John M. Devir, Berdibek Ahmedov
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.
All investments contain risk and may lose value. Investing in MLPs involves risks that differ from equities, including limited control and limited rights to vote on matters affecting the partnership. MLPs are a partnership organised in the US and are subject to certain tax risks. Conflicts of interest may arise amongst common unit holders, subordinated unit holders and the general partner or managing member. MLPs may be affected by macro-economic and other factors affecting the stock market in general, expectations of interest rates, investor sentiment towards MLPs or the energy sector, changes in a particular issuer’s financial condition, or unfavorable or unanticipated poor performance of a particular issuer. MLP cash distributions are not guaranteed and depend on each partnership’s ability to generate adequate cash flow. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Diversification does not ensure against loss.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
The Alerian MLP Index is the leading gauge of large- and mid-cap energy master limited partnerships (MLPs). It is a float-adjusted, capitalization-weighted index, which includes 50 prominent companies. The Barclays Investment Grade Corporate Index is an unmanaged index that is the Corporate component of the U.S. Credit Index. The index includes both corporate and non-corporate sectors and are publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. The corporate sectors are Industrial, Utility, and Finance, which include both U.S. and non-U.S. corporations. The non-corporate sectors are Sovereign, Supranational, Foreign Agency, and Foreign Local Government. BofA Merrill Lynch BB-B Rated Developed Markets High Yield Constrained Index Hedged into USD tracks the performance of below investment grade bonds of corporate issuers domiciled in developed market countries having an investment grade foreign currency long term debt rating (based on a composite of Moody’s, S&P, and Fitch). The Index includes bonds denominated in U.S. dollars, Canadian dollars, sterling, euro (or euro legacy currency), but excludes all multicurrency denominated bonds. Bonds must be rated below investment grade but at least B3 based on a composite of Moody’s, S&P, and Fitch. Qualifying bonds are capitalization-weighted provided the total allocation to an individual issuer (defined by Bloomberg tickers) does not exceed 2%. Issuers that exceed the limit are reduced to 2% and the face value of each of their bonds is adjusted on a pro-rata basis. Similarly, the face value of bonds of all other issuers that fall below the 2% cap are increased on a prorata basis. Prior to September 25th, 2009, the BofA Merrill Lynch Indices were known as the Merrill Lynch Indices. The Dow Jones STOXX 50 blue chip index consists of 50 stocks covering the market sector leaders in the Dow Jones STOXX 600 index. The Dow Jones STOXX 600 index is made up of the largest 600 stocks in the Dow Jones STOXX Total Market Index. The Dow Jones STOXX Total Market Index covers 95% of the free float market capitalization of the European investable stock universe. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.
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