs to grow their distribution and allow investors to stay ahead of inflation is a further attraction.
David Chiaro is Co-Head of MLP Strategy for Eagle Global Advisors, LLC
Co-Advisor 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.