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ETF Eyes Midstream MLPs
04/15/2015 10:00 am EST
Jay Hatfield, of InfraCap, discusses his firm's specialty ETF, which focuses on midstream master limited partnerships; he also discusses three of the ETF's largest current holdings.
Steven Halpern: Joining us today is Jay Hatfield, co-founder of InfraCap, which oversees the InfraCap MLP exchange-traded fund which focuses on the midstream MLP market. How are you doing today, Jay?
Jay Hatfield: I’m doing well, thank you.
Steven Halpern: Thank you for joining us. First off, could you briefly explain MLPs in general and the midstream part of the MLP market in particular?
Jay Hatfield: Okay. MLPs are publicly traded partnerships that are specifically allowed by a tax law that was passed in the late 1980s. Other types of corporations are not generally allowed to be publically traded partnerships.
Since it is a publicly traded partnership, instead of having to pay corporate tax, the individual investor gets a partnership return called a K1. The other thing that is interesting about publicly traded partnerships is that, in many situations, there is a limited partnership that is publicly traded—and then the general partner is also publicly traded—and those general partners have attractive participation rights in the cash flow of the operating limited partnership.
Steven Halpern: And your focus is on the midstream aspect of this.
Jay Hatfield: Right. In our view, the midstream aspect of master limited partnerships is a very attractive asset class to hold over long periods of time because rather than participate in some commodity space business—which an upstream MLP would be or some other type of business—Midstream MLPs—particularly the larger capitalization companies—have diversified operations that participate in the liquids, natural gas, and gathering and processing segments of the infrastructure industry.
Specifically, they normally have a substantial amount of their operations that are fee-based, or at least asset-based, so they are relatively stable compared to other types of companies, particularly E&P companies—or upstream MLPs—and generally more stable than just your average corporation that might trade in the S&P 500. They are good, long-term, attractive, and relatively stable investments.
Steven Halpern: MLPs often attract income investors. Could you explain the income potential in this sector?
Jay Hatfield: Well, most partnership agreements provide for a substantial part of the defined free cash flow to be paid out to investors in the form of partnership distributions. Actually, because of accelerated depreciation, often times those distributions are not taxed currently but only upon sale when the depreciation or when your lower basis gets taxed.
In this environment right now, we view the sector as being particularly attractive with the index that we track of the larger infrastructure MLPs trading at approximately 6.5% yield and then with the Treasury being sub 2% that’s a 4.5% spread over treasuries and normally this higher quality group of infrastructure companies trade with 2.5% to 3% spread over treasuries.
We see substantial upside to the sector and think it’s a good time to enter, particularly since we believe that over the intermediate-term that oil prices will probably have a tendency to trend upward and reduce some of the commodity headwinds that some of the companies are experiencing.
Steven Halpern: Now importantly, for those who are concerned about continued oil price risks, you note that investments in your fund aren’t necessarily impacted by crude prices. Could you explain that?
Jay Hatfield: Well, there are certain companies. If the three segments I mentioned: gathering and processing, natural gas, transportation and storage, and then liquids, transportation, and storage, of those three, gathering and processing has the most commodity exposure.
Fortunately, most of the companies in sector have moved away from direct commodity exposure through entering into an increased amount of fee-based arrangements. They get a fixed fee and it’s not based on commodity prices for their services, so that’s positive. Although they still retain some commodity risk and also some thru-put risk.
The other two segments have less exposure to commodity risk, and in particular, one of the reasons we like these larger-cap companies is they have very diversified operations.
They have a little bit of commodity risk in the sense that thru-put may drop and some of the margins and some of the transportation businesses might be effected, so they have some headwinds, but because they had diversified operations, some of their businesses have tailwinds.
For instance, the liquid storage companies right now are benefiting from the fact that you can sell oil in the futures market at much higher prices. In fact, it’s not well known, but 24 months out, you can sell oil at over $60 a barrel and so they are benefitting from that structure of the oil market. The sector is more complicated than people understand or at least the way they trade it.
It’s not necessarily going to directly correlate to commodities. There is a little bit of headwinds but other potential tailwinds depending on what’s going on in the commodity market.
Steven Halpern: Let’s look at some of the fund’s current top holdings. One of those is Williams Partners LP (WPZ). Could you tell us what all the attraction is there?
Jay Hatfield: Yes. Williams recently completed a merger with Access Midstream Partners, which substantially increased their overall coverage and access with the company in the gathering and processing, but much more fee-based.
We anticipated that after that merger close—usually there is a merger overhang—that the stock would outperform, which it has, and also it’s just a very large-cap, low credit risk company, so it’s attractive in a riskier environment.
Steven Halpern: Now another top holding is Plains All American Pipeline LP (PAA), what are your thoughts there?
Jay Hatfield: Well, that’s a good example of a company that benefits from the structure of the oil market. The technical word for that is contango, where the outer months in the futures market are much higher than the near months. And Plains is one of the largest storage—controls the largest amount of storage—in the United States.
We believe that that’s going to provide a substantial tailwind to their guidance that’s not reflected. In fact, this happened in 2011, where we had a strong contango market and they significantly outperformed.
We also have a holding, our fund, attracts, generally attracts, some of the larger industries like the AMZI, but we also include general partners.
Another position that is related to Plains All American is its general partner Plains GP Holdings (PAGP). We think that that’s particularly attractive, not only because they participate in the potential upside for Plains cash flow, but the company has been fairly transparent about being interested in making acquisitions.
Acquisitions are extremely beneficial to the general partner because they participate in the gross amount of cash flow of the partnership. We are quite bullish about both Plains All American and Plains GP Holdings; symbol PAGP.
Steven Halpern: Finally, what’s the attraction with Markwest Energy (MWE)?
Jay Hatfield: Well, Markwest is attractively structured in the sense that they don’t have any IDRs so there is no general partner that is taking a substantial amount of the cash flow upside.
They have a substantial amount of growth projects that participate in the Marcellus Shale and they’re about to start benefitting from the substantial amount of Capex that they put into the ground over the last two or three years and they are starting to ramp down that Capex, so that instead of it—all their free cash flow going into investments—some of it is going to be realized by them.
We think they are in quite good position there. However, I would note that even though it is one of our larger positions, we don’t have any substantial overweight to that company because they do have some commodity exposure.
It just happens to be a large constituent in the index and we are just neutral at relative to its benchmark, so, we tend to either be neutral or slightly underweight to companies with a little bit more commodity exposure.
Steven Halpern: Again, our guest is Jay Hatfield of the InfraCap MLP exchange traded fund. Thank you so much for joining us today.
Jay Hatfield: Thank you.
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