As long as the investment environment remains "yield-starved and growth-challenged," MLPs will remain attractive, says Quinn Kiley, Fiduciary Asset Management's senior portfolio manager. In this exclusive Energy Report interview, Kiley shares his tips for finding the best apples in the NLG basket, where sector is just as important as size.
Companies Mentioned: DCP Midstream Partners, L.P. - El Paso Pipeline Partners, L.P. - Energy Transfer Equity, L.P. - Energy Transfer Partners, L.P. - Enterprise Products Partners, L.P. - Targa Resources Partners, L.P.
The Energy Report: Quinn, you forecast total master limited partnerships (MLPs) 2011 returns of 8–12%. Given the negative news throughout the second quarter, how could that forecast possibly hold up?
Quinn Kiley: When we made the forecast at the beginning of the year, we thought that, given the MLPs' fast recovery from the 2008 sell-off, there was a chance MLPs might underperform the S&P 500, which has not recovered at the same clip. We were looking at the basic fundamentals of MLPs as a source of growth. MLPs are yielding a little over 6%. We thought distribution growth from MLPs would be about 6%. That 6%, plus no change in valuation metrics and an increase in that cash flow of 6%, should give you a 6% higher value, for a total return of about 12%.
In July, we're at a little less than 4% return and distribution growth is coming along at a clip north of 6%. We think that's a good portion of the return. The MLPs are going to pay their distributions at higher levels from today and definitely at higher levels than a year ago.
We also think the number and amount of organic capital expenditure opportunities—new builds, new infrastructure—by MLPs will be done at attractive multiples, which should further increase growth.
TER: Almost $30 billion (B) has poured into the MLP sector this year. With that much capital coming in, should investors rest more easily knowing that Wall Street power brokers aren't about to let the government tax one of its "golden geese," or is a less favorable tax structure for MLPs inevitable?
QK: You have to take into account that MLPs have a market cap north of $250B. Exxon's market cap is north of $400B. So, while MLPs are an attractive investment, and certain banks and investors have done well in them, the size and scale of MLPs compared to the broader market is small. I think calling them the "golden geese of Wall Street" is an overstatement.
That being said, MLPs provide an essential service in delivering fuels and commodities around the country. From an energy security standpoint, you could make an argument for preferential treatment for MLPs to ensure that access to capital continues and that our infrastructure is reinvested in and grows to make the economy overall more efficient.
At the very least, if the Bush tax cuts expire at the end of 2012, there will be a marginal change. Given the current discourse in Washington, I think you are going to see ongoing discussion of the tax code, tax policy and tax reform. MLPs will pop up as they do every other year when those topics get raised.
It would appear to me that you are going to see some sort of tax reform in 2013. Given that the goal is higher revenue, something will probably affect MLPs or their investors. However, I don't think it will negate the overall investment story, which is that energy infrastructure is necessary and growing, and investors are attracted to those characteristics.
TER: When we talked with you in September 2010, you said the total market cap on MLPs was around $190B. You just said that today it is $250B. That is about 32% growth.
QK: There are a couple of reasons for that. First, broadly speaking, MLPs are up over 20% since we last spoke. That's a significant portion of that 32%. Since then we've also seen about $17B in new equity raised. It's a combination of appreciation, which is the market realizing the benefits of the growth of the MLPs, and MLPs raising capital to fund that growth.
TER: Last September, retail investors made up about 70% of the space. What is that percentage now?
QK: Off the top of my head, I'd say the number is closer to 67% or 68% now. We have seen an uptick in institutional investors; in addition, more traditional investors like pension funds are starting to pay attention to the space.
Most state pension funds are significantly underfunded. As a result, they are looking for diversification and growth-oriented investments. Something growth-oriented with a significant yield, such as MLPs, is attractive and fits into a bucket for certain funds. We have seen several municipalities and states invest in MLPs as a class or conduct searches for the potential of adding them to their portfolio. That said, MLPs remain a predominantly retail-driven investor space.
TER: Do you think we will see the net market cap for the MLP sector eclipse a trillion dollars within the next decade?
QK: We look out five years and we see, on average, about $10B a year of new-build projects. A trillion is a long way between here and there, but if you look at the Real Estate Investment Trust (REIT) asset class as a corollary, U.S. REIT equities are about double MLPs. Getting to a trillion is possible, but probably not likely.
TER: The MLP sector relies heavily on an investment-friendly boomer generation seeking respectable yields in a low-yield investment world. How long can that thesis play out, and what other drivers do you expect to catalyze MLPs over the short to medium term?
QK: Clearly, there is a significant, rising population entering retirement. They will need income. MLPs can play a great role because they provide a significant yield, north of 6% right now. Compare that to Treasuries at 3%, money markets and cash are effectively at 0, and other yielding equities are in the 2% to 4% range. On a relative basis, MLPs provide a high yield, which is really a cash return. Real cash returns are attractive for any investor, especially those facing retirement or who are retired now.
But generally speaking, this is a yield-starved investing environment, regardless of your age or approach to the market. Our view is that if you are in an environment that is both yield-starved and growth-challenged, it's hard to find attractive returns driven by growth.
Where will the growth come from? In an essential asset like energy infrastructure, there is a need for growth; it has to happen or the economy won't function. So, you are delivering growth in a market that is probably not going to have significant growth-driven returns. Additionally, if you can get a large percentage of your returns through cash, it becomes very attractive.
As long as you have a low-yield environment, MLPs will look attractive. As long as you have a struggling economy, a growing yield will look attractive. MLPs have a positive, long-term outlook, but short-term it's anybody's guess as to what is going to happen. In the current market, it's going to be a very choppy.
TER: How long do you think it will be before the bond market is competitive with MLPs again?
QK: In the last quarter, it was superior to MLPs. The Barclays Capital U.S. Aggregate Bond Index returned about 2.3% for the quarter, compared to a negative return for MLPs.
There are a couple of tricks to comparing fixed-income investments to MLPs. First is taxes. You have fully taxable income from a bond, but some portion of your MLP distribution is return of capital and not taxed until sale. There is a near-term tax advantage on a comparative basis. The other big difference is that MLP distributions grow over time; bonds do not. Bonds have maturity rollover risk; MLPs are perpetual. Depending on the environment you are in, bonds can be a very attractive investment if they have good, underlying fundamental cash flow supporting them. We like energy infrastructure bonds right now, but we think MLPs have a better long-term outlook.
TER: Is bigger better when it comes to investing in MLPs in volatile markets?
QK: I guess the classic answer is, "It depends." It's not just bigger; it's which big MLPs you own. Over any short-term period, a bias toward large or small cap could be beneficial or detrimental to your portfolio. We tend to invest in names we think are well positioned for growth, well positioned to pay their distributions, and are of a high quality. Size isn't a metric; we think of the quality of the name. But when investors flee the markets, the more liquid names are better able to deal with forced or indiscriminate selling. Thus, they perform technically better in a volatile market.
In a rebound, the opposite is true; you tend to see large caps lag and small caps gain strength in the market for the same reason. In today's environment, large-cap MLPs outperform, but over the long term, it's more important to buy high-quality companies with a growth component that is better than another MLP on a relative basis. If you make that decision regardless of size, you are going to come out on the right side.
Another thing that is important is not just what the prospects look like, but how well supported their distribution is with the cash flow available. Some MLPs may not do as good of a job of harboring cash and marshalling it to grow distributions over time.
TER: What are some big MLP names that continue to boost distributions and are likely to do so for the foreseeable future?
QK: The largest MLP, which is about $35B, is Enterprise Products Partners, L.P. (NYSE:EPD). The company has a great history and a great track record of putting investor capital to work in a way that creates cash flow. It has increased distribution quarter-over-quarter, year-over-year for a sustained period. Given the attractive footprint of both where their assets are geographically and based on what they do, we think the company is well positioned to take advantage of the domestic energy boom resulting from the recent ramp-up of nonconventional oil and gas production. Enterprise is definitely a blue-chip name that has a great outlook for distribution growth.
El Paso Pipeline Partners, L.P. (NYSE:EPB), is about a fifth the size of Enterprise. El Paso just announced a 20% distribution increase over the same period last year. It is a great long-term story at El Paso; the driver is the quality of the assets of the business it is in, not the size.
TER: What areas of the MLP space do you expect to outperform the sector at large this year and into 2012?
QK: If you take market volatility and political uncertainty out of the discussion, several areas of energy infrastructure are going to do really well, especially those tied into natural gas and natural gas liquids (NGLs): ethane, propane—things that occur in, or are associated with, natural gas or oil reserves. When these materials are produced, they have to be removed from the base commodities. For example, natural gas, like that used in our homes, is of similar chemical quality and heat component all the way around the country; it's called pipeline quality gas. But to get that, you have to remove the chemical impurities. Those impurities have great value associated with them because they are priced off of crude oil.
If you have been following the energy world, you know crude oil is selling at very high levels, in the $90s/barrel (bbl.) range, and that natural gas has been anchored to the $4/Million British Thermal Unit (MMBtu) range for quite a long time. That means there is more value in NGLs than there is in natural gas itself. Anyone who has exposure to that, whether it be on the logistic side by storing, handling, or processing it, or the price side because they benefit from NGL prices, should do very well. I don't see that apple cart being upset for the remainder of the year.
TER: What are some MLP names with large exposure to NGL plays?
QK: One of the MLPs, in what I’ll refer to as the gathering-and-processing sector, is DCP Midstream Partners, L.P. (NYSE:DPM) which has a significant NGL business. It has some exposure to both the logistics side and the price of NGL, and has a large geographic footprint and a good growth profile.
Other names have more exposure on the logistics side, like Targa Resources Partners, L.P. (NYSE:NGLS), which has exposure to the growing need for NGL infrastructure and transportation. It also has exposure to processing the fractionation, where you break the NGLs into individual components into what in effect becomes petrochemical feed stock.
Targa has been a great story because the proliferation of domestic resources for NGLs has led to a pricing advantage relative to European imports. The chemical industry here has really turned an eye inward and is trying to make sure it has the best access to feed stocks. As a result, you need new infrastructure to deliver that product to the market. Targa, DCP Midstream and ONEOK Partners, L.P. have strong exposure in this area.
TER: What about Energy Transfer Partners, L.P. (NYSE:ETP)? Do they have exposure to NGLs?
QK: Part of Energy Transfer Partners' business is in NGLs; mostly it moves natural gas around the country through pipelines, including a significant pipeline system in Texas. It's a quality MLP that pays a recurring yield. However, growth has been a little bit muted; over the last couple of years, distribution has remained flat.
The story there is much more about its general partner, Energy Transfer Equity, L.P. (NYSE:ETE) and its attempts to acquire Southern Union Co. There has been a back and forth battle between ETE and the Williams Company (NYSE:WMB), which is the parent of another MLP, to pick up these assets. In the end, the Southern Union shareholders have been the big winners. It has seen the price of its equities go up significantly.
Southern Union's assets, combined with the existing assets of either one of those entities, will provide a lot of synergies and optimization that will allow for better profitability and significant cash flow growth regardless of which acquirer you are talking about. The question is, at what point do you pay too much for those assets? Currently, the market doesn't believe it has paid too much for them, but the story isn't over and we won't know who wins until the deal closes.
But Energy Transfer Partners is definitely a growth-oriented MLP. It is always trying to get bigger and better by creating broader exposure to natural gas infrastructure around the country.
TER: Do you have some parting thoughts for us in terms of the MLP sector, any insights into the market?
QK: Our view hasn't changed substantially over the year. It has been a rocky road, but we believe MLP valuations and returns will be higher going forward. There is a great long-term story of energy infrastructure build-out to deal with the ever-changing supply and demand dynamics of domestic energy. That fundamental strength, regardless of what is going on in the broader world economy, will play out over the next couple of years. Long term, more individuals and institutional investors are allocating some portion of their portfolio to MLPs. We think that will continue as the years go on.
TER: Quinn, thank you for your time and your insights.
Quinn T. Kiley is the senior portfolio manager of FAMCO's Master Limited Partnerships product and is responsible for portfolio management of the firm's various energy infrastructure assets. Mr. Kiley serves as portfolio manager for the Fiduciary/Claymore MLP Opportunity Fund, the MLP and Strategic Equity Fund Inc., the Nuveen Energy MLP Total Return Fund, the FAMCO MLP & Energy Income Fund and the FAMCO MLP & Energy Infrastructure Fund. Prior to joining FAMCO in 2005, Mr. Kiley served as VP of Corporate and Investment Banking at Banc of America Securities in New York. He was responsible for executing strategic advisory and financing transactions for clients in the energy and power sectors. Mr. Kiley holds a BS with Honors in geology from Washington and Lee University, an MS in geology from the University of Montana, a Juris Doctorate from Indiana University School of Law and an MBA from the Kelley School of Business at Indiana University. Mr. Kiley has been admitted to the New York State Bar.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Energy Transfer Partners.
3) Quinn T. Kiley: I personally and/or my family own shares of the following companies mentioned in this interview: DPM, EVEP, FMO, MTP, JMF, INFIX, and MLPPX. I personally, and/or my family, am paid by the following companies mentioned in this interview: Fiduciary Asset Management Inc.