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Energy

After the master plan

by John McKenna

These are heady days for U.S. oil and gas. The shale energy boom is now making its impact felt across not just the United States but worldwide, through both huge investments in domestic production of energy-intensive products such as chemicals as well as the prospect of natural gas being exported through the construction of liquefied natural gas export terminals.

Tied to the shale boom, the major financial success story of recent years has been the proliferation of master limited partnerships as the financing vehicle of choice for the construction and operation of infrastructure to move these new fuel resources to market.

MLPs are partnerships traded on major U.S. securities exchanges that, according to legislation dating back to the mid-1980s, must generate 90 percent of their revenues from the exploration, development and transportation of natural resources. More often than not this means the MLP is building and running a natural gas or oil pipeline, with companies operating midstream assets accounting for 83 percent of MLPs’ total market capitalization in 2013, according to asset manager CBRE Clarion Securities.

The MLPs are run by a general partner that is responsible for developing and operating the energy infrastructure asset. The general partner typically holds a 2 percent stake in the MLP. The remaining 98 percent ownership falls to limited partners, whose ownership is similar to that of a stockholder in that they provide capital by buying into the MLP publicly but have no say in the operations of the MLP. MLPs do not pay corporate income tax on earnings, the bulk of which are passed on to LPs through quarterly dividends.

Mastering investment success

While they have been around for nearly 30 years, MLPs have only really become a significant force over the past 10 years — a period that correlates with the explosion in shale oil and gas production.

For most institutional investors, meanwhile, MLPs have only been a realistic proposition since tax reforms signed by President George W. Bush in 2005 enabled tax-exempt structures such as mutual funds to invest up to 25 percent of their portfolio in tax-exempt pass-through structures such as MLPs before incurring unrelated business taxable income penalties.

Another potential barrier to investment in MLPs has been their administrative burden. Because MLPs are not taxed at the corporate level, they are instead subject to tax filings at the individual investor level, and as a result each investment in an MLP requires the filing of a K-1 tax return.

“The reality is from a tax standpoint MLP ownership can be tricky as, with the filing of individual K-1s rather than a single corporation tax 1099 filing, there is much more of an administrative burden,” says Benjamin Morton, senior vice president at fund manager Cohen & Steers, which runs two MLP funds currently holding nearly $760 million of oil and gas assets. However, despite this, investor interest in energy MLPs has taken off.

According to CBRE Clarion Securities’ January 2014 report, Master Limited Partnerships: Key Role in the U.S. Energy Renaissance, the total market capitalization of energy MLPs was $156 billion in 2009. By the end of 2013, the MLP market was worth $464 billion.

This growth has been driven by the attraction of average yields that at the end of 2013 were running at 6.4 percent. This, according to CBRE Clarion’s report, outstripped corporate bonds at 5.4 percent, utilities at 4.1 percent and REITs at 4 percent. MLPs have also outperformed competitors when it comes to annualized total returns, which between 2000 and 2013 averaged 19 percent per year, compared with REITs’ 11.5 percent and utilities’ 8.1 percent.

Winners and losers

However, despite this amazing overall performance of MLPs, CBRE Clarion senior global portfolio manager Jeremy Anagnos warns, “not every asset is created equal.”

There have been poor performing MLPs. The most notable recent example was the collapse of Boardwalk Pipeline Partners’ quarterly distribution in February from $0.53 per share to $0.10 per share. The firm blamed “market headwinds” for pipeline contract renewals, without going into specific details. The renewal of long-term contracts to use pipelines is perhaps the biggest single risk to an MLP, and with the bulk of Boardwalk Pipeline Partners’ assets in Southeast states rather than the now hugely productive Marcellus and Utica shale plays in the Northeast, it is easy to see why an understanding of geology can be critical in determining whether an MLP will be a successful long-term investment.

“The increase in North American energy production is changing the map of where energy commodities are consumed and produced,” says Larry Antonatos, global equities managing director at Brookfield Investment Management. “Our job is to understand how that’s changing today and in the future so we can invest in the companies that will be winners,” he adds. “One of the keys to our investment process is understanding the sources of oil and gas production,” Antonatos says. “We spend tremendous amounts of time looking at the exploration and production companies, who are the pipeline’s customers, to understand where they are drilling their wells, and the productivity rate of decline of their wells to make sure we understand whether the pipelines will be fully utilized over the next 15 to 20 years.”

Most contracts are long term, so the risk of firms not renewing is a long term one. Even if production dried up long before the pipeline usage contract is due to expire, E&P firms sign these on a take or pay basis, meaning that they have to pay for the space in the pipeline whether they use it or not. The fear is that a drying up of resources, or a collapse in oil prices, could render E&P firms bankrupt and unable to honor the contracts.

There is also concern that because MLPs often tap the capital markets to fund growth, rising interest rates will ratchet up the cost of capital and erode the high yields that make them so attractive.

However, Anagnos says that the nature of the energy infrastructure, tied up as it is so closely with the nation’s economic growth, should help ensure MLPs remain strong performers. Even if the distribution yields do fall off from where they are today, Morton says, they should still remain attractive compared to other options in the energy space.

“When you compare with, say utilities, you have a much lower dividend, just a 4 percent yield,” Morton says. “Three years ago [MLPs] was an asset class with 7 percent yield. Why shouldn’t MLPs trade instead of utilities at 4 percent, when they have a much greater growth profile? We don’t expect them to be up 20 percent per year, but they will continue to have a strong growth profile,” adds Morton.

John McKenna is a freelance writer based in Berkhamsted, England.

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