SAM’s Infrastructure Income and Energy Transition Strategies’ focus is on the midstream energy subsector. It is our preferred way to invest in energy given its modest exposure to fluctuations in commodity prices, stable and growing cash flows, strong balance sheets and relatively high dividend yield approximating 6.0% (based on the Alerian Midstream Energy Index).
FAMILY OFFICES SHOULD CONSIDER MASTER LIMITED PARTNERSHIPS (MLPs)
It’s time again to focus on MLPs for income-oriented investors given their favorable yield, mid-single digit growth potential, and favorable tax treatment. Family offices should find the latter very appealing. MLPs represent a meaningful weighting in SAM’s Infrastructure Income Strategy. We favor Energy Transfer LP (ET-NYSE), Enterprise Products Partners L.P. (EPD-NYSE) and MPLX LP (MPLX-NYSE), which collectively accounted for approximately 22% of the portfolio as of 2023 year-end.
There are a lot of reasons that family offices (especially those managing wealth across generations) should find MLPs particularly appealing:
HIGH CURRENT INCOME MLPs offer an attractive and competitive yield of ~ 7.0% relative to other income-oriented investments. This cash payment is well covered by cash flow and likely to grow over time, in our view.
MLP Yield Relative to Other Income-Oriented Investments
Source: FactSet, Bloomberg and Wells Fargo Securities, LLC Midstream Monthly Outlook: February 2024 report published on 2/5/24
(1) High yield index performance based on FINRA - BLP Active High Yield US Corporate Bond Index. (2) Investment grade performance index based on FINRA - BLP Active IG US Corporate Bond Index. (3) Municipal bond index performance based on the S&P National AMT-Free Municipal Bond Index. (4) U.S. 10-year Treasury performance based on S&P 7–10-year U.S. Treasury Bond Index.
GROWTH POTENTIAL AND HEDGE AGAINST INFLATION
MLPs, as well as midstream companies, should be able to generate mid-single digit cash flow growth supported by inflation escalators built into customer contracts and modest infrastructure investment opportunities.
FAVORABLE TAX TREATMENT
MLPs are structured as pass through entities. As such, the income generated is “passed through” to its unitholders, so corporate taxation at the entity level is avoided.
MOST OF THE INCOME GENERATED IS SHELTERED BY DEPRECIATION
Midstream companies and MLPs operate in capital intensive industries. Relatively high depreciation expense can offset taxable income for several years.
DISTRIBUTIONS PAID BY MLPS ARE SUBSTANTIALLY TAX-DEFERRED
MLP distributions are treated as return of capital and not income. According to Wells Fargo Securities research, approximately 75% to 80% of these distributions are tax deferred. Taxes come due upon the sale of the units.
EFFECTIVE ESTATE PLANNING TOOL
The transfer of MLP units to beneficiaries upon death does not trigger a taxable event. The cost basis of the MLP units steps up to the market value as of the date of death.
CONSOLIDATION TREND LIKELY TO CONTINUE – SCARCITY VALUE
The energy sector is undergoing a wave of consolidation in both the upstream and midstream. In our view, this is being driven by an emphasis on enhancing efficiencies of operations, moderating opportunities for growth in a mature industry, private equity investors needing to monetize their investments, and management teams’ focus on generating attractive returns on capital. We believe there is a scarcity value, given the current small number of publicly traded MLPs (i.e., 16).
OPPORTUNITY TO PARTICIPATE IN ENERGY INFRASTRUCTURE
Midstream companies own critical infrastructure to facilitate the delivery of energy. These long-lived assets are not easily replicated/replaceable. The terminal values are still meaningful given the likely co-existence of and need for both traditional and clean energy for many years to come, in our view.
ATTRACTIVE VALUATIONS
Yield plus growth potential for MLPs and midstream equate to total return propositions of more than 12% and 10%, respectively, according to Wells Fargo research. Additionally, MLPs screen very attractive based on their free cash flow yield that approximates 10% versus just 3.5% for the S&P 500. Free cash flow yield is a good indicator of potential cash return to shareholders.
Midstream Companies Provide a Double-Digit Total Return Potential
Source: FactSet and Wells Fargo Securities, LLC estimates
(1) MLP data is based on CQP, ET, EPD, MPLX, NS, and PAA. C-Corp data is based on ENB-CA, KMI, LNG, PPL-CA, TRGP, TRP-CA, and WMB. (2) Dividend growth and buybacks are based on our 2024E
MLPS HAVE ADOPTED A NEW AND IMPROVED BUSINESS MODEL
Over the last decade, energy companies broadly have altered their business models to focus on returns on capital rather than growth and have eschewed relying on external capital. Instead, they are financing growth with internally generated funds, paying down debt and returning excess cash flow to their shareholders. Indeed, MLPs have adopted this playbook and their balance sheets have never been stronger.
The number of midstream (read energy infrastructure) companies structured as publicly traded partnerships has dramatically shrunk from a peak of 63 in 2014 to just 16 today. The rapid rise of MLPs from 1994 to 2014 can be attributed to MLPs’ lower cost of capital relative to corporate structures. MLPs as partnerships (pass through entities) do not pay corporate taxes. MLPs were designed to distribute their cash flow after maintenance capital expenditures to their unitholders. The premise was that growth capital expenditures could be financed by raising external capital (debt and equity). It worked well for two decades as the returns MLPs earned on their invested capital exceeded the cost of that cheap external capital—until it didn’t!
It all changed with the collapse of oil prices in 2014 and fears that MLPs’ E&P customers would go bankrupt (only a handful did). The timing for an oil price collapse was unfortunate as MLPs were in the middle of an unprecedented infrastructure building cycle to support the shale boom and rapid expansion in oil and natural gas production. The sources of external financing ground to a halt and many MLPs had no choice but to cut their distributions (dividends). MLPs no longer enjoyed a cost of capital advantage and their business model broke. As previously noted, MLPs have significantly improved their financial positions and shifted their focus to returns on capital.
Number of MLPs That Have Decreased Over Time
Source: Wells Fargo Securities, LLC Midstream Energy Equity Research Team
THE UNDERAPPRECIATED ROLE OF NATURAL GAS IN THE QUEST FOR DECARBONIZATION
Earlier this month, we attended Williams Companies, Inc.’s (WMB-NYSE) Clean Energy Expo and Analyst Day meetings. The primary takeaway from these meetings was clear: natural gas must be a permanent part of the energy mix because it’s affordable, reliable, and clean.
Alan Armstrong, WMB’s President and CEO, pointed out that the U.S. was the only country to realize its targeted emissions reduction commitment under the 2015 Paris Agreement. U.S. emissions declined by 19% from its 2005 levels and surpassed its target of 17%. This was primarily due to the displacement of coal by natural gas and renewables. Specifically, the shift to natural gas was directly responsible for reducing ~500 MM metric tons of CO2 or ~60% of the total reduction when comparing 2022 to 2005 levels. The diagram below shows the significant increase in the market share of natural gas in the U.S. electric power market and the resulting decline in U.S. CO2 emissions.
U.S. Electric Power Sector: CO2 Emissions vs. Natural Gas Market Share
Sources: The Williams Companies, Inc. 2024 Analyst Day Presentation, U.S. Energy Information Administration (EIA), January 2024; Environmental Protection Agency (EPA) Greenhouse Gas Equivalencies Calculator.
ADDITIONAL POINTS TO HIGHLIGHT:
Rapid growth in power demand will require more natural gas. Electricity demand is forecast to grow three times faster this decade because of the growth in electric vehicles and emergence of large load data centers. Natural gas will be required to provide backup power when renewables (solar and wind) are unavailable.
Coal consumption has reached record levels globally in each of the past two years. U.S. is the world’s leading exporter of LNG (liquefied natural gas) and can help other countries to replace coal with natural gas.
Williams is investing in clean energy solutions. The company has created a New Energy Ventures Group, allocated capital for venture financing, partnering in two of the hydrogen hubs selected for fundraising by the Department of Energy, and developing carbon capture projects in the Haynesville and Wyoming to name just a few initiatives.
Williams is reducing emissions (as are many other traditional energy companies). Management has set a 30% intensity-based carbon reduction target from 2018 levels by 2028. Williams highlighted its 10.1% reduction in total 2023 methane emissions from a three-year average. The company noted that it has earmarked up to $1.3B in capital spending through 2030 to reduce emissions and cost through modernization of its transmission assets. By replacing compressor units, Williams has reduced compressor methane emissions by approximately 27% through year-end 2024 (vs. target of 50% upon program completion) and transmission NOx emissions by approximately 46% (vs. target of more than 75%).
LNG PERMITTING PAUSE: AN ELECTION YEAR POLITICAL MANEUVER
On January 26th, in what many observers have observed as an election year political maneuver, the Biden administration announced a temporary pause on approving new LNG exports to non-free trade agreements (FTA) countries. The purported rationale is to allow the Department of Energy (DOE) to update its analysis and reassess the economic, environmental and energy security impact of granting additional exports.
The pause should have no impact on the growth in U.S. exports for the intermediate term as permitted projects are completed. Indeed, U.S. LNG exports are expected to nearly double by the end of the decade. S&P Global Commodity Insights forecasts LNG feed gas demand to rise to almost 25 Bcf/d from about 13 Bcf/d currently based on projects already approved. For perspective, the U.S. is the world’s leading producer of natural gas, producing about 105 Bcf/d, and is the largest exporter of LNG.
The timing for the pause is suspect, given natural gas prices hovering near three-year lows and against the backdrop of an election year. One could surmise that the President may be kowtowing to his liberal base. We would like to think that the DOE can conduct an analysis without having to pause approvals as was the case in prior analyses.
We believe that the pause will be lifted soon after the November election. Why? Because it’s bad policy and some Democrats already recognize it as such.
WHAT LNG HAS GOING FOR IT:
Strong global demand. Global demand for LNG is expected to grow by more than 50% between 2024 and 2040, according to Shell’s 2024 LNG Outlook.
U.S. LNG is needed to replace Russian natural gas. Following the Russian invasion of Ukraine in February 2021, the U.S. stepped up its exports to Europe to replace Russian exports that accounted for about 40% of its gas supplies.
Energy security is national security. Our allies rely on U.S. natural gas. Russia has tried to weaponize energy by withholding natural gas supplies. If the U.S. is not a reliable partner, its credibility will be damaged, and nations will look elsewhere. Biden promised to supply LNG to our European allies to meet their energy needs. U.S. exports to the European Union surged to 45.6 million metric tons in 2023, up from 15.8 million metric tons in 2021. The European Union accounts for ~65% of U.S. imports.
Decarbonization. The U.S. produces the least carbon intensive natural gas in the world as its energy industry embraces electrification across the energy value chain. LNG is critical to achieve lower emissions globally. The U.S. is the world’s leader of exporting clean energy (read, LNG).
U.S. has substantial natural gas reserves. The U.S. has enough dry natural gas to last more than 85 years, according to the EIA (i.e., 2,973 Tcf of technically recoverable resources of dry natural gas vs. annual rate of U.S. dry natural gas production of about 34.5 Tcf in 2021).
Good for the economy. LNG exports have a positive impact on the U.S. economy. It supports the creation of jobs and growth in GDP.
Annual North American LNG Export Capacity by Project (2016-2027)
Source: U.S. Energy Information Administration, Liquefaction Capacity File, and trade press
Note: LNG=liquefied natural gas. Export capacity shown is project's baseload capacity. Online dates of LNG export projects under construction are estimates based on trade press.
There has been significant pushback to the Biden pause. The House of Representatives passed a bill to transfer export jurisdiction from the Department of Energy to the Federal Energy Regulatory Commission (FERC) that approves sites for LNG facilities. The legislation needs to be passed in the Democratic-controlled Senate and signed by Biden to become law. Both are unlikely.
There is, however, bipartisan support for permitting legislation that would be beneficial to both clean and traditional energy projects. Senate Energy and Natural Resources Chair, Joe Manchin, (D-W.Va.) plans on introducing a provision within a permitting bill to extend free trade agreements to our NATO allies. Currently, only 20 nations have free trade agreements with the U.S. and Canada is the only NATO member that enjoys that privilege. NATO has 31 members. If energy security is indeed national security, then NATO members should have unencumbered access to US LNG, in our opinion. Unfortunately, the chances that either bill gets to the finish line before the November election is highly unlikely.
JANUARY REVIEW: MARKET CONTINUED GAINS INTO JANUARY DESPITE LIKELY DELAY IN FED RATE CUTS
The rundown:
SAM’s Infrastructure Income Portfolio produced a return (net of fees) of -1.8% compared to 1.7% for the S&P 500 and -2.6% for its customized benchmark as of 1/31/24.
SAM’s Energy Transition Portfolio generated a return (net of fees) of -5.0% versus -5.8% for its customized benchmark as of 1/31/24.
Midstream remained essentially flat in January with a total return of 0.2%, as measured by the Alerian Midstream Energy Index (AMNAX).
Utilities posted losses and the clean energy sector underperformed, generating a total return of -2.9% and -10.9%, as measured by the Philadelphia Stock Exchange Utility Index (XUTY) and the S&P Global Clean Energy Index (SPGTCLTR), respectively.
In January, 5 out of 11 sectors in the S&P 500 reported a positive performance with Communication Services as the best performer and Real Estate as the worst. Energy was essentially flat with a -0.04% monthly total return. Energy performance was negatively impacted by lackluster commodity prices. January month-end WTI crude oil and Henry Hub natural gas prices were solidly below the ~$80 per Bbl ($76.28) and ~$3.00 per MMBtu ($2.19) levels, respectively, which was up ~6% and down ~15% from last month.
2024 Year-To-Date Total Return
Source: Bloomberg, NASDAQ and S&P Global
RESULTS: SINCE INCEPTION & ONE YEAR (2023)
SAM’s Infrastructure Income Portfolio produced a return (net of fees) of 60.5% and 1.4% for the periods since 11/10/20 inception and 1-year, respectively. This compares to a total return of 59.1% and -2.8%, respectively, for its customized benchmark and 43.7% and 20.8%, respectively, for the S&P 500 as of 1/31/24.
SAM’s Energy Transition Portfolio generated a return (net of fees) of -4.2% and -17.2% for the periods since 4/29/21 inception and 1-year, respectively. This compares to a total return of -2.3% and -14.0%, respectively, for its customized benchmark and 20.1% and 20.8%, respectively, for the S&P 500 as of 1/31/24.
Sam Partners’ Infrastructure Income and Energy Transition Strategies seek to provide sustainable income and growth with capital preservation. This is accomplished by investing in a concentrated portfolio of high-quality midstream energy companies, utilities and clean energy companies that are well positioned to participate in the energy transition to a net zero carbon future. A diversified approach to investments across these sectors should optimize risk-adjusted returns, in our view. Our Infrastructure Income Strategy offers investors a current yield of ~5% and growth potential of ~5-7%; while the Energy Transition Strategy that is more heavily weighted with clean energy stocks and aligns with favorable ESG ratings, offers investors a current yield of greater than 4%. In a world searching for yield, we believe these Strategies offer a compelling value proposition.
IMPORTANT DISCLOSURES
Siegel Asset Management Partners is a registered investment adviser located in Plainview, New York. The views expressed are those of Siegel Asset Management Partners and are not intended as investment advice or recommendation. This material is presented solely for informational purposes, and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness, or reliability. All information is current as of the date of this material and is subject to change without notice. Third-party economic, market or security estimates or forecasts discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates or forecasts. Certain products and services may not be available in all jurisdictions or to all client types. Unless otherwise indicated, Siegel Asset Management Partners' returns reflect reinvestment of dividends and distributions. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
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