Kenny Feng is the president and CEO of Alerian, a leader of MLP-market intelligence that provides benchmarks, data sets and analytics that are used extensively by a range of stakeholders such as investment banks, stock exchanges, investment professionals and consultants, and Master Limited Partnerships. He recently took time out of his busy schedule to talk about the nuances of exchange-traded products offering exposure to MLPs and the factors that may make this sector of the market appealing to investors:
ETF Database (ETFdb): Interest in MLP ETPs has surged over the last two years. What is the cause of such strong inflows to this corner of the market?
Kenny Feng (KF): I think there are two parts to that story. One is the Master Limited Partnership (MLP) side and the other is the exchange-traded product (ETP) side. Investors right now are focused on yield, highlighted by the fact that Wal-Mart (WMT) was able to issue three-year paper at 75 basis points last October. It’s part of a larger thematic story, with the retirement of baby-boomers and historically low interest rates. Everybody is looking for different ways to access yield, and MLPs, with an average yield over 6% are an attractive way to do that, because the underlying cash-flow streams of these companies tend to be more stable than many other businesses. Investors have also discovered that MLPs are a play on the necessary build-out of U.S. energy infrastructure over the long term.
On the ETP side, you have to keep in mind that we didn’t have a real-time index for the MLP space until June of 2006, when the Alerian MLP Index (AMZ) was launched. After the sell-off in MLPs in late 2007 and throughout most of 2008, there wasn’t really enough interest for a new product to be created. Much of it is fortunate timing – since April 2009 when AMJ was launched by JPMorgan, you’ve seen MLPs move very sharply off their lows.
ETFdb: With interest rates near record lows, some investors have gotten creative in their search for yield, venturing beyond investment grade fixed income securities. Can MLPs fill that “yield void?"
KF: North American investors looking for yield typically think of three asset classes: utilities, real estate investment trusts (REITs), and Canadian income trusts. From the utilities side, we use the example that you might go as a local utility company and ask to install electric meters at the homes of all of your consumers, and the local regulatory body will ask you why you are asking to do this. As the utility company you might say, “Well, first of all, it’s going to reduce my personnel costs, and second of all, it’s going to enable me to have more accurate readings, since there is no human-error factor.” The regulatory body might think it’s a terrific idea and say, “I like your plan, and now I want 50% of your cost savings for the consumers.”
Because of the local and often politicized process, a utility investor must, as a result, be familiar with the regulatory environment of every state, from the makeup of the board to prior rate case decisions. You don’t have that with MLPs, because all interstate liquids pipelines are regulated by one body, the Federal Energy Regulatory Commission. The overarching federal regulation for all of these pipelines is more streamlined and efficient, and when you look at the safety record for these pipelines over the long term it has been fairly strong.
You also have a comparison to REITs. The concrete building that you are sitting in right now has a permanent storage value associated with it because of the rents that it collects. We would argue that the pipelines that transport the natural gas to heat the building during the winter, or to cool it during the summer, similarly have permanent storage value associated with them. The difference is that rents on REITs move up and down with economic cycles, and fluctuate in a much more volatile fashion compared to MLPs. This is because MLPs are largely subject to inelastic energy demand growth as a function of things like the build out of the U.S. interstate highway system under President Eisenhower. This created suburbia, and as a result, you have to drive your son to football practice, drive your daughter to ballet practice, and drive to the grocery store, and all of these trips generate the consistent churn of gasoline demand.
When you compare MLPs to the traditional yield alternative asset classes, MLPs look very attractive. The long-term build-out of U.S. energy infrastructure simultaneously allows you to earn a significant yield with the chance for capital appreciation as well.
ETFdb: How strong is the relationship between MLP performance and commodity prices? How do you differentiate MLPs from, say, large oil companies?
KF: The cash flow of energy infrastructure MLPs is not directly exposed to commodity prices because they operate “toll-road” business models. The reason we say that is because if you’re on the Dallas North Tollway, when you go through the toll booth it doesn’t matter if you drive a Honda Civic or an Aston Martin – as long as it has four wheels, you will be charged the same tariff. Similarly, pipelines and storage tanks do not take title to the commodity price itself. What that means is that even as oil prices have fluctuated over the past eight years between $30 and $147 and currently sit at about $100 per barrel, the cash flow stream to MLP pipeline and storage assets has largely grown at a steady rate.
The way that these businesses make money is basically price times volume. On the price side, you have tariffs on all interstate liquids transportation pipelines that are federally mandated to increase every July by the Producer Price Index for Finished Goods (PPI-FG) plus 2.65%, resulting in a natural inflation hedge built into these contracts. On the volume side, as mentioned earlier, there is inelastic energy demand growth in the U.S. averaging about 1% per annum over the past 30 years. These assets also benefit from significant operating leverage. Because your main cost is a fixed asset – pipelines and storage tanks – most of every dollar that you make on the revenue side or cut from the expense side flows down to your bottom line. The contract structure makes for a much more stable cash flow stream than the profits you might see from some oil exploration and production companies.
ETFdb: Another appealing aspect of MLPs relates to the favorable tax treatment - an advantage that can be diminished when held within a mutual fund or ETP. So why are investors interested in achieving MLP exposure through ETFs and ETNs as opposed to buying individual securities?
KF: There are many reasons that MLP investors may prefer an ETP to buying individual securities. One of the factors is the burden of filing K-1 tax forms. When you own most stocks, for example IBM (IBM) or Google (GOOG), if they pay a dividend, you get a 1099 tax form, which most investors are comfortable filling out. But because MLPs are structured as partnerships, someone who invests directly in them is allocated revenues, deductions, and expenses. These line items are detailed in a K-1, which for some investors is not the type of accounting burden they want to deal with. Another advantage is diversification – being able to access a breadth of securities and avoid committing a significant amount of capital to one or a few specific stocks.
ETFdb: There has been a lot of debate over the pros and cons of accessing MLP exposure through an ETF as opposed to an ETN. Is one of these structures superior to the other? Or might different structures be appropriate for different investors?
KF: I believe that different structures are going to be appropriate for different investors. It is just like what every investment advisor goes through with his or her client: what are your investment objectives, what is your tax situation, and what specific areas of your investment portfolio you are looking to focus on. The fact that seven ETNs have collectively raised $2.9 billion in two years while one ETF, the Alerian MLP ETF (AMLP), has been out for six months and has raised over $850 million, I think speaks to the notion that different investors are looking for different products.
AMLP is going to be attractive for investors who are focused on after-tax yield. Because its distributions retains the underlying characteristic of MLP distributions, which is largely tax-deferred return of capital, AMLP allows investors to potentially benefit from that treatment, as well as qualified dividends.
The attractiveness of the ETN is that you don’t have any tracking error; it’s a formulaic return that is written into the prospectus. Neither of these structures employs leverage, which some investors still shy away from given what happened in the recent past with the financial crisis. There is a leveraged option available from UBS, the E-TRACS 2x Leveraged Long Alerian MLP Infrastructure Index ETN (MLPL), for those who are interested.
One of the drawbacks that people have noted with the ETNs is that they are unsecured debt obligations of the issuers. Some investors don’t want to deal with any sort of credit risk and want to limit their exposure to debt instruments. Investors in the ETN also lose a meaningful portion of their yield in taxes, as ETN dividends are taxed at ordinary income rates.
As an index provider, Alerian is focused on providing product and information access to MLPs. On the product side, we’re trying to identify what investors are looking for, and partner with investment banks and distributors that are able to create the products that fill different gaps currently in the market. On the information side, we’re striving to provide the objective data and analytics to help those investors who are new to the MLP space catch up to those who have been in the sector for many years and benefited from its strong returns and diversification benefits.
ETFdb: Thanks for sharing your thoughts – very interesting insights.
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