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Cohen & Steers MLP & Energy Opportunity Fund
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T:

Mapping Out Midstream
Cohen & Steers MLP & Energy Opportunity Fund
Ticker.com
Nov 8, 2018

Q: What is the history and core mission of the fund?

We have a long history of investing in the midstream energy asset class. In 2004, we launched our global infrastructure strategies, designed to invest in pipeline companies and master limited partnerships, or MLPs. In 2011 we launched a dedicated midstream energy strategy that focuses on North American midstream companies. In December 2013, we launched this particular fund to invest in midstream energy securities, which include master limited partnerships and midstream energy businesses utilizing other corporate structures.

Our core competency is investing in infrastructure businesses, which share some common characteristics. Typically, these businesses have minimal commodity price exposure and are regulated or semi-regulated. They have high barriers to entry and possess monopolistic characteristics, which are difficult to recreate once the assets are in the ground. Our job is to distill the midstream space or the energy infrastructure, which links sources of supply upstream wells and producing regions with sources of demand downstream and refineries. Then, based on our conviction, we build a portfolio that we believe should generate strong outperformance.

Q: How does the fund differentiate itself from other funds in the asset class?

A main differentiator of the fund is its structure and the definition of the investable universe. In the MLP space, there are types of funds - C-corp and RIC structured funds. Most of the mutual funds launched before 2012 are known as C-corp structured funds, which can invest up to 100% in MLPs. The problem with C-corp funds is that they are taxable vehicles, which have to book deferred tax liabilities for unrealized gains and then pay taxes on realized gains, which carry high expense ratios and cause material underperformance in an off market. 

We launched a RIC fund, which is like any other mutual fund and doesn’t pay taxes at the fund level. It is more tax efficient in the long run from a total return perspective. To qualify for RIC status, a fund needs to cap its investments in MLPs at 25 percent. The remaining 75% of the fund are invested in securities that are midstream in nature, but don’t utilize the MLP structure. 

There are different approaches within the RIC universe. Some RIC funds elect to include in their universe non-midstream businesses like E&Ps or upstream producers and integrated oil companies. Others have chosen to own up to 40% in fixed income in an effort to pay high yield at the fund level. We don’t do that, because we want investors to have a positive total return experience in a tax efficient way. We don’t seek to maximize yield but to maximize total return.

Our approach is unique within the RIC funds. We have opted for a broad definition of midstream, which includes MLPs, midstream energy corporations, general partners of MLPs, Canadian energy infrastructure companies and a small subset of utilities with large midstream businesses. Our universe consists of 40% MLPs and 60% non-MLPs. From a RIC perspective, we believe that’s a good universe, because it enables us to generate outperformance throughout the cycle with a portfolio of securities that share the common midstream characteristics that we focus on.

We believe that there are good midstream energy businesses that utilize different, non-MLP corporate structures. Overall, we take the broad definition of the investable universe, strip out the MLPs that don’t have the characteristics we look for and add the security structures that have midstream characteristics. That approach results in a more tax efficient fund with lower fees.

Q: Why should investors consider the midstream space? What is attractive about it?

The investment thesis of midstream is based on volume, not price. In an E&P company, the factors that affect revenues and cash flows are the quantity of the produced energy and its price. In downstream companies, the key aspect is how much energy is moving through the system and the margin. It is an investment that’s predicated on volume and margins.

Midstream is different because it is the toll road of the energy space. The midstream businesses charge fixed fees, which typically rise with inflation, so they represent a way to invest in North American energy volumes. If you think that energy volumes are growing because we are producing more, consuming more or exporting more, midstream investments provide participation in that growth story without being too dependent on commodity prices and margins to generate cash flow growth. 

The other attractive aspect is the high barriers to entry. Often pipelines are long - hundreds and thousands of miles in nature. Once they are built, they become a defendable economic moat against potential competitors. So, midstream is a business that can earn returns above its cost of capital and grow. It is a unique business model, which resembles real estate in the right location. In our opinion, such investments are likely to generate attractive returns on capital.

The key factor for its success is the demand for pipelines relative to pipeline supply growth. In the current environment, pipeline demand is driven by domestic energy production and consumption and exports. When a lot of oil, natural gas, and natural gas liquids are produced, they need to get pushed into pipelines, so the demand for pipelines increases. When consumption and exports rise, more energy needs to be pulled through the pipeline system.

We have high conviction that all the three factors will remain strong at least for the next few years. In North America we have a low-cost resource and E&Ps are well capitalized and efficient. We also believe that the position in the economic cycle is favorable, so a lot of energy is going to be pushed in the pipeline system to be consumed here or to be sent to foreign markets. 

Our thesis is that the demand for the underlying asset will grow, while the supply of new pipelines will grow less quickly. We just spent a lot of money building pipelines, so we have a lot of capacity in various regions. The cost of capital has risen and the regulatory approval process continues to be challenging. Management incentives have changed with a focus on returns. Overall, we expect that we won’t be building as many new pipelines, while the demand for the existing infrastructure will rise, and that’s a clear advantage.

Q: How will alternative or renewable energy affect consumption in the near future?

Renewable energy is definitely a factor in our analysis. In general, when I talk about domestic energy production, I mean not just oil, but also natural gas, which is often seen as a bridge towards renewables. Over time, it is expected that we’ll consume less coal-related energy and more wind and solar energy. However, many domestic places are likely to increase their consumption of natural gas and that’s good for pipeline systems.

For instance, we’ll see better efficiency and more electric vehicles in the automotive industry. While that’s not great for gasoline demand, it may be good for natural gas demand. Also, jet fuel consumption will continue to be strong, because it is difficult to make a huge airliner energy efficient in the near term. 

On a global scale, we are becoming more energy efficient, but with the ongoing urbanization, the rising middle class, the increasing travel and the growing consumption of plastics, we will continue to consume a lot of energy commodities. Renewables are becoming more cost competitive, but not in every geography and not in every part of the value chain.

Q: Do you invest in any European or Asian companies?

We have the ability to invest in many places, but our core thesis and our core positions are in the U.S. and Canadian domiciled securities and in North American infrastructure assets. Despite being in North America, the asset base is tied to the global consumption of natural gas. Investments in domestic midstream companies actually represent investments in the increasing consumption of LNG in China, India, Korea, Japan, Europe and South America. Energy is a global commodity and North America is a key part of the global value chain, so midstream is a way to participate in global trends.

Q: What are the key steps of your investment process?

The majority of our time, effort and analytical capability is spent on bottom-up company research, but we start our process with a top-down perspective. A unique feature of the Cohen & Steers platform is that while my team and I are entirely dedicated to midstream energy companies, our firm has capabilities that span across the energy value chain. 

For instance, we have a team that trades commodity futures and invests in oil, natural gas and other energy commodities. We have a natural resources equity team, which invests in upstream and downstream companies, as well as a real-asset, multi-strategy team. We have formal, bi-weekly meetings of the energy group, with constituents from each of these teams. The goal of these meetings is to share ideas and to come up with a global energy model of supply and demand, winners and losers, market share gains or losses. We come up with our own view on energy prices. 

Our process begins with taking that global energy view and thinking about North America’s positioning from the perspective of global supply, demand and price. Then we distill that information into drivers for midstream energy businesses. We consider in what regions of North America we want to have exposure and what types of businesses will perform well, given our position in the global energy cycle. 

Although we begin with a top-down analysis of global trends, our main focus is the bottom-up process. Our analysts travel to see the assets and meet the management teams; they analyze the financial statements and develop an understanding of corporate governance and incentives. Based on the analysis, we build financial proprietary models for every company in the universe. These models include forecast of cash flows, leverage, credit, liquidity, distributed cash flow per share, and also incorporate the top-down analysis.

The next step is the relative value process, where every company is valued on a DDM and net asset valuation basis. We look at the company’s business plans for the next 10 years. Then we discount net present value to come up with a value of the business and we marry that within that asset valuation. Overall, we rank and sort every company in the universe based on our upside to those two metrics. We are typically overweight in companies that screen attractively in terms of valuation and we avoid or trim those that screen poorly. 

Q: Can you describe the research process in more detail?

We have three dedicated midstream energy analysts and one dedicated midstream energy associate. It is a team of four people, who focus on bottom-up analytics. They are complemented by our global infrastructure team, but in terms of overseeing the research and building the financial models, the 115 companies in our universe are covered by the three analysts here.

A unique feature of our process is that every single company receives a score on a scale from A through F for corporate governance and alignment of interests. In the midstream energy space there are structural issues with the governance and the incentives. That’s why we formally score every company and we prefer the companies that score well because of the alignment of interest.

One of the key themes today is the continuing exposure and prominence of North America as an energy exporter. Based on that view, we have a general preference for midstream energy businesses with export capabilities.

Q: How do you determine the revenue growth of midstream companies?

When companies build infrastructure, they typically plan expansion capabilities. It is rare to entirely utilize a pipeline from the beginning. Once the pipeline is in the ground, the capacity can be increased fairly inexpensively. For example, a pipeline can be built with few compressor stations, but when new customers appear, compressor stations can be added inexpensively and the capacity may double. If the business is in the right region to capture incremental volume, there are opportunities to increase pumping and to utilize drag-reducing agents. 

Second, new infrastructure can be built to achieve growth. Third, many contracts have inflation-linked escalators, so companies can raise their rates annually with at least the inflation rate. That provides opportunities to generate top-line revenue growth and good returns, because they can get inflation plus pricing and volume growth linked to production growth.

In 2015 we saw a dramatic sell-off in midstream energy companies, but the cash flows declined only by 5% to 10% in the energy down cycle. Although commodity prices were down by 50% or 60%, cash flows were resilient. The issue was not the underlying assets, but the huge growth expectation embedded in 2014 valuations. 

Q: What is your portfolio construction process?

The goal of the process is creating a diversified portfolio of the names that offer most upside to our estimate of fair value. We begin the process with the entire universe. Each company has a valuation, which is incorporated in our fundamental, bottom-up view of the businesses. We spend a lot of time making sure that our estimates, earnings expectations and valuations are correct. Then we construct a diversified portfolio of 30 to 60 names, which represent our highest conviction views in terms of market mispricing. 

We are diversified based on geography, infrastructure type and security structure, but the portfolio is mainly the result of our bottom-up analysis and valuation. Our primary benchmark is the Alerian Midstream Energy Index, which is now called the Alerian Midstream Select Index. The index is not necessarily the best depiction of our fund, because it has had some flaws in the definition of the universe, the inclusion of regulated utilities, the categorization and capping of specific securities.

Within the total universe of 115 companies, probably 70 to 80 companies are MLPs, but they represent only 40% of the market cap of the index. So there are fewer non-MLP securities, but they are the names with the largest market capitalization.

It should be noted that the non-MLP component of the universe of opportunities has grown dramatically in the last two years. There is an industry trend of moving towards non-MLP structure through strategic restructuring. As corporate structures have improved, there have been many transactions, including mergers between MLPs and GPs. There is a great opportunity for active managers to be anticipatory of how these transactions will play out and utilize them as alpha levers.

Q: How do you define and manage risk?

Risk does not necessarily have a negative connotation, because when you don’t take enough risk, you can’t generate the alpha that you were hired to generate. Portfolio managers shouldn’t be scared of the risk. That being said, we need to understand the risks and utilize them to our benefit. We have an entire team focused on risk management, which makes sure that I understand and see all the risks that we are exposed to. 

With the goal of building a diversified portfolio of midstream energy companies, I pick about 40 securities that are best positioned to outperform and weight them accordingly. The reports from our risk team signal risks that can be missed by a naked eye. I formally review the report to see how much of the risk is coming from the security level and how much from factors like momentum, leverage, large cap, etc. 

For example, if the portfolio exposure to common factors is 25% of which 15% is momentum, and if momentum goes against the portfolio, we won’t do well. The risk report can help me mitigate the momentum exposure by avoiding certain investments of changing their weights. While it doesn’t force me to do anything, it gives a better perspective on risk/reward and the factors that can affect the portfolio in a positive or a negative way.

Q: You mentioned that midstream businesses have minimal commodity price exposure. What is the impact of oil prices on these businesses?
 
When you own energy infrastructure, the key elements are the assets, the volumes and the counterparties. It is a contract business, so it is crucial to have contracts that will be honored by the customers. A few years ago, when oil prices sharply went down, there was real concern about counterparties and contract durability.

So while the exposure of midstream to oil prices is definitely a second derivative, when oil prices drop, volumes may decline, counterparty risk may go higher and security prices may come down. The commodity prices are not important in the day-to-day process, but they do matter in the long term and it is important to have a view on them. The understanding of commodity prices affects volume expectations and counterparty risk.


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