Christopher Pavese's  Instablog

A number of forces affect the competitive environment for businesses today, but these forces are not of equal importance. We believe one is clearly more important than others -Barriers to Entry. If there are barriers, it is difficult for new firms to enter the market and challenging for existing companies to expand. Put simply, no other feature has as much influence on a company's success as where it stands in regard to these barriers. Measured by potency and durability, economies of scale, when combined with some customer captivity, provide the strongest and most durable moats. Pipelines earn high grades on both counts.

Although it may seem counterintuitive, most competitive advantages based on economies of scale are found in local and niche markets, where either geographical or product spaces are limited and fixed costs remain substantial. An attractive niche should be characterized by customer captivity, small size relative to the level of fixed costs and the absence of vigilant dominant competitors. In fact, companies can build quasi-monopolies in markets that are only large enough to support one company profitably, because it makes no economic sense for a new entrant to spend the necessary capital to enter the markets.

Infrastructure firms provide an extraordinary example of niche domination. MLPs have high barriers to entry due to capital requirements and geographical monopolies. A business in the midstream is a toll collector that takes products from one point to another. Many have monopolistic characteristics as building a pipeline requires clearing multiple regulatory hurdles which can be challenging to overcome given ongoing environmental concerns. Furthermore, when there is not enough demand between two points to profitably support multiple pipelines, a single pipeline enjoys niche economics and can charge the maximum allowable rates. Those rates can be quite attractive for owners as pipelines have a somewhat looser regulatory regime than utilities.

A Simple Investment Thesis

Thematically, MLPs represent an investment in the build-out of our domestic energy infrastructure over the next few decades. Nearly all other infrastructure is contingent upon pipelines and other energy assets to provide the lifeblood of our economy. These businesses operate toll-road business models supported by long-life real assets, with inflation hedges built into long-term contracts, regional monopolistic footprints, and relatively inelastic long-term energy demand growth. The resulting operating fundamentals allowed MLPs to generate predictable cash flows and pay consistent and growing quarterly cash distributions over the past few decades, which translate into very attractive investment characteristics: long-term stability and low volatility, attractive risk-adjusted returns, diversification via low correlation with other asset classes, and the potential for an effective inflation hedge.

The two most comparable asset classes to MLPs are Utilities and Real Estate Investment Trusts (REITs). Both Utilities and MLPs benefit from inelastic long-term energy demand growth. However, Utilities are subject to a more local and highly scrutinized regulatory body focused on returning cost savings to their constituents. The interstate pipelines owned by MLPs, on the other hand, are predominantly regulated at the federal level by the Federal Energy Regulatory Commission (FERC), where infrastructure assets are viewed as critical to energy security.

The commercial buildings held inside REITs are viewed as hard assets with inherent tangible value. Similarly, the steel pipelines and storage tanks that transport and store the nation's energy are hard assets with associated permanent value. The useful life of MLP income-producing assets is typically over fifty years. REIT rental income tends to fluctuate with macro-economic conditions and market demand; whereas MLPs benefit from inelastic energy demand and inflation-adjusted tariffs.

Meaningful new infrastructure investment requires capital, and both are needed to efficiently connect growing areas of energy demand with new areas of supply. Pipeline and related infrastructure assets are expected to support growing population centers and facilitate the transportation of natural gas and crude oil across North America, creating a compelling investment opportunity in the coming decades. Growth in the asset class will stem from additional organic projects, asset acquisitions from integrated majors, as well as the monetization of assets held in private hands. According to the Interstate Natural Gas Association of America, over the next two decades, roughly $130 to $210 billion of additional capital expenditures will need to be spent on natural gas infrastructure development to meet growing and shifting energy demands. On the acquisition front, we estimate that at least $200 billion of midstream assets are housed at public and private corporate structures, all of which could eventually be acquired by MLPs. Longer-term, we believe new midstream infrastructure development represents a highly sustainable secular growth story, with MLPs the natural structure to undertake the vast majority of such investment. Put simply, we are likely on the verge of the largest energy infrastructure build-out since World War II.

Tomorrow, we'll review the tax-advantaged cash flow that these businesses generate before we take a look at the current and potential valuation of the asset class.

Disclosure: I am long AMLP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

CFA North Carolina is hosting Tortoise Capital Advisors, an MLP investment adviser established in 2002 with approximately $9.1 billion in assets under management today. Tortoise will be leading three discussions on trends in North American energy infrastructure, in Charlotte, Winston Salem and in Raleigh. Feel free to visit CFA North Carolina for details if you would like to attend.

Like Tortoise, we believe pipelines offer a high quality and predictable means of gaining exposure to the growing investment in our nation's energy resources. The resilient nature of these real assets, combined with attractive and growing yields, offer a compelling opportunity in an uncertain world where high quality income is difficult to come by. In this series of posts - excerpts from our next Broyhill Letter - we will explore this opportunity in detail, beginning with an introduction to Investing in Infrastructure today:

Investing in Infrastructure

"A successful society is characterized by a rising living standard for its population, increasing investment in factories and basic infrastructure, and the generation of additional surplus, which is invested in generating new discoveries in science and technology."

- Robert Trout, "The Iron Man of Radio"

Oxford Dictionaries defines infrastructure as the basic physical and organizational structures and facilities (e.g. buildings, roads, power supplies) needed for the operation of a society. Broyhill characterizes an investment in the "operation of a society" as a safe bet amidst a hazardous macroeconomic backdrop. Providing access to essential natural resources required to uphold or improve standards of living are among the most fundamental of societal services.

Sources trace the origin of the word "infrastructure" in the English language to 1927, but the military use of the term achieved prevalence after the formation of NATO in the 1940s, and was later adopted by urban planners in its modern sense around the 1970s. The term came to prominence in the United States in the 1980s following the publication of America in Ruins, which kicked off a public-policy discussion around the nation's "infrastructure crisis" - instigated by decades of insufficient investment and inadequate maintenance of public works.

Today, infrastructure may be owned and managed by governments or by private companies, but in the economic context of an extended debt deleveraging, policy makers can no longer resort to the Rooseveltian Recipes reliant on massive borrowing to fund infrastructure projects without regard for the long-term fiscal consequences of such policies. Even so, existing assets must still be maintained and repaired, and new assets must be built to ensure the continued competitiveness of the western world. Given that the required investment is enormous and the traditional provider of that capital - government - does not have the resources to do that anymore, private sector interest has grown considerably in recent years.

According to Preqin, over $175 billion has been raised by banks and managers for private infrastructure funds since 2004 with pension funds the leading investors in the asset class. The OECD estimates that there will be a worldwide need for as much as $30 trillion of infrastructure investment in the next two decades. In other words, there is considerable room for additional capital flows considering that average allocations to the asset class only represent one percent of pension assets today. Interest is growing for obvious reasons - infrastructure is a natural fit for large pensions and sovereign wealth funds with long-term liabilities. These institutional investors need to protect the value of their portfolio from the toxic consequence of currency debasement and inflation, while minimizing volatility in order to maximize the recurrent cash flows to beneficiaries. As a result, infrastructure is an ideal investment that provides tangible advantages: long duration real assets; high and growing distributions with natural inflation hedges; and statistical diversification which reduces overall portfolio volatility.

Enter The Master Limited Partnership

Although long recognized as an attractive asset class for institutional investors, access to infrastructure investment has been historically difficult to achieve for individual investors, particularly in the United States, where the majority of infrastructure is government owned and controlled. Fortunately, a liquid alternative now exists. Domestic energy infrastructure assets are often organized as Master Limited Partnerships, or MLPs, which are listed companies that own, manage and operate qualifying assets. The MLP structure enables these firms to utilize the tax advantages of partnerships. Shares trade like a corporate stock, but only pay one level of federal income tax so they are not subject to the double taxation of public companies.

MLPs provide investors with a direct pathway to infrastructure investment. Traditional MLP assets include intrastate pipeline systems that take products to storage, regulated interstate pipelines that go across state borders, and the gathering and processing systems that take natural resources from the wellhead to the distribution point. These pipelines typically collect steady fees with long-term contracts, regardless of the types of and prices for the commodities that pass through the pipes. Upstream exploration and production MLPs find long-lived oil and gas assets after they have had a drop in production. These assets have a long tail, which means a slow decline in future production and steady cash flow. Downstream MLPs are the refining assets and chemical plants.

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By confining 90% of their income to these specific "qualifying" activities, MLP units are able to trade on public securities exchanges without entity level taxation. As of March 31, 2012, there were 81 publicly traded MLPs with two classes of ownership - general partnersand limited partners. GPs manage the partnership's operations, receive incentive distribution rights, and generally maintain a 2% economic stake in the partnership. LPs are not involved in the operations of the partnership and have limited liability, much like the shareholder of a publicly traded corporation.

We'll investigate the competitive dynamics of the industry, in addition to outlining our investment thesis for the industry, tomorrow.

Disclosure: I am long AMLP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.