Want to Invest in Energy? Consider the Plumbing

A basic premise for buying energy company stocks today is that $60-a-barrel oil, or higher, is here to stay.

But if that’s wrong, and $40 is more likely in 2006 than $80, the downside for highflying oil and gas stocks could be severe.

For investors looking to put money to work in energy, there may be a more comfortable approach than buying the big-name oil and gas producers that everybody knows: Instead of owning the commodity, bet on the infrastructure: the pipelines, processing facilities, storage depots and other properties collectively known as midstream energy assets.

The idea isn’t new, but its appeal has become more apparent with the realization that the world’s energy problems don’t just center on the prices of crude oil and natural gas. A major issue also is getting those commodities, and oil’s refined products such as gasoline, to the end users.

For individual investors, a key attraction of the energy infrastructure business is that it typically pays out high, and growing, income streams, well above the paltry yields available on most stocks and bonds.

Energy-infrastructure investing has been one focus of Kayne Anderson Capital Advisors, a Century City-based investment firm founded in 1984 by Richard Kayne and John Anderson. The latter is the name behind the UCLA Anderson School of Management.

The company manages about $4.5 billion for clients, the bulk of it in the energy sector. The firm’s top executives describe their approach as risk-averse: They want to make money, but they want even more to avoid losing it.

Bob Sinnott, Kayne Anderson’s chief investment officer, says the firm’s overarching strategy has been to “protect ourselves against the downside and try to take volatility out of the investment process.”

Energy-infrastructure businesses fill that bill, he says. Increasingly, these facilities -- particularly oil and gas pipelines and processing facilities -- have been spun out from large energy companies into master limited partnerships whose shares, or units, trade on major exchanges.

In the early 1980s, master limited partnerships had a bad reputation. They often were marketed solely for the tax write-offs they provided, and shady deals proliferated.

By the late 1980s Congress had changed the rules, and the result was that MLPs primarily became vehicles to promote energy-infrastructure investment.

The big advantage MLPs have is that they don’t pay taxes. They pass most of their often substantial cash flow directly to shareholders, who technically are partners. Those annual cash distributions also have tax-deferral advantages because they largely constitute a return of capital rather than income.

The bottom line: Many MLPs pay quarterly distributions that, at current stock prices, equate to annualized yields of 6% to 8% -- compared with dividend yields of 2% or less for major oil and gas companies.

Long Beach-based Pacific Energy Partners, for example, owns oil pipelines and storage facilities in the West. Its stock, at $32.10 on the New York Stock Exchange on Friday, has risen from $19.50 when the company went public in 2002. At Friday’s price, the annualized income yield on the stock is 6.4% based on Pacific’s $2.05-per-share yearly cash payout rate.

Because the tax reporting can be so complicated, however, some investors have shied away from MLPs. What Kayne Anderson and several rivals have done in the last 18 months is simplify the partnership investing concept, including the tax issue, by creating closed-end mutual funds that own a mix of MLPs.

The first was Tortoise Energy Infrastructure Corp. (ticker symbol: TYG) of Overland Park, Kan., which raised $275 million from investors in February 2004.

Kayne Anderson’s first fund, Kayne Anderson MLP Investment Co. (ticker: KYN), sold $830 million of shares to investors in September 2004; a second fund, Kayne Anderson Energy Total Return Fund (KYE), raised about $800 million in June of this year. Both trade on the NYSE, as does Tortoise.

The first Kayne fund invests in master limited partnership shares almost exclusively; the second plans to invest more broadly across the energy business, including MLPs as well as shares of tanker companies, coal companies and oil royalty trusts, Sinnott said.

Both funds share a goal of generating strong current income, the hallmark of the energy-infrastructure business.

Sinnott sees the long-term infrastructure story as compelling on two levels. One is that the facilities, such as pipelines, make money whether oil is at $20 a barrel or $100. Whatever the market price, oil (or natural gas, or propane) is passing through and generating income for the pipeline owner.

It’s the toll-road concept, Sinnott said: A toll road “doesn’t care whether you’re driving a Mercedes or a Volkswagen. It only cares about the 50 cents” you’re paying.

The second compelling aspect of the infrastructure business, he says, is the growth potential as the world demands more energy, and in more places.

“Energy supply routes are getting longer and longer,” Sinnott said. “We’re shipping to China, we’re importing more into the United States, we’re bringing pipelines from Canada ... we’ve got to bring in liquefied natural gas. All your supply routes are getting longer and therefore more valuable. More storage facilities are having to be built. There’s a stress on the infrastructure.”

For master limited partnerships, the challenge is to earn handsome enough returns on their infrastructure assets to keep their payouts to shareholders rising, which supports their share prices and thus gives them the ability to raise more capital.

David LaBonte, who helps analyze MLP investments for Kayne Anderson, said the historic average annual growth rate for MLP cash distributions had been about 5%. So the attraction isn’t just the current yield, but more income every year if the business grows, he said.

For Kayne Anderson, the introduction of the closed-end funds for individuals is a natural outgrowth of the firm’s investments in energy for well-heeled clients over the last 15 years, founder Ric Kayne said. With staff in L.A. and Houston, the firm has been active as a private-equity investor in energy, supplying capital to small oil and gas production companies as well as to infrastructure companies.

“I think we have some very, very strong resources and assets in the area,” Kayne said.

As for the firm’s energy price outlook, the executives say that they aren’t counting on dramatic increases. Still, it’s interesting to note that Kayne drives a Honda Civic Hybrid.

What could go wrong for energy-infrastructure investments? The stocks wouldn’t be totally immune to a collapse of energy prices, or a collapse of demand, of course.

The companies also could suffer if capital pours into the business and the infrastructure becomes overbuilt. But that doesn’t seem like much of a risk for the time being.

Finally, in the case of pipelines, they’re regulated either by the federal government or state entities, so there’s always regulatory risk (but also a regulatory assurance of a set return from the business).

As for the closed-end funds that buy the infrastructure stocks, the biggest risk may be that they might not invest well enough to justify the management fees they’re charging. Sponsors like Kayne Anderson aren’t creating these funds out of charity, after all; they’re reaping fee income from the portfolios.

Another issue: The market price of a closed-end fund’s shares can be above, or below, the true per-share value of the assets, depending on investor demand. All other things being equal, you’d rather buy the shares at a discount to net asset value than a premium.

Still, for investors who want more energy in their portfolios for the long haul, and especially for those who also crave an income return, the infrastructure idea may be worth investigating.

Three other closed-end funds besides the Kayne Anderson and Tortoise funds are Fiduciary/Claymore MLP Opportunity (ticker: FMO); Energy Income & Growth (FEN); and a sister to the first Tortoise fund, Tortoise Energy Capital (TYY).

For more information on individual MLPs, check out: www.ptpcoalition.org.

Tom Petruno can be reached at tom.petruno@latimes.com.