MASTERCLASS: MLPs - March 2017

In this edition of MASTERCLASS, Center Coast Capital’s Jeff Jorgensen and ClearBridge Investments’ Chris Eades join Asset TV to discuss the structure and outlook of Master Limited Partnerships. They share their expectations for oil and natural gas prices, comment on MLP performance, and discuss what impact U.S. policy will have on MLPs.

  • Jeff Jorgensen - Director of Research at Center Coast Capital

  • Chris Eades - Portfolio Manager at ClearBridge Investments

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  • 52 mins 27 secs
Gillian: Welcome to Asset TV, I’m Gillian Kemmerer. Master Limited Partnerships or MLPs outperformed the broader stock market last year. Forces ranging for OPEC to US shale and President Trump are waging a tug-of-war on energy prices in 2017. And a wave of MLP simplifications should be present interesting opportunities in the marketplace. In today’s program I am joined by two experts who will share their outlook for energy this year and will decode the advantages of the MLP structure. Welcome to the MLP Masterclass, gentlemen, thanks for coming in. It’s an interesting time to be talking about energy, as always I think. And I think it would be great to start with just the broad oil price outlook for the next year. Maybe we can break it down into some of the major macro events that are going to shape what happens in energy in 2017. So let’s start with OPEC, the last time I chatted with you, we had just heard the OPEC decision in Vienna. And according to Reuters, there was a survey in January that said OPEC had achieved 82% compliance, non-OPEC is looking somewhere around 60% according to the same author, curious to hear your thoughts, is this good or bad in OPEC standards? Chris, I’ll start with you.

Chris Eades: I think it’s great, and I think certainly compliance for this production cut has been greater than what we’ve seen in prior cycles where they’ve announced production cuts. My view on this has always been that the OPEC production cuts really just facilitated the inventory drawdown that was basically in my opinion going to happen in the back of 2017, it’s kind of moved it forward six months. I think the market was moving towards supply and demand equilibrium with or without the OPEC cut. But certainly with the cut it’s certainly accelerated the timeline to when we’ll see the market in balance.

Gillian: Okay. Jeff, what do you think?

Jeff Jorgensen: I think the compliance so far has been great, which is a surprise as Chris pointed out. They don’t have the best track record of complying with their promises in the past. But I think one of the things that’s different this time in my opinion is the Aramco IPO and the fact that they want to monetize a piece of that business and diversify their economy. I think they need to keep oil prices up and the cut has been successful in the sense that they cut 3-5% of production. And prices are up 15-20% from pre cut levels. So that was successful to their bottom line. I think all eyes are on Russia and Saudi Arabia as we move forward. And the bull case for oil is that this cut wasn’t needed and that US inventory is about to drawdown pretty drastically as imports come to a screeching halt. The bear case is that US shale is going to disrupt any kind of momentum that oil prices get. We believe whatever happens in the short term that lower for longer is probably the new reality.

Gillian: Okay. Now, you said Saudi Aramco IPO, I want to move over to that for a moment, we’re expecting it 2018, is that right?

Jeff Jorgensen: I think that’s right, yeah.

Gillian: So let’s say pumping for next year, it could be a $100 billion IP, or the biggest we’ve ever seen in history in any sector. That makes Alibaba look small. How will Saudi Arabia conceivably try to control prices in the medium term until we get to that IPO, what do you think?

Chris Eades: Well, they’re doing it now. I mean they’ve cut production. They’re trying to prop up prices. They’re trying to get rid of that inventory overhang that I talk about which will allow the markets to naturally gravitate towards 50/60, maybe slightly higher than that. But certainly cutting production in the market now has allowed them to, in effect, at a minimum put a floor on how low oil prices can go, and probably has propped it up to a level that otherwise it might not have gotten to until later in 2017, and perhaps into 2018 when they were trying to get the IPO out the door.

Gillian: It’s amazing that 100 billion only represents a stake. But does it at all alter OPEC’s control?

Jeff Jorgensen: Having them public, does it alter their control? I don’t think so. It’ll be interesting to see how they come out. Maybe they’ll come out like SNAP (SNAP Inc., NYSE: SNAP), where the new shareholders don’t have any control. I’m not sure.

Gillian: A fair plan, no voting chairs yet.

Jeff Jorgensen: Yeah, exactly.

Gillian: Yeah. It’s true. And then do you think that it could possibly trigger some kind of reaction, other Gulf States more oil companies going public?

Chris Eades: It certainly could, but I don’t think that’s going to alter the supply and demand equilibrium for oil in a global context. And certainly in the intermediate to long term, I don’t think that’s going to have a material impact on the price of oil. But certainly if this IPO goes off successfully you could see others follow.

Gillian: Okay. We’ve mentioned US shale, and I’m curious to know OPEC’s power in the context of US ramping up. We recently hit over one million barrels per day. So I’m going to pull up actually a graphic that I got from Bloomberg, it’s called Rigs Back to Work. So as it comes up on my screen back here, it has to do with US explorers boosting drilling as OPEC cuts output. Now, we haven’t quite seen the cut and that ramp up converge, but could we see it before the IPO?

Jeff Jorgensen: You could maybe see it. But you also have about 1-1½ million barrels a day of demand growth in oil. So I’m not sure that a 1.2-1.8 million barrel a day cut is going to be displaced entirely by shale, pre IPO. I think longer term though, and I said this last time we were here. I think when OPEC artificially left the price of oil at a 100 bucks for too long and incentivized the creation of unconventional drilling in the US, they permanently lost market share. The timing of that is going to be a game of chicken, you know, when they cut, when they don’t cut. But eventually we will take some market share from them and probably keep oil prices near that price for our marginal barrel, 55/60 bucks.

Chris Eades: But then also we’ve talked about OPEC, we’ve talked about shale. But if you look at non-OPEC production outside the United States, I mean production’s been flat to declining now for the last couple of years. And to Jeff’s point, obviously demand is increasing, you know call it 1.4-1.6 million barrels a day. That supply has to come from somewhere, partially it could come from OPEC, but certainly it’s going to have largely be met by increasing barrels out of the United States.

Gillian: Where does Russia fit into all of this in the medium to long term?

Chris Eades: Well, my view is the economics of drilling in Russia are anywhere close to the economics of drilling in the United States. And you know you have to look at the global cost curve to figure out at what prices certain barrels should come into the marketplace. And Russia’s at the higher end of the cost curve, not the low end of the cost curve. And as a result of that I still think that the incremental barrels that we’re going to see coming into the marketplace over the next 12/24, maybe even longer months is going to come from the United States.

Jeff Jorgensen: I think all of this is a testament to free market production and not state owned production. And the fact that we have a nimble economy where you have a pipeline infrastructure, a regulatory regime, where things can be done on the state level, a county level, that promote oil and gas drilling and have been doing so for years, puts us so many years ahead of being able to extract all of our resources. That’s why we’re light years ahead of where anyone else is on shale and unconventional. And I think that’s why we’ll stay ahead, just because we have a tremendous resource. But you can’t control a free market producer. And so they can do all they want. They can manipulate prices all they want. But we just wake up and go try to make money. And producers are going to keep doing that. And they’ll try to do it 40, they’ll try to do it 30, and I think ultimately they’ll prevail.

Chris Eades: I think that, if I can interject, I mean I think that’s what’s been lost on some investors is that at $30 oil, $40 oil which is obviously significantly lower than where we are now. A lot of shale players are still economic and generating very solid returns, which is why you saw as oil prices went into the 20s, but quickly rebounded, that drilling activity very quickly started picking up again and we’re now seeing production rise again in the United States, after having been down in 2016.

Gillian: So when we talk about OPEC’s cut though, it’s a representation of falling from an unnaturally high position, is that right?

Jeff Jorgensen: That’s our view a little bit. They ramped production ever since the non-cut in 2014 to, as Chris pointed out, where we’re all set to scare away the marginal producer, to scare away the producer that shouldn’t … they didn’t want to compete with. And then it had that effect. But where they were producing right before this cut was an unnatural level. So the fact that they’re cutting, it’s not a full cut from some sustainable level. They’re going back to where they should be.

Chris Eades: Well, I would only add on that that I think Saudi has kind of struggled, whether they want to go after market share or whether they want to maximize revenue. And as we saw in 2013, 14 and 15, as they were ramping production volumes it was obviously a market share grab. They collapsed the price of oil, drilling activity all over the world collapsed and production began to decline. And now we’re at the other end of that where they realized that the market needs more oil … needs less oil, rather and they cut their production. But on the flipside of that is we’re not getting pricing cyclicals in the market, that it’s allowing, you know, non-OPEC US production to begin rising again.

Gillian: Now, let’s talk about some of the factors that are impacting US production here at home and obviously we have a new administration in town, even since the last time that I saw you here in the studio. Let’s talk about what some of the Trump policy implications are. And I want to start with pipeline production, what do you see coming from Trump’s position here?

Chris Eades: We’ve already seen it. I mean we’ve had two executive orders here in … what was that, the first week? We had two pipelines that were being held up by the prior administration. A week into the Trump administration and we see the Dakota access pipeline (DAPL) get green lighted with an executive order. And then you saw the same thing with the Keystone XL pipeline, which never even began construction, even though all the pipe has been ordered. And those two pipelines, at least DAPL and perhaps Keystone XL are definitely going to come into service now.

Gillian: One of the main areas of Trump’s proposals that we haven’t gotten full clarity on yet, but we are expecting, has to do with tax reform. So let’s talk about C-Corps in relationship to MLPs. Do you think any reforms in tax, especially tax cuts to corporations will make them more attractive relative to MLPs?

Jeff Jorgensen: I think, yes, that answer is yes, if I was looking at an MLP versus C-Corp and I said, “Boy, I don’t like that one because of the 35% tax, and now at a 15% tax.” And that was my only justification for buying a C-Corporation versus an MLP, then I’d be foolish to say that they’re on a relative basis, that it wouldn’t matter, it does matter. That said, I don’t think anyone likes paying taxes. And so when you talk to a lot of the management teams like Plains (Plains All American, L.P., NYSE: PAA), who chose to continue to not pay taxes in its structure when it did its simplification. You talk to the management team, they say, “I don’t care if it’s 15 or 35, I don’t want to pay taxes.” There’s an advantage to being an MLP that we can still take advantage of. The fact of the matter is though, whether you’re structured as a C-Corp or an MLP, very few of these guys actually pay taxes.

Chris Eades: And one thing I’d add on to that is I think it depends on which MLP you are. I don’t think you can broadly generalize and say that all MLPs are going to be hurt because the corporate tax rate may be falling to the benefit of C-Corps. It depends on which MLP you are. I mean if you’re an older MLP that is paying up a high percentage of your cash flows, up to your General Partner, that effectively is a tax unto itself. And you know, that’s at 50%, you pay 50% of your cash flows to your General Partner for every incremental dollar of cash flow that a new project generates. Does it make sense to eliminate that General Partner tax, for like of a better phrase? Perhaps. But if you see corporate tax rates going from 35% to … I don’t know, pick your number, you know, 20/25%, that will benefit some C-Corp entities, certainly. But it’s not necessarily going to be to the detriment of all MLPs, only those that have the strong burden of having IDRs taking an ever greater cut of your cash flows.

Gillian: Okay. So it may impact some MLPs, but not going to hurt them all on the whole likely should happen?

Jeff Jorgensen: No. I agree with that as well.

Gillian: Okay. Let’s talk about demand drivers. You mentioned that demand is picking up. Who is demanding the most oil right now? And who should we expect to come online that perhaps hasn’t before? Jeff, I’ll start with you.

Jeff Jorgensen: Well, there’s actually a lot of talk these days about the lack of domestic demand for the finished products like gasoline. But if you talk to the bigger players in the game they think that that’s relatively flat to slightly down over time. I don’t think the forecast there has changed. The real demand drivers are the emerging countries, the BRIC nations. That’s who’s going to be driving crude oil demand. Now, one thing that’s very exciting from a demand perspective for MLPs domestically is all the things non-crude oil, natural gas demand has picked up tremendously and we expect that to continue. The L&G exports are driving demand. You have coal switching driving demand. You have industrial complexes and pet chem (Petrochemicals) driving demand. And then on the pet chem side you also have a huge demand for the natural gas liquids, ethane, propane, butane, all that good stuff. And there’s massive world scale ethan crackers being built right now on the Gulf Coast that should come on in later this year and in 18 and 19 as well as exporting massive amounts of LPGs (Liquefied Petroleum Gas) .

Chris Eades: Certainly oil side, and the story hasn’t changed. I mean it’s non-OECD demand that’s driving global oil demand growth. Developed country economies are certainly not seeing, and the US is the same, seeing demand growth for oil. So everything is outside of the developed world in terms of oil demand. I think to Jeff’s point, I mean the natural gas story, I feel like I’ve spent all of my time talking about crude oil and crude oil prices and supply and demand. No one wants to talk about natural gas.

Gillian: I do and I want to ask a question about that actually. But before I ask it, just one other thing, China and India, we haven’t seen India pick up in demand to the extent that perhaps we would expect. Do you think it’s the sleeping giant?

Chris Eades: It certainly could be an upside option for oil demand. Has it dramatically tipped the overall demand picture to being negative? No. But could it surprise us to the upside? Yes, it could.

Jeff Jorgensen: Yeah, I agree with that, I agree.

Gillian: Okay. Let’s talk about natural gas because I do want to talk about it. Just looking back at last week, we saw natural gas inventories rising, which is sort of unseasonable price behavior. What’s your fair share outlook for prices, before we go to demand?

Jeff Jorgensen: Prices is tough, I mean we’ve been structurally oversupplied natural gas for a long time now. If you recall going back to the early days of the shale renaissance, it all started with natural gas. And we flooded the market, we crashed the prices. We subsequently did that to natural gas liquids and crude. But we’ve been there for a while on natural gas. And it goes up to 5 when it’s really cold and it goes down to 2 when it’s really hot in the winter. And that’s where we are right now. I mean here in New York yesterday it was 75, very warm winter. So you’re seeing, you know, some very bearish indictors for this winter. A very warm summer can turn that around. So not being a meteorologist, I cannot say, but I think you will be, and this is the case for lower for longer crude, you will be range bound like we have been for years now on natural gas.

Chris Eades: I mean $2.50 cents to $3.50 cents, is where I think gas is going to settle in, to Jeff’s point when it’s mild in the winters it’s going to be closer to 2.50, when we have nice constructive weather it’ll be closer to 3.50. And we’ve found an enormous amount of relatively inexpensive natural gas through the shale revolution that is going to keep pricing at these kind of levels and certainly I don’t think we’re going to revert back to the big double digits levels that we may have seen 10 years ago.

Gillian: And what are you looking at for demand?

Chris Eades: Well, demand, as Jeff mentioned before, I think the outlook for demand is positive, when you take out the weather element. I can’t predict what the weather’s going to be, whether it’s going to be a hot summer or a cold winter, I’m not so concerned about. What I’m more concerned about is what I would probably just label secular demand. I mean you’ve got power plants that are switching from using coal to using natural gas. You have industrial purposes for natural gas increasing, you have these petrochemical plants that begin coming online, I think in September of this year is the first one, and those are ramped through 2019. And then we haven’t even talked about exports. Shale has become so prominent here at such a low cost that we’re now beginning to export natural gas via liquefied natural gas where you freeze natural gas, put it in a tanker and ship it to foreign markets. That’s effectively another source of demand. I mean this is demand that’s being consumed in another country and the overall demand picture I think is quite positive outside, you know, the swings in weather that we’re going to see every year.

Gillian: I want to stay on US policy for one more minute before we switch over to the structure of MLPs, which I think will be really interesting. The Fed Fund Futures is pointing to a 90% chance of a March rate hike. Janet Yellen was on TV today and I suspect it’s up even higher now. What is the outlook for energy and MLPs if we continue on this kind of three rate hike trend that she has projected for 2017?

Jeff Jorgensen: You know, we’ve been pretty resilient in the face of interest rate hikes. You know, to date there’s been very low correlation to interest rate hikes. I would say that we expect that to continue. The cushion for MLPs relative to the 10 year is still pretty wide. We’re not talking, this is 7% yielding asset class. If we were yielding 3½, then I’d be worried. As it relates to what we think is more important on the fundamental side, the cost of debt and the cost of financing, organic capital, I think investment grade companies will be just fine. They’re still issuing at really attractive rates. The high yield market’s pretty strong at, I think in the 5½% range. And so you’re seeing really attractive cost of equity or cost of debt financing and even in light of interest rate hikes and the high potential for that.

Chris Eades: I think what matters is the pace of increases. If we have spiking interest rates that tells you something’s wrong in the system. There’s something systemically wrong with the overall economic environment. If we have a slow gradual increase in rates I think MLPs will do just fine. If you look back in 2012 rates bottomed, in June of 2012, and they increased by almost 150 basis points into December of 2013. So 18 months later we had a slow creeping interest rate environment. And MLPs did exceedingly well. In contrast to obviously what fixed income securities would have done, MLPs were actually up almost 20% in that period and they outperformed the broader equity, they outperformed REITs and utilities, other income oriented investments. And so I think the pace is more important than the absolute level. But obviously if we get to a certain level then it becomes problematic from a returns perspective on new projects.

Gillian: Right. And it seems like they are looking to temper that rise, at least that’s what they’re saying.

Jeff Jorgensen: Yeah. And I think the tailwinds that are back from an OPEC and commodity price uplift, rigs being put back to work, production is on the rise again. And you have a very accommodative administration to say the least, I think all those tailwinds will offset any kind of small interest rate increase. And then whatever headwind that may present.

Gillian: So the environmentalist perhaps that we would have expected to come forward in the front line should we have had a different result in the US election, we’re not as worried about that anymore?

Jeff Jorgensen: Not as worried, I think they will still come out with the megaphones and do their best. But I think you will … the administration will not behave the same way as the last administration did, in light of those protests.

Chris Eades: And I think the companies themselves are learning how to handle situations better than what we saw for example, with the Dakota access issue, you know, this past year.

Gillian: Sure. Let’s switch over to the MLP structure. Obviously MLPs had a great year last year compared to broader equity markets. So if you have people that are coming in that are now interested but perhaps have not invested in MLPs before, can we just do a basic, how do MLPs operate versus a C-Corp, maybe you can start us off?

Chris Eades: Well, you have a partnership, which is a non-taxable entity in general. You typically have a General Partner who operates the asset and then you have a Limited Partner who actually are the public securities that constitute most of what Jeff and I are investing in. Again there’s no corporate tax rate there. So those are the big differences in terms of structure. In terms of how they work, in terms of the assets, are you talking about the tax situation?

Gillian: Let’s start with assets first and then we’ll move to taxes.

Chris Eades: Okay. I mean the assets of these companies, these are energy, primarily energy related assets, anything from production to transportation, to processing, to storage and then ultimately even induced refining is part of the asset class. The bulk of the assets that are available for investors to invest in, in this asset class are really the transportation, pipelines, processing, which is separating oil and natural gas from a production stream and then storage, those are the primary assets that we’re investing in. And what is interesting about those assets or perhaps beneficial to those assets is the cash flow characteristics of those assets. These assets are not generating cash flows based on the price of oil, not based on the price of natural gas, but rather the volume of oil, the volume of natural gas moving through that infrastructure system. So it’s effectively a toll road that more than it is a simple play on crude oil prices or natural gas prices.

Jeff Jorgensen: And I think what’s important is that MLPs pay out most of their cash flow. And so that’s kind of this dynamic. And why they need to be stable as Chris pointed out, that’s why the midstream asset class, which is just the transporters of oil and gas, very simply speaking it’s storage, those are the ones that, you know, are best for the MLP asset class. Because when you’re paying out all your cash flow, you need to know where it’s going to come from for the next 7-10 years. And investors need to know that because they expect to rely on that cash flow. And so that’s why I think midstream is most appropriate. Also when you’re paying out all your cash flow to grow your cash flow you have to access external markets. So you have to raise new equity and new debt roughly 50/50. You’d probably have some cash on hand or coverage cash, but it’s roughly 50/50 equity debt from new sources, unlike C-Corps. And then the final thing that I would say is that for people new to the asset class, the rights of a shareholder in a C-Corp are very different from the rights of a unit holder in an MLP.

Gillian: Tell us more about it.

Jeff Jorgensen: Holders have less rights than a shareholder. And the General Partner is the one that controls. And so when you're investing in a Limited Partner, you need to get to know who's running the company, and whether they're invested alongside of you. So most of the General Partners, I'll point out someone like Anadarko Petroleum, started a firm called Western MLP who are Western Gas Partners. They own 50% of the Limited Partners, so they're right there with you, there's no conflict there. There are other situations, but they're very low Limited Partner interest, and they're only playing for their GP, and those are where things can get difficult for the LPs.

Gillian: And the GP is playing for a management fee?

Jeff Jorgensen: The GP is playing for his Incentive Distribution Right. So not only ... this is, it will come up in a second when we talk about simplification. But the Incentive Distribution Right is another thing that I think is important to understand about MLPs. To incentivize the growth of cash flow from the GP, who controls the assets, and controls a lot of the assets that are already built, that are going to be dropped in, or a lot of the projects, and controls what's going to happen at the LP level. You incentivize then through effectively a carry, it looks like a private equity carry. The more LP cash flow grows, the more they get at that, all the way up to getting as Chris pointed out earlier, 50% of every new dollar that comes in. And that can be very burdensome over time. However, it's a good thing because it kick starts these MLPs, it gets these assets out there to the public, you just have to fix it later when it gets to be overly burdensome.

Chris Eades: So when you take one of these companies public, I mean the General Partner's getting a relatively low amount of the cash flows. And the Incentive Distribution Right is simply an incentive for the General Partner to raise the distribution of the income level to the Limited Partner. So at a 10 cent dividend, the General Partner gets 2% of the cash flows. At 15 cents, it might be 25%, and then at 30cents, it might be 50 cents. So there's an incentive for the General Partner to grow the income stream to the Limited Partner, but eventually it caps out at 50%. but at that point, ... every new project that the partnership undertakes, 50 cents of every dollar of cash flow goes straight to the General Partner, who didn't have to put up any capital to generate that new project. Obviously that's to the detriment of returns at the Limited Partner level, and ultimately it becomes such a burden that we've seen, you know, a simplification where some of these General Partner, Limited Partner relationships have been altered or changed.

Gillian: Before we go to the simplification trend that we saw last year, let’s talk a little bit about the differences in tax structure between MLP and the C-Corp, do you want to kick us off?

Jeff Jorgensen: Sure, an MLP doesn't pay taxes; a C-Corp does, so you have no double taxation. The unit holder however has a very interesting tax situation, most of the distribution is going to be deemed a return of capital. It has no income associated with it because of the high depreciation shield. So if I invest $10 on an MLP, and I get a dollar payout, a 10% yielding MLP, so I get a dollar for my distribution that year, my basis in that MLP goes down to 9. When I go sell at 11, we'll say it went up a dollar, from 9 to 10, will be a recapture of ordinary income rates, and from 10 to 11 will be capital gains. So I think that's another important thing for potential new entrants to the asset class to understand.

Gillian: Yeah, an important distinction.

Chris Eades: It is and also related to that, I mean if you hold these securities through an estate process, if you die and you pass them on to your heirs, that basis actually gets stepped back up to the price of the security at the day of your death. So a lot of people are actually using these as estate planning tools as well.

Gillian: And what are the different categories of MLP's available?

Jeff Jorgensen: Well, I guess you've got, broadly speaking there's so many different comp sets. I will say one thing though real quick. We talk about MLPs all the same. You know, we say, lot of people view MLPs the same, they call the MLP asset class, or this, and we’re MLP managers, and there's MLP investment bankers. But these are all separate companies, and they deserve their own due diligence and they're all, just like the C-Corps, you know, if I were to walk into a massive money manager and ask, "Hey, how are C-Corps these days?" They'd laugh me out of the room. And so I think each MLP needs its own analysis. It's just put into a different structure. But those assets need their own analysis, some are good, some are bad. They're not all the same. So the different types you can have, you can have ... there were upstream MLPs, they didn't do so well. And then there are some variable rate MLPs that are downstream, that's more on the refining side.

Chris Eades: And by variable rate, it’s means the distribution literally it can go up and down, quarter to quarter, there's no rhyme or reason to it sometimes.

Jeff Jorgensen: And then you have specialty MLPs, service MLPs. And then I think both of us focus on only is the midstream MLPs, within midstream, you've got crude oil transportation, refined products transportation, natural gas transportation, storage, and then gathering and processing, broadly speaking.

Chris Eades: And which again, the reason why we invest in those, is the stability and the predictability of the cash flows unlike an upstream MLP, which most of them went bankrupt in this past oil price collapse. Or the oil field service companies, the drilling rigs, the frack-sand providers, that is a very variable cash flow business, and it completely depends on where you are in the commodity price cycle. Unlike the midstream assets which again are based on throughput, not based on the price of the commodity.

Jeff Jorgensen: And some of that's based on various entries of the business models. You know, when a pipeline is almost impossible to recreate, I cannot go replicate Transco Pipeline, it's massive, it would cost hundreds of billions of dollars to go re-pipe Transco. And once someone … let’s say it's a utility is pulling off of Transco, from a smaller line, but pulling off of Transco to feed it’s, you know, as a feedstock that's it, there's no other pipe in town. And when times get tough, they're still going to rely on that, they can't go say, “Hey, sir, I'm not going to pay your contract, I've got this other guy.” No. This is a high varied entry business model. Whereas a drill ship, there are some drill ship MLPs, or even shipping or trucking or service ML's, a wrencher guy turning a wrench, times get tough, the guy turning the wrench, there's another guy turning the wrench that's cheaper, and it's a race to the bottom. It's not the case with MLPs and pipeline assets. I'm sorry midstream MLPs and pipeline assets.

Gillian: And can we weigh the pros and cons of the different investment structures in which you can own MLPs?

Chris Eades: Well, you can own them individually, but with that comes the burden of filing K1s for every single MLP that you own. A lot of investors don't like that. There are closed-end MLP funds of which I manage four of them, those are funds that have leverage, which is to the benefit of some. Some people don't like having leverage on them, but you also don't have a K1 with those. There are open ended MLP funds that are both actively managed, there's also passively managed ETFs in this space as well. So there's a wide variety of different ways for investors to gain exposure to the asset class.

Jeff Jorgensen: And within the mutual fund space you have C-Corp mutual funds, where we accrue for ... we run a C-Corp mutual fund, and I help manage one that's ... a fairly large one, the first C-Corp mutual funds, to get a RIC status, which is, I think it's Registered Investment Corporation, or company.

Chris Eades: My open-end fund is RIC.

Jeff Jorgensen: And ours is a C-Corp. C-Corp, or RIC you have 75% has to be non-MLP, the other 25% MLP. A C-Corp, is all MLP, but you have to accrue for taxes, and get a C-Corp kind of burden on the way up in your NAV. So if you're looking for a pure MLP asset allocation with a little bit of tax … difference in the tax status, C-Corps works for you, if you're looking for more of a total return vehicle, then the RIC structure is, you know, the way to go from a mutual fund perspective.

Chris Eades: Exactly.

Jeff Jorgensen: That way you're just getting one 1099 and it's really easy for investors of a lower net worth. I mean to get 20 k1s and an SMA strategy, you have to put a lot of money to work.

Gillian: We've alluded to the simplification trend a few times. But now I really want to drill down into it. We've seen some interesting headlines, we saw Williams Companies Inc. (NYSE:WMB) restructuring, their relationship with Williams Partners, L.P. (NYSE: WPZ) we saw it with MPLX, LP (NYSE: MPLX), what exactly is MLP simplification and what does it entail?

Chris Eades: Well you typically have a C-Corp General Partner, and then the public or traded Limited Partner. And we've talked about the Incentive Distribution Rights. And the older these MLPs are, the further and further they are into paying 50% of the cash flows up to the General Partner or the C-Corp, and eventually it increases your cost of equity financing. So what we've seen in this really accelerated ... well, I guess the first one was back in 2014 when Kinder Morgan took its partnerships and rolled them back up into the corporation. But it really picked up steam in the second half of 2016 ... I’m sorry, second half of 16, and certainly the first couple of months of 2017 is where you've seen that General Partner IDR, the Incentive Distribution Right get eliminated, and in return for the General Partner giving up those Incentive Distribution Rights, the Limited Partner issues more securities up to the General Partner, and sometimes it can be the other way around. So we've seen several of those transactions here just this year.

Gillian: How does it impact the end holder?

Jeff Jorgensen: Well, it depends on how the transaction structured. And that's what makes it difficult in playing this trend. If you, for example, let’s take Plains, and Plains’s GP, if you were to know whether they were going to buy in the LP, or buy in the C-Corp. You can go turn into a C-Corp, have the C-Corp gobble up all the MLPs, or you can take the MLP and buy out the C-Corp, and stay an MLP. The one that gets bought usually gets a slight premium, and probably benefits more than those that are the buying entity. And so you just don't know which way it's going to go in any one situation.

Chris Eades: You don't, but I mean also like that's a trade, trying to figure out which companies are going to benefit. And I think both of us are investing in these companies, not necessarily trading these companies. And the outcome from an investment perspective is typically a lower cost of equity, which makes their new growth projects more economic, and allows the combined entity, whether it's the C-Corp gobbling up the LP, or the LP buying out the GP, to have a better growth profile and a more economic growth profile for the owners, you know, post the simplification.

Gillian: Now when I hear the word simplification it might signal transparency, is this true? Does it become more transparent as a company?

Jeff Jorgensen: It becomes easier to model, easier to understand. And I think that's incredibly helpful. You're not trying to keep track of GP, IDR cash flows. There still is a General Partner that controls it that is not you, to the extent it stays in an LP form. But it does just become a simpler, easier to understand entity. and it's actually easier to value as well, because you can start using things like EBITDA multiples, whereas with IDRs it becomes pretty burdensome. So I think all in it's a great thing. There are two MLPs that did this in 2009/2010that really stand out to me as top performers through two tough times, and over the years, Enterprise Product Partners L.P. and Magellan Midstream Partners L.P. , tickers EPD and MMP, respectively. They took out their GPs a while ago, and so when the commodity crisis came, they also ran high coverage, a little bit of a different funding model. When the commodity crisis came over the last couple of years, they were fine. and they have a competitive cost of capital, they win projects, and their GP isn't a drain on their cash flow, like it was for others, who eventually are now solving that a little bit too late to take advantage of the last two years, but are really better for you know holders going forward.

Chris Eades: If you look over the cycle, and this is a cyclical business, energy is, irrespective of the fact that the assets that we're investing in don't have a lot of cash flow cyclicality. The companies that have done well over the cycles are those that have kept their balance sheets in good order, low levels of leverage, and those that have had a limited IDR burden, or zero to limited IDR burden. And over the full cycle, those companies have always, and they probably will continue to outperform the companies that tend to run with higher levels of leverage, and then ultimately end up in that level of IDR splits that becomes a huge burden on returns.

Gillian: Does a trend towards simplification signal anything about performance coming down the pipeline?

Jeff Jorgensen: I think it's good for performance coming down the pipeline. If I’m building a project, let’s say at eight times my EBITDA. And I'm able to fund that at a lower cost to capital for my unit holders. That's better for the LP, you know. So I get more cash flow accretion to the unit holders. Cash flow accretion, inorganic or M&A projects, that is going to be better for performance all-around.

Chris Eades: I mean a lot of these transactions that we've seen announced late last year and the first part of 2017, are kind of setting the table for, I think it's going to be another large wave of consolidation. We've seen, you know, so many simplification transactions occur. But I think given the lower cost of capital, and the large amount of new infrastructure that needs to be built in this country as a result of rising production, I think a wave of, you know, corporate consolidation is probably on the other side of the simplification process that we've seen with a lot of these names.

Gillian: I'm going to cue up a graphic that you will probably like to see, which has to do with MLP outperformance versus the broader markets over the past year. So as that comes up, what's your outlook just generally speaking when you think about MLP cash flows and distribution growth, what do you start with, Jeff?

Jeff Jorgensen: Well I think that we should have ... I've heard 2017 described as kind of a pivot, an execution year, a transition year. But I still see a lot of growth this year. I know for our funds we're forecasting for some funds about 5-6% distribution growth on the underlying constituents, and for some of our products, about 10-12% distribution growth for underlying constituents. That can come from dropdown transactions where the assets already exist, they're coming into MLP, they can come from new projects, which are as we've pointed out many times, there are many. And I think the table's set for a very good year from a cash flow perspective. But I would also like to point out that crude prices were cut in half from 2016 to 2014, the average crude price. Our cash flow for our constituents grew by 10% a year. So it doesn't matter what happens to the commodity, these companies are putting good assets, good projects to work, to re-plumb the US, to take it to, you know, do what we need to do for the North American unconventional revolution. And it's occurring to the benefit of the bottom line, already.

Chris Eades: We're looking for roughly 5-6% distribution growth in 2017, over 2016. The other thing I would add onto that is I think it's going to start accelerating as we work into the back half of the year. A lot of the turmoil that the oil price environment put forth on the entire energy space is obviously further and further in the rearview mirror. And as we see drilling activity increase, and the number of rigs drilling for oil for example, it’s up almost 90% from the bottom that we saw last summer. We're going to start seeing increasing volumes, and with increasing volumes obviously comes the need for more infrastructure. And those infrastructure projects are going to start coming into the project backlogs, kind of now, but accelerating as we move through the back half of 2017 and certainly into 2018, when I think we'll see accelerating growth relative to what we'll see this year.

Gillian: Is there a measureable obvious correlation between energy prices and MLP performance?

Chris Eades: It depends on what kind of market we're in. If oil prices are collapsing, we've seen this time and time again, and we'll probably see it again in the future, you know, correlations in that environment all kind of converge to one. But if you look at these as an investment, and look at them over an investment cycle, the correlation between MLP stock prices, and crude oil prices is actually fairly low, it's about .55. So don't get too fixated on short term correlations because everything in periods of stress can converge to one, over a full investment cycle, these are not directly tied to the correlation and there's not directly tied to the price of crude.

Jeff Jorgensen: It’s when you see moves about 20/25% in the price of crude you really start to see the panic that unwinds the asset class, and the correlations pick up. And we saw that through 15 and 16. And we’re seeing it alleviate now because people are getting back to work. They’re putting rigs in the field. And I’d say we’ve passed the activity threshold. And when you get back and you get on stable, more firm footing, you get back to that .4/.5 long term correlation, it does help, you know, for the stock price but it’s not a real meaningful number.

Gillian: Now, capital markets are very important to MLP growth, so tell us a little bit about your outlook there and the MLP ability to continue to acquire and to grow.

Chris Eades: I mean what a difference a year makes. I mean if we’d said only a year ago MLP stock prices had recently collapsed. Equity markets were completely closed for MLP companies. The debt markets were open then and they’ve always been open for MLP companies. It was the closing of the equity markets that caused pain for these companies. So they already had a backlog of projects that they needed to finance these things. They’d already started construction. They needed financing, couldn’t access the equity market so they went to the debt market and it left their balance sheets overleveraged, you know, going through that turmoil of a year ago. But here we are today and we’re seeing these companies rather easily access the equity capital markets, whether it’s through secondaries and at the market, kind of an ATM type program. And we’ve even started to see some initial public offerings, which I think is a true sign that the market, at least the equity capital markets, rather, have started to heal. We saw one IPO last fall, I think there’s another one that’s teeing up here that should be going out very soon. And all these things are signals that the capital markets, which to your point, were absolutely vital to these companies’ ability to finance what it is they’re doing in terms of building new assets or buying new assets, has definitely improved. It looks actually quite healthy right now.

Jeff Jorgensen: You know, last year Plains, this is a good example, Plains last year needed money and it had to go to its General Partner owners and get a $1 billion preferred because it couldn’t go access $1 billion of common equity. Last week they did a billion and a half of common and it’s up about 5/6% since they did that deal. It’s gone tremendously well, it was oversubscribed.

Chris Eades: And they did it overnight. This was not a marketed deal, this was an overnight offering and they raised, you know, $1½ billion overnight.

Jeff Jorgensen: So I think the capital markets are back. I think we’ll see some IPOs this year. There are some other even rinky dink MLPs that aren’t as great as Plains in our opinion, that have accessed the capital markets recently, and actually done well on a relative basis.

Gillian: Rinky dink MLP being a technical term?

Jeff Jorgensen: That’s right, yeah, the absolute quality of whether asset classes are MLPs, rinky dink is one of them.

Gillian: Yes. So I actually meant to ask and didn’t have a chance to. We’ve talked about LPs being publicly traded. Are the GPs ever publicly traded?

Jeff Jorgensen: They are, yeah, and they can come in a few forms. There are C-Corp versions of General Partners that are publicly traded. And there are those formed as partnerships. So you have EQGP and Western Gas Equity Partners and NuStar Holdings I think are the three GP, they’re formed as Limited Partners. GPs have Limited Partners, but still get a K1. And then you have … who’s left in the C-Corp land? You had WMB gone, ONEOK gone, PAGP gone.

Chris Eades: NGLS and the list goes on.

Jeff Jorgensen: TRGP gone, so those apart that have all done the simplification. There are a few … Tallgrass. Tallgrass is still around as a C-Corp. And then you have energy transfer equity. So they come and go. There was a big wave of GP IPOs in the 2013/2014 timeframe and the tail end of a great bull market when everyone was saying, “I don’t just want MLPs. I want a levered approach to MLPs. And so I’m going to buy a General Partner that’s seeking to monetize its IDR stake.” And so you saw that wave, then you saw that pain trade, because it’s a levered approach. And so when things got bad they went down more than LPs. And then now you’re seeing obviously the simplification waves who are saying, “Okay, those GP IPOs weren’t good.” Well, I’ve actually heard people talking about GP IPOs again.

Gillian: Well, you said the IPO market looked good, so.

Jeff Jorgensen: I know, and we’ve actually, you know, I’ve heard some talk of some GP IPOs which would be, look, I think the GPs need to be simplified, not necessarily IPO’d. But perhaps that’s a return of, you know, the height of investor confidence when they’re buying GPs.

Chris Eades: No, but I think you also need, it depends on where you are on the lifecycle. If it’s a younger MLP where the GP is not getting the 50%, hasn’t done so for years and years and years, I mean there may be an appetite for those.

Jeff Jorgensen: Yeah, and if it’s sponsored, right, if … and what I mean by sponsored is like earlier I talked about Anadarko Petroleum and Western Gas. So most of Western Gas’s pipelines are controlled and operated by Anadarko Petroleums,an upstream company. So they have a very vested interest in making sure that that cash flow is stable, those projects are good and that they are supported by someone who owns them. And so there’s a very common interest there from the person actually putting the volumes through the pipe. It’s not a third party relationship. They still have the GP structure and it works well because of that sponsor and that support that you get from someone with interest.

Gillian: We have danced around this topic a bit but now I really want to dive into it, and it has to do with doing due diligence on MLPs. And I want you each to kind of give me your process. Because it sounds like, at least from what you’ve alluded to, there are good ones and there are bad ones. So, Chris, let’s start with you.

Jeff Jorgensen: And rinky ding ones.

Gillian: And rinky ding ones, which fall … do they fall in between good and bad or are they all the way on the other end?

Chris Eades: There are some rinky dings at the bottom.

Gillian: So how do we avoid the rinky ding MLPs?

Chris Eades: Well, I think I mean as mentioned before, I mean there’s this common perception that all MLPs are created the same. They’re all kind of the same animal, they’re all the same assets. They all yield about the same. They all do the same business. But I mean nothing could be further from the truth. And I think what Jeff and I bring to the table as portfolio managers is understanding the differences between the MLPs and understanding that the growth profile and the risk profile from one Limited Partnership to another is quite different. So for us, I mean our first cut is the assets, there are certain types of assets that we will own in our funds and there are certain assets that we will not own in our funds. We will not own upstream production because of the commodity price exposure. We won’t own drilling rigs for the cash flow volatility. We won’t own frack-sand MLPs because of the cash flow volatility. But what we will own, as I’ve said before, are the transportation oriented assets, the pipelines, the processing plants, the storage facilities, because those cash flows are relatively stable.
So for us it’s the first cut at assets and then it goes down to geography. Because where these assets are located is probably equally as important as what the assets are themselves. A pipeline in Hawaii is not going to be worth nearly what a pipeline would be worth in Pennsylvania which underlies the Marcellus shale play. So where these assets are located and understanding which parts of the United States are best positioned to grow from a production perspective, and it’s not all the same, is the next cut. And then it gets to financial analysis. You’ve got to understand the balance sheets, the balance sheets and the balance sheets. I mean that’s a key thing for us is understanding how these companies are going to finance themselves, not only today, a year from now, two years from now, three years from now, because the companies that got most in trouble in the downturn were the ones that didn’t manage their balance sheets very well. And then it gets down to on the valuation metrics, EBTIDA, you know, distributable cash flow yield. And that’s kind of our big picture process for doing this.

Gillian: Okay. So assets, geography, balance sheets, balance sheets, balance sheets.

Chris Eades: Fair enough, I couldn’t have said it better. And you said it less shorter than I did.

Gillian: Well, we needed the in between. Jeff, what is your due diligence process like?

Jeff Jorgensen:] It’s very similar, it’s fundamentals based. And Center Coast is … founded by some guys who actually ran oil and gas companies, so the President of Enbridge founded Center Coast. And so we think we have a unique view, an owner operator view of kind of the pipeline infrastructure group. So we started the assets, we started the contracts, we’re looking at the counterparties, we’re making sure that there’s cash flows that we can count on for a while. And then it’s nice and growing, nice and stable and growing, regardless of what happens to the underlying commodities. But I can think, we talk about upstream bad, downstream bad, midstream good. But even in midstream, as he pointed out with geography, some of these pipelines, they’re not all good either. You’ve got to look at each specific asset, each specific system to make sure that what you’re invested in is transparent, you know where the cash flow is coming from, the contracts are long dated, they’re strong, they’re not weak. They can’t get torn up if something bad happens. On the other end is it a great counterparty with great credit and that that company has competitive access to capital, so they can keep going and keep growing that cash flow.

Gillian: To what extent are you also kind of digging up on the GP? I know you mentioned about alignment of interest, but what else are you looking at there?

Chris Eades: Well, you’ve got to look at the GP. I mean the GP’s controlling the Limited Partner. And the vast majority, I mean I think there’s over 100 publicly traded MLP stocks in the marketplace now, as we’ve said before, there’s like 5 or less that are actually the General Partner, so we’re Limited Partner owners when we own these securities. So we’ve got to understand who the GP is, what their credit profile looks like, how their business is looking and how well are they aligned with the Limited Partners as we think about the operations and the growth profile looking forward?

Jeff Jorgensen: But management teams and the General Partner are incredibly important. And not all management teams are good. Not all management teams are disciplined. Not all management teams run it for the benefit of the LP. And that we dig in hard on that, that’s very important to our investment process. We need to look these guys in the eyes. We need to know them well. They need to have the experience, the discipline to execute and to keep their promises.

Gillian: Is there an estimate for how much of a stake you want to see that the GP has?

Jeff Jorgensen: Well, when you IPO on these things, the typical structure at IPO is that 50%, and I’m using, there’s the 49/49 too, but let’s use 50/50, 50% is common, 50% subordinated. The subordinated units are all owned by the GP. And so what can happen over time is you have … if it were set up that way, which is a great set up, now you’ve got 50% owned by the guy controlling the company certainly aligned with you, right. And he actually owns more than 50%, he probably didn’t sell it all in the public offering. So that is the typical set up. Or can you see those as they access new equity over time, their stake dilutes to where they’re only getting 6% of the cash flows, 10% of the cash flows, or maybe they weren’t set up that way in the beginning. I like to see that traditional 50% ownership right alongside me, they subordinate their units for the first three years, they are fully invested, they’re fully interested. And they’re right alongside me on a cash flow perspective for the LPs. And they are burdened by that General Partner just as much as they’re getting General Partner benefit by owning it.

Gillian: Agreed?

Chris Eades: I couldn’t have said it better, yeah, that was perfect.

Gillian: Perfect. What would you say are some of the specific opportunities right now? You can either break it up by a specific sector or geography, is there any area that you’re really excited about in 2017?

Chris Eades: My stealth area, for lack of a better word, is kind of a bad one, stealth. But everyone’s all bulled up on the Permian Basin at West Texas. Everyone’s been perpetually bulled up about the Marcellus shale play underlying Pennsylvania and parts of Ohio. Now, one of the plays that’s kind of been left in the dust after the oil price downturn was actually the Eagle Ford shale play. And we’ve had a lot of very high profile public companies exit their acreage positions, the producers have exited their acreage position. And we deployed those dollars into the Permian Basin which has kind of added to the excitement about the Permian. You know, but at the same time we’ve seen a lot of very smart private equity money come in and be at the other side of that sale. And they’re buying up acreage in the Eagle Ford shale play, which is kind of in South Texas. And we’ve seen more than a doubling of the rig count there, production volumes are certainly stable and perhaps are going to start increasing. And no one’s really talking about this right now. And I think if there’s a region that’s going to surprise us in 2017, and really more in 2018, I think it could be the Eagle Ford. And there are some of the securities that we invest in that are more levered to that specific region than some of the others.

Gillian: Okay.

Jeff Jorgensen: I completely agree about the Eagle Ford. I mean it is no secret that the Permian and the STACK SCOOP are just, you know, the queen bees of the oil game. And everyone’s chasing those and it comes at a cost. All those names are bid up pretty high, Marcellus and the Utica for Natural gas (plays). I think on the gas side, Haynesville is actually starting to get a little bit interesting and what you could in the Haynesville. So we’re kind of looking at a kind of the middle of the cost curve basins as potential alpha generators, something that you want a little bit of exposure there. But you know, Permian STACK SCOOP, Marcellus/Utica, who are dominating the news and continue to do so.

Chris Eades: Those are great plays.

Gillian: So rightfully so.

Jeff Jorgensen: Rightfully so.

Chris Eades: The question is have we got a little too exuberant about how good those plays are. And we’ll find out but perhaps, yes. And if that’s true at least for us we’re also trying to make sure we have exposure to some of the areas that people aren’t yet focused on, but perhaps could be a year from now.

Gillian: Okay. We’re coming to the end of our discussion actually. So I wanted to give each of you an opportunity just to summarize any kind of key takeaways that you want to offer to someone who’s watching this program and is interested in getting involved with MLPs.

Jeff Jorgensen: I think it’s a great asset class, but not all MLPs are created the same. And the beginning of 2017, there are a lot of fantastic MLPs that were brought down in the commodity price downturn that shouldn’t have been. And we’re standing on much firmer ground, should give investors confidence that now is a pretty decent time that the administration, the rigs have been put back to work with an OPEC cut. A Saudi Aramco IPO, capital markets are helping, we’re in a pretty good spot and we’re still a little bit undervalued relative to historical levels. So the outlook looks good, we feel great about our companies and they actually performed really well from a cash flow perspective over the last two years.

Chris Eades: So cash flows have been stable, the business model for the kinds of assets that Jeff and I are investing in actually was quite resilient despite the commodity price cycle. But, you know, the cash flows were stable, but the stock prices were exceedingly volatile. So I think everyone needs to understand that these are stocks, they can be volatile. That’s the name of the game. But if you’re looking at these not from a trading perspective, but from an investment perspective, and you have confidence in those cash flows and you select the right stocks and go with the right portfolio manager to run that kind of a strategy. It is an asset class that I think has a lot of longer term potential. Again, it can be cyclical, it can be volatile. But certainly the story is much more stable than it was a year ago, at least from a sentiment perspective, even when the cash flows were always quite strong. But I think this is an asset class that it’s not really going to be a flash in the pan; I think it’s going to be a longer term story because of all the opportunities that we see for increasing production volumes in the United States. And obviously it will result in a need for all the transportation and infrastructure on the other side of that production growth.

Gillian: So good performances last year but still room to run in the years coming ahead?

Jeff Jorgensen: You can never make a promise, but you know, it feels like it. It feels, you know, cash flows are good and valuations are under historical norms, I think there’s some room to go.

Chris Eades: We had the chart up earlier showing the MLP universe versus the S&P 500, that was just a calendar snapshot of 2016, and that’s a little bit misleading because you’re not showing the depth of the downturn that we saw in the last half of 2015. So I guess these stocks look like they’ve made an enormous run relative to the broader equity market. And that’s true, but I also think that valuations are far from stretched at these levels. And in fact the normalization for slack of a better phrase, of stock prices for this sector is still ongoing. We’re not completely back to what I would characterize as normalized valuations for these stocks, which gives us a little running room in terms of stock price and then you still have the growth component on top of that.

Gillian: And that’s certainly a difference from the S&P 500 right now.

Chris Eades: That’s certainly true.

Gillian: Well, thank you so much for taking the time to chat with us, I certainly learned a lot and then hope to have you back to continue to hear what MLPs do let’s say later on this year or next year.

Jeff Jorgensen: Yeah, I hope that chart looks the same.

Chris Eades: Definitely, thank you.

Gillian: Thank you. And thank you for tuning in. From our studios in New York, I’m Gillian Kemmerer for Asset TV.