Q&A: Making MLPs Investor Friendly

Jan 25 2012 | 1:53pm ET

Established in 1986 to encourage the development of natural resources in the U.S., master limited partnerships have only “started to grow up and be a legitimate asset class” very recently, according to Brian Watson, head of research at the Dallas-based investment manager SteelPath. SteelPath specializes in MLPs—which are structured as limited partnerships but trade on public exchanges and must earn 90% of their returns from real estate, natural resources or commodities.

The MLP universe remains relatively small—there are about 80—but Watson believes they present an attractive risk/reward proposition. To find out more about this niche product, FINalternatives’ Senior Reporter Mary Campbell spoke recently with Watson.

When you’re talking to investors about advantages of MLPs, what do you tell them?

A lot of investors look at MLPs and assume they’re buying a pipeline company or a storage company, or something that’s getting a fee for moving volume and is very low risk. So, the first caveat is: Be aware that there are non-fee based MLPs. There are companies that are producers of oil and gas, or take commodity price risks through some particular service they offer.

We happen to find most attractive in the sector those companies that meet the common perception—those companies that truly are energy infrastructure firms earning a fee for moving volume. We like them is because, generally speaking, they are pretty low-risk entities, kind of cash-cow in nature, and yet for a couple of reasons they’re growing at otherwise pretty interesting rates.

The names we’re focusing on don’t expect to make 30% or 40% in a year, but they’ll give you a nice yield—5% to 6.5%—and grow the distributions at 5% to 7%. So, if prices keep track with distribution growth, which they have historically, it’s a low-teens sort of return, which we think is really attractive, given the risk of the assets.

How does the mutual fund MLP work?

There are a handful of closed-end funds that focus on MLPs; it’s exactly the same structure except ours is open-ended. And so, you trade in and out at NAV, you’re trading in the marketplace as opposed to a closed-end fund where you’re buying on the secondary market. We can offer better liquidity, since our liquidity is in the underlying marketplace as opposed to the particular liquidity of a particular closed-end fund’s shares. And the fact that we always trade at NAV is a bit of an advantage because investors don’t have to compound their exposure to the underlying investments and also have a market discount or premium to the closed-end fund shares.

The advantages of the closed-ends or our mutual funds to direct ownership is that if you own them directly, these are partnerships that happen to trade on public exchanges, so you’re becoming a partner in one of these partnerships. You have the tax accounting associated with being a partner and that includes receiving a K-1, which is a more complicated tax form than the 1099 that you typically received from a corp. You own a taxable entity that’s earning income in various states, so you may owe state taxes in various states if you own MLPs directly.

The closed-end fund structures and the mutual fund structures both essentially use a corporate blocker. So unlike your typical pass-through fund, these structures all have corporations that own the MLP stocks. The fund goes through that process as opposed to the individual having to go through the process.

Would it be correct to say that where the MLP may be more for sophisticated investors, the mutual fund has more appeal to the retail investor?

I think that’s a fair statement. We also offer private offerings, SMAs, LPs. If you’re already dealing with K-1s, and UBTI is no issue for you, the SMA program, or the private LPs are a great option because they handle all the K-1 reporting and it’s the cleanest way to own the space. If you can’t take the UBTI or you simply don’t want to deal with K-1s and potential state tax filings, then we think mutual funds are a great solution.

As head of research, what are you interested in currently? Where do you see potential?

We think 2012 looks a lot like 2011. We’re entering the year at almost the exact same place on a valuation basis. Most of the themes that were coming to the fore in 2011 are still here in 2012, such as the continued spread of the use of drilling technologies, increasing crude oil production domestically for the first time in a generation.

As new production continues to pick up steam, new midstream services are required and can serve to improve utilization of existing assets. The same thing can be said for natural gas liquids, which are really a by-product from producers switching from drier natural gas basins to what’s known as ‘wet’ natural gas basins.

Producers, obviously, are switching to the better economics, going after wetter natural gas plays, which is a bonanza for a midstream provider because not only do you need to provide the midstream service to accommodate that dry natural gas, but you provide the service that frees that natural gas, removes the contaminates and separates those natural gas liquids, segregates the natural gas liquids from one stream to several, provides the natural gas liquid transport... So you can just see that as you get this more complex hydrocarbon stream it multiplies the midstream services required.

The sector today is very clearly short of the infrastructure to handle that, so being a midstream provider in today’s world is a pretty good place to be. You’re able to get some of the best contracts that we’ve seen—very long-term, stable contracts. We think that needs to play out and pick up steam.

What are your thoughts about the possibility of the MLP structure being expanded to include green tech firms?

I think it’s a great idea and, obviously, the sector was established to promote natural resource development, and when you look at midstream MLPs they spent something like $65 billion in the last five years building pipelines, so I think it’s working. The efficiency of being able to avoid the corporate-level taxes is a help, and also that investors just know that the sector offers this fee-like return and I think it’s worked perfectly to align the risk of the assets to the appetite of investors. In fact, this environment of cheap natural gas is in no small part due to the fact that the midstream was built out as quickly as it was. I don’t think that would have happened if it wasn’t for the creation of MLPs.

Whether it happens or not, we’ll see. We have to look more at the economics. The thing about the space, whatever business it is, needs to have a very stable cash-flow profile, and it all comes down to how those contracts are written. Certainly, power transmission has been mentioned as perhaps the sector that could use the structure, and I know people who think that it is appropriate for the structure. Obviously, many people think we have to invest in our transmission system to accommodate new technology, so that would be great.

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