There is an abundance of curiosity and eagerness surrounding investing in the U.S. energy boom. At Fort Pitt Capital, we’re taking a cautious approach to capitalizing on the U.S. energy renaissance, a method that is synonymous with our overall philosophy of long-term, value-based investing.
There are two main reasons we remain cautious. First, companies that are developing land for drilling were generally quite small before the boom. As they grew, these companies have taken on a great deal of risk in the form of additional debt. Drilling is capital intensive and requires a hefty investment upfront. Additionally, the drilling process is lagging behind the extensive push to sign leases and secure land. Many of these lease agreements are five-year contracts, and companies often have trouble producing within this time frame. Some are overextended, and have underestimated the time, intensity and capital these projects require. Simply put, this risk profile does not fit with our investing style.
Second, there has been a push to invest in “midstream” opportunities. Once drilling begins, pipelines and equipment are required to extract the gas. These investments are generally organized as Master Limited Partnerships (MLPs), which trade like stocks, but aren’t taxed like stocks. The income is not taxed at the partnership level, but is instead passed down to the partnership owner, and reported on a K1. Given these tax implications, some investors think that a 401(k) or IRA is a way to invest in MLPs to avoid taxes entirely. This is where the complications come in, with something called UBTI, or unrelated business taxable income. When you invest in an MLP through a tax-deferred retirement plan such as a 401(k), the account becomes a partner in the MLP. The partners in an MLP are treated as if they are earning the income. Therefore a 401(k) holding an MLP could be earning income not related to the 401(k)’s tax-exempt purpose, and could become taxable as a result. Ultimately this tax complexity is not worth the investment for our clients.
We are finding areas for our client’s portfolios to benefit from the U.S. energy resurgence, however. One example is the boom in ethane as a natural byproduct of natural gas production. The ethane siphoned off and not used to generate energy can be put to work elsewhere – as raw material for plastics, for example. As production increases and ethane becomes more readily available, petrochemical manufacturers such as Axiall Corp. (AXLL) can benefit from the abundance of this resource.
Energy development companies generally have to continue to drill to hold the leases they have signed. As a result, there’s an abundance of natural gas, keeping the price near historic lows. We may revisit the energy exploration and production companies in the future — if industry consolidation occurs and debt is properly managed — but for now, we are finding opportunities elsewhere for client portfolios.