Master Limited Partnerships (MLP)
June 8, 2014
For some time, Cumberland has been offering a separately managed Master Limited Partnership investment style. In general, the asset class has done well – when the selection of the MLPs is carefully done. At Cumberland, we engage Richard Daskin, CFA and CFP, as a subadvisor to help us with MLP research. Rick is based in New York and has a private IA practice in addition to the special research work he does for Cumberland. We also engage Carla Plush Smith, CPA/PFS and CFP, to help us with the accounting issues. Carla is based in Sarasota.
I asked Rick to answer some questions about MLPs, knowing that his answers are likely to be of help to clients and other readers who may be interested in the details of the Cumberland MLP program. Below is our Q and A.
Kotok. Master Limited Partnerships can offer investors tax-advantaged income and a growing stream of distributions. Given the growth in the domestic energy business, how can you go wrong investing in, what others call, a low-risk, toll-road infrastructure enterprise?
Daskin. Long-haul pipelines, a midstream energy asset, are often compared to toll roads. They are far from it. Imagine a toll road where some of your users’ rates can change annually, and each year the demand for your road is likely to change significantly. Imagine that your road connects two big cities, but the cities can move away from your road over time. This is a fair analogy to a long-haul pipeline when demand or supply shifts in the energy market. We are not here to pick on long-haul pipelines as an investment – they are often attractive. But we want to explain, using this example, that any business, even a lower-risk one, has challenges along with opportunities.
Kotok. At Cumberland, our philosophy is to know and understand the risks in MLPs. How do you describe this process?
Daskin. We focus on diversification of those risks, since changes in the energy business are extremely difficult to predict, even with superior insight. Today's opportunity can turn into tomorrow's poor investment in fairly short order. The research process is complicated and time-consuming. There are some important recent trends affecting MLPs. Let me itemize a few of them.
1. Exploitation of shale deposits via new technology such as "Fracking" and "horizontal drilling" has made previously uneconomic oil and gas deposits suddenly profitable in the United States. In the last four years this trend has accelerated. The technology has been disruptive and has caused quite a few changes in energy markets. It has forced investors, energy providers, and end users to change their assumptions, outlooks, and forecasts. Here are some of the noteworthy changes:
2. Coal-fired generation is being reduced. Natural gas is cheaper and has a smaller carbon footprint. Thermal coal demand in the US is down. The new market for US coal is exports.
3. Newer shale basins located on the East Coast and in the Midwest have shifted the transportation of natural gas and natural gas liquids in many ways. Right now shippers are looking for ways to ship natural gas products from the Northeast to the Gulf. A large pipeline from the Rocky Mountain region used to ship natural gas east is being repurposed and reversed in sections. The Seaway Oil Pipeline in the Gulf was reversed, since imports from overseas are down; however, there was a surplus of oil accumulating in storage in Cushing, Oklahoma, that had originated in North Dakota and Canada. Few could have foreseen any of this ten or even five years ago.
4. The price relationship of natural gas and natural gas liquids versus petroleum has shifted. For many uses, natural gas products are now far cheaper. End users in the chemical industry are responding by constructing new petrochemical plants or expanding existing ones and are relocating back to the US. Methane ("dry gas") is now a byproduct of oil and gas production, not a main product anymore. Ethane is in oversupply and is not being separated out of natural gas in some cases ("ethane rejection"). And shippers are building export platforms to export many of the components of natural gas. Mexico is IMPORTING natural gas from the US now. Who would have expected this?
5. Petroleum derived from shale plays tends to be lighter (less dense, lower viscosity) and sweeter (less sulfur) than conventional oil. The US now has an excess of light sweet crude oil and a shortage of heavier, more sour crude than is optimal for our refineries. Refinery capacity is also running short. There is talk of changing the ban on exporting crude oil products, since we have a large surplus of light sweet crude petroleum that is hard to refine in an efficient manner to meet refined product demand. Could anyone have guessed the US would now be debating lifting the export ban on crude oil? How many even guessed five years ago that the US would be discussing the likelihood of energy independence now?
Kotok. Given the possible pitfalls of MLP investment, what is our approach to investing in these partnerships?
Daskin. We consider a number of important factors in our MLP investment process. To begin with, we look carefully at the partnership structure of each MLP in which we invest. Here are some key points:
1. We look for the weaknesses and risks as well as the opportunities in each partnership's business. Then we try to spread out the risk factors and opportunities in our portfolios. Sometimes the risks can offset each other naturally. Here is one example. Propane distributors often have trouble when propane prices shoot up. But many times partnerships that process gas benefit from higher prices for propane. By owning both we partially hedge this risk within our portfolios.
2. We attempt to assess a partnership's credit as though we were investing in a bond. One of the worst events for an MLP is a cut in its distribution (akin to a bond default). By using this approach we are better able take into account risks as well as rewards. We always keep in mind, however, that MLPs are NOT bonds and carry different risk parameters.
3. Diversification by type of business, growth prospects, partnership structure, business model, and type of energy product is also emphasized at Cumberland. Although we do invest in smaller-cap and some newer growth partnerships, the core investments of our portfolios are larger, more established MLPs, in order to reduce risk where possible. We have thus far avoided the nontraditional variable-distribution sector of MLPs as too risky and their underlying businesses as too untested for our clients.
Kotok. What does your crystal ball tell you for the next several years?
Daskin. 1. First, we will continue to avoid coal partnerships. Coal is going to have a rough go for quite some time due to stricter pollution regulation and competition from natural gas.
2. Many commentators have emphasized that the best investments are in MLPs connected to petroleum-based products, whether crude oil or refined products. We think this is probably correct in the very near term.
3. However, we believe that natural gas-oriented partnerships are due for improved performance in the next two to four years and should not be ignored. Natural gas products are very competitive with petroleum on an energy equivalency basis, and the market is adjusting to this reality in various ways. That is why you may be hearing more about using natural gas in buses and truck fleets; and that is why many end users, including petrochemical companies, are rushing to build plants to process and utilize cheap natural gas and gas-related products. In short, the natural gas business and markets are adjusting to the current ample surplus of gas.
4. There have been a slew of announcements regarding the development of various types of gas export facilities to take advantage of US gas product prices, which are so much lower than prices elsewhere in the world. The geopolitical problems facing Europe due to dependency on Russia for gas supply may accelerate this trend, and the reduced reliance on nuclear power in Japan and Europe is also helping to create an international market for gas products that can be efficiently transported long distances.
5. We will continue to invest along the energy supply chain to provide our clients with the best diversification possible and to control risk organically in our portfolios.
Kotok. What is your expectation for investment returns in this asset class?
Daskin. MLP performance does not exist in a vacuum. Returns are correlated to outcomes in other financial markets such as high-yield debt, REITs, energy-related equities, US Treasury bonds, and the stock market as a whole. We expect MLPs to offer a return roughly equal to their distributions, plus a distribution growth factor. We believe a reasonable long-term expectation is approximately 6, 7 or 8% in annual returns, after expenses. This represents an equal split on average between current distributions and price appreciation due to distribution growth. We think of this as a compounding mid-to-high single digit approach.
Kotok. What about tax code changes? Isn’t there a risk?
Daskin. Yes. Carla Smith has done extensive work for Cumberland on this subject and follows the asset class closely. Plus you use Washington-based research services to track proposed legislation that may impact MLPs. Anyone who is not staying on top of the political process is taking on risk.
In my view, the tax attack is ongoing. It was only slightly successful in the last round. The Obamacare tax was added to the taxable portion of an MLP distribution. Keep in mind that distributions are mostly considered return of capital, and taxes are deferred for most investors if they invest in individual MLPs. This makes the purer MLPs an attractive opportunity for patient, highly taxed investors who seek both income and growth.
And there is a long-term capital gain advantage if the distributions reduce the cost basis to zero. Then the additional return of capital is treated presently as a long-term gain. But the there are forces in Congress that would like to rewrite this portion of the tax code and eliminate the return-of-capital portion. Others would treat the whole distribution as a dividend. Still others would remove or alter the capital gain treatment. MLPs do have a tax-change risk. They are probably okay until 2016, but after that a political change could put them at greater risk for changes in tax treatment. Of course, a dramatic change in the 2014 election cycle could accelerate this risk. We don’t expect it but all things are possible in politics.
Kotok. Thank you, Rick, for these explanations.
Readers, please note that all tax questions should be directed to your tax advisor. For details on the Cumberland MLP approach, email me your postal mailing address and other contact information.
David R. Kotok, Chairman and Chief Investment Officer
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