A number of forces affect the competitive environment for businesses today, but these forces are not of equal importance. We believe one is clearly more important than the others – Barriers to Entry. If there are barriers, it is difficult for new firms to enter the market and challenging for existing companies to expand. Put simply, no other feature has as much influence on a company’s success as where it stands in regard to these barriers. Measured by potency and durability, economies of scale, when combined with some customer captivity, provide the strongest and most durable moats. Pipelines earn high grades on both counts.
Although it may seem counterintuitive, most competitive advantages based on economies of scale are found in local and niche markets, where either geographical or product spaces are limited and fixed costs remain substantial. An attractive niche should be characterized by customer captivity, small size relative to the level of fixed costs and the absence of vigilant dominant competitors. In fact, companies can build quasi-monopolies in markets that are only large enough to support one company profitably, because it makes no economic sense for a new entrant to spend the necessary capital to enter the markets.
Infrastructure firms provide an extraordinary example of niche domination. MLPs have high barriers to entry due to capital requirements and geographical monopolies. A business in the midstream is a toll collector that takes products from one point to another. Many have monopolistic characteristics as building a pipeline requires clearing multiple regulatory hurdles which can be challenging to overcome given ongoing environmental concerns. Furthermore, when there is not enough demand between two points to profitably support multiple pipelines, a single pipeline enjoys niche economics and can charge the maximum allowable rates. Those rates can be quite attractive for owners as pipelines have a somewhat looser regulatory regime than utilities.
Our Investment Thesis
Thematically, MLPs represent an investment in the build-out of our domestic energy infrastructure over the next few decades. Nearly all other infrastructure is contingent upon pipelines and other energy assets to provide the lifeblood of our economy. These businesses operate toll-road business models supported by long-life real assets, with inflation hedges built into long-term contracts, regional monopolistic footprints, and relatively inelastic long-term energy demand growth. The resulting operating fundamentals allowed MLPs to generate predictable cash flows and pay consistent and growing quarterly cash distributions over the past few decades, which translate into very attractive investment characteristics: long-term stability and low volatility, attractive risk-adjusted returns, diversification via low correlation with other asset classes, and the potential for an effective inflation hedge.
The two most comparable asset classes to MLPs are Utilities and Real Estate Investment Trusts (REITs). Both Utilities and MLPs 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 MLPs, on the other hand, are predominantly regulated at the federal level by the Federal Energy Regulatory 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 are hard assets with associated permanent value. The useful life of MLP income-producing assets is typically over fifty years. REIT rental income tends to fluctuate with macro-economic conditions and market demand; whereas MLPs benefit from inelastic energy demand and inflation-adjusted tariffs.
Meaningful new infrastructure investment requires capital, and both are needed to efficiently connect growing areas of energy demand with new areas of supply. Pipeline and related infrastructure assets are expected to support growing population centers and facilitate the transportation of natural gas and crude oil across North America, creating a compelling investment opportunity in the coming decades. Growth in the asset class will stem from additional organic projects, asset acquisitions from integrated majors, as well as the monetization of assets held in private hands. According to the Interstate Natural Gas Association of America, over the next two decades, roughly $130 to $210 billion of additional capital expenditures will need to be spent on natural gas infrastructure development to meet growing and shifting energy demands. On the acquisition front, we estimate that at least $200 billion of midstream assets are housed at public and private corporate structures, all of which could eventually be acquired by MLPs. Longer-term, we believe new midstream infrastructure development represents a highly sustainable secular growth story, with MLPs the natural structure to undertake the vast majority of such investment. Put simply, we are likely on the verge of the largest energy infrastructure build-out since World War II.
Tomorrow, we’ll review the tax-advantaged cash flow that these businesses generate before we take a look at the current and potential valuation of the asset class.