Passive Opportunities for Master Limited Partnerships (MLP) Investors: The Morningstar MLP Index Family

Transcription

1 Passive Opportunities for Master Limited Partnerships (MLP) Investors: The Morningstar MLP Index Family By Jason Stevens, Director of Energy Equity Research Morningstar Research Paper April 2013

2 Introduction Energy master limited partnerships have attracted a good deal of attention recently, thanks to their high yields and solid performance. In fact, master limited partnerships, or MLPs, have trounced the Morningstar US Market Index SM over the past one-, five-, and 10-year periods. As Figure 1 illustrates, a $10,000 investment in MLPs made in 2000 is worth more than $97,000 today. That same $10,000 invested in the broad Morningstar US Market Index, meanwhile, is worth $14,976. This level of performance has resulted in a plethora of new products. Figure 1. Growth of a $10,000 Investment, July 2000 March ,000 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10, Morningstar MLP Composite $97,370 Morningstar US Market $14,976 S&P 500 $13, At Morningstar, we ve introduced a new family of two indexes that track MLPs. The Morningstar MLP Composite Index SM is a diversified, dividend-dollar weighted index that targets the top 97% of publicly trading energy master limited partnerships by market capitalization. The Morningstar MLP Focus Index SM consists of the 20 MLPs that are trading at the greatest discount to their risk-adjusted fair values. Securities in the MLP Focus Index are assigned equal weights. MLP 101 Energy master limited partnerships engage in the transportation, treating, processing, refining, storage, marketing, exploration, and production of natural resources. MLPs are asset-heavy, capital intensive businesses. Their assets, particularly pipelines but also gathering systems, storage assets, and processing facilities, tend to enjoy partial structural monopolies that allow operators to earn above average returns on capital. In many cases, such as long-haul pipeline transportation, MLPs enjoy regulated rates of return that are generally more favorable than regulated utilities. The past decade has seen the number and market capitalization of MLPs soar as more and more quality assets migrated from legacy energy companies to more efficient, higher returning MLPs. Moreover, these assets are stable cash flow generators, allowing MLPs to pay out substantially all of their cash flow as distributions. If asset quality is what underpins the stable cash flows that allow MLPs to pay healthy distributions, it is the continued need for additional energy infrastructure that provides a path to growing distributions over time. The emergence of unconventional gas production created a structural shift that required the construction of new pipelines, processing plants, natural gas liquids fractionation capacity, and storage facilities. MLPs continue to invest in new projects to meet natural gas and natural gas liquids infrastructure needs, but most recently oil has moved into the forefront. The explosion of unconventional oil production has created a tremendous demand for new pipelines, rail terminals, and storage facilities. Morningstar estimates that 5-6 million barrels a day of new pipeline capacity will need to be constructed over the next five years, supporting strong capital spending among MLPs. The MLP growth story will continue into the foreseeable future, driven largely by changing infrastructure requirements as domestic oil and gas production shift continues to towards resource plays.

3 MLP Structure The MLP structure was created by Congress in 1986 to encourage investment in natural resources. As partnerships, MLPs are pass-through entities that allocate income, losses, gains, and deductions to limited partners. This also means that MLPs do not pay a corporate income tax, so investors avoid the double taxation inherent in corporations. The downside to the publicly traded partnership structure for investors is the relative tax complexities of investing in a partnership compared to a corporation. Most master limited partnerships have two types of partners. The general partner, which tends to be controlled by management, owned by financial interests, or owned by a parent company, manages the operations of the partnership and makes virtually all decisions relating to the partnership and its assets. The general partner typically holds a 2% stake in the partnership and may also own a considerable portion of limited partner units. Limited partners share in the income and losses of the partnership and are eligible to receive quarterly cash distributions in exchange for their investment in the partnership. However, limited partners have little say in how the partnership is managed. To align general and limited partner interests, general partners typically hold incentive distribution rights, which allocate an increasing share of the total cash paid out as distributions to the general partner as certain threshold levels of limited partner distributions are reached. At the highest levels, called the high splits, general partners can receive up to 50% of every incremental dollar paid out as distributions. This means that partnerships in the high splits have to raise distributable cash flow per limited partner unit by $0.02 a unit in order to increase the distribution by a penny. Because of this math, incentive distributions can act as a drag on distribution growth rates. To counter this, several MLPs have announced or completed transactions to eliminate or roll back incentive distributions. This is a favorable trend that is likely to continue. Another implication of MLP distribution policies that is important to understand is the impact of high distribution payouts on MLPs capital spending. Unlike corporations, which can use retained earnings and excess cash for growth purposes, MLPs retain very little of the cash generated each quarter, requiring MLPs to go hat in hand to the capital markets in order to raise cash for new investment. This forces a measure of capital discipline on management teams, as the market is unlikely to subscribe to debt and equity offerings for MLPs that fail to create value. It also means that MLPs virtually require capital market access to grow.

4 Why Invest in MLPs As of March 31, 2013, energy MLPs are yielding roughly 6%, and we think the average MLP can grow distributions at around 5% a year. This math alone, suggesting the prospect for double-digit returns, has attracted quite a bit of investor interest. But what we like to focus on is the business models and asset quality that allow MLPs to consistently invest in projects that generate returns in excess of their cost of capital. Moreover, we believe that new midstream infrastructure will be needed over the next decade and more to support the shift in crude oil and natural gas production from conventional to resource plays. On the refined products side, inflationindexed tariffs provide a cash flow hedge to prospects of future inflation and a path to revenue growth even if volume growth is absent. Lastly, we believe that integrated oil companies will continue to divest pipeline and storage assets, and in our minds MLPs are natural buyers. Moreover, MLPs can provide diversification to a portfolio. As Figure 2 illustrates, MLPs have shown little correlation with most other major asset classes. Figure 2. Correlation of MLPs to Other Asset Classes, July 2006 March 2013 Index Morningstar MLP Composite Morningstar MLP Focus Alerian MLP Morningstar US Market Morningstar Global ex-us Government Bond Morningstar Core Bond Morningstar Long Commodity to 0.61 Extreme Positive 0.60 to 0.21 Positive 0.20 to Moderate to Negative to Extreme Negative Finally, we think that MLPs as an asset class are just beginning to mature, similar to REITs in the 1990s. Investor appetite for income, new structured products, and increased institutional interest are bringing more attention to the sector, which we think will pave the way for continued outperformance of the broader market. Morningstar s Approach to Indexing MLPs Morningstar has developed two MLP-related indexes that offer a transparent and efficient way to gain exposure to MLPs. The Morningstar MLP Composite Index SM is a diversified, dividend-dollar weighted index that targets the top 97% of publicly trading energy master limited partnerships by market capitalization. Like other dividend indexes, the Morningstar indexes aim to maximize yield by using fundamental, dividend-based weighting system. Unlike other indexes, however, the Morningstar indexes take into consideration the principle of macroconsistency by using an available-dividend model that emphasizes company

5 size as well as dividend. Morningstar defines available dividends as: Dividend Per Share x Shares Outstanding x Float Factor For example, suppose Company A pays a dividend of $3 per share and has 4 million shares outstanding. The company is closely held with only half of its 4 million shares available for purchase in the market. Company A Available Dividend = $3 per share x 4 million shares x 0.5 = $6 million Company B, on the other hand, pays a dividend of only $2 per share, but it has 6 million shares outstanding, all of which are available for purchase. Company B Available Dividend = $2 per share x 6 million shares x 100% = $12 million Giving Company B twice the weight of Company A in the index, despite Company B s lower per share dividend, make the portfolio more scalable. The Morningstar MLP Focus Index SM is one of our Morningstar Dividend Indexes. The Morningstar MLP Focus Index is a subset of the Morningstar MLP Composite Index. Figure 3. Morningstar MLP Indexes Construction Process Morningstar US Market Index SM Total U.S. MLP Universe Morningstar MLP Composite Index SM Morningstar MLP Focus Index SM Begin with 97% of the U.S. Equity Universe Select MLPs listed on NYSE, NYSE AMEX, and NASDAQ Target the top 97% of publicly-trading energy MLPs by market cap The top 20 MLPs trading at the greatest discount to normalized fair value Our team of equity analysts covers 63% of publicly trading energy MLPs by market capitalization, generating detailed competitive and cash flow analysis that goes into determining the fair value of each partnership. Our independent research is focused on understanding each partnership s business model, its assets, and its growth strategies. In addition to a fair value estimate, our analysts determine each partnership s competitive advantage and business risk, reflected in our moat and uncertainty ratings. We use the moat and uncertainty ratings, along with our analyst s fair value estimates, to rank our MLP coverage by price to risk-adjusted fair value. We then equally weight the 20 MLPs trading at the greatest discount to fair value and rebalance quarterly. By focusing only on the highest-quality partnerships trading below their fair values, the Morningstar MLP Focus Index provides a significant opportunity for performance improvement versus a cap-weighted sector index.

6 Because it springs from the detailed bottom-up analysis performed by Morningstar s team of analysts, the Morningstar MLP Focus Index SM presents a unique proposition: bringing active management of MLPs to a passive index structure. The index provides exposure to a package of the least-overvalued MLPs. Figure 4. Risk Return Profile, January 01, 2006 March 31, 2013 Annualized Return % Standard deviation % Max Drawdown % Morningstar MLP Focus Morningstar MLP Composite Alerian MLP Infrastructure Alerian MLP Morningstar Gbl Ex US Govt Bond Morningstar US Market Morningstar Core Bond MCBI Morningstar Long-Only Commodity Sharpe Ratio As of March 31, 2013, the Morningstar MLP Focus Index has outperformed the Morningstar MLP Composite Index SM and other asset classes since inception. As one would expect with a focused strategy, however, this outperformance has come with slightly more risk than more diversified approaches and more dramatic swings in year-over-year returns, as Figures 4 and 5 illustrate. Figure 5. Historical Annual Return (%) YTD Morningstar MLP Focus Morningstar MLP Composite Alerian MLP Infrastructure Alerian MLP Morningstar Gbl Ex US Govt Bond Morningstar US Market Morningstar Core Bond MCBI Morningstar Long-Only Commodity Data as of March 31, 2013 Conclusion Offering generous income streams, MLPs will likely continue to intrigue yield-seeking investors and institutions especially in a low-yield environment. The Morningstar MLP Indexes provide transparent, rules-based, and innovative solutions to those seeking exposure to MLPs.