Frequently Asked Questions

Frequently Asked Questions
December 2013
Alerian
1717 McKinney Avenue
Suite 1450
Dallas, TX 75202
www.alerian.com
table of
contents
North American Energy Industry Basics
• What is the North American energy renaissance?
• Is energy demand still increasing?
• What does the LNG market look like currently?
• What is the status of renewable energy and how will renewable
energy impact energy infrastructure companies?
• What are expectations for natural gas prices?
• How will the Panama Canal expansion impact energy
infrastructure companies?
North American Energy Infrastructure Basics
• How much infrastructure will need to be built in North America
over the next few decades?
• How long does it take to build a pipeline? What is involved in
the regulatory process?
• What is the impact of foreign investment in E&P?
• When new pipelines get built, what happens to the old ones?
Master Limited Partnership (MLP) Basics
• What are Master Limited Partnerships?
• How are MLPs structured?
• What are the tax advantages of owning MLPs?
• Are MLP distributions guaranteed? Is there a minimum amount
of distributions that must be paid?
• Does an MLP unitholder have to pay state taxes in every state
where the MLP operates?
• Can MLPs be held in an IRA?
• Can MLPs be held by foreign investors?
• How do you value MLPs?
• What is Distributable Cash Flow (DCF) and how is it calculated?
• Why are earnings per unit (EPU) or P/E negative for many MLPs?
• What is the difference between maintenance and growth
capital expenditures?
Merits of Energy Infrastructure and MLPs
• Why own energy infrastructure companies and MLPs?
• How do energy infrastructure companies and MLPs compare to
other asset classes?
• How have energy infrastructure companies and MLPs
performed historically and what have they yielded?
• What has the correlation and beta been for energy infrastructure
companies and MLPs to the broader market?
• What has been the historical distribution growth for energy
infrastructure companies and MLPs?
Pooled Investments in Energy Infrastructure and MLPs
• Is there a way to gain exposure to MLPs but avoid filing K-1s
and state taxes?
• How can I invest in Alerian indices like the AMZ, AMZI, AMEI,
and ANGI?
• How do I choose between the different energy infrastructure
and MLP products?
• What does it mean to be RIC Compliant?
• What is the difference between an MLP exchange traded fund
(ETF) and exchange traded note (ETN)?
• What active management MLP products are available?
Energy Infrastructure Risks
• Legislative: What is the likelihood that Congress would abolish
the preferential tax treatment afforded to MLPs?
• Commodity Price: How correlated are energy infrastructure
companies and MLPs to movements in crude or natural gas
prices?
• Interest Rates: How have MLPs performed during periods of
inflationary environments?
• Regulatory: What sort of governing bodies regulate energy
infrastructure companies and MLPs?
• Industry: What is the status of hydraulic fracking? Is it safe?
• Environmental: How safe are natural gas and crude oil pipelines?
Alerian and the Alerian Index Series
• How do I buy the Alerian fund?
• How did the Alerian MLP Index (AMZ) become the benchmark
for the MLP asset class?
• In general, what is the difference between Alerian’s Index Series
and other MLP indices?
• When was Alerian formed?
• Where did the name Alerian come from?
• How can I get in contact with Alerian?
frequently asked
questions
NORTH AMERICAN ENERGY INDUSTRY BASICS
What is the North American energy renaissance?
The term “energy renaissance” refers to the overwhelming
production growth in energy resources that has occurred and is
expected to continue, with the potential for the US to be energy
independent from other nations for all energy resources by the
2020 to 2030 timeframe (estimates vary).
The US and Canada have vast reserves of natural gas, crude, and NGLs
trapped in between layers of rock; such reserves were previously
deemed unrecoverable, but a combination of horizontal drilling
and hydraulic fracturing has changed the game. The natural gas
industry began large scale application of such technologies in the
early 2000s. After seeing the overwhelming success, oil producers
began applying the same technologies to oil wells in the late 2000s
and have seen similar results.
Since 2010, oil production has doubled in Texas and tripled in North
Dakota. The US Energy Information Administration (EIA) projects
that total natural gas production will increase 44% from 2011 to
2040, with the bulk of the growth from shale gas production, which
is expected to increase by 133% during the same time period. In
addition, the EIA believes that the US could be a net exporter of
natural gas by 2020.
Is energy demand still increasing?
Natural gas energy demand is expected to grow from 24.4 trillion
cubic feet to 29.5 trillion cubic feet in 2040 (+21%). While coal is
currently the largest source of power generation in the US, one
trend that has gained considerable momentum is coal to natural gas
switching for power generation. The EIA expects the use of natural
gas for power generation to increase on average 0.8% annually from
2011 to 2040.
Industrial demand for natural gas has also grown considerably,
with many international corporations moving their petrochemical,
refining, and manufacturing operations to the US to take advantage
of cheap natural gas. Consumption in the industrial sector is
expected to increase by an average of 0.5% annually from 2011 to
2040. A potential and developing trend is the construction of gasto-liquid (GTL) plants that convert natural gas into gasoline or diesel
fuel. Typically, such products are refined from crude oil and not
natural gas, but the abundance of cheap natural gas in the US could
make such plants in the US a reality.
On the petroleum products front, consumption is expected to
increase steadily by 4.7% until 2019 and remain relatively flat
thereafter through 2040 as a function of vehicle efficiencies and
more stringent corporate average fuel economy (CAFE) standards.
What does the LNG market look like currently?
The global liquefied natural gas (LNG) market is typically segmented
by the Atlantic and Pacific oceans, with the Atlantic market servicing
Europe, and the Pacific market servicing Asia. The Pacific market is
the larger of the two, with countries such as Japan, Taiwan, and
Korea driving demand. Currently, Asia imports four times more LNG
than Europe, with Japan being the largest importer of LNG in the
world. On the Atlantic side, Russia is the largest natural gas supplier
to Europe and in the past has used its position as a political tool,
threatening to cut off gas supplies during times of tense pricing
negotiations. As such, European countries have increasingly tried to
diversify their supply sources.
Today, Qatar is the largest producer of LNG in the world, accounting
for nearly 25% of LNG exports. However, Qatar’s dominance is being
challenged by Australia, North America, and East Africa, each of
which has dozens of potential LNG export projects in the planning
stages. Australia’s main challenge is steep development costs, while
projects in the US are primarily constrained by permit approvals
from the Department of Energy. In contrast, projects in East Africa
have been delayed given regional instability and lack of existing
infrastructure. Until 2015, when many of these projects are slated
to start coming online, global LNG markets are expected to be tight,
with existing LNG facilities unable to keep up with demand.
LNG export contracts, which are typically locked in for 20 to 25
years, have historically been linked to oil prices because natural
gas was viewed as a substitute resource for oil. However, the US
priced its natural gas on domestic natural gas supply and demand
fundamentals rather than on oil prices. Henry Hub in Louisiana
evolved to be the pricing point for natural gas contracts. Over
the years, as the prices of crude and natural gas have diverged
dramatically, some countries are pushing for long-term LNG
contracts to be pegged to the price of Henry Hub natural gas
instead of indexed to oil, which would lower global LNG prices.
Nevertheless, oil-indexed prices are still dominant among LNG
contracts, and until North America becomes a leading exporter, oilindexed pricing models will remain the norm.
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frequently asked
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NORTH AMERICAN ENERGY INDUSTRY BASICS
What is the status of renewable energy and how will renewable
energy impact energy infrastructure companies?
In the US, renewables such as wind, solar, and tidal power are not
currently economic without government subsidies. If current
government and private programs give renewables enough of a
boost to where they can be profitable as stand-alone enterprises,
one day renewables could be an appropriate asset for the MLP
structure. To that point, the MLP Parity Act is currently before
Congress, which would expand the definition of MLP qualifying
income to include renewable forms of energy.
Canadians are well ahead of the US in terms of renewable energy.
In 2006, the majority of Canadian electricity was generated from
hydroelectric dams. In contrast, in 2012, only 13% of US electricity
was from all renewable sources combined. In 2011, Canada was the
sixth largest producer of wind power worldwide. Canada also uses
the tides in the Bay of Fundy (the largest in the world) to generate
electricity. Canadian solar power is most prominent in Ontario and
on the Prairies. One of the solar plants in Ontario was the largest in
the world when it was first constructed in 2011. Both citizens and
politicians in Canada are interested in increasing the amount of
electricity generated from these sources.
Pipelines already in place can be converted to transport various
forms of energy. Should North America convert to a hydrogenbased energy, the existing pipelines could be retrofitted to handle
those forms. Some pipelines are already transporting biodiesel and
ethanol along short distances.
What are expectations for natural gas prices?
Natural gas prices have plummeted over the past half-decade, as
supplies have increased at a faster pace than demand. In 2008, Henry
Hub natural gas spot prices peaked at nearly $13/MMBtu and have
declined until current pricing around $4/MMBtu. Looking forward,
most energy analysts expect natural gas prices to remain in the $4$5/MMBtu range for the next half-decade, as a function of waiting
for demand to catch up and in-service dates for US LNG facilities to
be reconfigured to export gas. This is in contrast to international gas
prices, which are twice as expensive in Europe as in North America,
and three times more expensive in Asia.
Beyond the next five years, the LNG export market will play a
significant role in setting the price of natural gas. With the opening
of international markets through LNG export centers, regional
natural gas prices may converge. Energy infrastructure companies
will continue to benefit from the need for infrastructure build-out
to transport these supplies to domestic demand centers and export
dock facilities.
How will the Panama Canal expansion impact energy
infrastructure companies?
The Panama Canal is currently being expanded to handle much
larger ships, and the biggest benefit for North American energy will
be to those companies involved in storing, transporting, liquefying,
and exporting natural gas as LNG or propane and butane in the form
of liquefied petroleum gas (LPG) to Asian markets. Currently, only 21
of the world’s LNG tankers are small enough to travel through the
Panama Canal. The remaining 349 must travel around the entirety
of South America to reach Asian markets, adding significantly to
the time and cost of transportation. The Panama Canal expansion is
expected to be completed in mid-2015.
What is the impact to AMEI constituents when the Panama
Canal expansion is complete?
The Panama Canal is currently being expanded to handle much
larger ships, and the biggest benefit for North American energy will
be to those companies involved in storing, transporting, liquefying,
and exporting natural gas as LNG or propane and butane in the form
of liquefied petroleum gas (LPG) to Asian markets. Currently, only 21
of the world’s LNG tankers are small enough to travel through the
Panama Canal. The remaining 349 must travel around the entirety
of South America to reach Asian markets, adding significantly to
the time and cost of transportation. The Panama Canal expansion is
expected to be completed in mid-2015.
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frequently asked
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NORTH AMERICAN ENERGY INFRASTRUCTURE BASICS
How much infrastructure will need to be built in North America
over the next few decades?
The June 28, 2011 study by the Interstate Natural Gas Association
of America (INGAA), “North American Midstream Infrastructure
Through 2035 – A Secure Energy Future,” notes that over $250
billion, or roughly $10 billion per year, of natural gas, NGL, and oil
infrastructure will need to be built through 2035 to meet shifting
energy supplies and demand. The bulk of the investment will
be in natural gas infrastructure ($205 billion) followed by crude
oil pipelines (around $30 billion) and NGL pipelines (around $15
billion). Not included in the study are other related crude oil and
NGL infrastructure such as fractionation plants, NGL and crude
storage, and export docks.
How long does it take to build a pipeline? What is involved in
the regulatory process?
There are many stages in pipeline construction, including planning,
application, and construction. During the planning stage, an
operator will hold an open season to determine market needs,
select a pipeline route, identify landowners and begin easement
negotiations, hold public meetings, and conduct land surveys. This
planning stage generally takes place 7 to 8 months before filing a
certificate application. Afterward, the operator will file a formal
application with the Federal Energy Regulatory Commission (FERC)
if the pipeline is being built in the US, or the National Energy Board
(NEB) if the pipeline is being built in Canada.
Then, the FERC and NEB will review the application for various issues
including whether the project would be in the public’s interest.
Review of environmental issues typically takes up the bulk of the
review process. There are several opportunities throughout the
application stage for public input, either via written or oral hearings.
There are no statutory time limits of when the FERC must complete
its review by, but most certificate reviews are completed within one
year. The Natural Gas Pipeline Permitting Reform Act, which has
passed in the House of Representatives, aims to set a time limit of 12
months for the FERC to either approve or deny a pipeline certificate.
What is the impact of foreign investment in E&P?
According to the EIA, between 2008 and 2012, foreign investors
have partnered with US exploration and production firms in 73
deals, totaling over $26 billion, or around 20% of the total $133
billion invested in the development of shale plays during that
period. Typically, these investments involve the foreign company
purchasing a percentage of the host company’s shale play acreage,
in addition to committing to pay a portion of the drilling costs.
These deals are considered mutually beneficial, with the domestic
drillers receiving a significant portion of upfront funding for their
projects, while their international partners gain access to horizontal
drilling experience and fracking technologies.
When new pipelines get built, what happens to the old ones?
New pipelines are not typically built to replace old pipelines.
Generally, they are built because existing pipelines are already
operating at full capacity, and yet more space is needed. This is what
has happened in the Permian and Eagle Ford, two existing producing
areas in Texas that have seen their production numbers significantly
increase. However, sometimes it does happen that an existing
pipeline is no longer needed due to changes in supply or demand
and the resulting shift in energy flow. In such cases, operators can
choose to reverse the flow of the pipeline to better serve markets or
convert the type of product shipped on the pipeline.
It is important to note that generally energy infrastructure
companies will not build a new pipeline for speculative purposes.
Long-term, fixed contracts are signed before a single shovel goes
into the ground, guaranteeing the constructing firm an acceptable
return above its cost of capital.
The final regulatory stage is construction. Operators are responsible
for completing rights-of-way acquisition and restoration,
construction, and adhering to environmental restrictions during the
process. Depending on the project, construction can take anywhere
from six months to up to two years for larger projects. The entire
process from start to finish takes four years on average.
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frequently asked
questions
MASTER LIMITED PARTNERSHIP (MLP) BASICS
What are Master Limited Partnerships?
Master Limited Partnerships, or MLPs, are engaged in the
transportation, storage, processing, refining, marketing, exploration,
production, and mining of minerals or natural resources. By
confining 90% of their income to these specific “qualifying”
activities, their units are able to trade on public securities exchanges
exactly like the shares of a corporation, without entity level taxation.
Most MLPs trade on the New York Stock Exchange (NYSE), NASDAQ,
or other public exchanges. As of November 1, 2013, there are 106
publicly traded energy MLPs with a combined market capitalization
of approximately $430 billion.
How are MLPs structured?
MLPs have two classes of ownership, which are general partners
(GPs) and limited partners (LPs). GPs manage the partnership’s
operations, receive incentive distribution rights (IDRs), and
generally maintain a 2% economic stake in the partnership. LPs are
not involved in the operations of the partnership and have limited
liability, much like the shareholders of a publicly traded corporation.
IDRs incentivize GPs to grow LP distributions by entitling GPs to
receive a higher percentage of incremental cash distributions when
the distribution to LP unitholders reaches certain thresholds.
Unlike regular corporations, MLPs do not pay corporate-level
tax. And whereas investors that own shares in a corporation are
considered shareholders, MLP investors are considered unitholders
that own interests (or units) in the MLP. Since the MLP itself does not
pay corporate-level tax, income and deductions are passed through
to the holders of their partnership interests. Instead of receiving a
Form 1099 detailing dividends and distributions, an MLP investor is
responsible for filing a partnership tax information return known as
a Schedule K-1.
What are the tax advantages of owning MLPs?
A unitholder’s basis is adjusted upward by the amount of partnership
income allocated and adjusted downward by the amount of cash
distributions received. For most MLPs, cash distributions received
exceeds allocated income. The difference between distributed cash
and allocated income will be treated as return of capital and reduces
the unitholder’s basis in the units. Typically, 70-100% of MLP
distributions are tax-deferred, with the remaining portion taxed at
ordinary income rates in the current year.
As long as the investor’s adjusted basis remains above zero, taxes
on the return of capital portion of the distribution are deferred until
sale of units. If an investor’s basis reaches zero, then future cash
distributions will be taxed as capital gains in the current year. Upon
sale, the gain resulting from basis reductions is recaptured and
taxed at ordinary income rates and any remaining gain is taxed at
capital gain rates for investments held greater than one year.
From an estate planning perspective, if units are passed along to
heirs, upon death of the unitholder, the basis is “stepped up” to the
fair market value of units on the date of transfer, thereby eliminating
a taxable liability associated with the reduction of the original
unitholder’s cost basis. As always, investors should consult a tax or
estate planning tax professional for advice.
Are MLP distributions guaranteed? Is there a minimum amount
of distributions that must be paid?
MLP cash distributions are not guaranteed and depend on each
partnership’s ability to generate adequate cash flow. Unlike Real
Estate Investment Trusts (REITs) that must distribute a certain
percentage of their cash flow each quarter, the partnership
agreements of individual MLPs determine how cash distributions will
be made to GPs and LPs. Generally speaking, partnership agreements
mandate that the MLP distribute 100% of its distributable cash
flow (DCF), less a discretionary reserve determined by the GP, to
unitholders within 45 days after the end of a quarter.
Does an MLP unitholder have to pay state taxes in every state
where the MLP operates?
Yes. An MLP unitholder is responsible for paying state income
taxes on the portion of income allocated to the unitholder for each
individual state. In most cases, however, unless the unitholder owns
a large position, the share of allocable income is small and the
unitholder may not have to file in certain states due to minimum
income limits. Additionally, some states in which MLPs operate do
not have state income taxes, such as Texas and Wyoming.
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frequently asked
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MASTER LIMITED PARTNERSHIP (MLP) BASICS
Can MLPs be held in an IRA?
MLPs can be held directly in an IRA. However, partnership income
– not cash distributions – may be considered unrelated business
taxable income (UBTI) subject to unrelated business income tax
(UBIT) if UBTI exceeds $1,000 in a year. The custodian of the IRA
is responsible for filing IRS Form 990T and paying the taxes. More
information can be found in IRS Publication 598, Tax on Unrelated
Business Income of Exempt Organizations, or in the Internal Revenue
Code, Section 512: Unrelated Business Taxable Income.
Distributable cash flow is considered a non-GAAP financial measure,
or not a Generally Accepted Accounting Principle (GAAP) measure
of liquidity or financial performance with set standards. Investors
should understand that the definition and calculation of DCF may
vary among partnerships, as ultimately, each MLP determines its
definition of DCF in its partnership agreement. The calculation
of DCF is typically net income, (+) depreciation, depletion, and
amortization, (-) cash interest expense, (-) maintenance capital
expenditures, (+/-) other non-cash items.
Can MLPs be held by foreign investors?
Foreign investors are required to file federal tax returns to report
their share of an MLP’s income, gains, losses, and deductions.
Federal income taxes are paid at regular rates on their share of
the MLP’s net income. Additionally, taxes must be withheld at the
highest applicable effective tax rate on MLP quarterly distributions.
An investor can get credit back on excess withholdings by filing a
U.S. federal tax return.
Why are earnings per unit (EPU) or P/E negative for some MLPs?
Due to accounting standards, there can be wide differences
between an MLP’s earnings per unit (EPU) and distribution per
unit (DPU). In most cases, EPU tends to be less than DPU, due to
non-cash items. Typical non-cash items include depreciation and
amortization expenses, non-cash mark-to-market adjustments for
derivative positions, equity income versus cash distributions from
unconsolidated affiliates, and non-cash amortization of interest
financing charges.
How are MLPs generally valued?
The most common valuation metrics for MLPs are Price-toDistributable Cash Flow (P/DCF), Enterprise Value-to-EBITDA (EV/
EBITDA), Yield Spread to the 10-year Treasury, and the Dividend
Discount Model. Generally, Price-to-Earnings (P/E) is not used, as it
tends not to be the best representation of cash flow.
What is Distributable Cash Flow (DCF) and how is it calculated?
Similar to how REITs define their cash flow from operations as Funds
From Operations (FFO), MLPs use Distributable Cash Flow (DCF) as
the primary measure of cash available to distribute to unitholders
or to fund growth.
What is the difference between maintenance and growth capital
expenditures?
In general, maintenance capital expenditures are expenditures
spent to maintain long-term operating capacity or revenue levels,
such as integrity spending, replacing compressors or valves, and
general repairs. Growth capital expenditures are expenditures that
increase capacity or generate new income opportunities.
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MERITS OF ENERGY INFRASTRUCTURE COMPANIES AND MLPS
Why own energy infrastructure companies and MLPs?
North America will require over billions of dollars of investment in the
built-out of energy infrastructure over the next few decades. Energy
infrastructure companies and MLPs operate toll-road business
models that benefit from inflation hedges built into their contracts,
regional monopoly footprints, and inelastic long-term energy
demand growth. Such business models allow energy infrastructure
companies and MLPs to generate predictable cash flows and pay
consistent and growing quarterly cash distributions. In addition,
energy infrastructure companies and MLP returns have historically
exhibited low correlation with the broader equities market.
How do energy infrastructure companies and MLPs compare to
other asset classes?
The two most comparable asset classes to energy infrastructure
companies and MLPs are Utilities and Real Estate Investment Trusts
(REITs). Utilities, energy infrastructure companies, and MLPs all
benefit from inelastic long-term energy demand growth. However,
Utilities are subject to a more local and highly scrutinized regulatory
body focused on returning cost savings to their constituents. The
interstate pipelines owned by energy infrastructure companies and
MLPs, on the other hand, are predominantly regulated at the federal
level by the Federal Regulatory Energy Commission (FERC), where
infrastructure assets are viewed as critical to energy security.
The commercial buildings held inside REITs are viewed as hard
assets with inherent tangible value. Similarly, the steel pipelines and
storage tanks that transport and store the nation’s energy, including
that which heats and cools those buildings, are hard assets with
associated permanent value. REIT rental income, however, tends
to fluctuate with economic conditions and market demand, while
energy infrastructure companies and MLPs benefit from inelastic
energy demand and inflation-adjusted tariffs.
Energy infrastructure companies, as measured by the Alerian
Energy Infrastructure Index (CME: AMEI), a composite of 30 core
North American energy infrastructure companies, have returned
24.5% annualized on a total return basis during the 5-year period of
September 30, 2008 to September 30, 2013. During the same time
period, the average yield on the AMEI was 5.3%.
What has the correlation and beta been for energy infrastructure
companies and MLPs to the broader market?
On a trailing ten year basis from September 30, 2013, the Alerian
MLP Index exhibited a relatively weak 0.5 correlation to the S&P 500
Index. This compares to a correlation of 0.8 for REITs and 0.6 for the
Utilities sector.
On a trailing five year basis from September 30, 2013, the Alerian
Energy Infrastructure Index exhibted a 0.7 correlation to the S&P
500.
What has been the historical distribution growth for energy
infrastructure companies and MLPs?
The weighted average distribution growth for the Alerian MLP Index
over the 10-year period of September 30, 2003 to September 30,
2013 was 7.8% annualized.
The weighted average distribution growth for the Alerian Energy
Infrastructure Index over the 5-year period of September 30, 2008 to
September 30, 2013 was 6.1% annualized.
How have energy infrastructure companies and MLPs performed
historically and what have they yielded?
MLPs, as measured by the Alerian MLP Index (NYSE: AMZ), a
composite of the 50 most prominent energy MLPs calculated
using a float-adjusted, capitalization-weighted methodology, have
returned 15.7% annualized on a total return basis during the 10-year
period of September 30, 2003 to September 30, 2013. During the
same time period, the average yield on the AMZ was 6.9%.
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POOLED INVESTMENTS IN MLPS
Is there a way to gain exposure to MLPs but avoid filing K-1s and
state taxes?
There are several publicly traded pooled investment products that
handle the K-1s and state tax filings for the investor, and in return,
distribute a Form 1099 to investors. Passively managed MLP products
that track indices include exchange-traded funds (ETFs) and exchange
traded notes (ETNs). Actively managed MLP products include openend funds and closed-end funds.
Investment products such as mutual funds, closed end funds, and
ETFs are structured as RICs. Most equity and bond mutual funds are
allowed to make the RIC election because the securities in which
they invest (stocks and bonds) are taxable entities. But because MLPs
themselves have no entity-level tax, the IRS requires any open-end or
closed-end fund that invests more than 25% of its assets in MLPs to
be taxed as a C corporation. This creates another level of taxation at
the entity level.
How can I invest in Alerian indices like the AMZ, AMZI, ANGI, and
AMEI?
An investor cannot invest directly in an index. Several companies
have investable products which are designed to track Alerian indices.
For more information about such products, visit www.alerian.com.
Thus, the term RIC-Compliant fund has been associated with funds
that hold less than 25% of their assets in MLPs. The remaining 75%
of holdings can vary from MLP affiliates, energy infrastructure
companies, E&P companies, refiners, utilities, or even non-energy
related companies such as REITs or other real asset sectors.
How do I choose between the different energy infrastructure and
MLP products?
Currently, there are over 60 different pooled energy infrastructure
and/or MLP products available in the marketplace including closedend funds, mutual funds, ETNs, ETFs, variable insurance trusts, and
unit investment trusts. Each investor should consider the vehicle that
most appropriate fits his or her needs and risk tolerance. In addition,
careful research and comparison of each product’s holdings should
be conducted. Some preferences to evaluate before selecting a
product include :
What is the difference between a 100% MLP exchange-traded
fund (ETF) and exchange-traded note (ETN)?
ETNs and ETFs are passively managed options designed to track the
performance of an underlying index. An ETF is a security that tracks
an index, a commodity, or a basket of assets like an index fund, but
trades like a stock on an exchange. An ETN is a senior, unescured,
unsubordinated debt security issued by an underwriting bank. Some,
but not all, of the differences are listed below.
•
•
•
•
•
Active versus Passive Management
Premium/Discount Trading versus NAV Pricing
Exposure to 100% MLPs or 25% MLPs
Comfortable with Credit Risk
Total Return or After-tax Yield Focused
What does it mean to be RIC Compliant?
A regulated investment company (RIC) refers to a company registered
under the Investment Company Act of 1940. By meeting certain
requirements, RICs qualify under Regulation M of the Internal Revenue
Code and pass taxes onto investors to be paid at the individual level.
Accordingly, taxes on capital gains, dividends, and interest are not
paid at the entity, or RIC level.
• IRA / 401k Eligibility. The ETF is IRA and 401(k) eligible and
does not generate unrelated business taxable income (UBTI). The
ETN can be invested in IRAs and 401(k)s; however, no should-tax
opinion (or official stance) has been obtained from a tax counsel by
any of the current ETN issuers, meaning IRA and 401(k) eligibility
has neither been confirmed nor denied.
• C Corporation Tax Election. An ETF invested 100% in MLPs can
not be treated as a Regulated Investment Company (RIC) for tax
purposes; instead must be taxed as a C corporation.
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POOLED INVESTMENTS IN MLPS
• Credit Risk. An ETN is a senior unsecured obligation of the issuing
bank, thereby exposing the investor to credit risk. Although the
maturity of the available MLP ETNs is currently over ten years,
credit exposure is limited to a one-week rolling basis. The minimum
repurchase amount is 50,000 notes, and repurchases are available
on at least a weekly basis. The ETF does not carry the credit risk of
the product issuer, but similar to any equity investment, the ETF
does carry the credit risk of the underlying companies.
• Corporate Taxes and “Tracking Error.” An MLP ETF must accrue
deferred income taxes for any future tax liability associated with
(1) the portion of MLP distributions from underlying securities
considered to be a tax-deferred return of capital and (2) capital
appreciation or depreciation of the underlying securities. The net
asset value (NAV) of the fund will be reduced (or enhanced) by
this deferred tax liability (or asset). An MLP ETN is not subject to
corporate taxes.
What active management MLP products are available?
Actively managed products include MLP mutual funds and closedend funds. When making an investment decision between an MLP
closed-end fund or mutual fund, it is important to consider the
investment team, their track record, and total fees of the fund. Both
are IRA and 401(k) eligible; however, the shares of a closed-end fund
trade throughout the day, whereas mutual funds only trade at the
end of the day. Some MLP mutual funds may choose to employ
leverage, whereas others may not. The benefits of leverage include
higher returns in an upward market; however, leverage also increases
overall volatility to the net asset value of the fund.
• Taxation of Quarterly Distributions. The quarterly distribution
for an ETN is treated as a coupon and taxed at ordinary income
rates. The quarterly distribution for an ETF will typically be similar
to that of its underlying companies, or 70%-100% return of capital.
The remaining taxable portion of the distribution will be taxed at
qualified dividend rates.
• Treatment at Sale. As an aside, upon sale of securities, a direct
investment in an MLP would require an investor to recapture the
portion of distributions considered tax-deferred return of capital
at ordinary income rates. In an MLP ETF, the entire deferred portion
will be taxed at capital gain rates. Separately, ETNs are treated as
prepaid forward or executory contracts for US federal income tax
purposes. Gains or losses are recognized upon the sale, redemption,
or maturity of the ETN and are treated as capital gains or losses.
Page 8
frequently asked
questions
ENERGY INFRASTRUCTURE RISKS
Legislative: What is the likelihood that Congress will abolish the
preferential tax treatment afforded to MLPs?
Most MLP industry analysts view a change in MLP tax status
as unlikely, as MLPs are an integral part of domestic energy
infrastructure. Moreover, MLPs have already experienced tax reform.
In 1987, Congress created Section 7704 in the tax code to define and
limit publicly traded partnerships to those with specific qualifying
income sources, mitigating the probability that something similar to
Halloween 2006 for Canadian Income Trusts will occur. On February
1, 2013, the staff of the Congressional Joint Committee on Taxation
(JCT) released its annual list of tax expenditures. For energy and
natural resource publicly traded partnerships, the total revenue loss
over five years (2012-2016) is estimated to be $7 billion, equating to
$1.4 billion per year. This amount, if collected, would likely have a de
minimis impact on the trillion-plus dollar U.S. deficit.
Commodity Price: How correlated are energy infrastructure and
MLP prices to movements in natural gas prices?
Since energy infrastructure companies and MLPs typically do not take
ownership of the commodity that is being transported, they have
historically had a low correlation to commodity prices. Over the past
15 years, the correlation between energy infrastructure companies
and MLPs and both crude oil and natural gas has been statistically
insignificant. However, external factors related to commodity price
movements may indirectly affect energy infrastructure companies
and MLPs, such as producers shutting in natural gas production
due to oversupply. Another indirect fundamental risk may be
from demand destruction given high commodity prices or the
proliferation of alternative energy sources. Despite these risks, the
demand for petroleum products and natural gas is largely inelastic
in the near term.
Interest Rates: How have MLPs performed during inflationary
periods?
On a day-to-day basis, there is generally no correlation between
interest rates and MLP yields. Over the past three decades, MLPs
have benefited from a trend of declining interest rates. However,
there have been three notable periods in which drastic interest
rate movements (1994, 1999, and 2004) have resulted in short-term
weakness in the asset class.
During the most recent 2004-2006 period, the Federal Funds Rate
rose by 25 basis points every six weeks from June 2004 through
June 2006. The news was first announced obliquely by Chairman
Greenspan during a Congressional hearing on April 21, 2004.
During the month that followed the initial announcement, Treasury
yields rose 31 bps, MLPs fell 4.1%, and the MLP-Treasury correlation
jumped to 0.92. By June, exactly one month after their near-term
low, MLPs had recovered to previous levels, with correlations falling
to 0.08. Indeed, on June 30th, when the rate increase of 25 bps was
finally announced, MLPs gained 0.8% that day.
During the actual two-year period from June 30, 2004 to June 29,
2006 when the target Fed Funds Rate increased from 1.00% to 5.25%,
MLP yields ranged between 5%-7% and the correlation between
MLPs and Treasuries was higher than normal at 0.55. Contrary to
investor fears, MLPs returned 38.7% on a total-return basis, anchored
by continued increases in their quarterly distributions.
As history has shown, MLP unit prices initially tend to respond
unfavorably to sharp increases in interest rates. MLPs are incomeproducing equities and when interest rates move, everything with a
yield is affected. But over a longer investment horizon, distribution
growth has mitigated or outweighed those moves.
Regulatory: What sort of governing bodies regulate energy
infrastructure companies and MLPs?
Similar to Utilities, though not to the same extent, energy
infrastructure companies and MLPs are regulated by several
organizations. Interstate pipelines are regulated by the Federal
Energy Regulatory Commission (FERC). Pipeline safety is overseen
by the Pipeline and Hazardous Materials Safety Administration
(PHMSA). Intrastate pipelines are regulated at the state level by
organizations such as the Texas Railroad Commission.
In Canada, the National Energy Board (NEB) regulates the
interprovincial oil, gas, and utilities industries. In addition, the NEB
serves many of the energy-related functions that the EPA would
provide in the US.
Any material change in regulatory requirements or standards could
impact energy infrastructure companies and MLPs and their assets.
Page 9
frequently asked
questions
ENERGY INFRASTRUCTURE RISKS
Industry: What is the status of hydraulic fracturing? Is it safe?
The application of hydraulic fracturing in the US shale plays
increases the volumes transported on pipelines. However, as energy
infrastructure companies do not participate in the actual fracking
process, their exposure to increased fracking regulation remains
limited.
Currently there is no consensus as to whether the use of hydraulic
fracturing should be banned. Some argue that the fracking process
itself contaminates ground water, while others argue that the
process is safe, but that more stringent regulations and processes
to prevent spillage (caused by human error) should be imposed.
The Department of the Interior is expected to release a final ruling
on requirements for drillers in 2014. In addition, the Environmental
Protection Agency (EPA) is completing a focused study on the issue;
a report is expected to be released for public comment and peer
review in 2014 with a final draft to follow..
The other issue that has emerged with fracking is the desire for
states to regulate such activities on their own. Some states such
as Wisconsin and New York have banned fracking, whereas other
states believe they are well equipped to regulate fracking as they
understand the land and industry players better. The Protecting
States’ Rights to Promote American Energy Security Act, introduced
by Representative Bill Flores (R-Texas), would essentially cede the
Interior Department’s regulation of fracking to states that have
already developed their own rules.
Environmental Risks: How safe are natural gas and crude oil
pipelines?
The Pipeline and Hazardous Materials Safety Administration
(PHMSA) monitors and regulates the United States’ pipeline
transportation system, as well as shipments of hazardous materials
by land, air, and sea. In June 2013, the Manhattan Institute for Policy
Research released a report that studied the data collected by the
PHMSA on hazardous material transportation safety. It concluded
that pipelines were by far the safest form of transportation for oil
and natural gas. For context, road transportation of oil and natural
gas was by far the most dangerous, averaging 19.95 incidents per
billion-ton miles per year, compared to 0.58 serious incidents per
billion-ton miles for hazardous liquid pipelines, making pipelines 34
times safer than road transportation.
In addition, a 2009 study by the American Petroleum Institute shows
that the number of spills per 1,000 miles has dropped by 60% in the
previous 10 years and the number of barrels released per 1,000
miles has dropped 42% in the same time period.
While the PHMSA is the federal organization responsible for the
monitoring, testing, and enforcement of pipeline safety regulations,
the individual companies themselves invest millions of dollars
into pipeline safety and reliability annually. The falling number of
incidents per pipeline mile is due to increased maintenance and
technology that enables more accurate and frequent monitoring of
pipelines. Typically, pipeline operators will use a risk-based system
to evaluate and maintain their pipelines. As pipelines vary greatly
in size, capacity, construction methods, and materials used, it is
impossible to draft a one-size-fits-all set of guidelines for pipeline
maintenance. As such, pipeline operators are often at the leading
edge of inspection and maintenance technologies, with many
companies having teams of engineers on staff to develop new
methods for leak detection and prevention.
Page 10
frequently asked
questions
ALERIAN AND THE ALERIAN INDEX SERIES
How do I buy the Alerian fund?
Alerian is an indexing company and does not own a fund. We are in
the business of creating indices that are most relevant to a variety
of stakeholders. In turn, we license our indices to various companies
that create investable products, such as exchange-traded funds and
exchange-traded notes. For more information about such products,
please visit www.alerian.com.
How did the Alerian MLP Index (AMZ) become the benchmark
for the MLP asset class?
The AMZ was launched on June 1, 2006 as the sector’s first real- time
benchmark. We have been very fortunate to enjoy the continued
support of the sector’s various stakeholders, including the MLPs
themselves, research analysts, buy-side asset managers, and
national media, among others.
In general, what is the difference between the Alerian Index
Series and other MLP indices?
When was Alerian formed?
Alerian was formed in 2004. Alerian’s original offices were in the Big
Apple (New York, NY) until we moved to the Big D (Dallas, Texas) in
2007.
• Transparency. Alerian aims to provide unbiased MLP benchmarks
that are both investable and replicable for stakeholders. Alerian
does not use a “black box” system to select constituents, instead
preferring a rules-based methodology. Alerian believes that it
is important for the methodology that stands behind each of
its indices to be completely transparent and available so that
stakeholders can replicate the process used to design, construct,
and maintain each of the indices. Alerian uses only publicly
available data (press releases, SEC filings, etc.) to create the indices
and all of the methodology guides are available on our website.
• Consistent Methodology. Methodology is consistently and
uniformly applied for special and quarterly rebalancings.
Where did the name Alerian come from?
Alerian is the name of our founder’s friend. We wish we had a more
interesting story to tell than that.
How can I get in contact with Alerian?
Please e-mail index@alerian.com or feel free to call us at
972.957.7700.
Page 11
disclaimers
Copyright. No Unauthorized Redistribution.
Alerian © 2013. All rights reserved. This document, in whole or in
part, may not be redistributed, reproduced, and/or photocopied
without prior written permission.
This Document Is Impersonal and Not a Solicitation.
In jurisdictions where Alerian or its affiliates do not have the
necessary licenses, this document does not constitute an offering of
any security, product, or service. Alerian receives compensation in
connection with licensing its indices to third parties. All information
provided by Alerian in this document is impersonal and not
customized to the specific needs of any entity, person, or group of
persons. Alerian and its affiliates do not endorse, manage, promote,
sell, or sponsor any investment fund or other vehicle that is offered
by third parties and that seeks to provide an investment return
linked to or based on the returns of any Alerian index.
No Advisory Relationship.
Alerian is not an investment advisor, and Alerian and its affiliates
make no representation regarding the advisability of investing in
any investment fund or other vehicle. This document should not be
construed to provide advice of any kind, including, but not limited
to, tax and legal.
You Must Make Your Own Investment Decision.
It is not possible to invest directly in an index. Index performance
does not reflect the deduction of any fees or expenses. Past
performance is not a guarantee of future returns. You should not
make a decision to invest in any investment fund or other vehicle
based on the statements set forth in this document, and are advised
to make an investment in any investment fund or other vehicle
only after carefully evaluating the risks associated with investment
in the investment fund or other vehicle, as detailed in the offering
memorandum or similar document prepared by or on behalf of the
issuer. This document does not contain, and does not purport to
contain, the level of detail necessary to give sufficient basis to an
investment decision. The addition, removal, or inclusion of a security
in any Alerian index is not a recommendation to buy, sell, or hold
that security, nor is it investment advice.
No Warranties.
The accuracy and/or completeness of any Alerian index, any data
included therein, or any data from 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.
Limitation of Liability.
While Alerian believes that the information provided in this
document is reliable, Alerian shall not be liable for any claims or
losses of any nature in connection with the use or misuse of the
information in this document, including but not limited to, lost
profits or punitive or consequential damages, even if Alerian has
been advised of the possibility of same.
Research May Not Be Current.
This document has been prepared solely for informational purposes
based on information generally available to the public from
sources believed to be reliable. Alerian makes no representation
as to the accuracy or completeness of this document, the content
of which may change without notice. Alerian expressly disclaims
any obligation to update the contents of this document to reflect
developments in the energy MLP sector. The methodology involves
rebalancings and maintenance of indices that are made periodically
throughout the year and may not, therefore, reflect real-time
information.
Policies and Procedures.
Analytic services and products provided by Alerian are the result
of separate activities designed to preserve the independence and
objectivity of each analytic process. Alerian has established policies
and procedures to maintain the confidentiality of material nonpublic information received during each analytic process. Alerian
and its affiliates provide a wide range of services to, or relating
to, many organizations, and may receive fees or other economic
benefits from these organizations.
Page 8
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