Rohan ReddyWith strong energy production in North America and rebounding oil prices, MLPs have enjoyed a strong start to 2019. In this webcast, we will examine the key factors impacting MLPs and energy infrastructure investments. We will further share our outlook for the rest of 2019 for the midstream energy space. Join us for this in-depth discussion that will cover:
- The Changing MLP Landscape
- Distribution Stabilization
- Active vs. Passive MLP Investment Approaches
- Remaining 2019 Outlook
Transcript
Jay Jacobs: Thank you for joining us today for our webinar, “What’s the Outlook for MLPs.” My name is Jay Jacobs, Head of Research and Strategy at Global X Funds. I’m joined today here by Rohan Reddy, our Research Analyst who specializes in the MLPs space among other income strategies.
We are going to dive into what we really think are the top of mind topics in the MLP space today. We’ll kick it off looking at 2019 snapshot, where we are in the energy landscape and the midstream landscape and provide a bit of an outlook for the rest of the year. We’ll also go into the changing MLP landscape, some of the major trends we see with C-Corp conversions, IDR eliminations, and other trends within the space leading us to the new MLP model that we see today. We will finalize the webinar by talking a little bit about active verse passive management in this space today looking at some of the latest stats there.
We will wrap it up with Q&A. Before we dive into it, we’ll just briefly share some disclosures. With that, Natalie, we will pass it back to you to kick it off with a poll question.
Natalie: Great, thank you, Jay. The first poll question reads, “What best describes your current attitude towards the MLP space?” You can choose from the following: “I’m bullish on the asset class and think MLPs have turned the corner; MLPs are complicated and I’d like to learn more before I can form an opinion; I’m frustrated by MLP performance over the last few years and looking for stability; I like MLPs for the dividends and view them as an income investment; or I would prefer to invest in the C-Corps as opposed to the MLPs.”
Again, “What best describes your current attitude towards the MLP space?” You can click your answer directly on the screen and press Submit. It looks like about 33% say, I’m bullish on the asset class and think MLPs have turned the corner, with about 21% saying, MLPs are complicated, and I like MLPs for the dividends and view them as an income investment. I’ll turn it back to you.
Jay Jacobs: Alright, perfect. Thank you, everyone, for the responses there. I think going into this we anticipated a variety of different responses as when we talk to investors, clearly there’s a range of opinions on MLPs. We’ll do our best to address many of these questions today in terms of where MLPs are and how we’re looking at things like their distributions and stability going forward. With that, I’ll turn it over to our MLP analyst, Rohan Reddy, to start walking through the 2019 snapshot and outlook.
Rohan Reddy: Thank you. As Jay mentioned, my name is Rohan Reddy and I specialize in certain income investments at Global X including our MLP suite. I think really one of the most attractive points in today’s environment for MLPs that’s been coming up in client conversations quite a bit are the valuations right now. You think about a period where the equity markets might be getting a little frothy, valuations as a whole are starting to rise. The energy sector including MLPs has experienced that bear market back in 2015 and so the valuations right now do look pretty attractive.
I think there’s really two areas where we’re starting to hear more conversations about MLPs and asset allocation start to pick up. It’s really out of the fixed income sleeve of investors’ portfolios, that riskier part of the high yield market, maybe leveraged loans, and high yield bonds where people are concerned about valuations in that area and what could possibly happen to their portfolio there. It’s making MLPs a little more attractive from a risk-adjusted perspective of maybe taking on a more valuation conscious approach.
Then on the other side on the equities, we’re starting to hear a lot more investors think about REITS and utilities and the good run that they’ve had over the past five, six years, and look at where can I take some money off the table, put it into different income-oriented asset classes, and maybe do so in a manner which is more valuation conscious. That’s where MLPs are also coming up. We’ve been seeing a variety of interest from investors from the attractive valuations that MLPs have been giving. A lot of that has been coming from both equities and fixed income. We think part of the reason why the performance has picked up a little bit in 2019 has been investors rotating out of some of these more richly valuated asset classes and into MLPs.
Jay Jacobs: Now, Rohan, we’ve been talking about low valuations in MLPs for a couple of years now. Why from 2008 on do we see such an aggressive dip in the valuations of MLPs on the EV to EBITDA valuation metric?
Rohan Reddy: It’s been a couple of items. Mainly the first and most important has been the shift to what’s been known as the self-funding model for MLPs. Basically, what that’s entailed is that there’s been this massive move in the asset class away from the traditional retail investor base that valued MLPs for the dividends and aggressively pursued dividends over all else that a typical company would retain cash flow. What MLPs were doing was that in order to make up that cash flow shortfall, they were going to the capital markets to raise that money.
However, as oil prices started to fall and the investor base began changing quite a bit, you’re seeing MLPs start to adopt more of an institutional outlook, try and be more self-funding in their approach and be able to fund projects without the need for capital markets. However, this has alienated some of the retail investors that bought MLPs for those dividends. Really, what you’ve touched on over the past four or five years has been a large move in the asset class away from the traditional retail investor base and a slow-moving inflow of institutional investors that we do believe eventually will start to become a larger part of the asset class moving forward.
You look at this chart here and really the biggest story for MLPs and midstream companies is the underlying strong macro story of growing energy production in the United States, the shale renaissance energy independence. Really what that’s brought here is a period where infrastructure capacity across the country is pretty strained. You look at this chart here and you see a pretty aggressive outlooks number for oil and gas production. The reality is that the underlying fundamentals for MLPs in midstream companies has been supported by rising production, hitting those bottom-line revenues numbers. What this has entailed is that there’s a lot of investment out there in the universe that is starting to move more into the midstream infrastructure space because they’ve realized that there just isn’t enough infrastructure capacity right now.
You see these forecasts moving forward and a lot of these numbers aren’t really projected to slow down a whole lot anytime soon on oil and gas. As these upstream drillers start producing more and more oil and gas, this is just going to put more of the focus on that midstream side of the equation which is needed to transport oil and gas from point A to point B. We’ve seen some of these issues start to arise especially in the back half of 2018. Regional price discounts in areas like the Permian Basin started blowing out quite significantly because of the lack of infrastructure in place. It is a fairly slow-moving process; it can take a few years for infrastructure to come online. As these aggressive forecasts of oil and gas production continue to take hold, there is more demand for that infrastructure to be put in place. We inspect investment to pick up.
Another area that’s been coming into the forefront a lot so over the past few years has been this idea of energy production and energy independence starting to leave the United States to move into more of an export-oriented market. If you just take a high level going back a few years to 2015, prior to 2015 it was actually illegal for crude oil to be exported just for legal reasons. Ever since that ban was lifted, you’ve been seeing a lot more oil and gas start to get shipped across to other countries like China and other Asian countries that are big demanders of US energy.
Between all the infrastructure coming online and into place for export-based production, this has given a bit of a tailwind to these midstream companies to be able to shift this across the sea into other countries, other continents. We do expect that a big source of demand moving forward will not just be the US domestic market, but it will also be international markets that will start to demand some of that cheap oil that the United States has been able to pull out of the ground with all the shale technology. This is another area where the main focus has been on domestic infrastructure and putting midstream infrastructure in place in the US but moving forward a big driver of growth is going to be that export infrastructure, putting that into place, and eventually sending that to customers across the globe.
It wouldn’t be a fun conversation unless we talked about the outlook for energy infrastructure for the rest of 2019 and into 2020. I think rather than just putting a plain ballpark what our outlook is on this, it’s important to look at all the factors here. Generally, our outlook is fairly positive right now on the midstream space. It’s really been undergoing this massive shift in paradigm between the changes in the business model, all these C-Corp conversions happening, changes in the investor base that’s really put a change in the facelift of how MLPs are composed and really how their business works. We think a lot of these overhangs that have been in place over the last few years that have really placed investor sentiment on a weaker scale have been alleviated. We do think that the story is a lot cleaner for the rest of 2019 and into 2020. I think the biggest source that we’re excited about for demand for MLPs will be that production side of the equation.
As we just discussed, there’s a pretty strong outlook for exports for domestic production. We expect that as the US starts to take a greater share of global market share away from some other countries that the midstream space is going to start to become as a thematic investment more of a demand driver in people’s portfolio. We do expect that production will probably be the biggest factor to look forward to and the outlook looks pretty strong there.
The other area that we are positive on is commodity prices. Typically, MLPs have been pitched as this vehicle that shouldn’t be all that sensitive to commodity prices. What we have seen is that when oil prices start to fall around $45, $50 a barrel that MLPs do get a little bit more sensitive around that area because that’s a point when certain upstream companies can’t break even at those prices. We expect oil to remain around this $55 to $70 range-bound price expectation over the next 6 to 12 months as part of the OPEC production cut agreement that’s in place.
Then demand and the global economy doing pretty well right now. We do expect that oil prices will remain less volatile. Generally, that will help energy-related investments like MLPs despite the fact that they don’t have a ton of direct underlying fundamental exposure to that.
The other area that we are pretty excited about is the growing generalist investor interested in the energy sector as a whole including energy infrastructure. I think one of the things that has kept a lid on investment over the past few years has been the MLP structure, the restrictions on investment mandates, and the tax consequences that come with investing in MLPs. It made investor interest in that generalist arena a little lower than you would expect in other investments. As MLPs have started to convert to the C-Corp structure, we do expect that there will be growing generalist investor interest in this area.
Jay Jacobs: Hey, Rohan, you mentioned that one of the more attractive areas is based off of that projection of higher US production growth of both natural gas and oil. Obviously, given that how much capacity is being used in MLPs today, that production growth can only really be realized as a positive for MLPs if you see additional projects coming online. Can you provide a little bit of context around just new projects, and CapEx, and the MLP space as another possible positives’ driver?
Rohan Reddy: Yeah, a lot of the overhangs on those production capacity limits that MLPs have right now in place is expected to be alleviated in the back half of 2019 and into 2020 as more of that capacity starts to come online. As I mentioned before, the process for bringing new pipelines online can be drawn out and last a few years and deal with federal and state regulations that can sometimes slow down that process. We do see that as we enter the back half of the year and into 2020, more production will start to come online. Based on expectations of production at various levels of oil prices, that production increased capacity that MLPs will bring online should actually be pretty positive. A lot of the heavy lifting that was done on the CapEx side a few years ago is going to start to come to fruition as these projects start to service more of that oil and gas.
A good example of this that we saw actually in the second half of last year was in the Permian Basin there were pretty steep regional price discounts. We did see one of Plains All American’s pipeline projects, their Sunrise Expansion, it did come online. It added hundreds of thousands of barrels in additional capacity. Right after that project came online, you started to see over the next few months those discounts started to tighten up quite a bit.
Now actually, the Permian discount are relatively light and are actually comparable to some of the broader benchmarks like the Cushing and the Houston Indexes. We expect that’s going to be a positive driver of growth in the energy infrastructure space because basically right now there is a lid from that upstream side on how much production can actually be serviced. Because if they can’t transport it right now, they’ll be forced with a choice of selling it at a discount or just waiting until production comes online. We think a lot of that production is going to start to increase as these projects come online in the back half of 2019 and into 2020.
Jay Jacobs: That’s an interesting feedback loop here of upstream producers are producing so much that it exceeds capacity which then drives their prices down until more capacity comes online which in turn brings prices higher again and closes that discount gap and then they start producing more. We almost see more capacity being a driver for more output in a lot of these regions that have had to experience these big price discounts.
Rohan Reddy: Yes, really as you start to see those price discounts adjust themselves with the changes in capacity, that should be a positive for the US industry. It might negatively impact the oil price outlook globally for certain OPEC nations and others, but for US producers and for the energy infrastructure providers, this is a fundamental positive.
Jay Jacobs: Excellent, and I think that brings us, Natalie, to our second poll question.
Natalie: Great, thank you both. The next poll question reads, “What aspect of investing in MLPs appeals to you most right now?” You can choose from the following: “yield potential, tax advantages of return of capital distributions, low valuations, growing US energy output, broad need for infrastructure, or none of the above.” Again, “What aspect of investing in MLPs appeals to you most right now?” You can select your answer directly on the screen and press Submit.
I want to remind everyone that if you do have a question for our speakers today, you can submit those in the box to the right of your slides. It looks like about 43% say yield potential, with 27% saying low valuations. I’ll hand it back to you.
Jay Jacobs: Excellent, thank you, Natalie. Now, we’ll continue on to the next section talking a little bit more about the changing MLP landscape. We’ve seen a few questions come in for more details around, what are these conversions to the C-Corp structure and the self-funding model. We’re going to dive into that right now. Rohan, let’s kick off the key industry factors.
Rohan Reddy: Yeah, the major move we’ve been seeing broadly within the midstream space both on the MLP on the C-Corp side has been this move to the self-funding model. Generally, across the energy sector there is this feedback from investors that they want companies to become more self-reliant and use less capital market issuance through the forms of equity and debt which can be relatively expensive especially during a period of weaker valuations and when yields have to remain high on that debt in order to take on more leverage. The investor feedback has been, why don’t you move to the self-funding model in order to close that loop? It has necessitated a pretty big change in the overall midstream universe.
Really what’s been happening is that a lot of companies in order to retain more cash flow, they’ve been getting rid of these IDR arrangements, and the MLP structure. They’ve been also reducing distribution growth or resetting distributions to a lower amount and then working off that. What that does is it improves their coverage of the distribution, but also gives them a pretty big cushion in terms of how much they can service on the project side without affecting the distribution too much.
Previously, the approach to MLP distributions used to be pay out aggressive amounts, almost all of their distributable cash flow, and then take it quarter by quarter so that we have aggressive distribution growth figures. I think that mentality is changing. What we’re seeing is distribution growth is probably more in the low single-digit ranges as opposed to at the height of the MLP boom probably double digits, low double digits on their distribution growth amount. That’s been what’s necessitated the move to the self-funding model. We expect that to continue in the future as MLPs start to adopt this and C-Corp companies start to adopt this.
The other thing that’s been happening a lot has been if – a lot of these MLPs, they’re in a tough situation where they really took on the MLP structure because they felt that the access to the capital markets was quite strong and they could service those distributions by being able to just aggressively issue capital in order to make up that shortfall. What’s happened is that as the capital markets have started to tighten up quite a bit and you saw tax reform happen at the end of 2017, and then the FERC ruling in 2018, it’s really necessitated an existential question from a lot of these MLPs that they’re asking themselves should we just abandon the MLP structure and move into the C-Corp model. That’s been really the second avenue of options that MLPs have elected to take.
Broadly, we haven’t seen a huge move away from MLPs and into C-Corps, but there has been a noticeable amount of the market share within the energy infrastructure asset class moving to the C-Corp model. A lot of this has to do with opening up a bigger investor base, alleviating some of the issues that come with being an MLP, and some of the complications on both the tax and investor restriction side that come with that. What some of these companies are doing, they’re saying, look, why don’t we just adopt a cleaner C-Corp structure and try to trim down our leverage and be more flexible with our distribution policy.
Whereas in the MLP structure, there still is a pretty big group focused on that yield potential. The way we’re seeing the development today in energy infrastructure is that people who are buying MLPs are really buying them for that yield potential. People who are buying C-Corps are doing so for more of a longer-term outlook, total return asset allocation, that type of investment.
Yeah, as we discussed just on the previous slide, there has been a big shift in the energy infrastructure world moving away from the MLP model and into the C-Corp model. The way in 2014 and 2013 that a lot of these MLPs were structured was that they started to IPO with this LP and GP model where the MLP was the limited partner and then the general partner was managing the business and has what’s known as incentive distribution rights or IDR agreements that were a form of profit sharing with those IPOs coming along with it. That was the traditional structure that a lot of these companies used. The reason for that was that valuations in MLPs were doing very well, capital markets were quite strong, and so this feeling that we can pay out a lot of the distributions and then just go to the capital markets feed very well into the LP/GP model.
Now, what’s been happening is that LP/GP model is being abandoned. Either the MLP is simplifying with the general partner and rolling up that GP/LP structure and then getting rid of those IDRs with it or they’re converting to the C-Corp structure. As you can see based on this graph, in 2018 there was really a massive shift away from the MLP market share and then moving into that C-Corp model.
The reason for this is as we discussed, tax reform, an inability of some of these MLPs to be able to contend with the shift to the C-Corp model, and then some were heavily impacted by the FERC ruling that happened earlier in 2018. We think that when the dust does settle, to use a baseball analogy, we think we’re around the eighth inning of these conversions, so a lot of them have already happened. We think when the dust settles, it will be somewhere along the lines of a 50/50 split in the market cap between simplified MLPs and those C-Corps.
Digging into a little bit further of why explore this C-Corp conversion just from a higher level, I think the biggest factor that a lot of MLPs have started to look at and say, well, if we get into the C-Corp structure, we really do have a much wider investor base that we can access. For those not familiar, MLPs are largely restricted from being eligible for passive indexes like the S&P 500 or the Russell 1000. Partnerships generally just are ineligible for those indexes. As we’ve seen this broader move in the universe, in the investing universe from active management to passive management, the MLPs have been losing out on a lot of those passive flows, that broader simplified investments like C-Corps do get. MLPs have been saying, why don’t we try and explore this, broaden out our investor base from being just that traditional retail base and moving more into the generalist institutional, and that passive flow base that a lot of investors have come to adopt.
The other thing is that the C-Corp structure does allow MLPs to be a little bit more flexible with their dividend policy. A lot of the investors aren’t just focused on income like many MLP investors are, and so they can be more flexible with reducing dividends or dividend growth and then being able to self-fund some of their capital expenditures. Balance sheet management and business cycle management across multiple time horizons tends to be a bit more self-sustainable for those C-Corps. Just to sum it up, a wider investor base and more flexibility are the real reasons for the use, the rationale behind converting to the C-Corp structure.
One of the common questions that we’ve been getting asked a lot recently has been as some of these C-Corp conversions have happened over the last year or two, how has that really affected those C-Corps? Has the investor composition base changed a ton? Are they acting differently from a performance standpoint? We have discussed in the past how a lot of that performance hasn’t actually been all that much better than the MLPs. What we haven’t really discussed is how has that investor base changed quite a bit.
We dug into it a little further and we started looking at the biggest C-Corp converters that have done so over the last couple of years, Oneok, OKE, and Williams, WMB, and then compared that to some of the larger MLPs in this space out there, Enterprise Product Partners, EPD, and Energy Transfer, ET. I think what you can see based on this chart here is that the big difference is that a lot of these C-Corp converters are benefitting immediately from those passive flows. The investor base has changed quite a bit where broadly passive index funds are starting to invest a lot more in those benchmark tracking indexes that own a Oneok and a Williams, but they don’t own an Enterprise Product Partners or an Energy Transfer because those MLPs are ineligible for those indexes. The main benefit that you can see here is that there’s slightly higher free flowed capital and just a more diverse investor base.
I think the one thing that has really plagued just the broad space across MLPs and C-Corps has been that there really hasn’t been a ton of generalist investor interest that was hoped for across the energy sector that would pick up if MLPs started to convert to C-Corps. I think that’s why you’ve seen performance start to not really be a whole lot better across the C-Corp model as compared to the MLP model. Part of the reason why the C-Corp conversions has slowed down recently is that the main reason to convert to the C-Corp model is obviously to get improved valuations and valuation expansion which a lot of these C-Corps have not been in.
It’s put these MLP management teams on pause as to say, well, we’ve seen some of the evidence play out. It doesn’t seem all that compelling, so we’d rather take more of a wait and see approach. Right now, I think the main difference is passive indexes are investing a lot more in these C-Corps, but there really hasn’t been that generalist investor base as of now that some of these C-Corps had hoped for.
We mentioned a little earlier in the presentation about having that simplified MLP structure. We discuss C-Corps a little further, but the second alternative for MLPs that have elected to stay in the MLP model is that they’re starting to simplify their structure a lot further. If you think about MLP investing in 2013 and ’14, it was quite complicated.
You had these LP/GP structures. General partners were managing the MLP. They had these expensive IDR arrangements that were complicated for certain investors to comprehend. Then also, you started having a ton of family complexion added onto it by having multiple MLPs within a certain family umbrella. The big move in the space of MLPs electing to stay in this structure has been simplifying MLP structures to just have one MLP as opposed to two or three under the umbrella, and then also, getting rid of these IDR arrangements that we’ll discuss a little further here.
Taking it a little higher level, IDRs are basically a form of profit sharing with the general partner. It was ironically actually created in order to alleviate any of those conflicts of interest concerns that general partners and limited partners might have. In reality, it actually increased the conflict of interest because general partners were incentivized to raise distributions on MLPs aggressively in order to take a bigger cut of those IDR payments that they were entitled to.
The MLP was negatively affected because they were retaining less cash flow and basically paying the general partner to manage them. What we’ve been seeing is that a lot of these MLPs have been buying out their IDRs in exchange for units to the general partners, so the general partner takes a bigger ownership interest in the MLP and you get rid of these IDRs. It lowers the conflict of interest by getting the general partner and the limited partner on the same page and it enables the MLP to be able to retain more cash flow.
This theme has been picking up quite a bit. IDRs have been an aggressive point of interest from investors who have been looking at management teams and saying, you really need to get rid of these IDRs as soon as possible because they’re starting to inhibit growth of the MLP quite a bit. Just in Q1, we saw three transactions for MLPs that were paying out a lot in IDR payments. We’ve been seeing this trend across the board over the last few years of getting rid of IDRs. They were really built for a different environment when the MLP was – had greater access to the capital markets and was growing distributions aggressively. As that need to retain more cash flows become more important, IDRs just take away from that goal tremendously. Getting rid of IDR arrangements has been top of mind for a lot of these investor teams.
If you look across the universe of existing MLPs today, you can see a lot of MLPs have worked pretty hard to get rid of these IDRs. Most MLPs, about 75% of them do not have IDRs in the investable universe. You can see there are a few that have IDRs, most notably, the ones with the highest payments, DCP Midstream, Phillips 66, Shell Midstream, they’re paying out a huge amount in their underlying cash flow to the general partner. They are definitely under the most pressure to address those IDRs as soon as possible. It will immediately be a positive to their bottom-line earnings which will be helpful to LP unitholders.
We think looking forward a year or two, if you start to look at this chart forecasting it, you’ll see a full list of MLPs that probably do not have IDRs in place because investors are just getting apprehensive about investing in MLPs with IDRs. It’s not helpful from the underlying fundamentals of having to divert a large amount of the cash flow away from the MLP, but it also makes investors hesitant about investing in those MLPs. We think that when the dust settles in the MLP space, you’ll see MLP structures that are simplified into one MLP and have no IDR arrangements onto it.
Jay Jacobs: Alright, and that brings us to our third poll question.
Natalie: Great, thank you, Jay. The final poll question reads, “Which industry trend to you believe is most significant for MLPs?” You can choose from the following: “the movement to self-funding model, increasing C-Corp conversions, rising oil output in the US, rising interest rates, or none of the above.” Again, “Which industry trend do you believe is most significant for MLPs?” You can select your answer directly on the screen and press Submit.
I want to remind everyone that if you are interested in a one on one meeting with Global X ETFs, you can click the One on One folder at the bottom of your screen and press Submit. It looks like about 35% saying rising oil output in the US, with 28% saying the movement to self-funding model. I’ll turn it back to you.
Rohan Reddy: Another question we’ve been getting asked quite a bit as fund managers in this space has been – we are a passive shop and we run passive MLP based ETFs. We have been getting asked a lot, how have active managers done in the energy infrastructure space. What does the outlook look like from there? The numbers have really not been all that compelling in the active management space of MLPs and benchmarking them against index funds. The reason for that is actually quite intuitive.
Basically, there are a lot of MLPs in the space today – in the space previously, but as the number of MLPs have started to shrink over time, the basics of how active management is designed really relies on having a larger investor base of MLPs that investors can invest in. As that universe starts to shrink quite a bit, it all the sudden makes active managers, they start to look at the same alpha opportunities. It starts to become a crowded trade.
As you saw on the previous slide where performance hasn’t been all that strong in the active space, we think that trend is just going to become more and more difficult over time for active managers to outperform benchmarks. Because if you look at this Fundamental Law of Active Management here, all else equal, assuming your skill level hasn’t really changed all that much, and your portfolio constraints haven’t changed, as the number of investment opportunities in an active manager’s universe starts to consolidate, it becomes more and more difficult to be able to achieve higher risk-adjusted returns. We think that looking forward over the next few years that passive indexing within the MLP space might be the preferred option as opposed to the previously preferred option of looking at active management in the MLP equity space.
It does make intuitive sense. We think that as investors do due diligence within this space and look at funds that the question will ultimately revolve around how the manager looks at the portfolio. Also, keep in mind that as the universe starts to – or has been shrinking, it will become more and more difficult for these managers to be able to identify unique opportunities that they previously had before. Even in that environment where there were a great number of investment opportunities, active management has really failed to deliver a lot of the alpha that their investors have come to expect. I think that trend is only going to become more amplified over time.
Jay Jacobs: If we think about peak MLPs, there was so much variety. There was upstream, midstream, downstream, large cap, mid cap, small cap, GPs, LPs, different LPs with different – part of the same family with different geographic exposures. There was a lot of ways to migrate a portfolio to play different aspects of the space. Now, we’ve seen pretty substantial consolidation. Frankly, people are just owning the same holdings in a lot of different funds. There’s just not a ton of movement to shift into different aspects of the industry.
Rohan Reddy: Exactly, as you think about it from a high level as an active manager, if you’re looking at the same opportunities that other active managers are, you start to – the industry itself starts to crowd out its own trade. It makes it more difficult not just for one active manager but for the rest of the active managers to be able to generate alpha because those alpha opportunities will just become more difficult to come by with the consolidating universe. Global X, as I mentioned before, we are a passive ETF issuer. We do offer two ETFs in this space: MLPA which is our all midstream MLP fund. We charge 46 basis points on this fund.
There are no K-1s; it is a 1099 fund. We handle the K-1s at the fund level. This fund given that it invests 100% in midstream MLPs, it’s most appropriate for investors looking for income and return of capital distributions. It is important to note the fund is classified as a C-Corp for tax purposes because it does invest 100% in MLPs, but it is more appropriate for investors looking for income.
Our other fund which is our MLPX ETF, this fund has actually been our fastest growing fund within our MLP suite. It’s structured as a RIC and it does invest in C-Corps and MLPs. It does cap the MLP exposure at 25% in order to remain a RIC, but the majority of the fund is composed of C-Corps and general partners in this space. It’s 100% midstream. It’s more appropriate for investors looking for asset allocation purposes to invest in energy infrastructure and for growth-oriented investors. These are just the Top 10 holdings in those funds.
Thank you for joining the presentation today. We will take Q&A. We have been seeing a lot of questions come in. For those of you interested in looking at our research in this space, you can go to globaxfunds.com/research. We do put out a lot of research in the MLP space across reports, quarterly insights that we do, and then we do webinars like these, too. Feel free to reach out with any questions if you have any or browse our website for additional information.
Jay Jacobs: Alright, so we have plenty of questions coming in, so thank you all for being very engaged and inquisitive on a Friday during March madness. A couple of questions coming in off the bat. The first one, Rohan, I’ll kick this over to you, “We’ve seen the correlation between MLPs and oil rise. Why is this happening?”
Rohan Reddy: It’s an interesting phenomenon. As we mentioned a little earlier in the presentation, when oil prices start to fall, we see a lot more correlation to the downside for MLPs. The reason for that is that there are concerns from the market as oil prices start to fall especially near that threshold range of around $40, $45 a barrel. There are concerns about whether production could be affected for MLPs in this area.
What’s been a little frustrating for investors is that as correlations on upside oil prices start to fall, the question is why is that happening? The reason for that is that as fracking and shale drilling have become so efficient, the expectations for oil production have just really risen through the roof. If oil goes from $60 a barrel to $100 barrel, given that most producers can still breakeven at $60 a barrel, it doesn’t really change the production expectations all that much for these upstream companies, and ultimately what they’re transporting through those midstream infrastructure systems.
Jay Jacobs: Alright, the second question, “Which source of energy production is expected to be the biggest driver of growth?”
Rohan Reddy: Yeah, it’s a great question. Generally, across the board, energy production has been rising at quite a rapid rate: oil, gas, LNG. I think the two areas to look for in terms of where energy production is going to be most prominent, it’s going to be crude oil production domestically that can ultimately be exported. Also, the LNG side that’s ripe for exports to other countries like China and other Asian countries that are big demanders of this. As that infrastructure starts to get built out in the export space and across the domestic area, we do see rising oil production and LNG exports as a pretty big driver of growth within the energy production space, and then ultimately, flowing through to those midstream companies.
Jay Jacobs: “How does the recent shift in monetary policy by the Fed impact MLPs?”
Rohan Reddy: Yeah, I think what you saw over the last six months or so and then starting in December with the big policy pivot by the Fed moving from a more hawkish tone to a more dovish one that interest rate expectations are fairly muted. Previously, the Fed, I thought they were going to raise rates twice. Now, they’ve backtracked on that last week and said they expect no rate hikes. The Fed future has curbed its pricing and no hikes also. What this does is that for income-focused investors looking for yield, ultimately, MLPs and energy infrastructure investments can be sensitive to yield spreads. As those yield spreads remain pretty wide, this should be constructive for MLPs and energy infrastructure investments because more income-oriented investors will start to look for MLPs as a solution especially with some of the positive tax benefits that come with MLP distributions like return of capital.
Jay Jacobs: “One downside to MLP indexing is you own the most over-leveraged, high-indebted MLPs when things go wrong.” I think I would disagree with that a little bit. That may have been the case in the bull market in MLPs from 2011 to 2013 where MLPs were really encouraged to pay out as much cash as possible and to grow as fast as possible. It was a growth and income story. It really depended on the capital markets to fuel that growth through easy access to debt and high valuations of their unit prices.
Since we’ve seen that reverse, higher interest rates, higher credit spreads, more concern of balance sheet quality, this has really reversed in the sense that many MLPs have been focused on reducing their overall leverage. In the bull market of yesteryear, those fastest-growing MLPs were among the most well rewarded. That’s no longer really the case. I think that’s very much flipped on its head where quality is really be rewarded by the markets and MLPs. The great energy infrastructure complex is really focused on reducing their debt and not overextending through leverage. Another question, “What are your thoughts on private equity being more active in the MLP space?”
Rohan Reddy: It’s a phenomenon that we’ve been hearing a lot more over the last year or so. Part of the interest in private equity within the MLP space has been that a lot of these companies since they’ve moved to the self-funding model on the MLP side have necessitated this need to be able to fund CapEx projects through more creative manners. One of those manners has been looking at joint ventures and sharing some of the cost burden with other companies like private equity companies to be able to fund projects without taking on the entire cost burden yourself. We’ve been seeing a lot of MLPs start to team up with private equity companies and even other MLPs in the space to be able to get a pipeline project funded for future capacity inquires. We do expect that working relationships between private equity and public midstream companies will start to increase in the future as well because as these JV’s become more common, we do think the self-funding model funnels through well into that phenomenon.
Jay Jacobs: A few questions around intricacies of MLPA versus MLPX. Off the bat, those MLPX produce a K-1. Neither MLP fund produces a K-1; both of them are 1099s only.
Another question, “If an MLP converts to a C-Corp, is it removed from MLPA?” It’s a great question. As we’ve seen in the past with Williams and Oneok, previously the only MLP in our MLP only fund, MLPA, when it converts to a C-Corp, it is removed. It no longer qualifies for MLPA.
It’s a little bit different in MLPX which in many cases owns both the MLP and the general partner. If you see a consolidation where those two become one entity and convert into a C-Corp, it would most likely stay in that index as a C-Corp because 75% of that fund is invested in general partners and C-Corp. It might change the weighting slightly, but it would be expected to remain in that fund versus being removed from MLPA.
With that, we really appreciate everyone dialing in on a Friday again. Thank you for all of the questions and a lot of engaging discussion around MLPs today.