Energy Infrastructure Primer: A guide for both new and experienced investors
Version 1.1 April 2020 Alerian 3625 N. Hall St., Suite 1200 Dallas, TX 75219 alerian.com Table of Contents
Introduction 3
Energy Infrastructure 101 4
Energy Infrastructure 201 9
Energy Infrastructure Investing 15
Classification Standard 21
Glossary 23
Disclaimers 27
2 // Introduction An investment in energy infrastructure is an investment in EI 101 is designed for those who are starting from the North America’s continued production and consumption of beginning or those who would like a refresher on the transportable energy over the next several decades. Energy basics of energy infrastructure. We’ve also detailed energy infrastructure companies own the pipelines, storage infrastructure business models, as well as the fundamental tanks, and processing facilities that bring energy from the backdrop supporting opportunities in this space. wellhead to America’s doorstep and increasingly to coasts for exports. In the energy industry, these activities describe EI 201 goes into further detail on energy infrastructure “midstream”, which is the bridge between production business models and gets to the importance of shale (upstream) and consumption (downstream). While still in growing US energy production. This section is for related to the energy industry, most energy infrastructure those investors wanting to have a firm grasp on energy business lines do not have direct exposure to commodity infrastructure economics before investing. We explain price fluctuations. Their businesses function primarily on the nuances of various midstream business models, a set fee per volume or fee for service basis. In short, the the regulations around pipelines and pipeline tariffs, business model is driven by volumes. and the valuation metrics typically used for the energy infrastructure space. The prices (or tariffs) that energy infrastructure companies can charge are determined either by negotiated contracts Energy Infrastructure Investing is designed for those who or are federally regulated. Typically, tariffs increase have decided to invest. This section walks through each each year by a measure linked to inflation. In terms of energy infrastructure access product, explaining the pros volumes, the significant growth in North American oil and cons as well as exploring which goals might be met and gas production has increased the need for energy by each. This section includes considerations for selecting infrastructure assets. While energy demand in North individual securities and investing in products, whether America remains fairly steady, global demand growth active or passive. continues, particularly for emerging markets, creating opportunities for energy infrastructure companies. Increasingly, these companies are processing, transporting, and storing hydrocarbons that will ultimately be sent to locations worldwide.
3 Energy Infrastructure 101
4 // Energy Infrastructure 101 The Very Basics volume side, growing production of North American oil and natural gas has necessitated more energy infrastructure Energy infrastructure companies are involved in the such as pipelines, storage tanks, and processing plants. transportation, processing, and storage of oil, natural gas, and natural gas liquids (NGLs). Historically, a majority of How Investors Make Money with Energy the midstream space has been structured as master limited Infrastructure partnerships, or MLPs (we won’t cover MLPs extensively in Energy Infrastructure 101, but those looking for more If you own a stock, there are two ways to make money. The information can find it in ourMLP Primer). However, price of the stock increases and you can sell it for more than C-Corporations have become more prominent in midstream you bought it. Formally, this is known as price appreciation. in recent years. The stock also likely pays you dividends. The amount of dividends relative to the share price is known as yield. The Basic EI Business Models1 The historical average yield of energy infrastructure 1. Transportation over the past 5 years has been nearly 6.0%, which means Just like it sounds, transportation involves moving energy that if you invested $100, on average, you would be paid commodities like oil and natural gas from one place to another. $6.00 each year. The chart below shows yields for energy In North America, most energy travels through a pipeline, but infrastructure, represented by the Alerian Midstream it can also move via truck, railcar, or ship. Pipelines are the Energy Index (AMNA), compared to other asset classes. cornerstone of the energy infrastructure space. Energy infrastructure boasts a higher yield than utilities and real estate investment trusts (REITs), which are asset 2. Processing classes known for their income potential. Processing encompasses any business that transforms a raw commodity into a usable form. It involves removing MLP Historical Average Yield (5 Years) impurities like water and dirt from wellhead natural gas . and separating the natural gas stream into pipeline-quality natural gas and natural gas liquids (NGLs), which are used as heating fuels and petrochemical feedstocks.
3. Storage Storage includes tanks, wells, and other facilities both above and below ground. These assets provide flexibility to the energy economy, so there is propane available for winter heating, gasoline for summer driving, and jet fuel for the holidays. .
How Energy Infrastructure Companies Make . Money
Energy infrastructure companies typically operate fee- based business models. EI companies earn a set fee for each barrel of oil or million British Thermal Unit (MMBtu) of . natural gas transported, stored, or processed (in the case of natural gas) regardless of the price of the hydrocarbon. . This is because these companies typically do not own the oil or gas. EI companies generally sign long-term contracts (5 to 20 years in length) with their customers, which makes for stable cash flows. Accordingly, the revenue equation for most business activities is fairly simple: price multiplied AMNA REITs Utilities Bonds S&P by volume. As such, more volumes means more cash flows. Source: Alerian, Bloomberg as of December 31, 2019 On the price side, a federal agency sets the fee charged by interstate liquids pipelines, and the fee increases with inflation. Pipeline fees can also be negotiated with a customer based on the cost of operating the pipeline and market rates for liquids or natural gas pipelines. On the
1 Please see EI 201 for an in-depth look at all energy infrastructure business functions. 5 // Energy Infrastructure 101 The Pipeline Business, Explained applying these technologies, oil producers began implementing the same drilling technology, seeing strong production growth The modern pipeline network2 in the United States has from oil wells. its roots in the outbreak of World War II. Before the war, the East Coast was the largest consumer of energy in In 2009, the US became the world’s largest producer of natural the country. Refined products (such as gasoline, diesel, gas. By 2012, the US had an abundance of natural gas, leading and jet fuel) were delivered from Gulf Coast refineries to lower prices, but gas production continued to grow. In 2014, via tankers. Tankers also carried raw crude oil from the rapid growth in US oil production had led to a global crude Middle East. However, once the US became involved in oversupply and weakness in oil prices. A multi-decade ban on the war, German submarines began sinking these tankers. US crude exports was lifted by Congress in December 2015. Oil Together, the government and the petroleum industry built prices gradually recovered from their relative bottoming in pipelines that could cover long distances and transport February 2016, and US oil production continued to increase. large amounts of oil. This network subsequently fueled the In 2018, the US became the world’s largest oil producer and is economic boom that followed the war., and many of those now exporting millions of barrels of crude each day. Global oil original pipelines are still in service today. prices fell significantly in early 2020 due in part to the demand impacts stemming from the coronavirus. Price weakness may There are both large diameter trunklines that function lead to a temporary reduction in US oil production, though the like interstates (instead of being four lanes wide, they are long-term view for production growth remains intact. often 42” in diameter, or large enough for a child to stand inside), as well as smaller delivery lines which connect the The term “energy renaissance” refers to the overwhelming large pipelines to each town. Product traveling through growth in US energy production that has occurred over trunklines is fungible—the customer will receive product the last decade, culminating in projections that the US will on the other end that is the same quality as that which become a net energy exporter by 2020. was sent, but they won’t be the exact same molecules. It is as if someone sent $100 to a college student through a Long-Term Growth Expected for US Energy Production bank. That student will not get the exact same $100 bill as his or her benefactor sent, but the student doesn’t care because $100 is $100. Money is fungible. However, smaller delivery lines operate on a batch system, where the exact same molecules are delivered as were shipped. In this case, our lucky college student gets a couple dozen cookies, and the ones delivered are the exact same cookies his or her parents baked, not cookies that some other people made.
Energy Renaissance
Prior to the 2000s, much of the energy industry was focused on peak oil and the ways companies and our society would have to shift in response. While producers knew that oil reserves existed, accessing the oil in a cost-effective way was still difficult. Experts forecasted that expensive and complex recovery methods would be needed to continue to produce even a modest number of barrels.
In the early 2000s, the natural gas industry in the US began widespread application of horizontal drilling and hydraulic fracturing. The technologies were not new, but the combination of both technologies makes it possible to profitably produce the large reserves of crude oil, natural gas, and NGLs trapped between layers of North American shale rock. Horizontal drilling was developed in the first half of the 20th century, and the first commercial applications of hydraulic fracturing took place in 1949. After seeing the success of natural gas companies in Source: US Energy Information Administration Annual Energy Outlook 2020
2 Source: Pipeline 101: https://pipeline101.org/The-History-of-Pipelines/1900-1950 6 // Energy Infrastructure 101 What the North American Energy Landscape Risks Means for Energy Infrastructure If you have listened to a company’s earnings call, viewed Energy infrastructure companies are not the ones engaging an investor presentation, or perused a company’s annual in horizontal drilling or hydraulic fracturing. Instead, report, you will have noticed disclaimers and/or a EI companies are typically focused on the more stable discussion of risk factors. Even if you don’t like reading fine businesses within the energy complex. The midstream print, PLEASE still read this. While some of these risks may company that provides transportation, processing, and be unlikely to occur, they could impact your expected total storage facilities for multiple producers has diversified return. its revenue stream and benefits broadly from energy production and exports. Commodity Price Sensitivity – Since energy infrastructure companies do not own the oil and gas they transport, their Oil production growth has created a number of business performance is not directly connected with the opportunities for midstream companies to build price of oil or gas. However, commodity prices can have new pipelines connecting producing regions with implications as there are indirect connections between demand centers, including the coast for export. Energy energy prices and the performance of midstream companies, infrastructure companies have also built crude export even though profitability may not be directly impacted by terminals. commodity price fluctuations. If commodity prices are very low, upstream companies will drill less and demand will fall On the natural gas side, growing production and rising for gathering pipelines and other infrastructure. Additionally, demand have created many opportunities for midstream. in an environment with falling commodity prices, investor For example, several companies have built or are psychology may connect energy infrastructure with the constructing liquefaction plants in the US and Canada broader energy sector and commodity prices beyond what where natural gas can be cooled and pressurized to a the underlying business models would otherwise indicate. liquid form. This liquefied natural gas (LNG) can then be In other words, commodity prices can impact sentiment for loaded onto ships for export. US LNG exports will help meet energy infrastructure companies. increasing demand for natural gas overseas. Midstream companies build and operate the pipelines that supply Environmental Risk – Some pipelines in major LNG export facilities, natural gas-fired power plants, and transportation corridors were constructed in the 1950s necessary storage facilities. They also own the processing and 1960s. An aging pipeline system as well as high-profile plants necessary for transforming raw natural gas into a oil spills and gas leaks have increased investor concerns usable form. regarding transportation safety and environmental risks. Pipelines are by far the safest form of transportation Complementing the growth in oil and natural gas, for oil and natural gas. Increased maintenance and new production of natural gas liquids (NGLs) has also technologies enabling more frequent and accurate grown. Natural gas liquids must be processed into their monitoring of pipelines has helped improve pipeline safety. component parts to be usable, creating more demand for fractionation facilities (the formal term for plants that Renewable Energy – The potential for renewable forms process NGLs). EI companies build NGL-dedicated pipelines of energy (solar, wind, hydro) to replace hydrocarbon- and fractionation facilities, as well as NGL export facilities based energy is both the largest and least immediate risk to meet overseas demand. to energy infrastructure. A game-changing technological breakthrough is likely many years away, and it will also The tremendous growth in US energy production over take many years to fully implement. As an example, even the last decade has necessitated a significant build out global demand for coal increased in 2018, reflecting the of energy infrastructure, including pipelines, natural gas longevity of energy sources and challenges in switching processing facilities, storage capacity, and export terminals. fuels. Moreover, petrochemicals are expected to drive For midstream, capital investment likely peaked in 2018 or significant demand growth for hydrocarbons, and 2019 in anticipation of more moderate production growth renewable substitutes may not be readily available for in 2020 (read more). The weakness in oil and natural gas petrochemical applications. If the next form of energy is prices in 2020 is likely to result in a temporary decline in US transported in a gaseous or liquid form, it is highly likely energy production, and midstream companies have further that existing steel pipelines and storage facilities can be reduced capital spending plans in response. Midstream converted. For instance, liquid hydrogen could easily be is expected to benefit from the fee-based cash flows of moved by our current infrastructure. previously completed projects, while reduced growth spending should provide additional financial flexibility.
7 // Energy Infrastructure 101 Permitting Risks – The permitting process for a new pipeline involves federal and state government approvals and permits, as well as environmental impact studies and potentially eminent domain complications. Each state has its own regulations, and pipelines often pass through many states. Should an approval not be granted (or conditionally granted), a pipeline may need to be rerouted, which is an expensive and time-consuming necessity. It is at this stage that community and environmental protesters often delay the timeline. Any delays or cost overruns in the permitting process may make the project less profitable, as well as potentially prevent the pipeline from being built, resulting in lost sunk costs for the company.
8 Energy Infrastructure 201
9 // Energy Infrastructure 201 Shale Revolution For many decades, producers drilled for oil and gas in rock formations such as carbonates, sandstones, and siltstones. Shale is a type of geological formation found in These formations, known as conventional formations, sedimentary rocks3. When the media refers to natural have multiple porous zones that allow the oil and gas to gas plays such as the Marcellus and Utica shales in flow naturally through the rock. This ability of rocks to Pennsylvania and Ohio, they are referring to a specific allow fluids to flow is known as permeability. Conventional layer of rock formed at a particular time in history. The formations have higher permeability than unconventional amount and type of natural resources found in that layer formations like shale rock. Vertical drilling, which involves will depend on what sort of life form, water, or lack of drilling straight into the ground, worked for many years water existed during that period. Notice how the Marcellus on conventional formations because once the drill bit hit a formation sits above the Utica formation. particular area, the high permeability would allow for the hydrocarbons to be extracted easily. For quite some time, Potsville Group the energy industry has known that oil and gas existed 318 MYA in shale. But because shale rock is not as permeable, Mauch Chunk Group using old techniques with vertical drilling did not make it economically feasible to recover resources because it Greenbriar Limestone would only capture a limited amount. Three technologies Pocono Group
Mississippian together truly changed the game for extracting shale 359 MYA resources: Ohio Shale 1. 3D seismic imaging Genesee / Sonyea / West Falls / Java Fms 2. Horizontal drilling Tully Limestone 3. Hydraulic fracturing
Hamilton Group While seismic imaging in 3D may be the least well-known Devonian Marcellus Formation component of the shale revolution, it plays a vital role Onondaga Formation Bois Blanc Formation / Huntersville Chert when it comes to drilling a successful well. Seismic Ridgeley Sandstone technology uses acoustic energy, vibrations, and reflected signals to determine the location and density of rock Helderberg Group formations. Think of it like an underground map. While 416 MYA Bass Islands Dolomite / Keyser Formation considerably more expensive than 2D seismic imaging, Salina Group 3D seismic imaging results in fewer dry holes4 and more Lockport Dolomite and McKenzie Formation productive wells.
Silurian Clinton Group
Medina Group / Tuscarora Formation 443 MYA Queenston Shale / Oswego Formation Reedsville Shale Utica Formation Trenton / Black River Limestones
Loysburg Formation Ordovician
Beekmantown Group
488 MYA Rose Run Sandstone
Copper Ridge Dolomite
Cambrian © Geology.com Source: geomore.com/seismic Source: geology.com
3 Sedimentary rocks are formed through the accumulation of layers and layers of grain and sediments, in water or on land, over thousands of years. Metamorphic rocks are rocks that have been transformed by an external force like heat, pressure, or chemicals. Igneous rocks are made from molten rock. 4 A dry hole is a well that is drilled but produces no oil or natural gas. It may produce water or small amounts of oil and gas, but not enough to recoup drilling costs. 10 // Energy Infrastructure 201 THEN NOW Horizontal drilling is another technology that has drastically improved the success rates and economic viability of shale drilling. Horizontal drilling allows the operator to drill a well, and then manipulate the drill bit underground to make a 90-degree turn and cover a much larger area. Multiple (up to 20 or more) horizontal wells can be drilled from a single drill pad, lowering drilling costs, increasing efficiency, and minimizing the impact to the environment. After the well is drilled and lined with casing, a second technique called hydraulic fracturing is used. Vertical Drilling5 Horizontal Drilling Hydraulic fracturing describes the process in which a mixture of water, sand, and other chemicals is pumped into a well at a very high pressure to break up shale rock. The highly pressurized mixture lets a driller open all those tiny pockets. The water is then removed, and the remaining sand props open the rock, allowing hydrocarbons to flow freely to the surface.
In short, 3D seismic drilling tells producers where to drill, horizontal drilling increases the amount of area drilled, and hydraulic fracturing solves the issue of low permeability.
Hydraulic Fracturing
The map below shows some of the major natural gas, crude oil, and NGL plays in the United States.
Source: National Energy Board, US Energy Information Administration
5 Ohio Oil and Gas Association. September 30, 2013. 11 // Energy Infrastructure 201 Energy Infrastructure Business Models In general, ethane and propane make up the bulk of the NGL stream, with a concentration ranging from 55% to In Energy Infrastructure 101, the pipeline business was 85%. Butane, isobutane, and natural gasoline are used to thoroughly examined and explained. Pipelines are perhaps produce motor gasoline. Butane is the primary component the most familiar of the assets that energy infrastructure of lighter fluid and can be used as a feedstock to make companies operate, but these companies are also involved butadiene, which is used in creating synthetic rubber. in a much larger swath of the energy value chain. The majority of fractionation is done on a fee-for-service Gathering & Processing – Before hydrocarbons enter a basis. However, the amount of fees earned depends on the large pipeline, they need to be gathered and, in the case amount of volumes fractionated, which in turn depends of natural gas, processed. Gathering involves connecting on something called the frac spread6. Essentially, the frac wells to major pipelines through a series of small diameter spread is a measure of the reverse of the adage “the whole pipelines. Gathering pipelines transport either crude oil is greater than the sum of its parts.” With NGLs, the sum or natural gas from the wellhead. Processing is required of the parts is worth more than the whole. Some NGLs for natural gas and involves the removal of potential must be removed for the natural gas stream to meet purity contaminants and separation of natural gas liquids (NGLs) standards, but often they are only removed for additional so that the gas can meet purity standards for pipeline profitability. The frac spread is the difference between the transmission. value of the NGLs if removed and the value of the NGLs if they are left in the natural gas stream and sold at the same Gathering and processing companies focus on obtaining price as natural gas. Ethane rejection is the industry term fee-based revenues by charging upstream companies a for when ethane prices are so low that it is better to leave set fee for every million British Thermal Unit (MMBtu) of ethane in the natural gas stream than extract it. natural gas or barrel of oil that is gathered or processed. The contract often includes a minimum volume The high cost7 of NGL handling, storage, and transportation commitment or acreage dedication, which provides additionally factors into the volumes of NGLs that will further cash flow stability. Occasionally, some companies be fractionated. In order for the hydrocarbons to remain will have different compensation structures, which may liquids, they must be kept under high pressure or cooled include payment in the form of keep-whole contracts. This to very low temperatures. Additionally, gaseous NGLs allows them to keep the extracted NGLs and sell them to are heavier than air and flammable, requiring increased third parties at market prices. Another contract structure safety measures. NGL storage typically takes place in is percent of proceeds (colloquially known as POP), in underground caverns for these reasons, while the smaller which the processor is paid by retaining a percentage of amounts stored above ground are placed in insulated tanks any processed natural gas or NGLs. As keep-whole and and thicker steel. POP contract structures expose gathering and processing companies to volatility in commodity prices, the vast majority of companies have moved (or attempted to move) to a purely fee-based revenue structure.
Fractionation – At a fractionation facility, NGLs are separated into their individual usable components of ethane, propane, butane, isobutane, and natural gasoline. Ethane is primarily used as a feedstock, or input, into petrochemical plants to make ethylene, which is used to make plastics and other chemical products such as solvents and adhesives. Propane by itself can be used as a heating fuel or used as a feedstock to make propylene, which can be used in the manufacturing of textiles or plastics, such as headlights, eyeglasses, foam bedding, and water bottles.
6 If you are familiar with crack spreads for refineries, this is very similar. If you are not familiar with crack spreads, the EIA has a great explanation – https://www.eia.gov/todayinenergy/includes/crackspread_explain.php 7 Compared to refined products 12 // Energy Infrastructure 201 Transportation – Transportation companies are the bread Pipeline Permitting and butter of the sector. The fee-based business model is the most well-known and most frequently referenced, Natural Gas Pipelines perhaps because it is one of the simplest to understand. According to the Natural Gas Act, companies that would Typically, midstream companies will enter long-term like to build an interstate natural gas pipeline must obtain contracts with customers committing to use a certain a “Certificate of Public Convenience and Necessity” from amount of pipeline capacity. The midstream company will the Federal Energy Regulatory Commission (FERC) before collect a fee per unit of hydrocarbon transported. Contract beginning a project. This is a multi-step process. provisions such as take-or-pay agreements or minimum volume commitments allow the pipeline company to 1. Pre-Filing and Environmental Review. Pre-filing collect specified fees even if the customer does not fully involves notifying all stakeholders of the proposed use its committed capacity. project and offering a medium for said stakeholders to voice concerns related to the project. This phase Interstate liquids pipelines are regulated by the FERC, and also includes a study of the potential project site. This rates are most often based on the FERC’s oil pipeline index. process begins about seven to eight months before Every five years, the FERC sets the rate by which tariffs will the application for the actual certificate is filed. be increased, with the rate based on the Producer Price 2. Application for FERC Certificate.This is the beginning Index for Finished Goods plus an adjustment. Through of the formal process. Applicants must turn in lots of 2021, these FERC-regulated pipelines will increase the tariff data on the project, such as construction plans, route they charge by PPI + 1.23% every July 1. maps, schedules, and more. 3. Environmental Review. An official study is carried out Interstate natural gas pipelines generate revenue by on how the project will impact the environment. The collecting a tariff for each unit of natural gas transported public is then given an opportunity to comment on the under long-term commitments. Customers enter contracts results of the study. After this, the FERC will consider for capacity for these pipelines in much the same way the comments and issue formal approval or denial of that apartments are rented, but instead of year-long the project. leases, interstate natural gas pipeline contracts are often for 5 to 20 years. Like a lease, customers are obligated The formal process takes about a year. However, this timeline to pay regardless of whether they use the space or not. is not guaranteed. In April 2018, FERC requested stakeholder Additional fees are charged when a customer needs to input on its current policies to review and authorize inject or withdraw hydrocarbons to meet demand spikes or interstate natural gas pipelines, particularly related to the oversupply. The length and terms of these contracts allow transparency, timing, and predictability of its certification the pipeline company to earn the rate of return necessary process. As of March 2019, there have been no updates. to break ground on new construction. Transportation companies have historically avoided building speculative Petroleum Pipelines projects (“on spec”), given the capital intensity of pipelines The permitting of oil pipelines is not subject to FERC in particular. Instead, pipeline companies will move regulation. While companies constructing oil pipelines are forward with projects once they have sufficient customer required to obtain federal permits such as those described commitments. under the Clean Water and Clean Air Acts, state approvals are the only governmental authorizations required Storage – Natural gas that is not immediately required for for oil pipeline construction projects to move forward. electricity generation or heating is stored until needed. The At first blush, this may seem like an advantage for oil same is true of crude oil waiting to be refined and refined pipelines. Many would agree it is easier to acquire permits products (such as gasoline, diesel, and jet fuel) waiting to build a pipeline from Oklahoma to Texas than from to be consumed. Storage facilities operate a fee-based Pennsylvania to New York, for example. However, dealing business model similar to rent, with contract lengths with landowner issues in multiple states is not necessarily generally ranging from one to five years. Storage tanks easy. If a landowner does not agree to the path of a pipeline for crude oil and refined products may also have inflation and eminent domain authority does not exist in that escalators. landowner’s state, then the oil pipeline could be forced to take a more expensive alternative route. For natural gas A full list of Alerian’s Energy Midstream Classification pipelines, FERC approval includes federal eminent domain – Standard can be found here, and Alerian’s Midstream a primary advantage of building a natural gas pipeline over Screener classifies each currently trading energy building an oil pipeline. infrastructure company and MLP according to its sector.
13 // Energy Infrastructure 201 Pipeline Regulation Similar to the FERC, the CER regulates pipeline tariffs to ensure that the rates are just and reasonable. The CER In the United States, interstate liquids pipelines are establishes tariffs in a way to allow companies to cover regulated by the Federal Energy Regulatory Commission their costs and earn a reasonable return for its investors. (FERC). Unlike the antagonistic relationship most utilities Canadian pipeline companies may only charge a toll have with their regulators regarding pricing, the FERC that has first been approved by the CER. This process focuses on the safe and efficient transportation of energy typically includes review and negotiation of the terms throughout America. The FERC mandates that tariffs on all and conditions of pipeline access and the responsibilities interstate liquids pipelines increase by PPI + 1.23% every of both parties. Tariffs are often based on cost-of-service July 1. This methodology will be in place until 2021, as the regulation. As a result, lower throughput can lead to FERC reviews the PPI escalator every five years. greater tariffs as costs are shared by fewer shippers, or an expansion of a pipeline could lead to higher or lower tariffs depending on the change to throughput and revenue. Aside FERC Escalator History from cost-of-service regulation, pipelines may also operate under negotiated settlements with the pipeline company 1995–2000 PPI -1.0% and its customers reaching an agreement on tariffs and 2001–2005 PPI operational matters, which is then approved by the CER. 2006–2010 PPI +1.3% Most of the major CER-regulated pipelines have operated 2011–2015 PPI +2.65% under negotiated settlements in recent years. For a further 2016–2021 PPI +1.23% overview of pipeline regulation in Canada, see the CER Source: FERC website here.
For interstate natural gas pipelines, the FERC enforces the Valuation Natural Gas Act, which mandates that the rates charged must be “just and reasonable.” This is determined by The most common valuation metrics for midstream calculating the pipeline company’s cost of service, plus a companies are enterprise value to EBITDA (EV/EBITDA), return on its investment. free cash flow yield, and the dividend discount model. Valuation metrics for MLPs have historically been based Intrastate pipelines are regulated by the states themselves. on yield or distributable cash flow, but valuation methods The most famous state regulatory agency is The Railroad for MLPs are evolving as the MLP business model evolves Commission of Texas (a legacy name). State regulatory (read more). Price-to-earnings ratios may also be used to agencies work with pipeline companies to maintain value midstream companies, but P/E ratios can sometimes standards of safety and maintenance. be distorted by the high depreciation expense for EI companies, which may make earnings appear minimal or Canada negative when in reality their cash flows remain stable and Headquartered in Calgary, Alberta, the Canada Energy growing. Regulator (CER) regulates the interprovincial oil, natural gas, and utilities industries in Canada. It does not create energy policy; it merely regulates construction, operation, and tariffs, and includes the energy-related functions that the EPA would provide in the United States.
14 Energy Infrastructure Investing
15 // Energy Infrastructure Investing Now that you’re read about the business models, risks, and Capital Markets Access – Midstream companies need fundamentals for energy infrastructure, perhaps you have access to capital to build or acquire assets. For these decided that an investment in energy infrastructure is right expansion projects and acquisitions to generate a positive for you and your portfolio. Now what? The first thing to do return, this capital must come at a cost below the expected is decide how much of your portfolio to allocate to energy return of the asset. Companies with a bigger footprint, infrastructure. Many investors use energy infrastructure in greater margin for error8, and lower business risk tend their equity income sleeve, their real asset sleeve, or their to have better and cheaper access to capital. Likewise, energy or equity growth sleeve. In Alerian’s conversations midstream companies with an investment-grade credit with investors over the years, we’ve seen a typical rating or access to alternative sources of capital (such as a allocation of 3%-6%, although depending on the portfolio’s DRIP or PIPEs) will also have more capital flexibility. objective, we’ve also seen upwards of 10%. It’s important to keep in mind that investments in energy infrastructure Growth Opportunities – Obviously, all investors would come with risks, as do all equity investments. like to own companies that continue to expand their asset footprint. Organic growth projects tend to generate a Buying Individual Securities higher internal rate of return (IRR) than acquisitions, so energy infrastructure companies with a larger backlog For investors willing to do the work of researching of projects relative to their current size are likely to have individual securities and comfortable with single security more visibility to growth. risk, direct investment in individual energy infrastructure companies may be an attractive option. Of course, once Financial Metrics – Low leverage ratios and low payout investors have decided to buy individual securities, there ratios mean greater margins of error in terms of is the question of which one(s) to buy. As an indexing and execution risk and during unforeseen macroeconomic market intelligence firm, our desire is to equip investors issues (including severe weather and commodity price to make informed decisions about energy infrastructure movements). and MLPs. To maintain objectivity, we do not make stock picks, and Alerian employees do not own individual EI/MLP Size – Larger midstream companies can more easily access positions. However, after years of following the space, we the capital markets and are more likely to get investment have these recommendations for investors looking to put grade ratings, have higher trading liquidity, and reach together a portfolio of energy infrastructure. a broader investor group. However, it also takes bigger projects, built or acquired, to move the needle for the Management Teams – Consider the management team of company’s bottom line. the corporation. Solid management teams are those that have led the company to build new projects on time and on budget, that have been effective and efficient stewards of investor capital, and who work well together and have excellent relationships with their customers, investors, and other industry stakeholders. They do what they say they will do and have a deep bench of talent.
Asset Footprint – Like Warren Buffet’s moat, those midstream companies which already own land and rights of way in growth areas benefit from their established position by being able to expand their position without excessive political or regulatory headwinds. Additionally, companies which own a variety of assets along the energy value chain can clip multiple coupons along the way while also realizing cost savings from integration. Companies with basin diversity have a natural hedge against changing hydrocarbon flows.
8 Through lower leverage and lower payout ratios 16 // Energy Infrastructure Investing The Myriad of Energy Infrastructure Products returns. Some funds will use leverage to offset some of the effect of taxes. While leverage can increase returns when For those investors not interested in buying individual performance is positive, when performance is negative, midstream securities, a variety of access products are leverage will also cause the fund to lose more money. These available, many of which include MLPs. MLPs are pass- funds are also able to preserve the return of capital benefit through structures that do not pay taxes at the entity level. for their investors, and since they can own 100% MLPs, the Instead, income and deductions are passed through to the proportion of income that is classified as return of capital end investor (read more about MLPs). Regulated Investment is greater. They tend to be favored by investors seeking to Companies (RICs) such as mutual funds and Exchanged maximize after-tax income. Traded Funds (ETFs) under the Investment Company Act of 1940 (collectively, “40 Act Funds”) are also pass-through Some funds are passively managed, where performance is structures. Under current law, 40 Act Funds seeking to linked to an index or benchmark. These funds tend to have retain pass-through status are prohibited from owning lower fees. An actively managed fund has higher fees to more than 25% of their assets in MLPs. Funds that abide by account for the fact that a portfolio manager must be paid this law are called “RIC-compliant.” Other access products to choose individual stocks. will be entirely C-Corporation focused, containing no MLPs.
There are funds that have more than 25% of their assets in MLPs; however, these funds are no longer pass-through structures and are required to pay taxes at the fund level. Functionally, this means that fund performance is reduced by the amount of taxes accrued (i.e. will be owed when positions are sold). Think of it like your employer withholding a certain portion of income taxes. In this case, the fund withholds (or accrues) a portion of the
17 // Energy Infrastructure Investing 40 Act Funds – 40 Act Funds – RIC Compliant – Less than 25% MLPs C corporation taxation – 100% MLPs
Funds which own less than 25% MLPs do not pay taxes at A 40 Act Fund, such as a mutual fund or ETF, which owns the fund level, enabling them to pass through the entire more than 25% MLPs will be taxed as a C-Corporation. As the return to their investors. The return of capital benefit underlying positions increase in value, the fund will accrue from owning MLPs is muted due to the limit imposed on a deferred tax liability (DTL) to account for taxes that will MLP ownership. Investors interested in RIC-compliant be owed should the position be sold. This DTL is assessed energy infrastructure funds should research what the at the corporate tax rate of 21% plus an assumed rate fund owns for the other 75%. Common positions include attributable to state taxes. The DTL is removed from the Net midstream C-Corporations, utility companies, exploration Asset Value (NAV) of the fund, meaning that if the value of and production companies, refiners, and MLP affiliates the underlying portfolio rises from $100 to $110, the fund’s structured as C-Corporations. NAV will move from $100 to $107.9. As the position falls, the DTL will be reduced. When the fund is in a net DTL position, Advantages: the DTL effectively reduces the volatility of the underlying • Ownership of the underlying securities portfolio, assuming no leverage is employed. If the fund • Little to no tracking error has no DTL to unwind, it will track the underlying portfolio on a one-for-one basis. Fund distributions track the return Disadvantages: of capital proportion of the underlying basket of securities • Maximum of 25% of portfolio invested in MLPs and lower an investor’s cost basis. • Other 75% performance can meaningfully deviate from MLP performance Advantages: • Generally lower yield • Owning the underlying securities • Tax character of distributions mirrors that of Suitability: underlying portfolio • Tax-advantaged investors • Fees are taken from the NAV, preserving the yield • Total return investors in a taxable account • Investors without exposure to the asset classes in the Disadvantages: other 75% • DTL mutes gains and losses when the fund is in a net • Investors that prefer broad exposure DTL position
As with 40 Act Funds that make a C corporation tax election, Suitability: RIC compliant 40 Act funds may be mutual funds or ETFs. • Taxable investors seeking after-tax yield
ETFs vs Mutual Funds ETFs trade throughout the day; whereas mutual funds price only at the end of the day. However, mutual funds always price at NAV, while ETF prices are determined by the market. ETFs may also be sold short. Typically, ETFs have lower fees, ranging from around 40 bps-100 bps. Mutual funds fees in this category are a bit higher and range from around 70 bps–140 bps. Mutual funds may also use up to 33% leverage.
Closed-End Funds CEFs were the first 100% MLP C-Corporation, 40 Act products. Like mutual funds, they can also use up to 33% leverage. Because CEFs do not have a creation/redemption feature, pricing may stray from NAV, causing them to trade at a premium or discount. Their liquidity is also constrained by the fund itself as opposed to the underlying securities held.
18 // Energy Infrastructure Investing Exchange-Traded Notes (ETNs) Separately Managed Accounts (SMA)
An ETN is an unsecured debt obligation of the issuer. It is An SMA is an account that is managed by a portfolio an agreement between an investor and an issuing bank manager. An SMA could own both MLPs and corporations under which the bank agrees to pay the investor a return without RIC constraints (i.e. MLPs not limited to 25%). If an specified in the issuance documents. MLP ETNs may track a SMA includes MLPs, it may generate Unrelated Business basket that is 100% MLPs without accruing for DTLs. Taxable Income (UBTI). Once UBTI exceeds $1,000 in an account, additional taxes may be assessed. Advantages: • Little to no tracking error as the bank agrees Advantages: to pay the return • Keeps tax characteristic of the underlying investment • Intraday knowledge of portfolio holdings • Typically lower fees than publicly traded products • 100% MLP exposure Disadvantages: Disadvantages: • May generate UBTI • Coupons are taxed at ordinary income rates • High minimum investment • Lower income as the expense ratio is removed from coupon payments Suitability: • Exposure to the credit risk of the underlying bank • Large institutions such as pensions and endowments • Very wealthy individual investors Suitability: • Tax-advantaged accounts such as 401(k)s or IRAs • Total return investors in a taxable account18 • Investors comfortable with the credit risk of the financial institution
9 Section 1260 of the Internal Revenue Code ( http://www.law.cornell.edu/uscode/text/26/1260) contains some ambiguity with regards to ETNs. If constructive ownership rules were to apply, then long-term capital gains could be recharacterized as ordinary income. Accordingly, investors are advised to consult with their tax advisors. 19 // Energy Infrastructure Investing Active Versus Passive Choosing an Indexed Product
Although this will vary by investor, the next thing to decide As an indexing firm, Alerian constructs and maintains in regards to energy infrastructure investment philosophy energy infrastructure and MLP indices which it licenses is active versus passive management. While this decision to its partners for the creation of passively managed is germane to any sector, there are a few things unique investment products. We launched the first real-time to the midstream space. Advocates of passive investing MLP index in 2006, which has since become the industry note that over the long term and after factoring in fees, standard benchmark, and we continue to work hard to active managers are unable to consistently outperform maintain energy infrastructure and MLP indices that the index to which they benchmark their performance. meet the most rigorous standards. With that bias in mind, Advocates of active investing argue that with extensive Alerian recommends that investors looking for a passive research on individual companies, selective investing, and investment consider the following when researching close monitoring of securities, a portfolio manager can underlying indices. generate alpha, or risk-adjusted outperformance versus a benchmark. Transparency – Passive investors should know what they are buying. The constituents of the underlying index should Choosing an Active Manager be available to investors, as should the methodology used to determine those constituents. If a change is to be made, For those investors who are not comfortable choosing their that information should be public as well. Any index that own securities, but still would like active management, lacks transparency is more like active management than Alerian recommends considering the following factors a truly passive investment. A transparent portfolio allows when selecting an active manager. investors to be sure the underlying portfolio matches their investment thesis. Not all EI indices are the same—some History – As stated ad nauseum, past performance is are midstream focused, others are focused on income, and not an indication of future returns. However, the energy others are 100% MLPs. infrastructure space is still relatively young. EI market capitalization has increased remarkably since the mid- Objectivity – An index provider may be tempted to include 2000’s. As one can imagine, with the outsized growth of the certain EI companies for subjective reasons: a personal space leading up to 2014, many money managers entered investment, a relationship with the management team, or the midstream space. It is worth looking into the track to juice returns on a stock already included in an actively record of an active manager being considered. managed fund. For each index, there should be rules in place to prevent personal opinions and emotions from Outperformance – The entire purpose of paying for impacting the construction and rebalancing of the index. active management is to outperform the benchmark Having a codified set of rules that is transparent and index after fees. If the active manager is not consistently freely available to the public, as well as prohibiting index outperforming the index, or, after fees is underperforming committee members from taking positions in individual the index, an investor is better served by investing in a EI companies in their personal accounts, all help maintain passively managed product. Outperformance in a single objectivity. Additionally, indexing firms should be careful year may be notable but consider whether the manager has to avoid conflicts of interest with actively managed outperformed in previous years and under various market investments. conditions.
Differentiation – An active manager whose portfolio closely mimics an index may be engaging in closet indexing. Investors are encouraged to examine the underlying portfolio to be sure it matches the investment thesis and philosophy of the manager.
20 Classification Standard
21 // Classification Standard
The Energy Midstream Classification Standard is a framework for standardizing the sector classifications of midstream energy infrastructure companies. Midstream companies are categorized by their primary business activity, with an additional delineation by product or customer made for certain activities to account for structural differences in business risk.
Pipeline Transportation Pipeline Transportation Petroleum Natural Gas
Transportation via large-diameter pipeline of crude oil and Transportation via large-diameter pipeline of natural gas refined petroleum products. and natural gas liquids.
Gathering & Processing Storage
Transportation of hydrocarbons from the wellhead to Storage of crude oil, refined petroleum products, natural processing plants, fractionation facilities, and aggregation gas, and natural gas liquids in above ground tanks, points for large-diameter pipelines. depleted gas reservoirs, aquifers, and salt caverns.
Liquefaction Rail Terminaling
Super-cooling natural gas and transforming it from a Loading and unloading of liquid hydrocarbons from railcars. gaseous state into a liquid, which can be shipped overseas.
22 Glossary
23 // Glossary
3D Seismic Imaging: a process that uses acoustic energy, Incentive Distribution Rights: please see MLP 201 – similar to sonar, to determine the density and topography Incentive Distribution Rights for a detailed explanation of underground rock formations Investable Weight Factor: the float, or percent of units At the Market: typically in reference to an equity offering available for public trading where new shares are created and issued at market prices based on demand Liquefaction: the process in which natural gas is converted from its gaseous state to a liquefied state Backwardation: the market condition where the price of a forward or futures contract is trading lower than the Proppant: according to the EPA, “a granular substance such predicted spotprice as sand that is used to keep the underground cracks open once the hydraulic fracturing fluid is withdrawn” Contango: the market condition where the futures price of a commodity is higher than the expected spot price Regassification:the process in which liquefied natural gas in converted from its liquid state to its gaseous state Distributable Cash Flow: please see MLP 201 – Understanding MLP Cash Flows and Financial Reporting for Shale: fine-grained sedimentary rock composed of silt and a detailed explanation clay, characterized by its many breakable thin layers. As it relates to energy, hydrocarbons can be found in these Horizontal Drilling (Directional Drilling): a drilling layers. technique that involves manipulating a drill bit underground so that it changes direction, please see MLP Take-or-pay contract: a contract between a seller and buyer 201 – Shale Revolution for a detailed explanation mandating that a buyer must purchase a certain amount of goods or services or pay a penalty Hydraulic Fracturing: a process in which a mixture of water, sand, and other chemicals is pumped into a well at Total Return: price appreciation plus yield a very high pressure to break up delicate shale rock, please see MLP 201 – Shale Revolution for a detailed explanation West Texas Intermediate: a grade of crude oil typically extracted from Texas that is commonly used as a pricing Hydrocarbons: a general term for crude oil and natural benchmark gas, encompassing all organic molecules with a molecular structure containing exclusively carbon and hydrogen atoms
24 // Acronyms
ATM: At the Market LNG: Liquefied Natural Gas
AUM: Assets Under Management LPG: Liquefied Petroleum Gas
CER: Canada Energy Regulator M&A: Mergers and Acquisitions
DCF: Distributable Cash Flow MLP: Master Limited Partnership
DOE: Department of Energy MQD: Minimum Quarterly Distribution
E&P: Exploration and Production NAV: Net Asset Value
EBITDA: Earnings Before Interest, Taxes, Depreciation and NGL: Natural Gas Liquid Amortization NGV: Natural Gas Vehicle EIA: Energy Information Administration NYSE: New York Stock Exchange EPA: Environmental Protection Agency PLR: Private Letter Ruling EPS: Earnings Per Share PPI: Producer Price Index ETF: Exchange Traded Fund PTP: Publicly Traded Partnership ETN: Exchange Traded Note PUD: Proved Undeveloped Reserves ETP: Exchange Traded Product REIT: Real Estate Investment Trust FERC: Federal Energy Regulatory Commission RIA: Registered Investment Advisor FFO: Funds From Operations RIC: Regulated Investment Company FINRA: Financial Industry Regulatory Authority SEC: Securities and Exchange Commission IDR: Incentive Distribution Right UBTI: Unrelated Business Taxable Income IEA: International Energy Agency WTI: West Texas Intermediate IPO: Initial Public Offering
IWF: Investable Weight Factor
25 // Units of Measure
C: Hundreds (100) CF: Cubic feet, a volumetric measurement for natural gas at 60 degrees Fahrenheit and 14.73 psi of pressure M: Thousands (1,000) CCF: One hundred cubic feet of natural gas MM: Millions (1,000,000) MCF: One thousand cubic feet of natural gas B: Billions (1,000,000,000) MMCF: One million cubic feet of natural gas T: Trillions (1,000,000,000,000) BCF: One billion cubic feet of natural gas
Bbl: Barrel, equal to 42 US Gallons TCF: One trillion cubic feet of natural gas
MBbls: One thousand barrels CCF/d: One hundred cubic feet of natural gas per day
MMBbls: One million barrels MCF/d: One thousand cubic feet of natural gas per day
MBbls/d: One thousand barrels per day MMCF/d: One million cubic feet of natural gas per day
MMBbls/d: One million barrels per day BCF/d: One billion cubic feet of natural gas per day
TCF/d: One trillion cubic feet of natural gas per day Btu: British thermal unit, a measurement of the energy content of natural gas
MBtu: One thousand British thermal units
MMBtu: One million British thermal units
MBtu/d: One thousand British thermal units per day
MMBtu/d: One million British thermal units per day
26 // Disclaimers This Document Is Impersonal and Not a Solicitation. In Limitation of Liability. While Alerian believes that the jurisdictions where Alerian or its affiliates do not have the information provided in this document is reliable, Alerian necessary licenses, this document does not constitute an shall not be liable for any claims or losses of any nature offering of any security, product, or service. Alerian receives in connection with the use of the information in this compensation in connection with licensing its indices to document, including but not limited to, lost profits or third parties. All information provided by Alerian in this punitive or consequential damages, even if Alerian has been document is impersonal and not customized to the specific advised of the possibility of same. needs of any entity, person, or group of persons. Alerian and its affiliates do not endorse, manage, promote, sell, or Research May Not Be Current. This document has been sponsor any investment fund or other vehicle that is offered prepared solely for informational purposes based on by third parties and that seeks to provide an investment information generally available to the public from sources return linked to or based on the returns of any Alerian index. believed to be reliable. Alerian makes no representation as to the accuracy or completeness of this document, No Advisory Relationship. Alerian is not an investment the content of which may change without notice. Alerian advisor, and Alerian and its affiliates make no expressly disclaims any obligation to update the contents of representation regarding the advisability of investing in any this document to reflect developments in the energy Master investment fund or other vehicle. This document should not Limited Partnership sector. The methodology involves be construed to provide advice of any kind, including, but rebalancings and maintenance of indices that are made not limited to, tax and legal. periodically throughout the year and may not, therefore, reflect real-time information. You Must Make Your Own Investment Decision. It is not possible to invest directly in an index. Index performance Linked Products. Alerian licensees its indexes to third does not reflect the deduction of any fees or expenses. parties for the creation of investment funds or other Past performance is not a guarantee of future returns. You vehicles. Alerian is not responsible for the information on should not make a decision to invest in any investment these websites or for anything that they provide. fund or other vehicle based on the statements set forth in this document, and are advised to make an investment in Policies and Procedures. Analytic services and products any investment fund or other vehicle only after carefully provided by Alerian are the result of separate activities evaluating the risks associated with investment in the designed to preserve the independence and objectivity of investment fund, as detailed in the offering memorandum each analytic process. Alerian has established policies and or similar document prepared by or on behalf of the issuer. procedures to maintain the confidentiality of material non- This document does not contain, and does not purport public information received during each analytic process. to contain, the level of detail necessary to give sufficient Alerian and its affiliates provide a wide range of services to, basis to an investment decision. The addition, removal, or relating to, many organizations, and may receive fees or or inclusion of a security in any Alerian index is not a other economic benefits from these organizations. recommendation to buy, sell, or hold that security, nor is it investment advice. Copyright. No Unauthorized Redistribution. Alerian © 2020. All rights reserved. This document, in whole or in part, No Warranties. The accuracy and/or completeness of any may not be redistributed, reproduced, and/or photocopied Alerian index, any data included therein, or any data from without prior written permission. which it is based is not guaranteed by Alerian, and it shall have no liability for any errors, omissions, or interruptions therein. Alerian makes no warranties, express or implied, as to results to be obtained from use of information provided by Alerian and used in this service, and Alerian expressly disclaims all warranties of suitability with respect thereto.
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