MASTERCLASS: ETFs - December 2019
November 22, 2019
Sue Lee: Welcome to Asset TV. I'm Susanna Lee. Master Limited Partnerships, otherwise known as MLPs have started this year strong, even beating the broader markets rally in January. The majority of these MLPs are in the midstream energy business and perhaps the most favorable characteristic is they combine tax advantages of a partnership, while having the liquidity of a stock. To discuss the outlook and opportunities in this investment vehicle, I'm joined by Ben Cook, Portfolio Manager at Hennessy BP Midstream Fund and Eric Kaufman, Managing Partner and Portfolio Manager at VE Capital Management, also with us is Quinn Kiley, Senior Portfolio Manager at Advisory Research.
Sue Lee: When we think MLPs, energy often comes to mind, so let's get the outlook there, starting with you, Eric. The EIA, their latest report on oil inventories was bullish, breaking a string of negative reports. Do you agree that the fundamentals are strong? Give us your outlook for oil and nat gas prices as well this year.
Eric Kaufman: Nat gas prices are probably more seasonal because they're an indigenous product to the United States, until we become more of an exporter. The valuation for WTI, which is the benchmark for U.S crude, depends a lot on global economics. It depends a lot on supply dynamics in the Middle East, which is a primary supplier of crude oil. It's hard to say, but it does seem that these prices, in this vicinity, between say, 55 and 65 are reasonable given world dynamics.
Sue Lee: Ben, what's your outlook for oil and Nat gas prices? Also, since, since MLPs are so connected with oil and Nat gas prices, can you give us a correlation of that?
Ben Cook: Sure. I'd be happy to. We're encouraged by what we're seeing in the global oil market. For the second time in two years, OPEC as acted with Russia to limit the amount of oil on the global market and the reason why they've done that is they've seen the dramatic growth in the United States. They're effectively joining forces to mitigate an oversupply situation. The data point that you're referring to, the weekly data from the DOE suggests that they are having a meaningful impact on the supply pictures as it relates to the DOE numbers.
Ben Cook: You know, our outlook, as part of our repeatable investment process at Hennessy BP, we incorporate both a low case and a high case, in terms of our outlook for crude oil. We believe that the low case is more than likely to settle in around $50 per barrel WTI. On the high end, we would say $70 WTI would be reasonable. Ben Cook: 02:58 As it relates to natural gas, I agree with Eric. Natural gas is generally consumed in a majority of what we consume over the course of the year as a country, during the Winter months, it's used for heating purposes. What we've seen as a result of the Shale boom over the last several years, we have an abundance of natural gas, and so prices will generally respond to where natural gas inventories are, in relation to where they've been. If we're under supplied, going into the Wintertime, it's not unlikely to see gas prices trade around $3, $3.50. During the periods of reduced demand during Summertime, you typically see gas prices around $2.50.
Ben Cook: What does that mean for the MLPs, back to your original question. There is a correlation of the MLP group, the sector, broader midstream company group. Typically and historically over a long period of time, you've seen a correlation of roughly 0.5 to 0.55, midstream companies to crude oil. Recently, just in the last several months, we saw weakness in December, the correlation to the sector actually rose. We saw a sharp downdraft in the commodity and the stocks followed. During periods of weakness, it's not uncommon to see a higher correlation, but over the long haul, it's generally 50 basis points to 0.55.
Sue Lee: Quinn over to you. Oil production remains strong, but the oil rig counts are falling.
Quinn Kiley: Mm-hmm (affirmative).
Sue Lee: The headlines about slowing U.S oil production growth, is that a concern for Midstream investors?
Quinn Kiley: If it were to happen, clearly it would be, but we don't think it's going to happen. If you look at what's transformed the space since the highs of 2014, is that we've seen rig counts get cut by more than half, yet production continues to grow. We think in this decade, we're going to see production grow by 57% percent from 2010 to 2020 and that's with a declining rig count. You're seeing gas production grow dramatically as well. While prices can oscillate on seasonality and different stories about what's happening in Venezuela or Saudi Arabia or what have you, Iran.
Quinn Kiley: The reality is that we have become a manufacturer of these things in a very increasingly efficient way and that should cause less volatility going forward and really anchor natural gas around $3.00 and we're projecting $55 this year for crude oil in our models, although we agree that a rational range is $50-70, and we're at the lower end because the market is still trying to find it's balance. As these cuts that we've seen, from whether it be Alberta or OPEC or Russia, or troubles in Venezuela ,they should put pressure on supply, which could push prices to the higher end of that range over the coming years.
Eric Kaufman: You know, there is also, to his point, been a huge increase in rig efficiency. When we look at an old set of numbers that says, well there were 1600 rigs running before 2015, now there are half of those. They are much more efficient and many of those rigs that were running at that time, are no longer in service, they've been scrapped because there's so much more efficiency now in pad drilling, horizontal drilling, from that pad is amazingly more efficient than it was 10 years ago, five years ago. While everybody was sleeping, something changed.
Sue Lee: Then let's talk about the Shale boom in America. How is the proliferation of that development impacting and playing out for MLPs?
Ben Cook: Yeah. When you talk about the initiation of the shale boom, it really started with natural gas and the shale play in North Texas called the Barnett shale and that started in 2005. Several years later, the technology was being applied to natural gas, shale formations was then being applied to liquids or crude oil shale formations. And so, what we've seen over the last several years is an incredible boom in technology. The application of horizontal drilling and completion technology as enabled producers to do more with less, effectively reducing the need to have elevated rig counts in order to produce the same amount of oil. With that boom, the U.S as been able to grow production from a very ... when you talk about production and the United States growing from five million barrels a day at the onset of the shale boom, now we're producing 11.9 million barrels a day and the natural gas numbers are following the same trends. It is a story of technology, and it's been an exciting one for the industry.
Sue Lee: Quinn, adding to the shale boom in this country, there is also been a big growth in hydrocarbon production here. Has the U.S filled the gap; the world's oil gap?
Quinn Kiley: I think you have to look at the global market in a couple of ways.
Quinn Kiley: One: There is natural gas, which is becoming an over-thewater product as LNG becomes ...
Eric Kaufman: Yep.
Quinn Kiley: More part of our exports, sorry. You've got crude oil, which I think is what people fixate on a headline. But then you've got everything that comes out of crude oil. We've actually been a net exporter of total petroleum, that's crude oil combined with petroleum products, since the financial crisis. That's because we're importing more crude oil than we're using and then sending petroleum products back out on the water to Europe and South America. I think we are part of the solution. I think it's maybe too fine of a point for a generalist audience, but the idea that we have fulfilled a product need, which is what consumer and companies actually consume, has been more of a part of our story, I think, over the last 10 years than the crude oil production part and the new exports that we're seeing in crude.
Quinn Kiley: Interestingly EIA, you cited a number there. They came out with their long-term energy forecast. They now think we're going to be a net exporter of crude oil by 2021, it used to be 2030, 40, maybe never. The combination of efficiencies and production growth has really changed. I would argue it's the most disruptive technology that's happened the last 10 years. It's not Uber, it's not Twitter, it's 3D, seismic, directional drilling and fracking of these new shales.
Sue Lee: You think this current administration is conducive of that?
Quinn Kiley: I think they're very conducive and supportive of drilling and opening up opportunities. We thought two years ago, that they were going to be very supportive of infrastructure. We've changed our view there. While I think a lot of people might think that the weakening of EPA would be welcome by people investing in energy, our view is, it's going to create a toxic, local environment and it's a bridge too far. And, really what we've seen over the last several years is that the local regulatory issue, with the exception of what FERC did to the pipelines last year, the local issue has been more powerful. So that's something that we pay a lot of attention to.
Sue Lee: Eric, your thoughts on the U.S filling the oil gap and also, where do you think the demand is coming from?
Eric Kaufman:Well, first of all, demand is not what it was 20 years ago. It's a lot more inelastic because of the use of petroleum being different than it was then. We ship a lot of refined product to the export markets, as it's been mentioned and the uses, as I said, are different now. I would say that we haven't filled it. We're very short cycle producers of oil. In a shale well, in a typical shale oil well, you might see a 60% decline from initial production rates in the first year, another 50% in year two. Wells pay out very fast, then they run for a long time at reduced levels. You have to run on the treadmill faster and faster to produce more and more consistently.
Eric Kaufman: Our view tends to be that there is a limit to what the U.S can do. It isn't clear to me that we've filled the gap, but we certainly, currently are the largest producer in the world of oil.
Sue Lee: Ben, you mentioned OPEC earlier and now we're talking about the U.S being the oil superpower. How does OPEC still play for MLPs?
Ben Cook: Yeah, sure. OPEC is very important and remains a primary source of swing supply on the global market between Saudi and UAE and another handful of countries. They have the ability to bring production on within a short period of time, 30 days, and maintain that production. Obviously, the direction of crude oil prices is important for midstream sector equities. These companies, they're dependent upon the price of oil, to a degree, and their operating and financial results are often not tied directly to oil, but the throughput of volume that they transport through their assets. The direction of the commodity prices it relates to the correlation we were talking about earlier, you can't escape the influence that the price direction has on the equities.
Ben Cook: On the one hand, you see influence in the public markets, the equity markets from the price of oil going up and down. There's another sub story in the sense that you have operating and financial results that are somewhat dependent upon the volumetric throughput trends that are affected by changes in oil prices as well.
Quinn Kiley: Yeah. I'll give you a stat around that point, because I think it's a good one, when you look at current enterprise value to EBITDA evaluations for the median midstream player today, it's actually cheaper today than it was at the bottom of oil in February of 2016. Think about that. We've had crude oil recover. We've had production hit alltime records, with a global leading producer of all these things and yet, midstream, the thing that carries this to market is now cheaper than it was almost three years ago.
Quinn Kiley: I think there's a great opportunity set here for investors if they can look through the windshield instead of the rearview mirror. The rear view mirror is scary, it's choppy waters. I would stay out of that water, but that's not the Page 5 of 21 water we have going forward, we don't think. Sentiment needs to improve. We need to have stable prices. We don't need high prices, we need stable prices, that'll allow these companies to shine and show their execution, which has been great. Then maybe investors step in and say, I want to own a value story that's really driven around a great ingenious innovation in the U.S energy production.
Sue Lee: You don't think what happened to MLPs back in 2015 would happen currently?
Quinn Kiley: No, I'm not going to say that. What I do think is that the MLP and the midstream company of today, in going forward, has lower leverage, higher coverage on its distribution, has a better contract model and has a much bigger footprint on what's to execute. All those things make them healthier companies than they were and they should be less susceptible to wild swings even in crude oil prices, but wild swings impact investor sentiment, and that's ultimately what drove MLPs down in '15.
Eric Kaufman: It's really at the margins where you see the correlations come in and usually it's on the down side in oil pricing. You will probably, I think my colleagues here would agree, that as oil prices moved up, the correlation between WTI or crude oil and MLP process seemed to disintegrate and I think probably, that the reason for that is because we don't need $70 or $80 oil, $50 is just fine for most of our industry and most of the companies in the midstream energy space have listened to the market and redone, as Quinn said, the contracts so that now they're based on minimum volume commitments in the pipelines. It’s a different opportunity set than it was in 2014.
Eric Kaufman: The other item is that the cork came out of the bottle, in terms of exporting crude oil in 2016, when that was once again allowed, which had not been allowed, really, in any kind of reasonable fashion since 1974. We're now an exporting country, we're now an energy economy per se because we are an exporting country, it's a very different opportunity set than it was in '15.
Sue Lee: Mm-hmm (affirmative). Ben with globalization, are Geopolitical events something you also keep an eye on? For instance, the unrest in Venezuela?
Ben Cook: Sure. It's part of the equation in forecasting crude oil prices and you know, it's part of our investment process at Hennessy BP Funds, we look at modeling crude supply and demand and when you think of what's impacting supply, it's not only OPEC's measures to reduce production there, but it's also Geopolitical issues, such as sanctions applied to Iran. It's also sanctions applied to Venezuela. It's very important to recognize the geopolitical dynamic has it relates to supply factors on the global market.
Sue Lee: Quinn, your thoughts on that.
Quinn Kiley: Sure. I think this is a great point of nexus between what's going on in the area we invest in, what's going on globally and what people are probably and the impact that all this has on the Geopolitical influences that U.S energy production has. If you think about Venezuela, we are the largest consumer of their crude oil, it's heavy crude oil, so it's different than the stuff that's being produced in the shales. It's also what's being produced in the Canadian oil sands, which can't get here because we won't build a pipeline to bring it here.
Quinn Kiley: We could solve our own problem and allow us to have bigger geopolitical influence on Venezuela if we had a different regulatory approach to infrastructure. It's all interconnected, and I think that's the thing that is frustrating to us, often, when we look at the regulatory framework is that it doesn't appear as though the people who make these decisions understand that. And that's why we've had what we thought was a very favorable outlook for energy policy two years ago and it's become more of a negative now and I think maybe that's a unique view. I don't know. But that's kind of where we are today.
Sue Lee: Is that how you feel about energy policy?
Eric Kaufman: I do. Geopolitical risk isn't really priced into the current valuation and in world oil pricing, especially Brent, and it would be hard to price it in because it changes overnight.
Eric Kaufman: For instance, Libya, which looked like it was getting back on its feet, now seems to have one of its biggest oil fields in the middle of a battle between two opposing forces in the country. These things happen while we're sleeping sometimes. As Ben said and as Quinn said, we watch these things, they're very important. What the take away, I think is, that the Middle East, since 2011, and the end of the Gaddafi thing and the Arab spring, as it were, as become a less reliable supplier than we are used to over the last 50 years. Now we have to watch more international flashpoints then we used to have to watch. It wasn't a big deal until, all of a sudden, there seemed to be more unrest in the area. We have Venezuela, we have Libya, we have things around the Strait of Hormuz. It's unclear, going forward, that none of that will explode. It's also unclear that it will. We just watch very carefully at our company VE Capital.
Sue Lee:The fast-new cycle, does that affect your investments?
Eric Kaufman: It can. Sure. I think it can.
Ben Cook: Yeah.
Eric Kaufman: It doesn't affect how we invest.
Sue Lee: Right.
Eric Kaufman: But it affects the valuation of the securities sometimes.
Ben Cook: Yeah. I think the designation of new shale production being short cycle means that more commodity, oil, natural gas can come to market more quickly ...
Eric Kaufman: Yeah.
Ben Cook: ... then it has probably at any time in the past and that as relevance for crude oil prices and as a result has implications for equity values as well.
Sue Lee: Then bringing it back specifically to MLPs, can you explain to us how MLPs operate, incentives to GP's, et cetera.
Ben Cook: Sure, be happy to. I think it's important first, to point out that the end of the term MLP really is more of a designation, as it relates to the tax status of the entity. Okay. The way a typical MLP will work, is you have a general partner that is operating or managing the assets, and then you have a set of limited partners that are effectively contributing capital. Okay. We like to use a comparison between a hedge fund model and an MLP incentive structure when we describe the similarities and differences between compensation structures between hedge funds and MLPs.
Ben Cook: If you were to line up a hedge fund incentive structure, side by side with an MLP, you'd see a fee structure of two. Two percent for management fee, 20% for incentive fee. If you think about the same sort of fee structure as applied to an MLP, MLPs have a management fee as well as an incentive fee and that incentive fee is called an incentive distribution right or IDR.
Ben Cook: Typically with a hedge fund, a 20% incentive fee is fixed. With an MLP, that incentive fee actually rises. In some cases, that 20% can rise to 25, 30 and in some cases 50%. It acts like a tax on the underlying cash flows that are generated by the assets in the MLP portfolio. That's important because what we're seeing today in the marketplace is a recognition by MLP managements that, that onerous incentive structure actually has been detrimental to the performance of the MLPs. The retail investor, even the institutional investor has said, look, we're not willing to compensate these management teams at the rate we were in the past. We want an alignment of incentives, we want an alignment of interests, and so you've seen a number of transactions to collapse IDR structures and in the process, make those MLP entities more comparable to their C-Corp counterparts. It's not an un-complex structure, but it's interesting in the sense that, in today's market, that MLP structure is, in a sense, moving more towards the C-Corp structure as those incentive structures are eliminated.
Sue Lee: Quinn, your insight in how things are changing in light of tax reform.
Quinn Kiley: Sure. Well, I think the biggest thing that's been the catalyst for these changes that Ben was talking about is that in the last 10 years, we've had two 55% corrections in MLPs in the index. And you compare that to the crude oil corrections. they were commensurate, not maybe, bigger, smaller, but similar magnitude. But, the cash flows were not dropping as much, they were dropping by, less than 10%. Those securities were not acting like the businesses, and people who thought they were buying stable businesses ended up owning very volatile stocks. When that happens twice in 10 years, something has to change. I think that was the biggest catalyst for these changes.
Quinn Kiley: If you layer on top of that, the reduced temporary tax rates, it makes the transition from an MLP and solving your incentive distribution rights by buying them in, maybe to being bought by a C-Corp general partner that's a diversified energy company, you end up in a C-Corp world. The result here, I think is that you've got to look ... not all midstreams are the same and those companies that are transitioning away from the traditional MLP model to more of a C-Corp model and S&P 500 model, are probably going to trade a lot more online with the XLE, then they are with the Alerian index, which is the MLP index.
Quinn Kiley: You're going to see a bifurcation between the ways those companies act going forward in short term volatility compared to the way MLPs act. I think that's something that will be interesting to see which one wins, because the S&P maybe is a little pricey right now and MLPs are definitely not. Whether you're cheap in the S&P or not, you're still part of the S&P. I think you saw that high correlation in the fourth quarter when the Alerian index and the S&P 500 basically traded lock step on a daily basis and high correlation for the entire quarter. Not with crude, but with the S&P.
Sue Lee: For the retail investor, tax advantages are always nice. But paperwork isn't. Do you think the K1 statements and all of that, kind of deter investors from investing in MLPs?
Quinn Kiley: I think, if you're going to me. If you lose 55% in your portfolio and then get a bunch of K1's, that's a less than ideal situation. That's part of why the transition happened. I do think though, that we have evolved over the last 15 years to have a lot of investment product that solves the K1 problem. They're not all great. Some of them introduce leverage, others introduce tax drag without overcoming it with leverage, others have a diversified portfolio that's not pure MLP, but still is very midstream oriented. You have to understand, not just what you're buying, when you buy midstream, what you're buying when you buy an MLP, what you're buying when you buy an MLP product. I think it's different than other parts of the market and really where financial advisors should pay a lot of attention.
Sue Lee: Eric, the era of low interest rates. It's kind of dwindling down now. What does that mean for MLP investors?
Eric Kaufman: If we have a long-term outlook for low interest rates, it acquits the MLP space very well. Right now, I believe the MLP space, if we benchmark to the Alerian index, is it around an eight percent current yield. If you're an individual holder of an MLP, the chances are fairly good that you'll have a roughly, an 80% tax shield, meaning a deferral of current income. In terms of it being an income vehicle that's useful as a direct owner, which is how we operate, we think it's exceptional. What I would say, and I think my colleagues would agree, is that selection is tremendously important.
Eric Kaufman: The filter that all of us employ, with the experience that we have; I've known Quinn for years, Ben I've just met, but I know his background and it's exceptional. I would say that our filter is, all of us, is significantly better than an individual investor just looking at one or two aspects of an MLP and deciding to acquire it. It's important to have, to employ people that really understand the space. In fact, I think it's become even more important now, after the decline in the space and the crazy changes in correlation between the S&P sometimes, WTI sometimes, it's very important to understand the individual companies. We think that that's a huge factor for individuals to consider. The pedigree of the manager is very important.
Sue Lee: Quinn has gone over this for us earlier, but can you explain to us a little bit more on the different MLP investment products?
Ben Cook: Sure. Yeah. Happy to. There's a range, a variety of assets that can be contributed into an MLP structure. From our perspective, there are probably a 100 MLPs out there with a market capitalization in the range of 600 billion dollars. That wide universe of MLP includes, gosh, shipping, propane distribution, even coal. There are a variety of energy MLPs. From our perspective, when we do our analysis of the industry, we take a more discreet focus of a subset of that MLP universe or midstream company universe. We focus on the companies that we believe fit into what we call the midstream energy value chain. That value chain would generally include gathering and processing assets that would include pipeline assets, that would include fractionation assets, that would include storage assets and in some cases LNG export capability.
Ben Cook: When you boil that larger 100 name universe down to 60 or so names, you're looking at a market capitalization of a little over 400 billion. We believe that there is an even further distinction to make and as part of our investment process, we focus on those companies that sit closer to the source of demand and we believe there are advantage is being closer to the source of the demand. Those are benefits that principally relate to the throughput volume trends on those assets. In other words, if I sit closer to an end user, let's call it a utility that's generating power to heat homes, I want to be close to that utility because there is going to be a need to have uninterruptible service into that utility. What that means for the pipeline operator is a very stable, predictable throughput profile of energy or natural gas or crude oil through a pipeline.
Ben Cook: For the investors and MLPs, what that means is, that by sitting closer to that demand centric asset, generally speaking, you're going to see less volatility and cash flows associated with those assets and you're going to see less variability and distribution payout. By virtue of having less variability, you're going to garner a higher valuation. That's how we look at the universe.
Sue Lee: Quinn, can you give me your thoughts on the MLP simplification trend, especially in light of lower interest rates and ... or higher interest rates, rising interest rates and lower corporate taxes?
Quinn Kiley: Sure. I think there's a lot of reasons given by the street, by pundits looking at the space, commentators, about all the reasons why these trends actually should be done. I think what it really boils down to in our view; two things.
Quinn Kiley: One is they were paying too much cash flow out, and they could not rely on the capital markets anymore. So they combined two entities, one that was lower yielding then a higher yielding name. The lower yielding name bought the higher yielding name, and that's an immediate cash flow savings. All of a sudden, they can fund the equity slug of their energy infrastructure build out without going to the capital markets. That's a huge motivation.
Quinn Kiley: The other one was that the ratings agencies mistakenly look at distributions as a use of cash that the debt holders do not have access to, which is not true, it's equity. We've seen a lot of these names that were on borderline high yield investment grade cut their distributions because it was what the ratings agencies wanted to see. That is cash flow that's being saved and it's cash flow that can fund equity, it's cash flow that can pay down debt. The idea that debt holders didn't have access to that cash flow is flawed in the first place. I think those were the two biggest drivers. Others are talking about governance and sharing upside and things like that.
Quinn Kiley: Governance hasn't really changed. The structure may have changed, but board members didn't change. You saw a collapse of two entities, the board didn't change, just the structure. I think governance is still something that's on the come, and it's going to become more in focus. It's something that if you invest in MLPs, you've got to be laser focused on governance because it's different than the rest of the market. That's changing a little bit, but it's still a big issue.
Sue Lee Eric, your thoughts on MLP management.
Eric Kaufman: Basically would be the same as Quinn's. There has been a lot of talk about the alignment of a management to investor interest. And in some cases, it's been very important for these companies to transition to a C-Corp structure to alleviate some of those concerns. We'll hear more talk of this over the next few years. But, as Quinn said, many times when we collapse the general partner into the limited partnership, or vice versa, when one buys the other, the gatekeeper, which is the general partner, is still there. It's still inside, it still lives. It's just that there aren't any direct, pecuniary compensation elements to that existence.
Eric Kaufman: 8 In a C-Corp, someone could make an offer, out of the blue, to buy that C Corporation. In an MLP, even when the general partner seems to have disappeared, the gatekeeper is still there. And so unfriendly takeovers simply don't work very well because the gatekeeper can say, well we're not interested. There are all sorts of little nuance governance items that I think all three of us look at, that are very peculiar to the space, which is why you don't want to try and do this yourself at home.
Sue Lee: Ben, what are your thoughts on the MLPs access to capital markets currently?
Ben Cook: Yeah. You know, I think MLPs
Quinn Kiley: Since then, it's come in meaningfully with 30% or so. The most recent IPO's in the space, two of the three have been MLPs. One sponsored by British Petroleum who can afford all the best tax advice the world can provide. I think that ... I'm not saying there'll never be another IPO and I don't think the existing number needs to come down. But I do think you have to take a broader view of energy infrastructure. One of the things that we did when we launched that fund is to look, not just at MLPs, but to look at C-Corp midstream, to look at something called yieldcos, which are monetizations, like MLPs, of renewable assets, and that's going to be a growing area. It's a very limited area right now, but it's going to be a growing area and we think you can see that in other areas as well.
Quinn Kiley: As the energy world changes, as the energy infrastructure mix changes, you have to have an investment policy that allows you to change with it, and that's why we launched our fund back then and so we've been well positioned with these changes because it hasn't really disrupted what we're trying to do. I do think some old line MLP funds, some of which we run as well, are going to have to change their investment guidelines going forward or names of the funds and we've seen that in the last 18 months as well. The landscape is shifting, not just in the company side, but on the investment product side. Clearly though, efficiency is the biggest driver of the change and consumption and we've seen that in oil and gasoline, we're seeing it in natural gas. Growth is going to be fed by two things, we think renewable and natural gas, and so you've got to have a growing part of your portfolio be gas. You've got to consider renewables because that's where the puck is going.
Sue Lee: Ben, you mentioned private equity’s interest in MLPs now, oftentimes the PE guys can be seen as the smartest guys in the room. Can you tell us the importance of distinguishing midstream infrastructure and where it lies in the value chain?
Ben Cook Sure. As part of our investment process we look at the entire midstream universe, but we think there really is a sweet spot in that universe, and that exists along the midstream energy value chain. Just a quick definition that midstream energy value chain would connect the source of supply with the end user. Think in terms of gathering and processing assets that would be connected to well boards that are going to collect natural gas, crude oil, natural gas liquids. Ultimately be collected and moved along a pipeline going to a storage facility or some sort of end user whether it be a fractionation plant or whether it be a refinery in the case of crude oil.
Ben Cook: The midstream value chain and understanding where you lie along the midstream value chain is important because if you're close to the source of supply and you're investing in assets that sit close to the well head, well then, you're going to be subject to more commodity risk. Simply because as oil prices go up or down, drilling activity will go up and down and throughput volume will follow. Cash flow is generated by those assets will follow the commodity.
Ben Cook: In contrast, if you're closer to the demand center or demand side of the value chain, you generally see more stable and predictable throughput on those assets. That's simply because consumption trends along those assets are driven more by macroeconomic trends, growth in the economy, electricity consumption in the case of the utility industry, natural gas is being used by the utility industry increasingly. For us, as part of our investment process, it's important for us to distinguish the risks that we're taking that may be tied to the commodity and those that are more stable and predictable, might be closer to the end user.
Ben Cook: Now, we are agnostic, we don't necessarily exercise a complete preference for demand centric assets, but we need to be fairly certain that the risk that we're taking closer to the well head is the right risk and we've appropriately forecasted operating and financial results in that particular basin. Sue Lee: 36:20 Eric, what are your thoughts on the benefits of throughput volume by demand pull Eric Kaufman: 36:25 Well I very much agree with what Ben has talked about. Some of the more volatile assets were the gathering and processing assets. We also look at the current cost of production in some of the basins. Some basins are higher cost to break even for the upstream oil producer than others and so MLPs associated with high cost basins are on our radar screen in the event that energy prices were to fall and throughput was to decline slightly. Sometimes you have to look inside an MLP to see what the individual assets do, what the contracts look like, how protected the MLP is from those fluctuations, very, very important to do. Very definitely agree with Ben that being somewhere down from the gathering and processing part of the midstream is tremendously important and we look at that when we make investments.
Sue Lee: Ben, where do you think project development needs to be facilitated? Ben Cook: 37:28 That's a great question. There are four principle areas that we see demand pull driving the growth in infrastructure build out opportunity in the U.S. We've been talking about this advantage that we have in the U.S now, a low-cost molecule of energy, whether it's crude oil, natural gas or liquids. The low cost of that energy is incenting or driving demand growth, not only here in the U.S but abroad as well.
Ben Cook: Four distinct areas. One would be export growth. We're seeing export growth in LNG. We're seeing export growth of crude oil, since the repeal of the crude oil export ban, and we're seeing increasing export of NGL's, ethane, LPG, et cetera. Exports are a big driver of demand. And with that demand comes the need for infrastructure to build out to facilitate that export.
Ben Cook: The second area where we're seeing demand growth is for natural gas by the utility industry. The utility industry is retiring coal-fired power generation plants and in their place, we're seeing natural gas-fired power plants come up. As the industry continues to transfer its sourcing of energy from coal to natural gas, we're seeing growth there. And, we're going to need to see infrastructure in place to facilitate that growth.
Ben Cook: We also see growth in the Petro Chemical industry. The natural gas liquids that we've been talking about are broken down, or fractionated, into their purity product components, and those product components are used as feed stocks by the petro chemical industry to produce ethylene, in which ethane is cracked to produce ethylene and ethylene is used as a feed stock to produce plastics. Tongue twister there.
Ben Cook: The fourth area where we see demand is in refined products. You and I as consumers, we're driving more, vehicle miles traveled is tracked by the DOE, continues to show growth and growth in gasoline demand and distillate demand is going to drive and increase throughput of refined products. We see growth in those four principle areas.
Eric Kaufman: There is one addition to this and that is that oil fields have a tendency, in fact, they all decline over time, so when you drill one up, there is a decline curve that begins. Even in newly drilled oil fields that have finished their declines from the very high initial production levels that we see in fracked wells, there is at least, a five percent decline over many, many, many years after that. In the world, if we look at a 100 million barrels a day as what the current demand side is for basic crude oil in the developed world and undeveloped world.
Eric Kaufman: We lose about five million barrels per day, per year to normal field declines, that's just how much less a field produces and probably that's a very conservative number. Then we have a whole grouping of countries in Asia and the subcontinent Pakistan, India, Bangladesh, Indonesia, Malaysia and certainly China, that are increasingly developing middle classes that want to drive cars. In addition to that, China is moving from a coal-based energy generation structure to a natural gas-based or distillate based structure. We have about a six and a half million barrel per day, per year gap that we have to fill in the world in energy production. If we take six and a half, call it, times five; that's 32 and a half million barrels a day, that's what OPEC produces right now. In five years, the world has to replace everything that OPEC produces today. Not to say that it can't. But that would militate for a stable pricing at the very least.
Sue Lee: Going back to the investor, what's different this year? The fundamentals were strong in 2018, but pipeline stock prices, you know, they pretty much sagged. What's different this year?
Quinn Kiley: I think one of the things that always happens in the MLP space is that many of the investors are very tax aware, and so if you tick into a negative returns period for the year, which happened in September, October of last year. You're going to see tax loss selling. I think the owner of MLPs tend to be more tax sensitive than the average investor. Clearly you saw tax loss selling across the board last year with returns. But that money comes out, they wait 31 days and they bring it back in, so it causes an acceleration of the decline in December, which really was the main driver of overall returns for the year. Then those dollars flow back in. That is without any change in the investor base, just a 30-day difference. You get a huge draw down and then a big V back up and I think that's what we're seeing now.
Quinn Kiley: We do think people are starting to recognize the underlying value of strong fundamentals, but I don't think we've really seen it yet in fund flows.
Sue Lee: Ben, do you think this group is still priced as sharp discounts compared to historical levels?
Ben Cook: Yeah. There is no question. If you had to describe December performance of equities, it really was a fire sale environment. Many high-quality companies with great assets, great management teams, and improving distribution coverage levels and very manageable debt levels, those stocks traded off meaningfully. From our numbers, we believe that the sector now trades about one, 1.5 times below, in terms of enterprise value to forward EBITDA, it's 1.5, multiple points below its historical average. We see tremendous value across the sector right now.
Sue Lee: Eric, where do you see the sector opportunities?
Eric Kaufman: The sector ...
Sue Lee: Opportunities within the sector.
Eric Kaufman: Within the sector.
Sue Lee: Yeah.
Eric Kaufman: Okay. Primarily it's with the higher quality companies that have individually worked on those things the market indicated to them they needed to work on. Certainly the larger companies that have a value chain which is more complete than some of the smaller ones have. It's in the demand side of the midstream, closer, as Ben said, to the consumer. In some cases, it's important to know what the export potential of one of these companies might be because that's becoming more and more interesting over a period of time. It's the companies that have worked on remediating things that needed to be fixed, too much debt, not enough coverage of distributions. Those kinds of individual issues, those companies are getting our attention. that have really worked on it.
Eric Kaufman: What we look at it, basically a three-legged stool. It's assets, do they work together? Management teams, have they always acquitted themselves in a good way, meaning that did they get greedy at a $110 a barrel, oh if we build a pipeline, they'll come. No. We like to see managements that have retained discipline over the years. And then of course, there's the indebtedness levels. We like to see lower debt, you know, somewhere around four times or lower to EBITDA. We think that's quite good. Then we want to see a three to four-year potential ramp in distribution growth.
Eric Kaufman: Those are things that we consider to be opportunities and it's a relatively small subset of the midstream, compared to 60 or so midstream companies that are around and public.
Sue Lee: Going down the line. Ben, let's start with you, what are the key issues MLPs will focus on in 2019?
Ben Cook: Yeah. I think probably the key issue for the sector today is one of capital allocation. After years of repairing itself and eliminating these onerous IDR structures, many of these companies are now free from that onerous IDR take. So with the rebound in drilling activity and throughput volume in the lower 48, we're seeing very, very strong cash generation. The question becomes, what are these companies doing with the cash after they've covered their capital expenditure program? They’ve had free cash beyond that cap ex program, they then cover their distribution or in many cases have coverage levels that are at 1.5 up to 1.7 times, by historical standards, very high coverage levels.
Ben Cook: These companies have flexibility to use that cash in a variety of ways, and what we're seeing from a number of those companies is the decision to engage and share repurchase, unit repurchase programs. We're seeing increased distributions and so for investors I think 2019 will be a time of focus on how those companies choose to return the cash to shareholders.
Eric Kaufman: There's one other thing I might mention to and that is, that we look at what the capital expenditures for expansion, expansion cap ex, looks like going forward. It seems to us, that a great deal of the necessary capital expenditure for new projects will tail off at the end of 2020, early '21, mid '21, and at that point, the cash flow becomes even more important because if you're not spending the money on projects as much as you were, there's more cash flow to either distribute, do share repurchase programs, all sorts of opportunities. Do asset purchases, some assets are going to be rationalized out because they were done at too expensive a price level. Many of these companies will have an opportunity to buy assets perhaps cheaply. It's a tremendous time of opportunity in the midstream, for companies that are doing a good job.
Sue Lee: For companies that are doing the good job.
Eric Kaufman: That are doing what they need to do to be stable, solid, income producing. The reason you're an MLP, the primary reason is to make distributions to unit holders, it's not to do other things. You need to do distributions or you need to do share repurchase to enhance valuation. That's what I think, going forward, is going to become tremendously important.
Sue Lee: Quinn, over to you. For 2019, what will be the focus for this sector?
Quinn Kiley: I think the focus for us is that we see a continued solidification and some incremental improvement in fundamentals, but really, what we're looking for is a catalyst for the group because that's what we've been lacking for the last couple years is a catalyst. We think we need to see an inflection point in distributions. We've been having management decisions, whether forced by shareholders, credit agencies, what have you, reduce their distributions to shareholders, and I mean cash payouts, so yield. I think we need to see cash payouts bottom and then start to grow again, even if at modest four to five percent rates, not the seven, eight that we had before the crisis in energy. If we see that, then you're going to get yield investors and you're going to get some incremental growth investors back looking at the space who right now have been alienated by management decisions over the last couple of years, by cutting distributions or by eliminating growth or tax aware investors, they also got a tax bill. If you bring those people back to the group, I think we can see bluer skies ahead of us.
Sue Lee: Obviously you think that MLPs will be a good income generator?
Quinn Kiley: Well, yeah. The question over the last two years is, if I buy this seven and a half, eight, nine percent yield company, am I going to get it? The answer in many cases has been no. I think the answer today is much more closer to yes, and you can bank on it, as opposed to what it was a year or two ago. That mind shift needs to happen and the only way to do that is for distribution to have an inflection point and start going higher.
Eric Kaufman: That's where a selection comes in because the experience of all of us here, hopefully is sufficient to filter out the things that are not going to do well and companies that won't do well because of various factors that we might see and the regular investor might not. It's going to be very interesting going forward. There's a huge opportunity set here for people to invest in this space. As Quinn said, there were a lot of investors who were very badly tax damaged when MLPs were converting to C-Corporations or when they were purchased by C-Corporations because that brings due all of the deferral that was done over the years for investors. With a lot of that accomplished in the space, there's less danger of a future that looks tax unfriendly to a regular investor. I think as people who are interested in the space begin to see this, they'll come back.
Sue Lee: Great. Thank you all for sharing your thoughts with us today.
Quinn Kiley: Thank you for having us.
Eric Kaufman: Thank you very much for having us.
Ben Cook: Thank you.
Sue Lee: Thank you for joining our guests today. Ben Cook, Portfolio Manager at Hennessy BP Midstream Fund, Eric Kaufman, Managing Partner and Portfolio Manager at VE Capital Management and Quinn Kiley, he is the Senior Portfolio Manager at Advisory Research.
Sue Lee: From our studios in New York, I'm Susanna Lee and this has been Asset TV's MLP Masterclass.