Alerian’s midstream energy ETF offers powerful income opportunity

Aug 20th, 2020 | By | Category: Equities

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ETFs providing exposure to North American midstream energy companies offer a compelling investment proposition characterized by high yields, attractive valuations, and the potential for portfolio diversification.

Stacey Morris Alerian

Stacey Morris, Director of Research at Alerian.

This is the view of Stacey Morris, Director of Research at Alerian, the MLP and energy infrastructure industry’s foremost research and indexing firm.

Dallas-based Alerian recently made its ETF debut in Europe in partnership with London-based white label provider HANetf. However, it is well known in the US as the sponsor of the Alerian MLP ETF (AMLP US), the largest infrastructure ETF globally.

Listed on NYSE Arca, this ETF has some $3.7 billion in assets under management, a ten-year track record, and is the go-to vehicle for midstream exposure.

Its maiden ETF in Europe, the Alerian Midstream Energy Dividend UCITS ETF, has the potential to play a similar role this side of the Atlantic.

The ETF has been listed on London Stock Exchange in US dollars (MMLP LN) and pound sterling (PMLP LN), and on Xetra (JMLP GY) and Borsa Italiana (MMLP IM) in euros. It comes with an expense ratio of 0.40%.

According to Morris, who recently shared her views on the midstream space in a webcast hosted with HANetf, the fund’s introduction is timely as recent volatility in the energy sector has lowered valuations in the midstream segment to favourable levels compared to industry fundamentals.

Morris kicked off the webcast by outlining the operations of midstream energy companies. These firms, she said, own and operate energy pipelines, storage facilities, refineries, and import/export terminals that facilitate the transportation or processing, for fees, of crude oil, natural gas, and natural gas liquids to customers in domestic and international markets.

Midstream companies are typically organized with tax-efficient corporate structures – such as master limited partnerships (MLPs) and C-corps – that enable their earnings to be passed on to investors in the form of attractive dividend distributions.

In terms of the Alerian Midstream Energy Dividend UCITS ETF, the fund gains its exposure to the midstream segment by tracking the Alerian Midstream Energy Dividend Index (AEDW). The index includes US and Canadian companies, including both MLPs and C-corps, which belong to the Oil & Gas Storage and Transportation sector, according to the Global Industry Classification Standard (GICS).

Constituents are weighted by aggregate annualized dividends in a bid to boost income potential, while any individual security is capped at 10% to ensure diversification.

US energy renaissance

Morris explained that the US energy sector has experienced a renaissance over the past ten years, driven by advancements in hydraulic fracking, which has transformed the US into the world’s top producer of oil and natural gas and significantly increased world supplies of both commodities.

This rapid expansion was facilitated by substantial capital expenditure in the midstream segment, leading to the creation of robust infrastructure that will support the US energy sector for decades. With this core infrastructure largely set, many firms in the midstream segment had actually begun reducing their capital expenditure levels in recent years, switching their focus to fortifying their balance sheets and passing on juicy dividends to investors.

The collapse in oil prices this year, driven by an acute supply glut caused by sparring oil producers and the Covid-19 pandemic’s impact on global crude demand, presented the first major disruption to the US energy renaissance. The upstream segment reined in production and these companies suffered dramatic stock price plunges and credit rating downgrades.

The midstream segment was also dealt a significant blow – the Alerian Midstream Energy Dividend Index plummeted 59.9% between 21 February and its bottom on 18 March. While the index has recovered somewhat since then, it is still down 31.7% year-to-date (data as of the market’s close on 14 August).

According to Morris, however, the midstream sell-off has been overdone and presents a compelling opportunity for investors.

She highlighted the segment’s resiliency due to steady cash flows based on long-term contracts that are often linked to inflation. The fee-based nature of midstream operators makes their cash flows less sensitive to commodity prices than other parts of the energy value chain, providing useful defensive characteristics. Indeed, following the oil price collapse, analysts re-adjusted their 2021 EBITDA expectations for companies within the Alerian Midstream Energy Dividend Index down by just 11.2% compared to downgrades of 34.5% for the broad US energy sector and 61.7% for oil and gas producers.

Furthermore, Morris believes that, despite the short-term disruption, the long-term outlook for upstream operators is highly favourable which will add additional support to the midstream segment when production ramps up again. She noted key benefits for oil producers in the US compared to their global counterparts including significant known reserves, falling costs through innovation, efficiency by market competitiveness, and a favourable legislative environment.

Yet, while crude markets tend to capture the majority of headlines, Morris highlighted that the ETF’s investment proposition also extends beyond oil. The fund contains significant exposure to midstream companies specializing in natural gas operations which tend to be underrepresented in pure MLP indices. According to Morris, this broader coverage helps to diversify the risks associated with oil while also providing exposure to a commodity that is expected to be an important bridging fuel as the world shifts from oil to more environmentally friendly energy solutions.

Morris noted that another consequence of the dramatic midstream sell-off is that falling valuations have pushed the segment’s yield near all-time highs, potentially representing a huge moment for income-seeking investors in the record low-interest-rate environment. The yield on the Alerian Midstream Energy Dividend Index is currently at 11.1%, notably above its five-year average of 7.4%, and strides ahead of other income-producing asset classes such as REITs (3.5%), utilities (3.4%), and bonds (1.1%).

Despite the index’s unusually high yields, fears of a value trap are probably overdone given investment-grade-rated credits make 84% of the total weighting, as of the end of July.

Importantly, investors will receive the majority of the yield available as the ETF gains its exposure through synthetic (or swap-based) replication based on the index’s gross performance.

This structure allows European investors to participate in the sector’s favourable tax treatment by avoiding withholding tax on foreign income. The swap counterparty is JP Morgan.

Finally, Morris pointed out that MLPs are typically omitted from mainstream indices, such as the S&P 500, while their historically low correlation to other income-yielding securities makes them attractive portfolio diversifiers.

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