We’re into earnings season for public companies including Master Limited Partnerships (MLPs). Quarterly report cards on performance should provide useful information on the nascent recovery in the U.S. energy sector.

When they reported 3Q16 earnings Buckeye Partners (BPL) caught our attention with their investment in VTTI BV, a global owner of storage and terminalling assets headquartered in the Netherlands. VTTI BV is owned by Vitol, a privately held energy company. Beneath VTTI BV is a publicly traded MLP, VTTI Energy Partners, LP (VTTI). BPL and VTTI/Vitol  are in similar businesses, albeit BPL is in the U.S. while VTTI/Vitol are worldwide.

BPL has bought 50% of the General Partner of VTTI for $1.1BN, an investment whose returns are virtually all going to come outside the U.S.. It’s quite a thought provoking move. The MLP structure is a consequence of the U.S. tax code. MLPs generally don’t pay tax on their income because their investors do. There are substantial tax disincentives for non-U.S. investors and U.S. tax-exempt investors to invest directly in MLPs. It’s not impossible but in most cases prohibitively costly. Because MLPs aren’t taxed, they have a cost of equity capital advantage over an otherwise identical business structured as a C-corp.

(Diagram from Buckeye’s presentation on the deal)

But this advantage ought not to extend beyond the U.S. The profits  earned by a refined product terminal located in, say, New York aren’t taxed at source because the investors are U.S. taxable and report their proportional share of the income on their tax return via a K-1. But why would the Dutch, or South Africans similarly extend this advantage to physical assets in their country owned by VTTI, a U.S. listed MLP? And in fact they don’t, which ought to eliminate the MLP cost of equity advantage and restrict the MLP structure to holding U.S. assets.

VTTI is a partnership but chooses to be taxed as a corporation. And it does pay tax, at an average rate of 24% over the past four years according to their 2015 10K. The Netherlands, Malaysia, U.S. and Belgium all receive tax from VTTI, reflecting their far-flung footprint. So we have a tax-paying entity with a GP entitled to Incentive Distribution Rights (IDRs), a low growth investment that trades at a 7.3% yield based on their most recently declared quarterly distribution of $0.3281.

Most MLP GPs are earning 50% of the marginal dollar of Distributable Cash Flow (DCF) earned by the MLPs they control. VTTI isn’t yet there. IDRs come with DCF thresholds, similar in concept to the marginal tax rates that kick in as your income rises. VTTI’s GP is at the top of the 15% IDR share. Beyond $0.328125 per unit they get 25% and above $0.39375 they get 50%. Vitol, and now BPL, will increasingly participate in per unit DCF growth. Vitol  retains storage assets at the parent level which they can sell (“drop down”) to VTTI as well as $600MM of new projects under consideration. So there’s some visibility around how they might grow DCF.

The question is, why is this structure working with non-U.S. assets whose income is already being taxed before it reaches the equity owners? For the answer, look to Williams Companies (WMB). In August, we noted that WMB had recognized they had two types of investor: income-seeking MLP investors who hold Williams Partners (WPZ), and growth seeking investors who hold WMB. So when WMB cut its dividend in order to invest in WPZ, both sets of investors found something to like. WPZ investors liked the support this gave to their distribution, while WMB investors cheered the redirection of their dividends into a high yielding security. Both securities rose. WPZ is “YieldCo”, generating steady income. WMB is “GrowthCo”, with better growth prospects. In Williams Satisfies Two Masters we explained our thinking.

The VTTI structure works because VTTI investors are most focused on income, and won’t drive the yield on VTTI down much for the promise of faster growth. So that growth is partly redirected via the GP IDRs to VTTI BV, and now to BPL as well.

It’ll be interesting to watch, because on the earnings call BPL didn’t identify operating synergies as being that important to them. They are financial investors in a sector they know pretty well. They now own a GP. The MLP model  is showing its applicability globally, not through a tax advantage but via its ability to separate cashflows and meet the specific needs of different investor segments, lowering its cost of equity.

We are invested in BPL and WMB.

Many people think of fossil fuels as coal, crude oil and natural gas, with the nastiness of their toxic emissions lying in that order. Among the less colorful comments during the second Presidential debate was Hillary Clinton’s reference to natural gas as a “bridge” fuel, sitting between today’s reliance on hydrocarbons and a future of renewables (solar, wind and so on). Methane (or, to use its Chemical symbols, CH4 since it combines four hydrogen atoms with one Carbon atom), is colloquially known as natural gas, and is the simplest and cleanest burning fuel.  It  is helping the U.S. limit its carbon footprint since as the Shale Revolution has made it plentiful domestically, it’s replacing far dirtier coal as the fuel of choice for power plants.

Natural Gas Liquids (NGLs) are a set of hydrocarbons that lie between Methane (also called “Dry” Gas”) and the lightest blends of crude oil (such as Naphtha). Methane is often extracted mixed with NGLs and crude oil.  It’s used for residential gas stoves and heating, electricity generation and, when chilled to -260F turns to Liquid Natural Gas (LNG) in which form it can be transported by ship. The mix of NGLs and oil found in a well with methane affects the value of the play since after being separated from the dry gas the NGLs can be put to other purposes.  “Wet” gas wells that contain more NGLs often generate more attractive returns as NGLs fetch higher prices.

The energy infrastructure business provides the ability to gather and process the mix of hydrocarbons into Gas, NGLs and Crude Oil.  Dry gas then is piped to customers, crude oil heads to storage & refiners, and NGLs are sent to fractionation plants.  By exploiting their different boiling points the NGLs are then separated into into their components: Ethane (C2H6), Propane (C3H8), Butane(C4H10), Iso-Butane (C4H10 with tertiary carbon), and natural gasoline (C5+). Although NGLs are gases, their production is usually expressed in barrels a day, like oil. The conversion is based on energy equivalence, so a barrel of an NGL has the same energy output measured in BTUs (British Thermal Units) as a barrel of oil. Nothing gets moved in barrels anymore, but the industry has retained it as a common measure of volume.

Although often ignored, NGLs are significant. The U.S currently produces 3.6MMBD (Millions of Barrels a Day) of NGLs.  Compare this with U.S shale oil production of 4.5MMBD  and it’s a big business in its own right.

Ethane is most readily found with methane, although it’s also a by-product of refining crude oil. Some portion of ethane can be left in the gas stream for residential and commercial use if its price doesn’t justify separating it out. However, by far its most important use is as a feedstock for petrochemical plants to produce polyethylene, the most commonly created organic compound in the world. It winds up as plastics in various forms with thousands of ultimate uses across consumer products as packaging, containers, plastic bags carpeting and clothing (including swimwear). As the U.S. steps up its production of ethane, the low price caused by America’s shift towards energy independence is leading to a substantial cost advantage in polyethylene production. Currently the U.S produces 1.3MMBD of ethane.

Credit for the first industrial synthesis of polyethylene generally goes to Imperial Chemical Industries (ICI) in the UK in 1933.

Propane exists as a gas at temperatures above -44F, but turns to a liquid under pressure when it occupies 1/270th of the space, allowing it to be stored in propane tanks and bottles (such as the one under your gas grill outside).  It has many other uses as a fuel from heating homes (particularly mobile homes which often lack a permanent connection to the local gas supply) to drying crops.  The U.S produces 1.15MMBD of Propane. Butane is the fuel in pocket lighters, the propellant in aerosols, and is blended with gasoline during the summer to reduce pollution (it’s the vapors that come out while you’re pumping).  Iso-butane is primarily used to increase the octane in gasoline while making it cleaner burning.  The U.S produces 300MMBD each of butane and i-butane.

The chart below shows forecast growth in NGLs (referred to as “Natural Gas Plant Liquids”) provided by the U.S. Energy Information Administration (EIA) in their 2016 Annual Energy Outlook.

The first point of this brief summary on NGLs is to illustrate that the composition and uses of the hydrocarbons we produce vary enormously. Master Limited Partnerships (MLPs) own and operate the pipelines, storage assets and processing facilities that handle this output, which includes providing treatment and separation of methane from the NGLs with which it’s found.  They process the mixed NGLs into their individual components, providing storage and then transportation of the pure products to their end users.

The second point is that, just as natural gas and crude oil production look set to continue growing in the U.S., so does NGL output. Their increasing use is another side to the story of energy independence. Moreover, exports are increasingly driving this growth; as recently as 2014 the U.S. was a net importer of ethane, and marine exports were not considered economically viable.

According to the EIA, U.S. production of ethane and propane have substantially exceeded demand in recent years. This has led to ethane at times being “rejected,” meaning some portion of it is left with the methane in the natural gas supply rather than being separated out. But the growing supply of ethane has also has led to significant investments in petrochemical plants and export capacity.

Ethane exports were non-existent before 2014 when two pipelines  came online to ship it to petrochemical complexes in Canada.  Pembina’s (PBA) Vantage pipeline recently added 70KBD (Thousands of Barrels a Day) of capacity from North Dakota,  and Sunoco Logistics (SXL) moves  50KBD from their Mariner West line in southwestern Pennsylvania. In March of this year the first waterborne ethane left SXL’s Marcus Hook terminal on the Delaware River just south of Philadelphia, headed for Norway. Subsequent shipments for Norway have also left  from Texas. Just as the U.S. is selling methane to the Middle East, a region not exactly short of it (see Coals to Newcastle), we’re able to sell to Norway even though they produce almost 4MMBD equivalent of crude oil, NGLs and natural gas.

In July, refrigerated ships began taking ethane from Enterprise Products Partners’ (EPD) 200KBD Morgan’s Point terminal, now the largest ethane export facility in the world, on the Houston Ship Channel. We are in the middle of the ramp-up now as ethane export capacity is expected to increase from 65KBD in 2015 to almost 400KBD by the end of next year.  Additionally, Kinder Morgan’s (KMI) 50KBD pipeline from eastern Ohio is expected to come online early 2018.  Adding in propane & butane docks, the U.S will have waterborne Liquid Petroleum Gas (LPG, NGLs when they’re condensed to liquid form for transport) capacity of 1.5MMBD by 2017.  This includes  1.2MMBD on the gulf coast held by Targa Resources (TRGP), EPD, Phillips 66 (PSX), Occidental Petroleum (OXY), and SXL. There’s an additional 275KBD in the northeast being developed by Energy Transfer Partners (ETP) and SXL. In other words, there’s a lot of energy infrastructure being built that will increase MLP cashflows.

Domestic processing of ethane into ethylene has risen by almost a third in the last three years. Demand from ethylene producers for ethane feedstock is expected to soak up another 600KBD in the next five years, a more than 50% jump from today’s level.  Propane can be converted into polypropylene, with similarly wide application in plastics to polyethylene although polypropylene is produced as a clear plastic whereas polyethylene is opaque, like a milk jug. Polypropylene production capacity has tripled since 2013 and is expected to consume another 135KBD of propane in the next five years. With all the new demand for NGLs, pipeline capacity is being expanded in multiple regions. Examples include Oneok Partners’ (OKS) Bakken NGL network; EPD’s Aegis system on the Gulf of Mexico and EPD’s ATEX line from the Northeast to the gulf; SXL’s Mariner East line.

New pipelines are being built, such as KMI’s Utica Marcellus Texas pipeline, and idle ones re-purposed, including a JV between EPD and Marathon Petroleum (MPC) called  Centennial. Another example is NuStar’s (NS) Mont Belvieu line to Corpus Christi.

The picture of widespread investment in new midstream energy assets is clear enough. Last year’s sellers of MLPs gave no heed to the secular theme that is unfolding.

The chart below shows how the petrochemical industry is gearing up to process increasing volumes of ethan and propane into plastics.

Natural gas and crude oil for power generation tend to dominate the headlines about the Shale Revolution. But the associated production of NGLs and their use in wide-scale production of plastics represents a growing and increasingly important part of the economics of domestic hydrocarbon production. Fully utilizing this resource is another driver of demand for new energy infrastructure, another source of growth for MLPs. Unsurprisingly, we are invested in many of the names listed, often through their General Partner (GP) since that’s where the returns to growth are best realized. Of the names mentioned above, we are invested in the following:

EPD, Energy Transfer Equity (ETE, GP of ETP and SXL), KMI, NuStar GP Holdings (NSH, the GP of NS), Oneok (OKE, the GP of OKS), PBA, PSX (GP to PSXP) and TRGP.