DNAmarkets: April 2012

Monday, April 30, 2012

Gold Update

This piece was originally written on April 19th, 2012 for IPI

The first quarter of 2012 has proven challenging for many investors in different asset classes. While volatility unexpectedly collapsed in the US equity market wrong-footing many underexposed investors, it picked up significantly in most commodities – including gold – and it produced varied responses in currencies.

This mixed bag is the result of many and often conflicting dynamics. Europe was forced into large liquidity injections in order to buy time and attempt to heal its sovereign debt crisis. Such liquidity injections in the form of the LTRO program (Long Term Refinancing Operation) helped the short term performance of risky assets but more cautious or at least less dogmatic comments from the Federal Reserve provided headwinds to these rallies. Other interesting events include the first Japanese trade deficit in decades and a much forecast Chinese economic slowdown.

Gold ended up higher for the quarter but with a level of volatility much higher than its historical average; the yellow metal’s annualized volatility measured 20.4% versus its historical average of 16% (source: World Gold Council). While much of this volatility manifested itself on the upside, it is important to note significant price drops such as February 29^thwhen the metal dropped almost $80. Increased volatility seems to be here to stay as the second quarter already registered a more than $50 drop in the first couple of days.

On a short term basis correlations between gold and US equities have also increased as the risk on/risk off dynamic continues to play out. Long term correlations, however, continue to remain insignificant.

The long term macro picture does not seem to be changing; excess global liquidity remains the recipe du jour to stabilize a financial system still afflicted by enormous global imbalances. As a result real interest rates continue to remain negative providing support to the metal. From this perspective, the current volatility and the upcoming negative seasonality bias may provide opportunities.

On the subject of correlations, I would like to quote a recent study by Credit Suisse: “Commodities as an Asset Class: Correlations Have Peaked.” There has been much controversy on the increase in correlations between commodities and traditional asset classes after the 2008 crack. One widely held opinion stressed the “financialization” of commodities as the major culprit, or in other words, the securitization of commodities and the proliferation of long biased, retail oriented products crucially correlated to other assets. Credit Suisse argues for a different approach and it has looked at correlations in other historical periods when massive macro shocks occurred and it found similar increases in correlations in terms of magnitude and time horizon. Looking forward, their strategic call is for a de-linking between the performances of commodities in general and traditional asset classes.

I tend to believe that securitization and the inevitable ramifications of macro global shocks have both played a part in the new correlation dynamic. But I do concur with Credit Suisse and I expect a more independent performance going forward between commodities and traditional assets.

Disclaimer: PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. THEREFORE, NO CURRENT OR PROSPECTIVE CLIENT SHOULD ASSUME THAT FUTURE PERFORMANCE OF ANY SPECIFIC INVESTMENT AND/OR INVESTMENT STRATEGIES MADE REFERENCE TO ABOVE AND RECOMMENDED OR UNDERTAKEN BY CERVINO CAPITAL MANAGEMENT, WILL BE PROFITABLE OR EQUAL THE CORRESPONDING INDICATED PERFORMANCE LEVELS. DIFFERENT TYPES OF INVESTMENTS INVOLVE VARYING DEGREES OF RISK, AND THERE CAN BE NO ASSURANCE THAT ANY SPECIFIC INVESTMENT WILL EITHER BE SUITABLE OR PROFITABLE FOR A CLIENT OR PROSPECTIVE CLIENT'S INVESTMENT PORTFOLIO. HISTORICAL PERFORMANCE RESULTS FOR INVESTMENT INDICES AND/OR PORTFOLIO BENCHMARKS DO NOT REFLECT THE DEDUCTION OF TRANSACTION AND/OR CUSTODIAL CHARGES, THE DEDUCTION OF ADVISORY MANAGEMENT FEES, NOR THE IMPACT OF TAXES, THE INCURRENCE OF WHICH WOULD HAVE THE EFFECT OF DECREASING HISTORICAL PERFORMANCE RESULTS.
HYPOTHETICAL RISK DISCLOSURE: HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN, IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

Friday, April 13, 2012

Update on Master Limited Partnerships

On April 12, 2012, I was on a conference call with Swank Capital for an update on the Cushing 30 MLP Index. The following are a few highlights:

- MLP as an asset class as of 3/31/2012 has a market cap of approximately $350 Billions

- An additional $250 billions may be needed to build infrastructures by 2035

- Based on the Cushing 30 Index the spread between MLPs and 10 year US Treasury is at 420 basis points; a spread over 400 points historically has forecast a very positive 12 month forward return for he sector. I calculate the spread using the Alerion Index and we are not quite at 400 bips but close enough (373)

- While Nat gas prices remain nvery low, spreads and margins continue to be attractive for MLPs that process and transport Natural Gas Liquids

- Domestic onshore Crude Oil development possible new area of expansion for E&P companies

- Growing supply of shale gas and declining supply of conventional resources are changing the pipeline blueprint

- MLP Subsectors Nat Gas, Propane and Coal continue to underperform while Shipping ad Transportation continue to outperform. Significant dispersion of returns among the subsectors is expected to continue

- M&A trend should continue

Thursday, April 5, 2012

Update on Exotic Fixed-Income

A while ago I commented on the expanding opportunities in Emerging Markets Corporate Credits as our domestic fixed income market looked increasingly less attractive; this exotic fixed income update wants to highlight the specific Asian segment as a potentially attractive idea.

The Asian bond market can be attractive in terms of Sovereign issues and Corporates as well; the credit quality of many Asian Sovereigns has improved dramatically over the years and it is backed by large current account surpluses. Especially when compared to the Euro Sovereigns and the highly expensive US Treasuries, Asian Sovereigns seem to deserve attention. This is not to say that they are risk free as this concept is becoming increasingly disconnected from the old fashion definition of government issued securities anywhere in the world. Teresa Kong of Matthews Asia reports significant increases in liquidity, transparency and diversification in the Sian bond market.

An exposure to international bonds carries an additional element to the investment; the position will be affected not only by the general level of interest rates, credit changes and liquidity but also currency exposure. Exposure to different currencies is a new element of smart diversification that at least large portfolios should consider. Teresa Kong of Matthews Asia makes a good point when she states: “If one were to think of investments as a way to generate income to cover expenses over the long term, having a proportion of income denominated in the same currency as future expenses might act as a currency hedge. Given that Asia accounts for an increasingly larger portion of U.S. imports, having an income stream derived from underlying instruments denominated in Asian currencies might be prudent.”

The higher yield and the diversification effect do come with a price: a higher level of volatility when compared to US bonds. However, Asian fixed income carries half the volatility of US equities and roughly one third of the volatility of Asia Ex-Japan equities (source: Matthews Asia).

Trading Master Limited Partnerships

This is an excerpt from an article written for Active Trader Magazine March 2012 Issue

Introduction to Master Limited Partnerships

Diversification, high income, tax efficiency, lack of correlation to traditional asset classes; these four elements would seem to be the pillar of every well designed investment vehicle. Master Limited Partnerships (MLP) have delivered just that for the last decade. But what is exactly an MLP? They are publicly traded, limited partnerships which own and operate gas and oil pipelines, storage terminals and refineries. They are structured like partnerships to take advantage of favorable taxation and to create income focused investment vehicles.

MLP have over the years concentrated in sectors related to energy but unlike their earlier versions of the 1980s which were structured solely for the purpose of exploiting tax loopholes in the oil and drilling area, these new partnerships have become efficient and dynamic utilities. They have acquired cheap assets with predictable cash-flows like pipelines and terminals and became very good at operating them.

These investment vehicles retain only a mild correlation to the price of oil and gas since they care mainly for its transportation. However, as the economy grows and demand for energy grows with it, the profits of the MLP increase accordingly. MLP also offer protection against inflation in two ways: via their portfolio of real assets and via “inflation-plus pricing,” or in other words their ability to price their services and products at a premium of the PPI rate.

Due to the partnership structure, MLP generally do not pay income taxes eliminating the problem of double taxation of dividends that corporate investors face. MLP generally pay out all available cash flow defined as cash flow from operations less maintenance capital expenditures in the form of quarterly distributions. Additionally, limited partnerships receive a tax shield equivalent to 80-90% of their cash distributions every year. This allows an investor to pay income taxes only on 10% to 20% of the distribution received. The rest is deferred until the investor sells the security. This tax deferral reduces the investor’s tax basis in the partnership unit. Because of these reasons, MLP seem perfect for estate planning.

There are different risks associated with this type of investment. The first would seem to be the competition MLP face from other fixed income products. As interest rates in general increase, so must the rate of MLP’s distributions, otherwise a price correction will occur. Generally MLP are priced to yield anywhere between 6% and 10% depending on the level of risk associated with each utility. Accordingly to Wachovia Securities research, movements in interest rates explain approximately 25-30% of MLP price changes.

Additionally, like in every company, macro-economic performance and management execution are important elements in the valuation process; therefore distributions could vary depending on such factors.

While one of the main elements of attraction is the tax efficiency enjoyed by the MLP, such advantage could be erased by a hostile Congress.

MLP may have some restrictions for IRA accounts. While they can be held in such accounts, MLP should not generate more than $1,000 per year in UBTI (Unrelated Business Taxable Income) or the exceeding income would be subject to taxation.

Trading Master Limited Partnerships

MLP are usually considered long term investments generally included in an income oriented portfolio. Their large distribution and the consistency of growth of such pay-outs made the sector a staple of passively managed portfolios. However, the combination of today’s low rates of returns for most asset classes, MLP consistent total return outperformance and an increase in the sector volatility should make them interesting for more active investors as well.

Master Limited Partnerships (and we focus on energy related names which comprise the large majority of this universe) are divided in 10 subsectors which cover the whole spectrum of the energy chain – upstream, midstream, downstream – with a concentration of companies in the midstream sector (transportation, storage, refinery).

There are different indexes that allow monitoring of the performance of the sector in aggregate but the two main benchmarks are the Alerian MLP Index which is made of 50 MLP and it is cap weighted and the Cushion 30 which includes 30 MLP and it is equally weighted. It is important to note that in the Alerian Index, the five largest companies represent over 40% of the index.

MLP have provided an annualized total return of approximately 20% in the last decade (there are small differences depending on the Index used) and even when expanding the historical analysis to a longer time horizon, the total return does not vary much. A large portion of this performance clearly comes from distributions which have averaged anywhere between 6% to over 7% depending on the benchmark. The current distribution level, its expected rate of growth and how it compares to alternative income sources is a traditional way to determine value in the sector and trigger trades. Classic comparisons are run against the US Treasury 10 year note, REITs and BBB bonds. The average spread over the 10 year Treasuries is at 321 basis points and we are today at a 413 point spread (this is based on the Cushion 30 Index, when looking at the Alerian Index the spread seems to be a little lower than 400 points). Spreads over other income products are also above their historical norm as of this writing; the average spread over REITs is approximately 190 basis points and we are now trading at 241. The spread over BBB bonds is on average at 129 basis points and it is now at 162. Spreads over 400 basis points versus Treasuries have consistently shown a positive forward returns for MLPs. Normally this metric tends not to exceed 500 basis points but it did experience an aberration of 1200 points during the 2008 credit crisis climax. Spreads at around 200 basis points are generally precursor of underperformance.

Another valuation metric typically used for MLPs is Current Price over Distributable Cash-flow; such metric now stands at 11.6 times which is line with historical fair value (source: Swank Capital)

As mentioned in the introduction, another useful trait for this sector is the lack of correlation to stocks and a mild correlation to energy prices. Correlation to stocks did increase during the 2008 crisis as the result of most asset classes increasing correlations and because the core of the crisis generated from the credit market which is vital to this sector. As far as correlation to oil and gas, the degree varies depending on the subsectors but overall there is more correlation to GDP than to spot crude. The following table shows individual correlation to oil and gas for some of the most common names:

	APU	BPL	EEP	EPD	FGP	KMP	MMP	NRGY	NS	PAA	SPH	SXL	TCP	NAT GAS	CRUDE
APU	1
BPL	0.404	1
EEP	0.449	0.444	1
EPD	0.42	0.296	0.4	1
FGP	0.48	0.315	0.332	0.387	1
KMP	0.487	0.373	0.493	0.383	0.264	1
MMP	0.376	0.422	0.5	0.371	0.241	0.425	1
NRGY	0.38	0.508	0.54	0.367	0.323	0.324	0.603	1
NS	0.374	0.524	0.471	0.373	0.227	0.371	0.615	0.675	1
PAA	0.414	0.289	0.445	0.384	0.273	0.286	0.44	0.475	0.43	1
SPH	0.617	0.256	0.462	0.473	0.416	0.434	0.466	0.502	0.516	0.4	1
SXL	0.344	0.427	0.409	0.273	0.164	0.295	0.505	0.555	0.544	0.357	0.432	1
TCP	0.431	0.256	0.465	0.413	0.351	0.229	0.291	0.35	0.361	0.27	0.448	0.251	1
NAT GAS	0.068	-0.06	0.069	0.116	-0.015	0.186	-0.002	0.038	0.039	0.031	0.087	0.031	-0.013	1
CRUDE	0.061	0.105	0.234	0.172	0.154	0.059	0.013	0.093	0.014	0.057	0.002	0.01	0.2266	0.24262	1

As indicated previously, MLP in aggregate also show mild correlation to other asset classes at 0.49 versus the SP500 and 0.35 versus REITS (Source: Swank Capital). One caveat, correlations can change and depend largely on the time period chosen.

It is also important to remember that while most analysis is generalized by looking at aggregate numbers, the MLP universe, as I mentioned earlier, is represented by 10 different subsectors which may show significant delta in their performance. Trading opportunities surface regularly by evaluating subsectors against each other. As an example, last year the best subsector was General Managers while the worst one was Natural Gas Storage; the performance delta was a significant 60%. The following is a list of the available subsectors:

- General Managers

- Natural Gas Gatherers and Processors

- Refined Products Pipelines and Terminals

- Natural Gas Transportation

- Crude Oil Transportation,

- Upstream

- Shipping

- Coal

- Propane

- Natural Gas Storage

As investors’ interest in the space has grown over the last few years, more investment vehicles have also come to market. While it is usually a much better trading proposition to utilize individual MLP (unless there is a need to avoid the additional tax reporting complication of a K-1), some Closed-End funds may offer arbitrage opportunities. Closed End funds can trade at a premium or discount to NAV and can therefore provide additional opportunities to extract value.

Conclusion

There are many fundamental factors that will increase active investors’ interest in the MLP space. The sector has now a market cap of $325 billions and it is estimated that another $250 billions will be needed by 2035 just to service and distribute the existing energy reserves. The evolution of the natural gas story after the large reserve discoveries in the United States will offer many opportunities in the future. Additionally, Merger and Acquisition activity should continue to provide arbitrageurs opportunities to participate in the consolidation trend.

Enough to keep everyone interested!

PS Tables calculations provided by Rosario Rivadeneyra