In markets where value is hard to find in either stocks or bonds, we have searched for investment vehicles that do not correlate highly with these assets, but are compelling investments that are performing well on a standalone basis. Several months ago we found such an investment in Oppenheimer’s MLP Alpha Fund. The following blog discusses their unique value proposition. We hope you enjoy it! – SS
Many risk assets got off to a rocky start in 2014, but Master Limited Partnerships (MLPs) actually posted a positive return during January,1 which we didn’t find to be particularly newsworthy. Some of our clients disagreed, however. We’ve fielded questions on a variety of matters, such as on the resiliency of “midstream” MLPs or their growth potential in a low growth–and now, seemingly more uncertain–economic environment. In an effort to educate our clients, here are some answers to questions we’ve been getting.
What do midstream MLPs do, again?
Midstream MLPs are energy infrastructure companies that primarily transport and store oil, natural gas, and refined products. In other words, midstream assets are those logistical assets that connect oil and gas producers (“upstream”) to consumers, such as refineries (“downstream”). While success in upstream and downstream companies is largely influenced by commodity prices, midstream operators typically receive a fee or earn fee-like margins–just like a toll road. So whether a barrel of oil sells for $50 or $150, midstream MLPs can offer a compelling avenue to participate in the U.S. energy production renaissance.
Midstream MLPs are participating in the energy boom, right?
The march towards energy independence is real, and U.S. energy infrastructure will have to grow substantially over the next decade and beyond to keep pace with increases in oil and gas production and demand. Through 2018, production of crude oil is expected to increase about 7% per year, and production of natural gas is expected to increase 3% per year.2 Even though the U.S. already has a well-developed system of pipelines, railroads and storage facilities, much more capacity will be needed to keep up with this growing supply. The long-term benefits of improving volumes through these existing systems and the investment opportunities required to build out additional infrastructure have the potential to provide for a unique and compelling growth opportunity.
Source: Bentek, October 2013. Data is representative of the rising production of natural gas and crude oil.* Estimates may not be achieved.
Isn’t the energy infrastructure build-out complete?
Capital spending on oil and gas midstream and downstream infrastructure has certainly been running at a high clip, having grown at a compound average annual growth rate of 17% over 2010-2013.3 During this time, such investments helped drive MLP distribution growth to 8.1% per year.4
However, there’s plenty of room to go, according to a recent study by IHS Global.5 IHS Global estimates that oil and gas infrastructure investment over the next 12 years (2014-2025) may reach $890 billion, which they deem to be a base scenario. We neither agree nor disagree with the exact figure, but directionally, we think it is clear the energy infrastructure build-out is not complete and substantial investment remains necessary.
However, we caution investors not to simply assume those MLPs with the largest capital spending budgets will be the best growers. We believe the best positioned companies are those with assets that will benefit from future volume growth and can accommodate those volumes with only minimal capital investment.
Could volatility in emerging markets affect commodity prices and midstream MLPs?
While crude oil prices may experience volatility, the need for additional energy infrastructure remains acute. Importantly, we believe crude oil pricing could fall substantially while still supporting robust producer activity and volume growth to the benefit of energy infrastructure operators. While we consistently monitor the pricing environment for major energy commodities, we seek to exploit the logistical needs surrounding these products through energy infrastructure MLPs that are not overly exposed to changes in these prices.
In conclusion, we believe the environment for midstream MLPs remains constructive, and the growth story remains intact. We’ve advised clients to maintain allocations to midstream MLPs, an asset class that may offer diversification, income and the potential for inflation protection. To those investors who are worried about the recent volatility, I hope they’re now calling their advisors to chat about actively managed midstream MLP opportunities.
- Alerian, 1/31/14.
- Bentek, October 2013.
- IHS Global Inc., “Oil & Natural Gas Transportation & Storage Infrastructure: Status, Trends, & Economic Benefits” (December 2013).
- Bloomberg, 12/31/13.
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The Alerian MLP Index is a composite of the 50 most prominent energy MLPs. The index is unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results.
Investing in MLPs involves additional risks as compared to the risks of investing in common stock, including risks related to cash flow, dilution and voting rights. Each Fund’s investments are concentrated in the energy infrastructure industry with an emphasis on securities issued by MLPs, which may increase volatility. Energy infrastructure companies are subject to risks specific to the industry such as fluctuations in commodity prices, reduced volumes of natural gas or other energy commodities, environmental hazards, changes in the macroeconomic or the regulatory environment or extreme weather. MLPs may trade less frequently than larger companies due to their smaller capitalizations which may result in erratic price movement or difficulty in buying or selling. Additional management fees and other expenses are associated with investing in MLP funds. Diversification does not guarantee profit or protect against loss.
The Oppenheimer SteelPath MLP Funds are subject to certain MLP tax risks. An investment in an Oppenheimer SteelPath MLP Fund does not offer the same tax benefits of a direct investment in an MLP. The Funds are organized as Subchapter “C” Corporations and are subject to U.S. federal income tax on taxable income at the corporate tax rate (currently as high as 35%) as well as state and local income taxes. The potential tax benefit of investing in MLPs depend on them being treated as partnerships for federal income tax purposes. If the MLP is deemed to be a corporation, its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution which could result in a reduction of the fund’s value. MLP funds accrue deferred income taxes for future tax liabilities associated with the portion of MLP distributions considered to be a tax-deferred return of capital and for any net operating gains as well as capital appreciation of its investments. This deferred tax liability is reflected in the daily NAV and as a result a MLP fund’s after-tax performance could differ significantly from the underlying assets even if the pre-tax performance is closely tracked.
This post originally ran on Forbes and has been posted here with permission.