Master Limited Partnerships: Investing in Energy Infrastructure May 2011 www.clearbridgeadvisors.com
Executive Summary The number of Master Limited Partnerships (MLPs) in the energy sector has grown rapidly in recent years and investors have come to understand the attraction of MLPs as part of a diversified investment portfolio. The MLP business model has demonstrated a track record of regular and growing distributions to investors. Distribution growth has underpinned capital appreciation in MLP stocks. Future growth in distributions will continue to come from a mix of acquisitions and organic growth projects. However, organic growth opportunities are quickly shifting from natural gas infrastructure projects to crude oil and natural gas liquids (NGLs) infrastructure. This paper examines the universe of MLPs and the investment opportunities they present to investors. Background Following the energy supply shocks of the 1970s, Congress allowed the creation of MLPs and granted them certain tax advantages as a way to encourage robust development in the domestic energy industry. To qualify for the tax benefit, an MLP must obtain at least 90% of its income from qualifying sources as delineated by the U.S. Internal Revenue Service mainly assets involved in the extraction, processing, transport and storage of petroleum products, natural gas and coal. In practice, the majority of the more than 90 publicly traded MLPs are in the business of processing, transporting and storing natural gas, natural gas liquids, oil or refined petroleum products. The universe of MLPs has been grown rapidly over the last decade and we expect that to continue. There were nine initial public offerings of units in MLPs in 2010 and we believe there could be a similar number of IPOs in 2011. From a shareholder perspective, MLPs are particularly attractive because of their relatively high and tax advantaged yields. Most MLPs make regular quarterly distributions and a substantial portion of these distributions are characterized as a return of capital, which makes the distributions tax efficient. Operational Considerations A Durable Business Model Most MLPs are focused on transportation, processing, storage, and delivery of crude oil, refined products, natural gas and NGLs. The majority of such energy infrastructure assets are backed by long-term contracts (often at government regulated rates of return) and/or fee-based business 2
models. As such, most assets domiciled in MLP structures have little to no direct commodity price exposure. Volume drives MLP cash flow streams not the underlying price of the commodity moving through the infrastructure. As a result, most MLPs have readily predictable and stable cash flow streams. Further, MLPs have also shown themselves to be relatively resilient even during times of economic stress. Despite the severe recession of 2007-08, the average MLP still managed to modestly increase its distribution over the period. 1 Avenues to Growth MLPs pursue two avenues to achieve distribution growth; organic growth projects and acquisitions. Roughly half of MLP distribution growth has come from organic growth projects and half from acquisitions. Acquisitions come in two forms acquisitions of assets from an independent third party or acquisitions of assets from an affiliated parent company (so called drop downs). Without the burden of income taxes, MLPs have an advantage in acquiring assets as potential acquisition targets are worth more in an MLP structure than in a traditional C-corporation structure. Organic growth projects include the build out of new energy infrastructure or the expansion of existing energy infrastructure. Over the past 3-4 years, natural gas infrastructure projects dominated the organic growth opportunities for MLPs. The emergence of natural gas shale production resulted in a 25% increase in U.S. natural gas production over the past four years. With that increase in production came the need for new natural gas infrastructure. However, the natural gas market become over-supplied and drilling for natural gas has declined. As such, demand for incremental natural gas infrastructure is likely set to wane. In contrast, organic growth opportunities for crude oil and NGL infrastructure are surging as the same drilling technologies and techniques that led to significant increases in natural gas production are now being applied to crude oil and NGL fields. With accelerating growth in oil and NGL production, demand for infrastructure to bring this new production to market is accelerating as well. Looking forward, organic growth opportunities focused on crude oil and NGL infrastructure will likely far outstrip the organic growth opportunities for natural gas infrastructure. This presents opportunities for investors as the market has largely failed to distinguish the relative growth prospects of one MLP from another, in our view. 1 FactSet, as of 12/31/10. 3
As MLPs generally pay out all of their excess cash flow to unit holders, they usually access the capital markets to finance both acquisitions and organic growth projects typically with an even mix between equity and debt. General Partner and Limited Partner From an organizational perspective, MLPs are no different than typical Class C corporations, with similar management and personnel structures. The difference is in their ownership structure and how they are taxed. MLPs are generally composed of one general partner (GP) and several limited partners (LP). The GP manages day-to-day operations of the MLP s assets and holds a small stake in the limited partnership, typically around 2%. The LPs have no role in the management of operations, but they do provide capital and they receive regular quarterly distributions. While the GP typically owns only a small amount of the overall partnership, Incentive Distribution Rights (IDRs) entitles it to growing portions of the MLP s cash flows over time. At increasing quarterly distribution rates to the LPs, the GP receives an ever higher percentage of distributable cash flow. These IDRs exist to incentivize the GP to grow the distribution to the limited partners. In the early years of the MLP industry, IDRs worked well and energized managements drove dramatic growth in distributions for the LPs. In the past couple of years, IDRs have become a bit challenging, as they result in the GP ultimately getting a greater and greater share of the partnership s cash flows, effectively raising the MLP s cost of capital. As a result of the rising IDR burden, we have seen many MLPs renegotiate their IDRs or merge the GP and LP. Investment Characteristics Tax Advantages The U.S. tax code treats MLPs and similar partnerships as pass-through entities in which earnings are not taxed at the partnership level, but instead are taxed as they are passed through to the individual limited partners. This stands in contrast to traditional C-corporations where the company pays taxes on it earnings and the investors then pay taxes on the dividends they receive from the company. The MLP structure eliminates this double taxation, leaving more cash available for investors. The tax advantages of the MLP structure go beyond simply the elimination of double taxation. Because of the nature of the assets that MLPs operate and the types of cash flow those assets throw off, MLPs are able to generate substantial cash flow without showing much in the way of 4
taxable income to the IRS. As a result, a substantial portion of the MLP s distributions are treated as return of capital rather than as dividends or ordinary income. To the extent that the distribution is made up of return of capital, there is no tax burden associated with the distribution received in the current period. Rather, the return of capital serves to reduce an investor s cost basis in its MLP holding. By reducing the cost basis, the distribution is not tax-free, but rather tax deferred as it trades a tax payment in the current period for a capital gains tax payment in the future, when the MLP unit is sold. A History of Growing Distributions For the five-year period ended March 31, 2011, the total distributions of energy sector MLPs within the Alerian MLP Index grew an average of 14.68% on a weight-adjusted basis. For the one-year and three year periods ended March 31, 2011, total distribution growth averaged 3.70% and 8.00%, respectively. 2 For all energy sector MLPs, we estimate the average distribution per 100 shares at $306 in 2011. With growing distributions, MLPs trade very differently than fixed income instruments through an interest rate cycle. As depicted below, MLP stocks actually appreciated during the last cycle of interest rate increases a striking contrast to the performance of fixed income instruments. 2 FactSet, as of 3/31/11. 5
3/1/2001 9/1/2001 3/1/2002 9/1/2002 3/1/2003 9/1/2003 3/1/2004 9/1/2004 3/1/2005 9/1/2005 3/1/2006 9/1/2006 3/1/2007 9/1/2007 3/1/2008 9/1/2008 3/1/2009 9/1/2009 3/1/2010 9/1/2010 3/1/2011 Alerian MLP Index Federal Funds Rate MLP pricing vs. Federal Funds Rate 600 6.00% 500 5.00% 400 4.00% 300 3.00% 200 2.00% 100 1.00% 0 0.00% Alerian MLP Index Fed funds rate Source: Zephyr StyleADVISOR, as of 3/31/11 The Outlook for Distributions In our opinion, MLPs remain positioned to grow their distribution at about a 5-6% annualized rate over the next two years based on announced acquisitions and organic growth projects. Incremental acquisitions and organic growth projects (likely in our view) will only be additive to this expected growth rate in distributions. Such distribution growth and compelling current yields compared to common stocks, Treasuries, or investment grade bonds leave MLPs as a compelling income investment. Diversification Historically, MLPs have shown a low correlation to other asset classes. MLPs have negative correlation to 10-year Treasury notes. Further, MLP stocks have low correlations to the underlying oil and natural gas prices. 6
10-year Correlation 4/1/01-3/31/11 0.5 0.45 0.4 0.3 0.28 0.24 0.2 0.1 0-0.1-0.2-0.03-0.3-0.4-0.3 S&P 500 S&P GSCI Energy Barclays Capital Municipal Bonds Barclays Capital U.S. Aggregate Bond Barclarys Capital U.S. Treasury (7-10 Year Note) Source: Zephyr StyleADVISOR, as of 3/31/11 Risks Because MLPs predominantly operate in the energy industry, the risks inherent in their business models include those that face other energy companies. The most immediate risk is that of malfunction or accidental rupture in pipeline infrastructure, processing plant or storage facility. While the immediate risk from a financial perspective is the impairment of revenue generating assets, the secondary risk is that a large disaster involving energy infrastructure could generate greater state and federal regulatory oversight of particular operations within the industry. In 2009, legislation was introduced but never passed in both houses of Congress to amend the Safe Water Drinking Act giving the U.S. Environmental Protection Agency authority to regulate the process of hydraulic fracturing. Hydraulic fracturing has come under scrutiny due to the potential for contaminating drinking water. To date, regulation of hydraulic fracturing has only been at the state level. It remains possible that federal regulation could be enacted. However, most oil and gas companies have proactively changed how they dispose of hydraulic fracturing fluids in advance of any potential increase in federal or state regulations. One of the most attractive investment aspects of MLPs is the tax advantage provided to unit holders. As such, any potential changes to the tax status of MLPs are a key risk. Yet, Congress 7
(both Republicans and Democrats) have openly voiced support for MLPs as they are responsible for building infrastructure that reduces dependence on foreign energy sources. Finally, MLPs require access to capital markets to finance their growth initiatives (both acquisitions and organic growth projects). In periods of capital markets turmoil, MLPs can struggle to finance growth projects. Considerations for Investors Direct investment in MLPs results in investors receiving K-1 tax forms for each of their individual MLP holdings. For those investors who wish to eschew filing K-1 tax returns, but want to participate in the sector without the hassle of K-1s, closed-end funds specializing in MLPs may offer a simpler way to invest in MLPs (with a standard Form 1099 rather than K-1 forms). For individual investors, the tax advantage of investing in MLPs can be jeopardized if the units are held in tax deferred IRA accounts. However, ownership of MLPs through a closed end fund eliminates the risk of incurring a taxable event in an IRA account. Conclusion Master Limited Partnerships are an attractive area for investment. They offer significant current yield and the potential for meaningful growth of distributions. These cash flows are generally undergirded by stable predictable businesses with little direct commodity exposure and are largely tax deferred. MLPs offer portfolio diversification and have historically performed well in various interest rate environments. 8
About ClearBridge Advisors Legg Mason s largest equity manager, ClearBridge offers investment opportunities for institutional and individual investors in a broad range of styles, market capitalizations and vehicles, with a common focus on seeking high-quality companies through a fundamental-driven approach. ClearBridge traces back its asset management strengths over 45 years to a number of prominent and well-established firms that have made meaningful contributions to our modern-day culture and investment philosophy. The views expressed are those of ClearBridge Advisors, LLC and are current as of May 15, 2011 and are subject to change based on market and other conditions. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Any statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of the information cannot be guaranteed. The information provided is intended solely to describe the managers investment strategies and securities selection process, and does not have regard to the specific investment objectives, financial situation and particular needs of any specific person who may receive it. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase or sell such securities, and the information provided regarding such individual securities is not a sufficient basis upon which to make an investment decision. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies discussed should consult their financial professional. ClearBridge Advisors and its employees are not in the business of providing tax or legal advice. These materials and any taxrelated statements are not intended, or written to be used, and cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties. Tax-related statements, if any, may have been written in connection with the promoting or marketing of the transactions or matters addressed by these materials, to the extent allowed by applicable law. Any such taxpayer should seek advice based on the taxpayer s particular circumstances from an independent tax advisor. Past performance is no guarantee of future results. 9