Simon Lack is managing partner at SL Advisors, a registered investment advisor and issuer of the American Energy Independence ETF (USAI), which tracks an index of U.S. and Canadian master limited partnerships (MLPs) involved in midstream energy infrastructure. The fund was launched last December and has almost $10 million in assets under management.
Lack says that, for various reasons, sentiment on MLPs has soured, prompting many MLPs to convert to corporations. He argues that a more balanced approach to the sector that combines investments in both MLPs and corporations is now needed. ETF.com spoke with Lack to discuss his views.
ETF.com: MLPs continue to struggle this year. Even with U.S. oil production at record highs and oil prices at four-year highs as recently as October, MLPs haven’t budged. Why do you think that is?
Simon Lack: There's been a lot of distribution cuts, and investors don't forget that.
It’s important to think about what the business model was and what it’s turned into. Before the shale revolution, these pipeline companies generated cash—but they didn't really need the cash to do anything, because America's pipeline network was fine as is—we pretty much consumed roughly the same quantities of energy from the same parts of the country year after year.
Thus, pipeline companies got in the habit of paying out 90% of their distributable cash flow, which is basically the cash flow that they generate after they pay all the maintenance costs on the pipelines they've got (it’s very analogous to funds from operations, which a real estate competition or a REIT would use).
That worked well for a long time, and MLPs attracted older, wealthy Americans who didn't mind the K-1 [tax form] and wanted the income.
The shale revolution completely changed the model, because now these MLPs suddenly had new projects. But because they were paying out all of their cash flow, how were they supposed to pay for the new pipelines?
They tried doing bigger secondary offerings and they tried taking up their leverage. But neither one of those really worked. The fundamental problem was that the investor base for MLPs is very narrow. It is older, wealthy, taxable Americans.
In contrast, stocks are owned by institutions in America—CalPERS, pension funds, sovereign wealth funds. None of these can own MLPs without a lot of big tax impediments.
MLPs found their investor base, and then they changed the deal.
Kinder Morgan really exemplifies what happened. The company had a slide in their deck, "promises made, promises kept." Every year, they paid a bigger distribution.
But then they had this huge growth backlog, and eventually found they couldn't fund it with more debt; they had to convert from being an MLP. They cut the distribution.
Countless investors are still extremely bitter because they signed up for these stable distributions and then they got cut—they didn't get cut because business went down; that's one of the big misnomers of the sector. The credit performance was fine; it's just that they wanted to pay for growth.
A lot of the biggest MLPs have converted to corporations because they've concluded that these older, wealthy Americans are too narrow of an investor base; they need to be able to attract capital from the whole world, just like any other corporation.
Dividends are going up and earnings are good, but the core MLP investors are still not rushing back.
If you look at the biggest MLP ETF, the Alerian MLP ETF (AMLP), distributions are down 30%. The reason for that is these funds are using the cash to pay for growth.
ETF.com: Given that investors are shunning MLPs, is there value in the sector?
Lack: The values are there and the yields are attractive. The yield on the 10-year Treasury bond is over 3% and the yield on the Alerian MLP Index is a little over 8%. You've got a 500 basis point [5%] spread; historically, that's very wide.
But it's been there for three years, give or take. If something is cheap for three years, you need to go back and ask yourself why.
There have been a lot of decisions made by management teams that weren't fair to that initial investor base.
ETF.com: In the ETF world, some energy infrastructure funds are structured as C-corps and hold exclusively MLPs, while others are structured as ’40 Act funds that can only hold 25% of their portfolio in MLPs. With more firms converting from MLPs to corporations, are the ’40 Act funds starting to look more appealing?
Lack: It’s true that a lot of the biggest MLPs are becoming corporations, so now the MLP-dedicated funds aren’t invested in Kinder Morgan (KMI), ONEOK (OKE), Targa Resources (TRGP), Trans-Canada (TRP), Enbridge (ENB), Tallgrass (TGE), and a lot of the biggest corporations in the industry.
Before, if you wanted to invest in pipelines, you had to own MLPs and didn’t really have any choice. But now, if you invest in those MLP-dedicated funds, you’re actually missing a lot of the bigger companies because they've left the MLP model behind.
ETF.com: What factors do you see driving energy infrastructure companies going forward? Is it U.S. oil production, oil prices or just the sentiment of the investor base?
Lack: Clearly, sentiment is a big overhang. It’s very hard to figure when that could change. Certainly, we have the fundamentals to allow that to happen.
Although crude oil tends to drive sentiment, natural gas is a much bigger driver of returns than crude oil. We just move a lot more natural gas and it generates more cash flow.
There’s also a clearer growth path for natural gas. As we move towards electric vehicles, we're going to be using more electricity, and in the U.S., natural gas is the biggest source of electricity.