Global X Research TeamThe replay of our webinar, “Where MLPs and & Energy Infrastructure Fit in Your Portfolio” is now available. In this webinar, we are joined by Ben Lavine, CIO of 3D Asset Management, to discuss the state of oil and the MLP asset class in 2017.
Webinar Transcript:
Stephanie: Hello, and welcome to today’s webcast, Where MLPs and Energy Fit into Your Portfolio, sponsored by Global X Funds. Today’s live webcast has been accepted for one CFP and one CE credit. For questions on credit, please use the number on your console. A copy of today’s presentation as well as additional documents can be found in the green folder. We also have a brief survey, which can accessed from the teal folder.
Our speakers will be taking advisor questions. Please type your question into the box to the right of the slides. We’ll get to as many of your questions as possible. A replay of this webcast will be made available. All registrants will receive replay information by email 24 hours after the webcast ends. With that, I’d like to turn it over to today’s first speaker, Jay Jacobs, Vice-President, Director of Research for Global X Funds. Jay?
Jay: Hi, Stephanie. Thank you for the introduction and thank you, everyone, for joining the webinar today. My name is Jay Jacobs. I’m the Director of Research at Global X Funds. We have 57 ETFs covering a variety of different markets from income investing, smart beta, international, thematic, and more. Today, of course, we are focused on our income suite and specifically looking at two MLP funds and strategies related to MLPs and energy infrastructure.
I’m very excited today to be joined by Ben Lavine from 3D Asset Management. He is the CIO of 3D and refines and enhances the investment architecture underlying 3D’s ETF managed portfolios. We’re really excited to have him here. I think the way we’re going to set it up is I’ll do the play-by-play with the slides coming up, and Ben is the experienced portfolio manager here and is going to have some great commentary and insights to share on the MLP space.
Specifically today, we’re going to keep it pretty broad. I think we’re looking at about 50 minutes of presentation, and we’ll leave about 10 minutes at the end or so for questions. As Stephanie indicated, please feel free to use that Q&A box to send in any questions along the way. Hopefully we’re addressing some of them throughout the webinar.
Specifically we’re going to start off looking at the oil market and what we’ve seen over the last few months. We’ll actually comment on what we’ve seen over the last couple of days as well. We’ve certainly seen some volatility here. Then we’re going to transition into MLPs and energy infrastructure as an asset class where we’re going to talk more about portfolio application and how one can use MLPs in the portfolio.
Third, we’re going to look at trends in the MLP industry. There’s obviously some movement happening in the industry right now and some new trends emerging. We’re going to talk about those. Last, we’ll look at MLP outlook and talk about some of the headwinds and tailwinds for the industry going forward. Of course, we’ll leave it open to questions after that.
Let me just pause for a few moments here. We’ve got a couple slides of disclosures to share with everyone. Starting off with the oil market outlook, I think it’s important to take stock of what really has happened over the last couple of years and more recently this year as well. We’ve got two charts up there that I think tell a pretty interesting story about oil. Of course, everyone’s very aware of oil output really peaking at about 9.6 million barrels a day in the US, the ensuing cutbacks in production over 2016, and a very sharp recovery that’s really accelerated into this year.
To put it into context, US oil production is about 3% below all time highs. This has been a very rapid recovery in the space. I think it’s also important to look at it within the global context and to really see how the United States is growing production in a world where everyone else is cutting back. We broke this out by the US just shy of 3% growth year to date in oil production.
Of course, OPEC has cut back given their deal late last year. We’re seeing Russia cut back as well given their deal with OPEC. But we’re also seeing nations across the board inside and outside of OPEC that are cutting back in production. Everyone is really scaling back. The US has really come in to fill that void in a very aggressive fashion right now. Stephanie, we’re going to pause for a poll question, if you don’t mind leading us right now.
Stephanie: Absolutely. This brings us to our first poll question of the day. Which feature of MLPs is most important to you; high potential yield, low correlation to other asset classes, attractive valuations, thematic exposure to US energy infrastructure, or none of the above? You can simply select your answer and then press submit. I’ll give you another moment or so before I turn it back over to Jay, and we’ll review the results. Okay, Jay.
Jay: Thank you, Stephanie. This is going to be foreshadowing a little bit here about what we’re going to talk about later when we get to the asset class discussion. It’s very interesting to see people’s responses here. I think this is in line with what I’ve expected where many people look at MLPs primarily as a high yield potential asset class. It’s interesting to see people look at it from a correlation and valuation prospective as well as a thematic approach. I think we’re going to touch on all of these a little bit later. Then we’ll certainly have some interesting insights to go along with us.
Before we turn it over to the asset allocation discussion, we’re going to spend a little bit more time on oil production in the United States. Certainly we saw a big uptake in oil production year to date, really something that’s extended to the last six to eight months or so. Why is it really happening right now? I think a really simple explanation here is to look at is it profitable or not for oil companies to be producing oil?
On the left hand side we’ve plotted the annual average price of oil in the blue line. Then the US shale breakeven price, the cost that it is costing oil producers to extract this oil. It creates a pretty compelling case for what’s happened in 2017, which is an expansion in the breakeven between those two lines. A lot of that- Frankly, all of that is being driven by breakeven costs starting to fall.
There’s a few reasons for that. One is what we call high grading. That’s when oil companies are only using the most efficient wells, so they’re shutting down inefficient ones, only using the efficient ones. That tends to really reduce the breakeven cost of oil.
We’re seeing lower oil field service costs. We’ve seen some estimates saying that they’ve fallen about 40%. This is oil production companies going to their service providers and saying we can’t pay you unless you take a huge haircut on fees. Most service providers have been very aggressive about cutting those fees as well.
The third reason, this is a little bit more structural in nature. This is improving technology and efficiency. This is always something that’s a little bit difficult to judge in terms of how much of an impact it’s having on the space. Of course, any improvement in technology is a positive, but it can happen in fits and starts over time. We do know this is a trend that’s always sort of improving.
If you look at some of the other things here like high-grading and lower oil field services costs, those are more sort of short term or cyclical in nature, they’re more a reality of what’s happening in the oil markets today, but they’re probably not sustainable over the longer term. Improving technology and efficiency is something that is sustainable and probably accelerating over the long term. That’s one we definitely look to as well.
The last one on our list is write-downs for offsetting taxes. This is essentially the fact that many oil producers are able to pretty aggressively write down assets on their balance sheet, take a loss on that in the current year, and avoid paying taxes. For the oil that producers are taking out of the ground right now, their tax bill is very minimal because of those offsetting write-downs. Again, that’s another thing that probably can’t be extended to infinity. It’s more of a short-term nature because of where we are in this market with pretty low oil prices.
In general, I think if you see that spread between the average oil price and the breakeven price expanding, we’re going to see more production. That’s what we’ve seen year to date. If you start to see a contracting, that could be an indication that we’re going to see a slowdown in increases in rig count or a slowdown in increases in production.
We’re going to transition a little bit here into our discussion of MLPs as an asset class. Forty percent of you answered that the reason for looking at MLPs is because of the attractive potential yield. Here we’ve plotted MLPs and their yields across a few different asset classes.
I think these are very common asset classes that investors who are looking at for above average yield in their portfolios -are going to look to incorporate. MLPs, high-yield bonds, preferreds, emerging market bonds, REITS, utilities; these are usually asset classes, maybe Ben you can speak a little bit to this, that people looking for above-average yields from their portfolio are going to look to incorporate rather than of course munis and investment grade debt.
Ben: For us, we look at the MLP space more as an equity surrogate as opposed to fixed income. Yield doesn’t really factor into our decision about investing because we consider it to be part of equities. From a factor standpoint, we do target dividend yield as a strategy, so to the extent that we invest in MLP or something like MLPX, which is a hybrid of general partnerships and limited partnerships, that will certainly play into our view on the contribution to yield, but for the most part we’re not playing MLPs for yield. We’re doing it more from the other response, which is the diversification it brings to other equities.
Jay: We will get into that a little bit later when we look at some correlations. I do think what’s interesting for people to take away from here is this is just purely the nominal yield on these different instruments. What’s not listed here is the characterization of these yields. MLPs, their yield tends to be fairly tax efficient because much of it is considered return of capital. Meaning if you get a dollar in distributions from MLPs, if it were entirely return of capital, it would reduce your basis for a dollar.
It’s a tax-deferred distribution, which can be advantageous if you’re looking to hold the investment for a long period of time. You really get to delay paying that tax payment. Some other asset classes on here like high-yield bonds, emerging market bonds, and REITS, those yields are taxed at ordinary income rates. If you really look at the after tax yields for some of these instruments, I think you would see MLPs even becoming more attractive, not just on the nominal basis where we really do see it as one of the highest yielding asset classes right now.
In addition to simply looking at it from a yield prospective, I believe about 25% of the listeners here talk about MLPs in terms of attractive valuation. We did want to touch on that a little bit as well. On this slide, we’re looking at the MLP yield spread to 10-year treasuries. In the blue line we have 10-year treasury yield. In the orange line MLP yield. With the blue line, the light blue line in the middle being that spread, so essentially how much extra yield are you getting from MLPs over 10-year treasuries.
On average over the last five years or so, it’s been about 363 basis points. Right now it’s at 440 basis points. This is kind of a good way to look at MLPs in terms of purely from yield perspective, how do MLPs compare to themselves over the last five years, as well as how much do they compare to 10-year treasuries and sort of a baseline income generating asset. From this perspective, we certainly see value in MLPs having a higher yield spread than average.
The other way to look at it is also from the perspective of the more traditional asset class valuations. In the MLP space, many people like to look at it from an EV to EBITDA perspective, enterprise value to EBITDA. We’ve plotted MLPs here with a few other asset classes, REITS in the blue, utilities in the light blue.
There’s really two things I’d like to point out. One is MLPs over the last five years are trading at a slight discount. We’re looking at about a 2% discount on average in the EBITDA perspective. When you look at that on a relative basis, I wouldn’t focus too much on how it ranks versus the other asset classes because each of these has sort of their own unique characteristics. REITS almost always trades with higher valuations given how people view real estate and some of the tax advantages, but more of the trend line.
We’re seeing MLPs fairly flat in valuations, 2% under the long-term average. If we compare that to utilities on the other hand, we’re seeing those traded at about a 20% premium to the 5-year average. There’s a lot of theories behind why. Obviously, we’ve continued to be in a low income environment. We’ve seen a lot of people migrating towards lower volatility or more defensive stocks as well, and utilities have picked up a lot of those flows. We’re seeing a very high valuation on utilities.
REITS are another asset class where it has been selling off a little bit as well. We do see at least on the five-year numbers, REITS are creating at about an 8% discount towards their long-term averages. Ben, I want to loop you back into the discussion here. How do you guys look at MLP valuations versus other asset classes?
Ben: Just as you show it here, the standardized measure here is to look at it from a cash flow to enterprise value basis because of all the idiosyncratic things that happen when you get down to earnings. This is one way to kind of look at it. I think the other aspect too is you have to look at within the context of our macro environment. It would suggest here that the valuations and MLPs kind of reflect more of investors recent experience prior to this uptick in cyclical reflation, which frankly we’ve seen prior to the Trump election.
Really it was after post Brexit that we were looking at a move at cyclical reflation with higher interest rates and a steeper yield curve. I think to the extent that in a rising rate environment that’s brought on by cyclical reflation and higher global demand, that normally what is a yield sensitive asset class like MLPs in some ways should benefit from higher end demand use. To me I would think that would warrant a higher valuation relative to more yield sensitive assets like REITS and utilities.
Jay: The next slide, we alluded to this a little bit already. We’re going to MLPs and their correlations to other asset classes. We did a little bit of a correlation chart here showing pretty broad asset classes, equities with the S&P 500, 10-year treasuries, Bloomberg commodities, utilities. REITS. We actually broke out two different types of MLPs, which we’re going to talk about a little bit more.
We have an MLP infrastructure index which think about it as 100% midstream MLPs, and the Solactive MLP and energy infrastructure index, which includes a little bit broader definition of the asset class MLPs, general partners of MLPs, and energy infrastructure corporations. Ben, you were alluding to the correlations with MLPs with other asset classes. Do you want to walk us through this slide a little bit?
Ben: The way we look at equity allocation within our global equity ETF program is we really start from the Fama-French or dimensional framework of looking at it from a risk premium standpoint, and then looking at it from a diversification and correlation standpoint. Anyone familiar with dimension or DFA funds knows that they break up commodities and REITS separately from the rest of equities. Our investment process is similar in the sense that we have our global equity allocation, but then we have a separate sleeve of what we call equity surrogates or equity alternatives where we look at different sub asset classes within equity.
If there’s something that is specific to how they’re structured from a tax standpoint or from a pass-through standpoint that makes them behave or at least helps explain why they would behave a little differently from the rest of the equity universe, we tend to segment those separately from the rest of our equity program. Historically, we’ve done that with REITS and commodities just like what DFA has done. With the advent of the GPLP structure for midstream infrastructure, we find the historical correlations, at least based on the Solactive index; and I’m referring to the second one, the MLP and energy infrastructure index; you find that the correlations are similar to that of what you would find with REITS.
The Bloomberg commodities index over a longer period of time has a higher correlation than what it’s just showing here, which is just over a two-year period. Again, when you look at sub asset classes and that 0.5 to 0.7 type of range for correlations, in a way they’re like equities, but something about them makes them behave differently like equities. We don’t include utilities as part of that separate equity asset class partly because there’s nothing really unique about the structure of utilities themselves apart from the fact that some are regulated and others are not.
What makes REITS and MLP different is the underlying exposure, in this case real estate for REITS. Also, just how they’re structured. The REITS structure means that as long as you pay out 90% of your net operating income and dividends, then you get favorable tax treatment.
Similarly you have the same situation with the GPLP structure. With MLPs that makes them in a way behave differently from equities. We’ve broadened our equity surrogate to include this midstream infrastructure type space. I think the key, though, for that to be maintained is that the GPLP structure needs to continue to exist because if they basically re-consolidate and move to just the straightforward energy infrastructure company, like what we saw before the advent of the LPs, I don’t think this space would be viewed the same as we view it today from an asset allocation standpoint.
Jay Jacobs: Got it. We’ll talk a little bit about that in a couple of slides – about some of those simplification efforts. I will put you on the spot a little bit here because we didn’t include this on the slide. I can voice over a little bit. We’re getting a few questions about oil and correlations to MLPs, and this is probably a good time on our correlations page to discuss it. We were looking at it over the short term. About year-to-date through mid-April, we saw correlations between MLPs and oil about 0.6. In the last couple of weeks since oil’s started to sell off, we’ve seen those correlations increase to about 0.75. What do you make of that? How much do you think about oil prices when you’re looking to allocate to MLPs?
Ben Lavine: I mean, certainly they’re an important component, but I think longer term – one of the scatter plots that your research team has produced is looking at the sensitivity to oil prices in different areas. You find that energy infrastructure, the correlations with oil prices will converge to one during a major sell-off type of event, like what we saw in February of ’16, where oil prices dropped to the mid-20s. Basically, the correlations went closer to one.
Correlations, I think longer term, will be influenced partly by what’s happening on the credit side. As oil prices drop that puts more and more pressure on the credit side, and the energy infrastructure tends to be leveraged. At some point, the operating attractiveness of producing oil, and storing it, and so forth, will be influenced, to some extent, by credit costs. Where you tend to see correlations increase is when those lower oil prices start putting stress on the credit side. Otherwise, I think the kind of volatility that we’re seeing in oil prices today, where it’s not putting as much pressure on credit spreads – and you can see that even though energy has under-performed, high-yield credit and investment-grade energy credit have actually done okay during this period. As long as the oil prices aren’t putting pressure on the credit side, then I think it’s noise in your terms.
Jay Jacobs: Yeah. That’s actually one of the trend’s we’re seeing in the MLP space right now. A lot of these MLPs are really prioritizing, reducing their debt load over trying to maximize their distribution, so if they do have the opportunity to maybe pay out more distributions, they’re actually funneling some of that money towards paying down their debt.
I think a lot of that is being driven by some of the things you’re talking about, which is trying to reduce some of that credit risk, in the sense that if oil prices do sell off they really don’t want to be as exposed to that credit risk if that is the case. If we do go back to our EV/EBITDA slide, we have seen some falling in the enterprise value of these MLPs because they have been pretty aggressively trying to reduce their debt burdens over the last couple of quarters.
We eluded to two different indexes on that correlations slide. I kind of want to dive a little bit deeper into what we mean about MLPs versus MLPs and Energy Infrastructure because I think there can be a little bit of confusion around that nomenclature. I think we have to think about – inherently, MLPs are a structure for a specific type of investment, which is energy infrastructure, specifically oil, and natural gas pipelines, and storage.
There’s different characteristics depending on what kind of structure it’s in. It could be structured as an MLP, which we’ll talk about some of those structural changes, but it can also just be structured as an energy infrastructure corporation, avoiding the entire MLP structure and being a very simple company, like every company in the S&P 500 or so. We do want to break this out a little bit.
I think if we look at the MLP and Energy Infrastructure universe, it really comes down to three different types of entities. On the left hand side is limited partners, or overly the LP in the MLP equation. If you own units in a limited partnership, you’re owning units in pipelines and storage facilities. It’s structured as a partnership. They issue K-1s. The obvious example of this would be energy transfer partners or ETP. They’re paid based off of contracts to transport and store crude oil and natural gas. As 40% of you answered earlier, the main advantage or attraction of this structure is the yield and the tax advantages that are offered in this yield, through the fact that it’s a pass-through partnership and many of the distributions are taxed as return of capital.
On the other hand of the equation is the company that actually manages those limited partnerships. Those are the general partners, or what we’ll call the GPs from time to time. They manage and operate the pipelines and storage facilities. They can either be structured as a partnership or a corporation. If they structured as a partnership, they’re sort of like an LP themselves. More simple and straightforward is for a general partner to be structured as a corporation and issue a 1099. The example in this case that we give is energy transfer equity, which is the general partner to energy transfer partners. They’re compensated by having a small economic interest in the underlying MLP, about a 2% economic interest. That’s essentially like owning 2% of the shares.
The bigger component of their compensation is through Incentive Distribution Rights or IDRs. The way these work, it’s sort of like a carried-interest structure for private equity. Essentially, the more an MLP distributes, the general partner gets to get an increasing percentage of those distributions. What this means is, essentially, the general partner in a lot of cases is sort of levered to the underlying MLP. If the LP units are able to greatly grow their distributions, the general partner’s going to get more and more of those economics. This is actually something that’s driving one of the trends we’re seeing – and we’ll talk about in a couple of slides but – some simplification efforts as well as some IDR suspension efforts as well. Really, general partners tend to be structured in that corporate structure and they’re more of a distribution growth play. If you were to think of MLPs as more of a yield play, general partners tend to be a little bit more about distribution growth.
The third structure in this space is energy infrastructure corporations. This is basically a company like Kinder Morgan, where actually in the past they were structured as an LP/GP structure, and they consolidated, and just decided we’re going to be structured as a corporation, we’re going to be taxed like a corporation, and we’ll issue a 1099. We will own and operate our own assets and really have the flexibility afforded of that type of structure.
They’re not forced to distribute. They can do whatever they want with their cash, whether they want to pay dividends, if they want to reduce debt, if they want to fund organic growth – really is the most flexible of the three structures but does not get the tax advantages that being structured as an LP has. When you put these three together, that’s what we call the MLP and Energy Infrastructure Universe because this, in total, is sort of the private assets in the energy infrastructure space.
What we like to look at is what are the market caps of these segments look like because there’s obviously a huge focus on MLPs from a yield perspective, but when you really break it down into it’s parts you see that MLPs are really only half the equation. When investors are really looking at owning energy infrastructure in the broader sense, not owning the general partners or not owning the energy infrastructure corporations, really does sort of take out a big chunk of that opportunity set. Ben, I want to loop you back into the conversation as well. Why do you guys think it’s important to not just look at MLPs but to really look at everything, the energy infrastructure corporations, the general partners?
Ben Lavine: I think to get the full benefit from the infrastructure side of energy transportation and storage you just don’t look at the underlying assets themselves, but if there’s a growth component associated with it, which is what you get out of general partnerships, and you actually participate in the growth of the build out and future usage of those assets, and this is where the IDRs, I think, are a critical link. I’m sort of – on the one hand, I can appreciate the simplification strategy that some of the GPs are looking at, in terms of helping either reduce the debt load or reducing the servicing burdens from at the MLP level. The IDRs are kind of what give the growth component to this space, as they are incentivized to really grow, and take advantage of the enhanced distribution, and maximize the usage of those assets.
Again, we don’t look at it just from a yield standpoint or from the MLP side. We kind of look at it more holistically, as what is this asset class bringing to us? Giving us exposures in a way that really aren’t fully incorporating the rest of the equity space. You get higher infrastructure spending. You get higher cyclicality. You get a growth component that is not directly tied to just being in MLPs themselves. Again, that’s why we focus more on an ETF like MLPX, which holds more of its portfolio at the GP and energy infrastructure level, as opposed to the MLP level.
Jay Jacobs: We’ve talked a little bit about trends in the MLP industry. We’ve certainly touched on simplification efforts, but I did want to walk through two of these major trends we’re seeing more of in the structuring space. This is why I think it was important to lay out the LP/GP structure as well as talk about energy infrastructure corporations because we are essentially seeing two different trends that are happening in the space, and we’ll talk a little bit about why they’re happening.
The first is the GP-LP Rollup. This is when the general partners essentially buy out the limited partners and restructure as an energy infrastructure corporation. This is something that Kinder Morgan did back in 2015, is something that Oneok is doing with their MLP as well. It’s happened six times since 2015, which means there’s certainly a little bit of a trend here. It’s for a lot of the reason we talked about beforehand, with the potential advantages of being a corporation versus an MLP. It’s a simpler structure. You don’t have two entities, you have one. It’s not a partnership, it’s a corporation.
For many investors, that’s a simpler investment, a 1099 investment, not having to deal with partnership income, or K-1s, or anything like that. They have a ton of distribution flexibilities. It’s on a flexibility on their distribution policy, so if some of these LPs are in trouble, if they are looking to reduce their distributions, or if they’re actually seeing a lot of growth opportunities and they would prefer to pursue those growth opportunities with their own cash, rather than distributing it out to share holders, there’s a pretty good incentive for them to turn into an energy infrastructure corporation. One of the added potential benefits of that approach is when a GP does buy its LP and roll that up into a new structure, it usually gets to take a step up in basis of that new asset.
In a lot of these instances where we’ve seen this simplification effort, we’ve seen that the new entity actually predicts how long it’ll be before they have to start paying income tax again because they can use this new asset on their balance sheet to depreciate down and off-set a lot of their income. There are some tax benefits to that structure as well at the new entity level, so certainly a trend we’re seeing.
I would point out on the disadvantages side, usually after that simplification effort, individual owners of those MLPs, if they’d gone out and bought those MLPs, it can be a taxable event to them. For many MLP owners, they’re hoping to never sell their MLP and this could be sort of forcing a sell. Two, the existing entity is now an energy infrastructure corporation that will have to pay tax, if not immediately, down the road when they’ve run out of depreciable assets. Usually the yields in those structures do tend to be lower than the MLP investment someone may have originally invested in.
The second trend we’re seeing, which is a little bit less disruptive to the structure, it keeps the structure in tact, but can also help in an MLP if they want to reduce some of their cash flow burdens, is to eliminate or suspend those IDR payments. With that LP/GP structure, we’ve seen in a lot of instances that the LP is paying a lot of economics to that general partner. The general partner may have done a good job managing the LP, and they’ve grown the distributions a lot, and they’re taking 50% of those distributions in some cases. That can cause a handcuff situation for those limited partners, where they’re paying a lot of economics to the general partner and that’s really hurting their ability to either grow distributions to their other investors, or their ability to pay down debt, or their ability to organically fund growth projects.
In some instances we’re seeing that the GPs suspend those IDR payments to them. They’re saying we’ll forgo taking those payments, so that the limited partnership can pay down their debt or can pursue this organic growth opportunity. It’s usually not free; there’s usually something that the GP gets in exchange for that. More recently we’ve seen that what they’ve been getting is basically underlying units of the limited partnership. It does give more flexibility to the limited partners. It keeps the original structure. It often improves the coverage ratio because less of that distributable cash flow is going to the general partner.
One of the examples we site here is Plains All American and their suspension of IDR payments to their general partner, Plains GP Holdings. There are five instances of this happening recently. These really are the two trends we’re seeing in the space, and it’s interesting to see that they’ve been pretty even. I do think each MLP that’s looking to make changes is going to evaluate either doing an IDR suspension or some sort of simplification, but many are not going to change. Many have great coverage ratios, are not worried about that, and can fund growth opportunities in ways that they see fit. This is sort of on the – a little bit on the edges around what’s happening in the MLP space. It has become common enough that I think it’s worth this discussion of explaining what has been happening in these two different instances.
The question we might be getting the most often these days, and I don’t know if you guys get this question a lot as well, but of course, everybody’s trying to figure out how the new administration is going to impact MLPs going forward. Actually, before I go through this slide, I wanted to ask you as a portfolio manager, how much do you consider policy when making asset allocation decisions? Is it something you guys debate in your investment committee? Is it a big driver of the changes you make or is it something you kind of put on the side?
Ben Lavine: It doesn’t play that big of a role. I think making investment decisions around policy outcomes is a low probability exercise because you basically have to get two forecasts correct. You have to get the policy regime correct and then you have to get the market reaction to that policy regime correct. Those probabilities compound on themselves. Really, for a successful trade to occur, you have to get both of them right, and any one of them you get wrong could trip up that positioning.
We try not to let policy influence our decision-making much. Really, we’re kind of focused more on longer term macro headwinds or tailwinds. As I eluded to earlier, post that Brexit decision we started seeing real tangible sounds of a cyclical reflation taking place. I think that in and of itself made the environment for investing in an area of the markets that is more sensitive to cyclical dynamics like MLPs. It certainly means that there is more of a tailwind to that investment, as opposed to headwind. What happened in November and near-term, what’s happening geopolitically, we try not to let that influence our decision on whether to be in MLPs or not.
Jay Jacobs: Great. We did want to walk through some of the things that we have been seeing at the policy level that could be a tailwind for MLPs. Again, I do think it’s hard to predict what the ultimate outcome of some of these things will be. We have seen a willingness from the Trump Administration, in terms of executive orders, in terms of being supportive of the pipeline industry and expanding the growth of that industry, specifically with a few more targeted executive orders and things like expediting the approval process for portions of the Dakota Access Pipeline and Keystone XL. We’ve also seen Trump’s tax plan be very supportive of MLPs.
I think that many assumed that a tax plan that would reduce the corporate rate would not apply to pass-through entities like MLPs.
What we did see is that at least the initial plan floated by the Trump Administration would lower the tax rate for pass-through entities like MLPs to 15%. This is a reduction of the tax rate. I think you need to look at it in terms of if you’re an MLP owner and you’re getting distributions from MLPs, a large portion of that is already tax-deferred, so the structure already does have pretty strong potential tax advantages. This is kind of on that remaining 20%, where you might find paying some income tax, that tax rate could be brought down. I think it’s any time you see the after-tax yield on a investment increase, because tax rates fall, that’s usually supportive of some sort of tailwind for those prices.
Think about how people value munis. Usually it’s looked at in terms of a tax equivalent yield, where you look at the muni yield divided by one minus the tax rate to sort of equate it to investment grade bonds. I think that’s what MLPs would be priced at as well. If you saw a reduction in the tax rate, you would see that it’s equivalent tax yield actually increase from that, so it would make them more attractive. This definitely, if this comes through, would be, in our opinion, a positive driver for MLP prices.
Then, more on the growth side, infrastructure spending, the Trump Administration put out a $1 trillion infrastructure stimulus plan. Reading through the plan, it’s actually very much focused on private companies and private infrastructure spending, rather than at the state and local level. When you really look at where there’s infrastructure in the US that’s not being developed by public funds, most of them are concentrated either in the energy space or in the utility space. If you look at the energy space a lot of that is MLPs. If that’s the case and if there’s tax incentives given to the private sector with energy infrastructure corporations, or general partners, or whomever getting tax credits for developing new energy infrastructure, I do think an infrastructure plan of this magnitude could be very supportive of essentially reducing the costs of building new infrastructure and possibly accelerating the growth in the MLP space a bit.
Stephanie, I think we’ll rely on your help again for this poll question here.
Stephanie: Absolutely. The final poll question is which trend do you think is the most important to the MLP and Energy Infrastructure space? Restructurings: simplification efforts (GPs and LPs combining) and IDR Suspensions. Government Policy: Executive Orders, Tax Code Changes, and Infrastructure Spending Bills. Oil and Natgas industry: domestic production growth and OPEC dealings. None of the above.
Again, you can click directly on your screen to select your answer choice, and click submit. I’m going to give you just another few moments to get your selections made before we move to the results and turn it back over to Jay. Okay, Jay, go for it.
Jay Jacobs: Alright, so interesting results as always. Just over 50% looking at domestic production growth and OPEC dealings as the biggest drivers in the MLP space. It does look like a lot of people out there are going to be very focused on oil prices and how that relates to MLPs; clearly, very interesting. Over a quarter, as well, focused on government policy and how policy might influence the MLP space as well. Oil and policy really do seem to be what is top-of-line for many people on the call here, so that’s very interesting to see.
Last couple of slides here before we jump into Q&A. I think we’re doing pretty well on time. We did want to highlight some of the tailwinds and headwinds for the industry. We’re trying to be pretty even handed about what we see as possible tailwinds and headwinds here. This is not a comprehensive list, but I think these are most of the concerns and opportunities that we hear from clients and that we’re seeing in our own research.
On the tailwinds side, one of the first things we talked about on this call, improvements in technology and efficiency. That can continue to be a force to reduce break-even prices for oil production. Increasing exports of crude and LNG. We’re possibly seeing that on the policy side as well, as more supportive policies for the exports of US energy. Continued growth of natural gas as a fuel for electric power plants. We’ve seen a huge expansion of power plants being powered by natural gas. I think a lot of people forget that MLPs are in the natural gas game as well, and it makes a big portion of their revenues. A continued growth of the demand side of natgas can be very supportive of MLPs. Changes in the tax rate can improve earnings and after-tax yields. That’s what we just talked about with the new tax plan that was proposed. Political support for infrastructure development, which could reduce the costs and time to market for new projects. These are all the potential tailwinds we see, which could be positives for the MLP industry.
To be fair, we also want to look at the potential headwinds as well. One of them, rising interest rate environment. Ben, you had some interesting thoughts on that as well, so this might not be – I think interest rates can absolutely be a headwind for high income investments. You were talking about how MLPs might be a little bit more better position than some other investments, like real estate. Rising interest rates could increase the costs of borrowing and make their yields look less attractive. Environmental concerns could certainly derail or delay development of new infrastructure assets. We do see the transition of electric vehicles as something that could reduce oil demand, gasoline demand, in the future.
Always OPEC risk, I would call it. Ultimately, we get asked a lot of questions about forecasting oil prices, and how much is the US going to be producing versus OPEC or other countries. It’s extremely difficult because it’s not just a quantitative exercise. Sometimes it comes down to a few people in a room in Vienna deciding are they going to go for market share or are they going to go for profit margin? There’s very unpredictable outcomes from that type of situations. I think that’s certainly a risk as well. I guess we won’t find out on May 25, if OPEC decides to extend that production cut, but I think it’s certainly a risk worth recognizing.
Ben, we’ve put together a list of headwinds and tailwinds here. Which ones do you really look at, in terms of your asset allocation decisions? You’ve talked a little bit about looking at some headwinds and tailwinds, and how you think about the thematic aspect behind your allocation. Which one of these stands out to you?
Ben Lavine: Certainly I think anything that influences end-demand is, in my mind most influential. Part of that’s just the health of the macro-environment. If we look at business indicators, manufacturing indicators, anything to basically indicate what is the general appetite for taking on new infrastructure spending, new capital spending, and ultimately that is going to entail some energy usage. Something that’s a little more concerning near-term, I think, is just the falloff that we’re seeing in final in-demand for gasoline and other energy products.
I think longer term, if cyclical reflation continues to help drive global demand, which is what you’re seeing, as long as that gap between supply and demand is narrowing or remains stable, I think this will certainly play out well for the midstream space. Something that I would stay particularly focused on near-term is whether that gap between supply and demand is growing. We’ve seen a little uptick in that global supply/demand gap, which I think is some of the reason why we’re seeing near-term weakness in oil prices. We just need to see demand keep growing because ultimately I think that’s what drives the performance of this asset class.
Jay Jacobs: Great. Before we open it up to questions, just two things to recap on. First, we wanted to just list out our takeaways from today’s presentation. The first takeaway in our discussion of what’s happening in the oil markets, US oil output has been recovering faster than the rest of the world, and actually the only place that’s recovering in the world, which is creating growing demand for US energy infrastructure. There’s actually certain places in the US where energy infrastructure is fairly strained right now and very much at capacity. From an MLP perspective, I know – I think it was about 50% of you that said oil is the driving concern here, but oil prices alone is not really necessarily the thing that matters. For MLPs that are in transportation and storage, it’s production. Of course, if oil prices go lower you’d expect to see production come down. We’re seeing oil prices lower and production’s going up, so that tends to be a pretty good positive for the MLP and Energy Infrastructure asset class.
The second thing, more on the asset class itself, we’ve seen MLPs demonstrate high yields and attractive valuations when compared with other income-producing asset classes. The third thing I would highlight when looking at the energy infrastructure opportunity set, it’s much more than just MLPs. MLPs are really only half the equation when you also consider general partners and energy infrastructure corporations, so looking at the asset class as much bigger than just the MLP structure. Lastly, more from the policy side, what we’ve seen from the Trump Administration, which has been very supportive of MLPs and US infrastructure, with a variety of different tools, from executive orders, to tax policy, to infrastructure spending.
Before we open it up to questions, here’s a quick Global X Fund overview. We do have two funds we wanted to highlight in the MLP space, with expense ratios that are about 48% below the industry average. Two different funds, two different strategies. On the left hand side, MLPA. That is our Global X MLP ETF. It is 100% midstream MLPs. We’ve seen very high correlations with leading MLP indexes. It does not have any K-1s, it’s a 1099 fund. We think it’s really designed for people looking for that pure MLP exposure, and really getting that yield potential in their portfolio.
The other fund we have is Global X MLP and Energy Infrastructure ETF, MLPX, which is designed to be – you can kind of think about it in two ways. One is more of a tax-efficient exposure to MLPs. It does not have the tax drag that is common in many MLP funds because it limits MLP exposure to less than 25%, and gives the remaining exposure to the general partners of MLPs and energy infrastructure corporations. It is entirely in the midstream space, but it is capturing a little bit more of that whole energy infrastructure space, not just looking at the MLPs but really looking at the whole opportunity set there. We think it’s really more appropriate for investors seeking total returns because of its tax-efficient structure. Those are the recap of the two funds. Stephanie, I’ll turn it back to you to do a quick recap and then we’ll dive into some Q&A for a few minutes.
Stephanie: Yes, thank you. Thank you Jay and Ben for a great discussion. I wanted to remind everyone that a copy of today’s presentation, as well as additional documents, can be found in the green folder at the bottom of your screen. We do appreciate your feedback. Please take a few moments to fill out our brief survey, which is also located at the bottom of your screen in the teal folder. We’ve received quite a few questions so far. In the even that Jay and Ben are unable to answer your questions on today’s call, a member of their team will reach out to you. With that, Jay, I’ll go ahead and turn it back over to you to take our first question.
Jay Jacobs: Great. Thank you. I’m seeing a lot of questions in here, so I do apologize because I know we’re not going to be able to get to all of them. I do appreciate all these questions coming in and we will try to select a few. The team at Global X will hopefully try to reach out to you guys afterwards and get all these questions answered. We’ll start off with the first one here. If MLPs are a toll-road, why are they so sensitive to the price of oil? We talked a little bit about the correlation between MLPs and oil, and how it’s increased a little bit recently. Ben, do you want to take this one?
Ben Lavine: Yeah. I think part of the reason sensitivity, again, has to do with concerns about demand – right now we’re not seeing the seasonal draw-down and final stockpiles in inventories that we typically see. There might be some concern there that there’s real tangible slow -down, whether it’s cyclical related or if it’s more structural nature, with people driving less or companies not as energy intensive as they were before. I think there’s some uncertainty concerning near-term demand, which may be affecting what we’re seeing inventory levels.
Again, I think it goes back to what is the nature of what’s driving the oil prices, and to what extent does that drop affect the underlying cap structure of the energy corporations? At some point, oil prices become a problem for credit. When it becomes a problem for credit, that’s generally when you’re going to see a convergence of correlations to one, with the underlying equity investments. I think as long as oil prices can stabilize at these levels – you just saw from an earlier slide that the break-even costs for US shale production continued to drop, so there’s a nice healthy spread even at prices that are at a lower level than what we saw maybe earlier in the year.
Again, the thing to keep an eye on is to what extent is the oil prices, dropping oil prices, putting pressure on credit. We’re not seeing that so far. Any further drop in oil prices, you might start to see that show up in credit spreads and that’s where I would expect those toll-roads to be highly sensitive to oil prices.
Jay Jacobs: This is sort of a follow-up question. Do you think the drop in MLPs recently is justified by the drop in oil prices? You were saying you didn’t really see the credit spread start to expand, so are you saying that the drop might be not justified yet or is it trying to measure the –
Ben Lavine: I think it’s just near-term volatility. It’s a large investor basically making a macro-call on the energy space overall, and they’re in some ways freaked out by either the perceived waning decline in final end-demand or things like trying to slow down them tightening credit conditions, and that’s causing reverberations through the whole commodity food chain. I think it’s near-term noise, but at the same time, if we are seeing some structural trends happening and reducing demand, that could potentially be a headwind I think for infrastructure. Although, I think that ultimately it’s industrial activity that’s going to drive the fortunes of this space. You do – ultimately in a cyclical reflation, you would expect to see higher energy usage and therefore a higher need for transportation for storage and so forth. If the global economy or the US economy remains stuck or starts to turn down, that probably will affect the space.
Jay Jacobs: Got it. I’ll answer a really quick question here, which has come in a few times. Do either of those two funds, MLPA and MLPX, generate K-1s or are they 1099s? Both of those funds distribute 1099s. There’s no K-1s for either of those funds. I’ll take that one pretty quickly.
The second one that comes up here, again, on this topic of oil and MLPs. Do MLPs need to maintain a certain minimum oil price, in your opinion, to sustain or raise their distributions? We’ve done a lot of research on this. I think there’s a difference between looking at it in the short term and the long term. When we looked at midstream MLP distributions last year in 2016, we actually saw that they were very robust. We didn’t just look at it from the distribution perspective, but we looked at it from the sales that the MLPs were doing as well as their volumetric data. How much were they still transporting? Even in an environment where oil fell below 30 bucks a barrel, and we were seeing production come offline pretty quickly. We saw that it was a very robust business model.
Of course, oil prices didn’t stay below $30 for that long, so it didn’t really stress the MLPs for that long of a period before we started to see the rebound back into the 40s, then a bit of stabilization in the 50s. When we look at it in the short term, I do think MLPs are a more robust model than frankly a lot of people gave it credit for back in 2016. I do think over the long term, there’s just no way that under $30 a barrel certainly that production can remain at levels that it is now, and even probably levels that we saw back in 2016. We have seen really in this $50 level, given where break-even prices are, given how we’ve seen production really come within 3% of where it was a few years ago, that I do think a lot of these MLPs can maintain distributions at this level.
The next question is what about raising distributions? Part of this comes into how you value an MLP because you can look at it one, from the current income perspective and two, from the growth in that income perspective. To the extent that MLPs are able to grow their income, they become a lot more attractive. It sort of implies much higher valuations on MLPs. Right now, we’re still seeing the valuation on that growth aspect of MLPs being pretty low. Expectations as a whole is probably around maybe two to four percent distribution growth, whereas if you go back to 2013, 2014, I think the common figure was 7%, is what people were saying.
In terms of distribution growth, a lot of that is frankly going to be driven by do oil prices remain stable so that we see continued production, and do we see some support for infrastructure development? Whether it’s in the vein of an infrastructure spending plan, any sort of tax credits, executive orders, I think those would all actually be very supportive of the growth component of MLP distributions.
I’m looking at the clock and I think we’re exactly at an hour here, so unfortunately, we could not get to too many questions today but we see a lot of them coming in. We will do our best, Ben and I, to reach out and answer questions here. Thank you so much everyone for joining. Ben, thank so much for your insights.
Ben Lavine: Sure. Thank you for having me on.
Jay Jacobs: Really appreciated it. I hope this was as useful to all of you. Please be on the lookout for more research from Global X or 3D Asset Management. We’re always talking about the MLP space and love to share it with you. Thank you for joining, and we’ll talk to you next time.