ENERGY MLPs: A Suitable and Sustainable Asset Class

Key Takeaways:

1. MLPs have provided income with little correlation to other asset classes and little sensitivity to interest rates, commodity prices or economic cycles.
2. The market for MLP stocks has expanded greatly and offers liquidity which appeals to long-term institutional investors.
3. The renaissance in U.S. energy production is driving sustainable growth in the infrastructure that MLPs own and operate.

The marketplace for Master Limited Partnerships has recently become much more investable for many institutional investors. Just two or three years ago, the universe of MLP stocks was not broad enough to be attractive to some institutions. The liquidity, from a trading perspective, was not deep enough to provide a viable asset class to attract many institutional investors. At that time, there was roughly 20% participation by institutions in MLPs as an asset class, with the balance being held by individual investors. Today, that ratio has crept a little bit higher to 30% held by institutions and 70% held by individual investors. However, as the depth and the breadth of the market have expanded, the unique advantages and characteristics of MLP stocks have grown increasingly attractive for long-term institutional investors.

The chart below shows the number of investable names has steadily risen, and is now close to 100 energy MLP stocks. The market capitalization of the space has also grown. Just two years ago there was between $250 billion and $300 billion in combined market capitalization for the space, and today we are rapidly approaching $450 billion in total market capitalization.¹

Liquidity within the MLP space has grown as well. Five or six years ago, daily trading in MLPs was about $200 million. Last year, that figure had increased to $550 million per day and today it’s in excess of $800 million per day. This means the liquidity of the market continues to improve and we expect it will continue to do so going forward. ²

Investable Universe of MLPs

Past performance is no guarantee of future results.

Source: FactSet, as of 3/31/13.

A Discrete Asset Class

Beyond the growth in size and liquidity, MLP stocks have been particularly appealing when compared with other asset classes. MLPs have generated attractive levels of income and have demonstrated consistent growth in income, which is a very important objective of investing in MLPs. Even in the financial crisis of 2008-09, MLPs continued to increase distributions to investors. Importantly, particularly compared with fixed-income securities, MLP stocks have traditionally had a very limited exposure to interest rates and equally as important, MLP stocks have had a limited amount of economic cycle exposure.

Energy MLPs vs. Competing Asset Classes

All investments are subject to risks, including the possible loss of principal. The risks associated to energy MLPs include risks relating the energy sector, including the risks of declines in energy and commodity prices, decreases in energy demand, adverse weather conditions, natural or other disasters, changes in government regulation, and changes in tax laws. Equity securities are subject to price fluctuation and possible loss of principal. Fixed income securities involve interest rate, credit, inflation, and reinvestment risks; and possible loss of principal. As interest rates rise the value fixed income securities falls. High yield bonds possess greater price volatility, illiquidity, and possibility of default. Asset-backed, mortgage-backed or mortgage related securities are subject to prepayment and extension risks. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Derivatives, such as options and futures, can be illiquid, may disproportionately increase losses, and have a potentially large impact on fund performance. Potential active and frequent trading may result in higher transaction costs and increased investor liability.

Past performance is no guarantee of future results.

Source: ClearBridge Investments, Bloomberg. Investment Grade Bonds: Barclay’s Government Credit I Shares ETF; High Yield Bonds: KDP High Yield Bond Index; Common Stocks: S&P 500; Energy MLPs: Alerian MLP Index; March 31, 2013.

While MLPs are well known for their income characteristics, it is important to understand that MLP stocks are also growth stocks. Driving that growth is the renaissance in U.S. energy production that began in 2006-07, with the technological advent of drilling into shale formations. Oil production had been in decline for almost four years and natural gas production had been in decline for almost five years, until the advent of shale drilling. Shale formations are not new. The energy industry has always known they were there. It was simply a matter of getting those resources out of the ground economically. The advent of horizontal drilling, as well as improvements in completion technologies, has allowed the shale boom to kick off and the results in production have increased greatly.

Past performance is no guarantee of future results.

Source: U.S. Energy Information Administration; Dec. 31, 2013.

Natural gas was the first commodity to benefit from the shale revolution. Natural gas production, which many thought was in secular decline five years ago, has since grown 35-40%. Oil production started increasing about 18-24 months ago and is continuing to grow at roughly a 15% annual pace. In aggregate, U.S. energy production is growing at 10-12% annually, and the runway for that growth is not one or two years, but a multi-decade expansion of production growth.³ Even if the energy companies that are involved in shale production merely maintain their current levels of drilling activity, we believe energy production will continue to grow for 20 years. All this energy production requires infrastructure to facilitate moving those increasing volumes from the wellhead to end-user. It’s the MLP companies that are building out the required infrastructure. Last year, there was $35 billion of new energy infrastructure built in the U.S. Just two years ago , there was $11 billion invested in new U.S. energy infrastructure.² That is a three-fold increase over a very short period and we believe that infrastructure build-out is going to continue for years.

All of this energy production and infrastructure build-out is driving MLP distribution growth. In 2012, MLP distribution growth was about 6.6%. It is important to keep in mind that the total return in an MLP stock or an MLP fund is simply the yield plus the growth rate of that yield over time. The sector’s 10-year average of slightly more than 13% annualized total returns.

Past performance is no guarantee of future results.

Source: ClearBridge Investments; March 31, 2013.

As a sector, MLPs have done well this year. It’s true that the stocks currently are trading at the high end of their typical valuation range. However, MLP stocks ultimately look attractive even if they appear fully valued ­— or perhaps even expensive — at any given time. At March 31, 2013, MLP stocks were yielding 5.8%, compared to their historical average yield of between 6% and 8%, toward the low end of their yield band. However, given the visibility of growth, we believe distribution rates will very likely increase at the end of this year.

Past performance is no guarantee of future results.

Source: ClearBridge Investments; March 31, 2013.

We believe there is no corner of the U.S. equity market that is more inefficiently valued than the MLP space. Among the reasons for this is who actually owns these stocks today. It’s still an asset class that’s 70% held by individual investors and individual investors focus mainly on one thing; current yield. While yield is important, the growth rate in distributions is equally as important. Yet, many investors only focus on the yield. As a result, MLP yields by subsector show little variation. Certainly, there’s some distinction in yields among the various subsectors, but in general yields are very much on top of each other. That would be unremarkable if the growth rate in distributions over time were roughly the same. But that is far from the reality. If you bought a natural gas storage stock one year ago, you received a 7.3% yield on purchase but had no growth in the income stream. That is not a bad return, but at the other extreme, if you bought an oil/refined product MLP stock one year ago, you obtained a slightly lower yield, around 6%, but you received 12% growth in the income stream over the past 12 months. That’s a total return of 18%. From an investment point of view, the difference between getting it “right” and getting it “wrong” was basically 11 percentage points of performance. It very much matters which MLP stocks you own. Yet most investors continue to believe what matters for MLPs is whether or not you have exposure to the asset class, rather than which stocks or which strategy you chose to employ to gain exposure.

Looking at this slightly differently, if you bought a bucket of low-growth to no-growth MLP stocks three years ago, those that were growing distributions by 0-3% annually, that bucket generated an annualized total return of 8.5%. That’s a very solid return. However, if you could have tilted the portfolio toward those higher growth stocks, the ones that were growing their distributions by 10% or more per year, you generated an annualized total return of almost 28%. In this case, the difference between getting it “right” and getting it “wrong” in terms of security selection was 20 percentage points of performance a year.

Past performance is no guarantee of future results.

Source: Alerian MLP Index, Bloomberg; Dec. 31, 2012.

…but distribution growth rates have varied widely.

Past performance is no guarantee of future results.

Source: ClearBridge, Bloomberg; Dec. 31, 2012.

Perceptions and Reality

There are some misconceptions about the MLP asset class. First and foremost, many investors still believe that if they’re buying energy MLP stocks that they are inherently taking on oil-price exposure and natural gas-price exposure. It’s true that there are ways with MLP stocks to take on those exposures, but most of the securities within the entire asset class have a very limited amount of commodity price exposure. These assets are essentialy toll roads and what matters is not the value of the commodity moving across that toll road but rather the quantity of the commodity moving along that toll road. It doesn’t really matter if oil is $50 a barrel or $150 a barrel. The important factor is the volume of that commodity moving across these infrastructure assets.

Most energy MLP stocks have limited direct price exposure to crude oil and natural gas commodities. Energy infrastructure assets generate cash flows based on long-term contracts, usually with fee-based revenue structures. Further, these assets often operate with government regulated rates of return. Such assets can generate a consistent and predictable cash flow in both high and low commodity price environments.

It’s been argued that if oil prices are at $50 a barrel, that indicates the U.S. economy is weak, and a weak economy means volumes must be lower on these MLP infrastructure assets. There’s some truth to that assertion. However, what’s lost in that argument is the fact that energy demand in the U.S., and for that matter, globally, is exceedingly inelastic. Consumers need to light their homes, drive their cars to work, use air conditioners to cool their homes in the summer and heaters to keep their homes warm in the winter. As a result, energy consumption and the volumes of energy commodities moving across MLP infrastructure assets are rather stable. This means MLPs have a rather low economic cycle exposure.

Many investors believe that because MLP stocks are high-income or high-yield securities, they must have enormous sensitivity to interest rate cycles. Effectively, some investors view MLP stocks as quasi-bond securities. However, MLP stocks are not fixed-income securities. If you look back over the past 10 years, in periods of a rising 10-year Treasury rate, MLP yield spreads to Treasuries narrowed and in periods of declining 10-year U.S. Treasury yields, MLP yield spreads to Treasuries widened.⁴ The key factor is not MLP yield spreads relative to some fixed-income benchmark, but the absolute level of yield.

The Risk Picture

While MLP stocks provide growth and income, they do not operate in a risk-free environment. Like other asset classes ­— and all financial investments in general — there are specific external and internal factors that may change the way MLPs operate in terms of both management and finance.

Legislative: As an asset class, energy MLPs were created through a function of the U.S. tax code, and to the extent that the tax code may change, it brings into play a material downside risk for MLP stocks. However, it is a manageable risk and we are not overly concerned about the possibility of legislative incursion. The reasons are very simple: MLPs are the No. 1 job creating sector in the entire U.S. economy at the moment. The infrastructure operated by MLPs legitimately helps reduce the amount of oil imported into the U.S. and that goal has been a mantra of the federal government ­— regardless of Democratic or Republican administration ­— since the Arab oil embargoes of the early 1970s. A year ago, the U.S. was importing slightly more than 10 million barrels a day of oil. Currently, the U.S. is importing roughly 8 million barrels a day, so we have seen a 20% reduction in the amount of oil that is being imported into the U.S., largely as a function of production growth but being facilitated by MLPs.

Legislative efforts to change the tax structure that governs MLPs would put job growth at risk and put oil-import reductions at risk. Beyond that, it would do effectively nothing to impact the federal budget deficit. Moreover, the estimated net revenue benefit to the federal coffers from changing MLP tax status to a typical “C” corporation does not provide enough political incentive for Congress to act.

Regulatory: A portfolio of MLP stocks necessarily holds a lot of regulated assets. We believe this provides certainty to cash flow within a structured regime. However it is important to remember that regulations can change. Currently, there are no signs that regulators at the state or federal levels are reviewing the rules regarding MLPs, but it is an area that requires vigilance.

Capital Access: The MLP business model is very simple. These entities largely pass through all cash flows to the investors in the partnership. Thus, to the extent that they have any projects that will allow them to grow — building a new asset or acquiring a new asset — MLPs must have access to capital markets, both equity capital markets and the debt capital markets. However, as we saw in 2008-09, capital markets can “shut down” periodically in times of crisis or deep uncertainty. In such a case, it ultimately means the growth profile of MLPs would be stunted until capital markets resume full and robust functioning.

Operational: The nature of MLP assets means that they are subject to accidents. Obviously, it’s a factor that is difficult to analyze from an investment viewpoint and MLP companies are insured financially against such incidents, but it is a factor that must be acknowledged as an inherent risk.

Execution: We believe this is the most relevant risk that we need to focus on. Given the ballooning backlog of energy infrastructure projects in the U.S., there is a real risk of cost overruns and timing delays in completion of these projects. It is notable that despite a three-fold increase in energy infrastructure projects, execution risk has not proven to be a significant negative to date.

Conclusion

For institutional investors, MLPs can deliver portfolio diversification in an asset class that is lowly correlated to both stocks and underlying commodities, while being inversely correlated to fixed-income securities. As the market for MLP stocks has increased substantially in terms of both the number of investable names and the liquidity in the trading of those names, the attributes of this asset class have only grown more desirable. MLPs are a suitable, and arguably an essential, component of a comprehensive, long-term investment portfolio.

About ClearBridge

ClearBridge Investments is a global equity manager with approximately $68 billion in assets under management. Established in 2005 with a legacy that dates back over 45 years, our long-tenured portfolio managers and fundamental research team focus on building equity portfolios for clients who seek income solutions, high active share or managed volatility. Owned by Legg Mason, ClearBridge operates with investment independence from headquarters in New York and offices in San Francisco and Wilmington.

At ClearBridge Investments, all equity strategies start with the same fundamental principle: the key to long-term success is selecting high-quality companies through rigorous research and analysis. Driven by the insight and expertise of portfolio managers and analysts, ClearBridge’s time-tested investment process has guided the firm throughout its history. Strengthened by advanced trading and risk management systems, ClearBridge’s disciplined, methodical approach is designed to achieve consistent top-tier performance over the long term.

For more information, please visit www.clearbridge.com.

Chris Eades

Managing Director,

Portfolio Manager

• 21 years of investment industry experience
• Joined ClearBridge Investments in 2006
• Saranac Capital - Energy Analyst and Portfolio Manager
• Simmons & Company - Analyst following Energy Exploration and Production companies
• UBS Warburg - Energy Analyst
• NatWest Securities - Energy Analyst
• BA in Economics from Vanderbilt University

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