us energy infrastructure (mlps) 2014...

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© 2014 PARKER GLOBAL STRATEGIES, LLC

February 2014

MLPs: 2014 Encore Opportunities Following a Strong 2013

Overview

MLPs delivered a banner year in 2013 with the Alerian Index up 27.6%. How will we provide an appropri-

ate encore for 2014? There was important MLP price dispersion in 2013, with 80 out of 90 energy MLPs

up for the year. Individual MLP performance ranged from a high of +117.4% to a low of -35.6% for those

energy MLPs listed for the entire year. As the US energy revolution continues to transform the transpor-

tation and storage needs for the energy market, the MLP landscape has become a story of the “haves”,

the “have nots” and the true turnarounds.

The US energy revolution continues in full force. The traditional economics of supply and demand are

continuing to drive price changes for crude oil, natural gas and natural gas liquids (NGLs) that are forcing

the evolution of the gathering, processing, transportation and storage business for these commodities

and their by-products. 2012 saw significant change in the needs of the US energy network; 2013 saw the

emergence of the export markets’ growth. 2014 will likely see the US energy revolution’s impact on

parts of the global energy markets. The US annual capital expenditures are 14 times greater than Russia

and 28 times greater than Saudi Arabia. Last year we wrote that “the energy revolution is revitalizing

and reshaping manufacturing in the US, especially the chemical and steel industries. Electric utilities are

quickly migrating from coal to natural gas as the cheaper and cleaner fuel.” This trend will continue

through 2014. A big topic in Davos this year was the large differential in energy prices between the US

and Europe. In fact, now some European companies are considering moving their manufacturing to the

US where the cost of energy is a mere fraction compared to Europe. US energy products are so cheap

and in such abundance that we are watching as billions of dollars are committed towards the building of

export infrastructure. The EIA predicts that the US will be energy independent by 2016. MLPs are in the

sweet spot, reconfiguring and growing their transportation networks in the fastest growing energy mar-

ket in the world, responding to their customers’ needs for solutions. MLPs enjoy visible earnings stability

through long-term contracts, growing demand for their services and expertise, and an infrastructure

landscape requiring years of additional development. We believe one of the most important themes for

the next five years will be hydrocarbon exports, as producers seek new markets and higher prices while

the world market seeks lower prices from the US.

Although US interest rates have begun to rise, the prospect for MLPs are still strong. Historically, MLPs

have outperformed other yield strategies and often the broader equity market during periods of rising

US rates. MLPs offer the benefit of growing distributions, an inflation hedge and participation in the US

energy revolution.

US ENERGY INFRASTRUCTURE (MLPs)

2014 Outlook

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2014 Will Be A Stock Picker’s Market

Price dispersion among MLPs defines a stock picker’s market. Our portfolio approach applies a top-

down analysis identifying the most important themes and a fundamental bottom-up process for se-

lecting the best positioned MLPs. 2014 will require our getting both the themes and our names correct.

We believe that the important themes for this year are:

Above average, sustainable distribution growth via a strong pipeline of dropdowns from a

sponsor or visible organic growth

This has been an important theme for the past 3 years. MLPs with strong corporate sponsors

having a portfolio of MLP eligible assets to dropdown to their MLPs have been a win/win/

win strategy for the MLP, the sponsor and the investor. We expect this trend to continue in

2014. We continue to favor MLPs with exposure to crude oil and refined product logistics.

General Partners

As they say in the industry, if one likes the MLP, one should love the GP. GPs have a levered

exposure to the earnings of the MLP. GPs do not generally issue equity, as their capital needs

are usually minimal, and a GP’s distribution tend to grow at multiples of the underlying

MLP’s distribution growth. Of course, the attractiveness of the GP is driven by the attractive-

ness of its underlying MLP/s.

Turnarounds with an above average, safe distribution

There are several MLP management teams that have done a masterful job transforming

their MLP footprint over the past several years. A few continue to have high yields and are

starting to grow distributions again. With these MLPs, we anticipate strong capital apprecia-

tion along with an attractive yield. Eventually, these MLPs’ spreads will come in line with their

lower yielding peers.

MLPs with minimal commodity risk and in the lower GP splits

Commodity prices may be volatile in 2014. There has been a trend in recent years for the

gathering & processing (G&P) MLPs to move closer to an all fee business. Some G&P MLPs

have price risk exposure to NGLs. Ethane prices collapsed in 2012, when propane and butane

prices also weakened. Propane and butane prices have seen strong recovery as the export

market grew and demand picked up in 2013. Some MLPs have faced ethane rejection in

2013 and will likely see this continue in 2014. Experts expect the ethane market to come

back into balance in 2016 to 2017, as petrochem projuects come online and demand increas-

es. Most analysts forecast a modest drop in WTI by year-end. If there is a significant drop in

the price of crude oil, some MLPs may have less favorable terms for contract renewals. Oth-

ers may be in a strong position to capitalize on basis and quality differentials that emerge

across various parts of the US. With the continued low volatility and price of natural gas,

MLPs exposed mostly to natural gas transportation and storage may also have less favorable

contract renewals.

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US Energy Outlook 2014

The EIA’s annual outlook for 2014 shows that the recent growth of crude oil and natural gas production is

expected to continue for many years. By 2016, crude oil production is expected to equal the high set in

1970 of 9.6 million barrels per day. The EIA projects that crude oil production will level off by 2020, but

natural gas production will grow steadily with a 56% increase from 2012 to 2040. Other key findings from

the report include:

Low natural gas prices boost nat-

ural gas intensive industries in

the US

Natural gas overtakes coal as the

largest fuel for US electricity gen-

eration

Higher natural gas production

supports increased exports of

pipeline and LNG

Car and light truck fuel use de-

clines sharply

The EIA projects declines in U.S. oil and natural gas imports as a result of increasing domestic production

from tight oil and shale plays. U.S. liquid fuels net imports as a share of consumption is projected to de-

cline from a high of 60% in 2005, about 40% in 2012, to about 25% by 2016. The U.S. is projected to be-

come a net exporter of natural gas by 2018 when sufficient LNG export facilities come online to accommo-

date flows.

Exploration & Production

E&P MLPs underperformed midstream MLPs in 2013. We believe they are poised for potential

outperformance this year. E&P MLPs are 50% less volatile than their C-Corp counterparts. E&P

MLPs tend to hedge 70%+ of their commodity exposure. The average yield is 9.4%; these MLPs

have a different business model than midstream MLPs, thus providing diversification and high

yield. Following a year of underperformance, the E&P MLPs often outperform. There is an

abundance of more mature producing assets at attractive prices for E&P MLPs to acquire, be-

cause C-corps would rather redeploy capital into the drillbit exploring emerging shale plays like

the Spraberry/Wolfcamp.

MLPs with strong business and low correlation to the traditional midstream MLPs

Over the past few years we have found some interesting, opportunistic MLPs that have strong

stories and a low correlation, (for various reasons) to other MLP names. Last year there were a

number of MLP IPOs for nontraditional MLPs. We look at this group as a source of income,

growth and diversification. The number of opportunities is growing, so we look at this sector

with keen interest.

Increased Tight Oil production, vehicle efficiency reduce petroleum and liquid imports

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Natural Gas and Natural Gas Liquids (NGLs)

There is a significant low cost supply of natural gas and NGLs in the US. Prices for natural gas should be

higher during 2014 as inventories have fallen and the winter has been unusually cold across much of

the country. On January 24, natural gas hit $5 for the first time since 2011. The continued growth of

the export market will be key to getting the US back into balance. The increase in natural gas demand

will likely match supply growth over the next decade. Today, there is a preference for producing wet

gas (natural gas with NGLs), because it is more valuable than dry gas, despite the low price of the NGL

barrel, especially ethane. The Marcellus has become the lowest cost supplier and fastest growing gas

production region in the US. US imports of natural gas continue to fall, as we replace imports with the

US’s own abundant source. The chart on the following page shows the regional breakeven level for nat-

ural gas prices. Natural gas production is profitable for most producers when the price is between $4

and $5. The Marcellus has a clear advantage driving its infrastructure build out to accommodate flows

in all four directions. The area accounted for 18% of US natural gas production in December 2013. The

Marcellus has proven to be ideally located as a natural gas/NGL hub, driving much of the profitability

for MLPs with strategic assets in the region. Names that we particularly like are EQM, MWE and WPZ.

We believe that nat gas transportation and storage traditional MLPs are one of the less attractive op-

portunities for 2014. The NGL exposed MLPs are more interesting. Since January 17, 2014, the NGL bar-

rel has recovered about 15% YoY with propane up 70.6%, ethane up 35.4%, butane down 5.5%, isobu-

tane down 11.4% and natural gasoline down 2.6%. Significant nat gas and NGL infrastructure should

come online during the first half of 2014 including over 5 bcf/d of processing capacity, numerous frac-

tionators and NGL pipelines. NGL extraction is expected to increase by over 600 thousand b/d by 2015.

Propane was the big winner in 2013.

Pennsylvania is the fastest growing natural gas-producing state

Marketed natural gas in the top 10 producing states (2011-12)

Ranking 2011-12

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and is spiking in January 2014 as demand explodes. The propane market recovery was due to exports. Pro-

pane exports are forecast to grow at a 5 year CAGR of 13%. EPD, NGLS, SXL and OILT are well positioned

for the propane export market. The large growth of NGL supplies coming online will continue to put pres-

sure on ethane prices, as the market will not likely come back into balance until petrochemical crackers

come online. Petrochem demand and ethane exports should see 5 year CAGR of 9% and 24%, respectively,

but ethane rejection is expected through 2018 to help balance the market. The export markets will be im-

portant for normal butane and natural gasoline as well, where the expected 5 year CARG is 29% and 15%,

respectively.

Breakeven Gas Prices

Source: Enterprise Products Partners, Barclays Research

Crude Oil and Refined Products

We forecast that WTI crude oil prices should remain in the range of $85 to $100 for 2014 despite the ro-

bust US production. As the chart on the following page shows, most oilfields breakeven with WTI in the $80

range. Eagle Ford production is expected to increase 27% in 2014. Barclays’ survey of producers in this re-

gion indicates that most are unlikely to curtail drilling activities until the wellhead prices have dropped be-

low $55-$60/bbl, or an implied WTI price of $50-$55. Much of the new US production is light sweet crude,

displacing light sweet imports. US refiners are optimized to use mostly heavy crude. A growing abundance

of US light sweet coupled with inadequate takeaway will likely widen regional and world price differentials,

creating opportunities for MLPs in the crude oil logistics sector. Crude oil and refined product pipelines

have a 4.6% tariff increase that was set in place for the 12 months beginning July 2013. We particularly like

PAA and TLLP. What if US crude oil prices drop to $50? E&P MLPs would be impacted, although most hedge

a significant portion of their reserves several years out. Transportation and storage MLPs would be impact-

ed when their contracts come up for renewal. Most contracts are for a minimum volume commitment at a

specific fee. Generally, a small portion of an MLP’s contracts come up for renewal each year. So the real

impact may be seen a few years out, if prices did not recover. Moving a few years out the timeline as crude

oil supply expands, the global markets may be helped on the demand side by growth from China and the

emerging markets. There are several MLPs that are refiners. These MLPs represent an interesting potential

hedge for a lower crude oil price, so long as the various oil spreads and crack spreads remain attractive.

The blue bars represent the breakeven price; the black horizontal lines indicate the amount of reserves not yet drilled.

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Breakeven Oil Prices

Source: Enterprise Product Partners, Barclays Research

The big talk in Washington now centers on the potential removal of the 1970s ban on exporting crude

oil. The President may make the change, if he believes it to be in the national interest. Otherwise, lift-

ing the ban will require an act of Congress. E&Ps are lobbying in favor of exports; refiners are against

the change, since would be impacted. Few believe that a lift of the ban will happen in 2014 or under

the current Administration. A potential compromise is to allow exports to “swap” light sweet exported

in return for heavy crude imported. A near term solution is to mix light sweet to “refine” it, and then

export, since there is no ban on exports of refined products. Global crude oil fundamentals are begin-

ning to shift. Non-OPEC supply is growing at its fastest rate in decades and is forecast to exceed de-

mand in 2014 for the first time since 2002. OPEC continues to struggle to meet its demand given the

issues in Nigeria, Libya, Iraq and Iran. When one or more of these countries returns to a more normal

level of production, we could see pressure on world prices.

Total infrastructure build out

over the next three years is

$120 billion including acquisi-

tions

Announced capital invest-

ments for MLPs are already

$53 billion through 2016

The major oil and gas basins

are driving most of the new

demand for infrastructure

Shale oil and shale gas resources are globally abundant

Major US Infrastructure Projects 2014-2016

Source: Company filings, EIA, Tortoise Capital

The blue bars represent the breakeven price; the black horizontal lines indicate the amount of reserves not yet drilled.

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The Significance of US LNG Export

LNG export from the US is one of the most important developments for the natural gas markets since

the combination of gas shale, hydraulic fracking and horizontal drilling. The US is expected to be a net

exporter by 2020, when the EIA estimates that

14-19% of US production may be exported, as-

suming 12 Bcf/d of export capacity come

online by then. Reports suggest that 70%

of this demand will be met from new nat-

ural gas production. As of January 1, 2014,

the U.S. Department of Energy (DOE) had

approved only five applications for permits

to export liquefied natural gas (LNG) to

non-FTA nations. There are currently 21

pending applications, covering 19 facilities

where U.S. businesses are seeking to build and

operate terminals to process LNG for sales abroad. Eight of nine approved LNG export facilities (four

to FTA countries) are at some stage of development. The estimated cost of converting an existing

LNG import facility to export ranges from $6-10 billion and $20 billion for a new terminal. The current

estimated cost to liquefy, ship and regas LNG from the US to Europe/Asia is $4-6/mmb. This presents

an important arbitrage opportunity. The norm for pricing of LNG is based off of crude oil. Cheniere,

the first facility that will come on line, has based their contract in Henry Hub +$15 and a fee for lique-

fying the gas. Japan and other countries

dependent upon LNG believe that pricing

LNG off of oil is unfair. Some potential

LNG operators have said they will not

proceed unless their contracts are priced

off of oil. Of the 21 additional applica-

tions submitted, several more may be

approved. MLPs with an extensive Gulf

footprint are at an advantage for provid-

ing services to the exporters. Many MLPs already have a presence servicing LNG import facilities. This

sector may be a strong growth driver for specific MLPs over the coming decade. Several of the larg-

est MLPs have announced major projects that are linked to exports. Natural gas transportation to and

storage near the LNG terminals is im-

portant. Additionally, there are several

shipping companies with MLP affiliates

that will be actively involved in moving

LNG. Dominion’s facility has been ap-

proved in the Chesapeake Bay which

should bode well for Dominion’s planned

MLP and other Marcellus MLPs that pro-

vide natural gas processing and transpor-

tation to this facility.

Net US Natural Gas Imports (tcf)

Source: EIA

Projected 4

2

0

-2

-4

Source: American Petroleum Institute See interactive website: http://bit.ly/GQN5KY

LNG Proposed/Pending Facilities

January 2014

http://bit.ly/GQN5KY

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2014 MLP Outlook Summary

The US energy revolution has created a dynamic

landscape and portscape that is creating multiple

expansion and growth opportunities for MLPs.

We expect to see more M&A in the MLP sector as

the larger MLPs expand their footprint and try to

make their network of infrastructure more

efficient. Our preferred themes for 2014

include: visible dropdowns and organic

growth, turnarounds, MLPs with minimal

commodity exposure servicing the key shale

basins, Exploration and Production, and several of the non-traditional MLPs. We believe there is very

little chance of any US tax change impacting MLPs

for the remainder of the Obama Administration’s

term. There is bipartisan support of the US ener-

gy revolution and acceptance of the role MLPs

play. Historically, MLPs have performed well in a

rising interest rate environment, because when

rates rise the economy is usually expanding

(which suggests increased pipeline and transpor-

tation flows) or inflation is rising. We are not con-

cerned about high inflation in the US at this point,

but MLPs do have built in inflation protection

through inflation pass-through. Most of their debt

is fixed rate and they have excess distribution cov-

erage. 2014 will be a stock pickers market. We see the MLP space ripe with opportunity. We are con-

cerned that there will be market volatility this year, so we plan to manage our portfolios with maxi-

mum flexibility. MLPs should provide the opportunity for a 10-12% net return this year, given that dis-

tribution growth should be between 6.5%-8% and current yields average 6.0%. Given MLPs’ attractive

yield compared to other yielding assets, we expect continued investor interest and additional invest-

ments from institutions. The coming year should

also see C-corps with MLP eligible assets form

and IPO MLPs. This has been a trend with inte-

grated oil companies, utilities, and pipeline com-

panies. Activist investors have also pushed cer-

tain of these companies like Marathon Oil, be-

cause the economics and efficiencies are so com-

pelling. In summary, we believe 2014 will be full

of challenges but ripe with opportunity in the

energy sector, as MLPs participate in a rapidly

changing environment.

5.8%

4.0% 3.9% 3.9%

2.2%1.9%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

MLPs US Utilities US REITs C-CorpPipelines

US Bonds US Equities

MLP Yields Remain Attractive

January 2014

us energy infrastructure (mlps) 2014...

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