The sharp decline in oil prices during 2014 and 2015 raised questions concerning the long-term outlook for North American energy assets. But as John Devir and Bek Ahmedov discuss in the following Q&A, the energy revolution in the U.S. remains very much intact – and PIMCO’s MLP & Energy Infrastructure Strategy can provide an attractive way to gain exposure to it.
Q: What is PIMCO’s MLP & Energy Infrastructure Strategy?
John Devir: PIMCO MLP & Energy Infrastructure is an actively managed strategy that invests in publicly traded Master Limited Partnerships (MLPs) and related midstream energy companies. The strategy provides exposure to one of the most attractive secular growth stories in North America – the revolution in production techniques that has opened up vast reserves of oil and gas for exploitation.
Midstream energy companies derive their revenues from operating critical infrastructure, ranging from transportation pipelines for crude oil to gathering and processing pipelines for natural gas liquids, as well as storage and terminal facilities. Since MLPs generate the majority of their revenues via fee-based contracts which are usually capacity- and not price-driven, they have less direct exposure to commodity prices than more traditional equity investments. The sector has become more investable in the last few years and in our view has reached the critical mass needed to achieve sufficient diversification with an attractive risk/return profile.
PIMCO MLP & Energy Infrastructure Strategy focuses on total return rather than simply yield. Whilst the target universe is predominantly equity securities, the strategy has the flexibility to tactically invest in both the equity and debt of midstream energy companies. This allows us to look for the best opportunities across the whole capital structure.
Q: What is your outlook for the MLP sector?
Devir: The MLP sector has rebounded strongly over the last 12 months, in line with oil prices stabilizing. Although the sector underperformed in 2015, when a number of large companies cut dividends, much of this was due to company-specific issues rather than problems with business models as a whole – a point we made in a blog post in September. Since then our views haven’t changed. We think MLPs continue to offer attractive long-term total return potential, backed by a favorable blend of fundamental and technical factors.
Q: Can you talk more about the fundamental and technical factors supporting this view?
Devir: From a top-down perspective, we think that oil prices are likely to be more stable going forward, underpinned by strong global demand growth and better production discipline by OPEC. This should lead to an increase in North American production, which would be positive for midstream MLPs as it means higher volumes through the pipelines and higher revenues for the sector. We also think that the Trump administration could be net positive for the energy sector – for example, we already saw support for the Keystone pipeline within the administration’s first week. And if inflation picks up, as the market expects, MLPs should perform well as many revenue streams are inflation-linked.
From the bottom up, MLP balance-sheet quality has improved as a result of deleveraging in the last 14 months‒18 months, and the worst of the ratings downgrade cycle is likely behind us. Importantly, we see some $50 billion‒$60 billion of growth opportunities for MLPs during FY2017-2020, which should allow them to increase distributions over time. In fact, we expect distributions to grow by 3%‒5% over the coming years – a stark contrast to the market’s expectations; judging by current prices, many investors expect distribution cuts in 2017 and no growth in distributions over the next three to four years.
In terms of valuations, the MLP sector is trading at a discount to long-term averages, yielding 7% versus an average close to 6%, reflecting greater uncertainty among investors. MLPs have also historically traded at lower yields than high yield bonds, but currently they are yielding 150 basis points more (see figure 1). In our view, these valuation levels are attractive as fundamentals are stronger than what the market is pricing in.
Q: Are there any risks to this outlook?
Devir: While much of the damage from lower oil prices has played out, certain companies in the exploration and production (E&P) sector still face credit issues. We do not generally see near-term refinancing risk, but some firms could be challenged if oil prices stay below $50/bbl, given their operating costs. However, it should be noted that the PIMCO MLP & Energy Infrastructure Strategy is focused on midstream assets (pipelines) not upstream assets (E&P).
Q: Can you comment on PIMCO’s experience investing in midstream energy?
Bek Ahmedov: PIMCO has been investing in energy for many years – including the debt and equity of firms across the E&P, pipeline, integrated oil, coal, refining, chemicals and utilities sectors. We have a world-renown team of portfolio managers and dedicated energy credit analysts who conduct fundamental analysis across the energy value chain. Our credit research team also benefits from the insights of PIMCO’s commodity team, who are experts in supply-and-demand dynamics within crude oil, natural gas and other commodity markets.
We think we have a particular edge in differentiating winners and losers within the MLP sector given our experience of investing in MLP debt for over a decade and our role as one of the largest lenders to the sector. We have in-depth knowledge of individual companies, both at the individual operating subsidiary level (individual pipelines) and at the corporate level. We tend to know the underlying assets of MLPs very well because they often issue debt.
Q: What is your approach to analyzing MLPs?
Devir: We incorporate a view on underlying commodity prices and their impact on companies, from the viewpoint of both debt and equity investors. We then conduct exhaustive primary research and modeling on each target company, leveraging over a decade of on-the- ground research and relationships with issuers.
We look for opportunities across the capital structure, focusing on companies with high barriers to entry and attractive assets in high- growth and low-cost production regions. We aim to invest in companies with a sustainable cost advantage, operated by experienced management with proven geological expertise.
Q: What role can the strategy play in a portfolio?
Ahmedov: We see its primary role as an income-producing solution in a multi-asset portfolio. It can serve as an alternative or complement to equities and high yield bonds in light of its relatively high distribution yields and the potential for distribution growth (see figure 2).
Historically, over longer time periods MLPs have generated similar returns to equities, with similar to slightly higher levels of volatility, but lower correlations to broad equity and fixed income markets. So from that point of view, the strategy can also be used as a diversifier within a portfolio. For energy-focused investors, it can be used to diversify existing energy-related equity investments, as MLPs are not included in broad benchmarks.
Finally, the strategy could be used as an inflation-hedging solution. MLPs own physical infrastructure assets, which in many cases have revenues with built-in inflation escalators. That may make this strategy attractive for the inflation- hedging buckets within portfolios.
Q: How important is active management in this sector?
Ahmedov: Valuations and returns of MLP equities have historically varied significantly due to differences in business models, barriers to entry, counterparty quality, cost differences in production regions and the experience of management teams. In 2016, the best-performing MLP in the market was up more than 100%, whereas the worst- performing company was down close to -30% (see Figure 3). This level of dispersion has existed since the inception of the asset class, and in our opinion makes active management, with the resource to help pick winners and losers, an essential component of investment success.