Mapping Out Midstream
Cohen & Steers MLP & Energy Opportunity Fund
Author: Ticker Magazine
Last Update: Nov 08, 12:40 PM EST
|Midstream companies, with their high barriers to entry and inflation-linked fees, can be described as the toll roads of the energy infrastructure. Energy is a global commodity and North America is a key part of the global value chain, making midstream a viable way to participate in trends around the globe. Tyler Rosenlicht, portfolio manager of the Cohen & Steers MLP & Energy Opportunity Fund, and his team distill the midstream space to build a conviction-based portfolio.
ďCash flows in the midstream space tend to be derived from volume growth as opposed to changes in commodity prices. Our core thesis is that the demand for the underlying pipelines will outpace new project development, leading to accelerating cash flow growth.Ē
Q: What is the history and core mission of the fund?
We have a long history of investing in the midstream energy asset class. In 2004, we launched our global infrastructure strategies, designed to invest in pipeline companies and master limited partnerships, or MLPs. In 2011 we launched a dedicated midstream energy strategy that focuses on North American midstream companies. In December 2013, we launched this particular fund to invest in midstream energy securities, which include master limited partnerships and midstream energy businesses utilizing other corporate structures.
Our core competency is investing in infrastructure businesses, which share some common characteristics. Typically, these businesses have minimal commodity price exposure and are regulated or semi-regulated. They have high barriers to entry and possess monopolistic characteristics, which are difficult to recreate once the assets are in the ground. Our job is to distill the midstream space or the energy infrastructure, which links sources of supply upstream wells and producing regions with sources of demand downstream and refineries. Then, based on our conviction, we build a portfolio that we believe should generate strong outperformance.
Q: How does the fund differentiate itself from other funds in the asset class?
A main differentiator of the fund is its structure and the definition of the investable universe. In the MLP space, there are types of funds - C-corp and RIC structured funds. Most of the mutual funds launched before 2012 are known as C-corp structured funds, which can invest up to 100% in MLPs. The problem with C-corp funds is that they are taxable vehicles, which have to book deferred tax liabilities for unrealized gains and then pay taxes on realized gains, which carry high expense ratios and cause material underperformance in an off market.
We launched a RIC fund, which is like any other mutual fund and doesnít pay taxes at the fund level. It is more tax efficient in the long run from a total return perspective. To qualify for RIC status, a fund needs to cap its investments in MLPs at 25 percent. The remaining 75% of the fund are invested in securities that are midstream in nature, but donít utilize the MLP structure.
There are different approaches within the RIC universe. Some RIC funds elect to include in their universe non-midstream businesses like E&Ps or upstream producers and integrated oil companies. Others have chosen to own up to 40% in fixed income in an effort to pay high yield at the fund level. We donít do that, because we want investors to have a positive total return experience in a tax efficient way. We donít seek to maximize yield but to maximize total return.
Our approach is unique within the RIC funds. We have opted for a broad definition of midstream, which includes MLPs, midstream energy corporations, general partners of MLPs, Canadian energy infrastructure companies and a small subset of utilities with large midstream businesses. Our universe consists of 40% MLPs and 60% non-MLPs. From a RIC perspective, we believe thatís a good universe, because it enables us to generate outperformance throughout the cycle with a portfolio of securities that share the common midstream characteristics that we focus on.
We believe that there are good midstream energy businesses that utilize different, non-MLP corporate structures. Overall, we take the broad definition of the investable universe, strip out the MLPs that donít have the characteristics we look for and add the security structures that have midstream characteristics. That approach results in a more tax efficient fund with lower fees.
Q: Why should investors consider the midstream space? What is attractive about it?
The investment thesis of midstream is based on volume, not price. In an E&P company, the factors that affect revenues and cash flows are the quantity of the produced energy and its price. In downstream companies, the key aspect is how much energy is moving through the system and the margin. It is an investment thatís predicated on volume and margins.
Midstream is different because it is the toll road of the energy space. The midstream businesses charge fixed fees, which typically rise with inflation, so they represent a way to invest in North American energy volumes. If you think that energy volumes are growing because we are producing more, consuming more or exporting more, midstream investments provide participation in that growth story without being too dependent on commodity prices and margins to generate cash flow growth.
The other attractive aspect is the high barriers to entry. Often pipelines are long - hundreds and thousands of miles in nature. Once they are built, they become a defendable economic moat against potential competitors. So, midstream is a business that can earn returns above its cost of capital and grow. It is a unique business model, which resembles real estate in the right location. In our opinion, such investments are likely to generate attractive returns on capital.
The key factor for its success is the demand for pipelines relative to pipeline supply growth. In the current environment, pipeline demand is driven by domestic energy production and consumption and exports. When a lot of oil, natural gas, and natural gas liquids are produced, they need to get pushed into pipelines, so the demand for pipelines increases. When consumption and exports rise, more energy needs to be pulled through the pipeline system.
We have high conviction that all the three factors will remain strong at least for the next few years. In North America we have a low-cost resource and E&Ps are well capitalized and efficient. We also believe that the position in the economic cycle is favorable, so a lot of energy is going to be pushed in the pipeline system to be consumed here or to be sent to foreign markets.
Our thesis is that the demand for the underlying asset will grow, while the supply of new pipelines will grow less quickly. We just spent a lot of money building pipelines, so we have a lot of capacity in various regions. The cost of capital has risen and the regulatory approval process continues to be challenging. Management incentives have changed with a focus on returns. Overall, we expect that we wonít be building as many new pipelines, while the demand for the existing infrastructure will rise, and thatís a clear advantage.
Q: How will alternative or renewable energy affect consumption in the near future?
Renewable energy is definitely a factor in our analysis. In general, when I talk about domestic energy production, I mean not just oil, but also natural gas, which is often seen as a bridge towards renewables. Over time, it is expected that weíll consume less coal-related energy and more wind and solar energy. However, many domestic places are likely to increase their consumption of natural gas and thatís good for pipeline systems.
For instance, weíll see better efficiency and more electric vehicles in the automotive industry. While thatís not great for gasoline demand, it may be good for natural gas demand. Also, jet fuel consumption will continue to be strong, because it is difficult to make a huge airliner energy efficient in the near term.
On a global scale, we are becoming more energy efficient, but with the ongoing urbanization, the rising middle class, the increasing travel and the growing consumption of plastics, we will continue to consume a lot of energy commodities. Renewables are becoming more cost competitive, but not in every geography and not in every part of the value chain.
Q: Do you invest in any European or Asian companies?
We have the ability to invest in many places, but our core thesis and our core positions are in the U.S. and Canadian domiciled securities and in North American infrastructure assets. Despite being in North America, the asset base is tied to the global consumption of natural gas. Investments in domestic midstream companies actually represent investments in the increasing consumption of LNG in China, India, Korea, Japan, Europe and South America. Energy is a global commodity and North America is a key part of the global value chain, so midstream is a way to participate in global trends.
Q: What are the key steps of your investment process?
The majority of our time, effort and analytical capability is spent on bottom-up company research, but we start our process with a top-down perspective. A unique feature of the Cohen & Steers platform is that while my team and I are entirely dedicated to midstream energy companies, our firm has capabilities that span across the energy value chain.
For instance, we have a team that trades commodity futures and invests in oil, natural gas and other energy commodities. We have a natural resources equity team, which invests in upstream and downstream companies, as well as a real-asset, multi-strategy team. We have formal, bi-weekly meetings of the energy group, with constituents from each of these teams. The goal of these meetings is to share ideas and to come up with a global energy model of supply and demand, winners and losers, market share gains or losses. We come up with our own view on energy prices.