Kevin McCarthy, the world’s best- performing energy fund manager in the past year, stared at the tangle of tax-exempt partnerships and corporate parents that drive the U.S. oil and gas pipeline business and kept his cool.
That was in 2010, when the Kayne Anderson Capital Partners LP manager in Houston said he found a way to profit from the mess: He realized the most undervalued of the bunch were the companies managing the partnerships, the so-called general partners, especially since they were positioned to earn escalating shares of cash flow as pipeline assets expanded.
McCarthy’s Midstream/Energy Fund Inc. (KMF:US) made 32 percent in the last 12 months, the best return of 259 energy funds with more than $100 million worldwide, data compiled by Bloomberg show. His top investments are general partners such as Williams Cos. (WMB:US) and Kinder Morgan Inc. (KMI:US), according to Sept. 30 data. The industry has room to increase profit in 2013, as the drilling boom in U.S. shale fields creates a need for more pipelines, processing plants and compressor stations, McCarthy said.
“We think the development of the unconventional fields is a multiyear, if not a multidecade, process,” McCarthy, 53, formerly a banker at UBS Securities LLC, said in an interview.
Oil Boom Leftovers
Until 10 years ago, tax-advantaged master limited partnerships, or MLPs, were leftovers from the oil boom of the 1980s, when they were used to attract individual investors to the exploration business. They emerged in the 2000s as the vehicle of choice for pipeline companies that hurried to keep up with the pace of drilling in new fields like the Marcellus Shale in Pennsylvania and the Bakken Shale in North Dakota.
The fund rose less than 1 percent to $27.95 and was trading at a 3.3 percent discount to its net asset value, or the value of its underlying investments, at 10:15 a.m. in New York. The fund has averaged a 5 percent discount to its net asset value this year.
It would take $251 billion in investment over 25 years to build pipes, processing plants and other infrastructure needed for all the new exploration, the Interstate Natural Gas Alliance of America trade group estimated in a 2011 report. The spending is already ahead of those estimates, and most of it is being done by MLPs, according Eduardo Seda, an analyst at Ladenburg Thalmann & Co. in New York.
MLPs don’t pay U.S. income taxes and distribute most of their free cash as taxable income to investors through partnership units, which trade like stock.
In many cases, the corporation that controls an MLP -- the general partner -- gets a bigger share of cash flow as the partnership grows. The corporate parents build or buy assets and then sell them to the MLPs, which in turn pushes more cash flow back to the parent.
“The way you get the full-cycle economics is, you invest in the parent,” McCarthy said in the interview. “It’s willing to take those longer lead-time projects. Once it gets into the MLP, we benefit from that as well.”
To be sure, MLPs have risks. Kayne’s Midstream/Energy Fund dropped (KMF:US) 9 percent in the week after the U.S. presidential election amid concerns that the Obama administration might change the partnerships’ tax treatment, reducing cash available to the general partners.
Also, about 30 percent of the fund’s portfolio is paid for with borrowed money, according to filings. While that leverage boosts investors’ returns when the portfolio does well, it can worsen the pain when the portfolio falls, said Mike Taggart, a closed-end fund analyst at Morningstar Inc. in Chicago.
“Looking at their funds, they tend to be a little more volatile than other MLP closed-end funds that have been around for a long period of time,” Taggart said in an interview.
McCarthy said his knowledge of the pipeline industry helps offset the risks. He and vice president Jim Baker came to Kayne from UBS, where they worked in mergers and acquisitions. McCarthy helped take MLPs public and has helped others finance major purchases.
“We’ve had relationships as long as 25 years with these management teams,” he said.
One of Kayne’s strengths has been its consistency, said Viktoria Baklanova, an analyst with Fitch Ratings Ltd. Fitch has a AAA rating on $165 million worth of the Kayne Midstream/Energy fund’s bonds, and a AA rating on $65 million worth of its preferred shares, largely because of the fund’s stability, Baklanova said in an interview from New York.
“It’s been the same team of people since the beginning of the fund and they all stick around, executing on the strategy,” Baklanova said. “They have great access to the capital markets.”
First Trust Energy
After Kayne Midstream, the best performer from a different money manager is the First Trust Energy Income & Growth fund (FEN:US), with a 17 percent return in the past year and run by Jim Murchie, according to data compiled by Bloomberg.
Pipelines are popular with individual investors because much of their revenue comes from long-term transportation contracts that don’t depend on the price of oil or natural gas, Seda said. Payments also can be locked in regardless of volume shipped under some contracts.
“You might give up some of your growth for stability, but I think nowadays people reward that,” he said. “Having those fixed-fee contracts where you get paid regardless of volume is a nice guarantee.”
McCarthy declined to comment on specific companies in the Kayne portfolio, citing a company policy. Public documents show the fund invested in firms that have been at the front of the pipeline-building boom.
Williams Cos., the fund’s top holding, has risen 70 percent to $32.24 since the Kayne fund went public in 2010. Williams benefited as its underlying partnership, Williams Partners LP (WPZ:US), bought $6.8 billion in pipelines and other assets in the past two years. The partnership’s cash dividends have risen to $373 million in the third quarter from $221 million two years early - - and about two-thirds of that goes to Williams Cos.
The Kayne midstream fund also held stock in El Paso Corp., which Kinder Morgan Inc. bought for a 47 percent premium in May, creating the biggest U.S. pipeline operator. Kayne also held shares of Sunoco Inc., which was acquired by Energy Transfer Partners LP for a premium of about 15 percent in October.
The next round of activity may come as integrated oil companies create MLPs to manage their pipeline networks, McCarthy said. Phillips 66 (PSX:US), the refiner spun off from ConocoPhilips, has discussed expanding its pipeline MLP or creating a new one. Marathon Petroleum Corp., the refiner spun off from Marathon Oil Corp., formed an MLP in October.
The other driver will be geography, McCarthy said.
“It’s just like the real estate business, you want to put your store on a busy corner,” he said. “You want to have a pipeline or a processing facility in an area where you think there’s going to be multiple opportunities to grow.”
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