MLPs (as well as other midstream companies structured as C-Corps), own, maintain and operate most of the energy infrastructure in North America. As oil prices declined sharply between late 2014 and early 2016, MLP and midstream equity prices also fell meaningfully. Despite a recent recovery in oil prices, the midstream energy sector has continued to fall. Importantly, from our perspective, midstream energy companies should be less sensitive to changes in commodity prices as revenues are generally tied directly to commodity volumes as opposed to commodity prices. Immediately after oil prices fell in 2015, we suggested that investors make an allocation to midstream energy debt as yields for both investment grade and below investment grade bonds had risen significantly. During 2016, the midstream energy high yield index returned 27.3% while the midstream energy BBB long duration index returned 34.1%, both of which outpaced returns for traditional high yield (+17.1% in 2016). Currently, we feel that midstream equity is a far more attractive opportunity as credit spreads on midstream debt have largely returned to long-term normal levels. The balance of this paper will provide an overview of the midstream energy space, present the case for making a near-term allocation, discuss potential risks and, finally, cover the potential implementation options for different investor types.
Investors have historically used the term "MLPs" to describe opportunities in the energy sector. From our perspective MLPs are a legal structure that represent a subset of the midstream energy opportunity set. More recently, there have been a number of companies moving from the MLP legal structure to more traditional C-Corps. Part of the rationale for companies to shift to C-Corps (and away from MLPs) is to eliminate incentive distribution rights ("IDR") which entitle the General Partner to a higher proportion of an MLP's quarterly distribution. From our perspective, removing the IDR mechanism and the need to pay an ever-greater share of distributions to general partners better aligns the interests of all shareholders and gives companies more flexibility in how they allocate capital.
There are several other reasons why we find the C-Corp structure attractive. Namely, the legal structure is simpler and may encourage more institutional capital to invest in the asset class given that investors do not need to deal with various tax consequences, some of which we outline later in this paper. Further, C-Corps are available for inclusion in traditional indexes (such as the S&P 500 or Russell 3000) whereas MLPs have historically been excluded from these popular indexes. Inclusion in broader equity indexes may lead to a more stable profile for midstream companies over time. We are not suggesting that the MLP structure will go away entirely or that investors should ignore this segment of the market. However, we suggest that investors consider the broadest opportunity set when investing in midstream energy, including MLPs and C-Corps.
As mentioned above, midstream energy companies are involved in the transportation, storage and processing of crude oil and natural gas. Midstream MLPs and C-Corps also own real assets such as pipelines, gathering and processing facilities, and storage facilities. Such assets tend to produce relatively strong, predictable cash flows, and have more stable earnings and higher barriers to entry than upstream-related energy MLPs or C-Corps. There is also less commodity price risk in the midstream sector as most of these companies tend to rely on commodity volume-based fees to generate revenue.
While energy spot prices remain well below highs experienced a few years ago, demand and production for crude oil, natural gas and related products continues to increase (see Figure 1). In the event that demand softens, midstream energy companies have a partial safeguard against falling demand. Some midstream contracts with oil and gas producers are structured as "take-or-pay" contracts with minimum volume commitments, meaning that the midstream companies collect a baseline level of income even if producers slow or stop production. A resilience in cash flows, high debt service coverage ratios and high asset coverage ratios relative to stressed liquidation values are just a few of the key fundamental features which we believe are attractive for midstream companies. Below are additional fundamental observations which we find compelling.
Beyond the attractive fundamentals we outlined, we believe valuations for midstream equities are attractive. To start, the yield on MLPs is far superior to the yield on traditional public equities as well as many fixed income asset classes (see Figure 2). As of April 9, 2018, the Alerian MLP Index (a common proxy for the MLP asset class) was yielding 8.3%. This is well above the dividend yield for the S&P 500 (1.9%) as well as the yield on U.S. Treasuries (2.8%) and broad U.S. investment grade corporate bonds (3.8%). Even the yield on below investment grade bonds (6.2%) is below that of MLP yields. Additional valuation metrics, such as EV/EBITDA and spreads to other asset classes (such as U.S. Treasuries), also suggest that MLPs are attractive. For example, at the start of 2018, EV/EBITDA for the broad MLP asset class was 11.0x. This compares favorably to both the trailing 5-year average of 13.7x and the trailing 10-year average of 12.8x, both of which included periods of weakness for the energy sector as oil prices fell sharply in 2008-2009 and 2014-2016. Further, at the start of the year, EV/EBITDA was trading at a discount to the S&P 500 for the first time since the financial crisis in 2008.
From an earnings perspective, MLP earnings per share have recovered to the levels seen prior to the decline in oil prices which began in 2014. In the most recently completed quarter where earnings are available (4Q 2017), MLPs achieved medium EBITDA growth of 12.3% year-over-year. Strong earnings in 2017 allowed midstream MLPs to increase distributions 6.1% year-over-year, leading to the aforementioned 8.3% yield on the Alerian Index.
While we have presented what we believe to be a compelling case for midstream energy, we also acknowledge that there are certain risks investors should understand before making an investment. The following is a list of the primary risks that we believe exist in the midstream energy space.
While midstream equities present a compelling case for investment, there are challenges associated with owning the asset class. Notably, the tax treatment for MLPs can be complex. Direct investors will generally receive a K-1 instead of a 1099 (although some vehicle structures, such as mutual funds, will provide investors with a 1099). Further, investors may have state tax filing requirements in the states in which the MLPs do business or owns assets. Practically speaking, many individual investors are not burdened by these requirements because the income allocated among the states will be relatively small and is often below state filing thresholds. Tax-exempt entities (such as pensions and endowments) will typically incur UBTI. This will necessitate the need to file tax returns and generate a tax liability if the UBTI exceeds $1,000 per year.
Perhaps most importantly, there are limitations to mutual funds, closed end funds, exchange traded funds ("ETFs") or other regulated investment companies ("RICs"). Since the passage of the American Jobs Creation Act of 2004, mutual funds (and RICs) are permitted to own MLPs, but MLPs in aggregate cannot exceed 25% of the fund's assets nor can the fund own more than 10% of any one MLP security. Some funds that are sold as "MLP mutual funds" (or ETFs) have complied with this rule by purchasing the 25% maximum alongside midstream C-Corps, energy equities or other similar allowable securities.
Our preference is for taxable investors to own midstream equities through long-only private LP funds, as these funds offer "pure" MLP exposure (and thus higher yields), a single consolidated K-1 (which preserves the tax benefits of the sector and reduces complexity), and the lowest overall fee drag. For tax-exempt investors, we believe that vehicles structured as variable annuities by insurance companies have the potential to be an effective way of gaining exposure to MLPs while blocking UBTI with an acceptable degree of counterparty risk. There are also emerging strategies that only invest in C-Corps in the midstream space which could offer a UBTI-free option to tax-exempt entities.
From our perspective, both valuations and fundamentals are compelling for midstream energy equities. As many other asset classes, including U.S. equities, have significantly elevated valuations, we find midstream equities to be one of the few attractive asset classes at this time. Total-return oriented investors who can withstand significant volatility may want to consider investments in midstream energy equity. We would recommend that investors who are inclined to add to positions in the midstream equity space do so over time. Investors should also be mindful of sizing this type of investment appropriately. An allocation of 3-5% at the total portfolio level is generally appropriate for many investors with the understanding that individual investor situations and risk tolerances can vary greatly.