US Oil Through an ETF? A New Idea

by | Apr 10, 2014

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Dominic Clabby from Source ETF explains how an innovative ETF product can sidestep US withholding taxes and let your clients benefit from a US government incentive

Technological advances in the extraction of oil and gas have allowed the United States to significantly increase their production of oil and gas, and also introduce cleansing methods like Brownfield Remediation. This boom has hugely benefited the U.S. economy, of course, and investment opportunities are numerous. Including some that can be accessed very effectively through exchange traded products.

Master Limited Partnerships (MLPs) are a particularly interesting niche for gaining access to mid-stream oil and gas infrastructure. These MLPs operate a large portion of the new energy infrastructure assets across the United States.

How MLPs Work

The U.S. energy landscape is undergoing profound structural changes. Since 2005, energy production has been growing rapidly, taking advantage of new drilling technology to exploit oil and shale gas in reserves which were previously inaccessible. The process, known as hydraulic fracturing, combined with horizontal drilling techniques, enables the extraction of these resources by fracturing the rock layers and thus freeing the oil and gas they contain.

In the United States, the production of oil and gas has recorded double-digit growth. If growth continues at this rate, the US will become the world’s largest producer of oil by 2015. This would mean a reversal in the U.S. energy balance deficit. Given the relative stability of consumption, the country may be energy independent within the next few decades. This production surplus may lower energy prices at the national level, and eventually they are expected to get to the point where they will be in a position to export gas – and in future, oil – to offshore markets.

Tax Benefits

This growth and change presents many opportunities for investors.  Many focus on large companies that benefit directly, or obviously from the energy revolution that is happening across the United States.  In reality, a multitude of the interesting opportunities are smaller companies, very flexible and agile, which were the first to embrace and master hydraulic fracturing. And many of these companies are structured as Master Limited Partnerships (MLPs) – which means that they benefit from compelling tax incentives, and as a result act as holding companies to operate centralized infrastructure assets.

MLPs were established in the 1980s as an incentive to encourage the growth of the oil industry. To qualify for its status as an MLP, a company needs to engage in specific activities in the energy industry, such as offering and providing maintenance of pipelines, storage facilities, collection networks and treatment facilities.

Around 100 companies currently qualify as MLPs, and by no means are all of them are small. Some of the better known ones include Enterprise Product Partners, Energy Transfer Equity, Access Midstream Partners, Genesis Energy and Dorchester Minerals. The market capitalisations of these MLPs range from under US$1 billion to over US$50 billion.

Why ETFs Have the Edge

Although MLPs are structured as partnerships, their shares are traded on the U.S. stock market like other traditional shares.  And in recent years, these securities have recorded impressive growth. But, due to the nature of their business revenue, their performance has shown low correlation with stocks, bonds and commodities.

With business models that are often based on inflation-linked charges, MLPs usually generate high and long-term, stable cash flows. Dividends yields range from around 5% to more than 10%. But the snag is that most foreign investors are subject to a withholding tax of 30% on distributed dividends, and that any tax refund (if eligible) is operationally intensive to reclaim.  Thus, it has not been easy for foreign investors to obtain exposure to this asset class.  In addition, the complexity of holding MLPs directly was onerous and made holding a well-diversified portfolio of investments unattractive.

Fortunately, however, MLPs are now accessible via many investment vehicles – and Exchange Traded Funds (ETFs) offer an option that allows investors to participate in the booming US energy market in a more diversified manner.

A Wide Choice of Benchmarks

There are also many indices to consider when looking for exposure to MLPs. The better known benchmarks include the Yorkville MLP Universe Index, which covers a broad measure of eligible MLPs – nearly 100 companies in total. Or there’s the Alerian MLP Index, which is slightly more focused and comprises 50 constituents.

The Morningstar MLP Composite Index Composite Index offers a more targeted version of its peers. This transparent, rules-based, fundamentally-weighted index, was launched in 2010 and selects holdings by market capitalization and weights the index by the constituent’s dividend distributions. It targets the MLPs with the highest dividend payout, limiting the weighting of any index component to 10%. This benchmark is currently composed of 53 MLPs, many of which are regularly followed by research analysts.

A Continuing Revolution

The rapid growth of the oil and gas industry in the United States continues to indicate that the infrastructure build-out that these MLPs participate in is far from over. Naturally, there are risks that should be taken into account. The process of hydraulic fracturing and related activities is highly technical, and the environmental concerns need to be considered. The advantageous tax status of MLPs which has been granted by the US government has regularly been debated. However, the role of onshore oil and shale gas in bringing the US closer to potential energy independence, a major concern of the US government, should encourage the policy makers to continue to promote this sector of the economy.

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