ALTERNATIVE INVESTMENTS
Investing in the North American energy revolution A country once expected to be perpetually dependent on imported oil now has the potential to evolve into a net exporter of energy. How did this happen? And what does it mean for investors? Another revolution comes to America. Twenty-five years ago, America’s energy future looked bleak. The conventional wisdom—born in the iconic gas lines of the 1970s and held until recent times— was that America was destined to perpetually import its fuel. Despite periodic optimism within America’s energy industry, proven reserves of crude oil and natural gas continued a downward trend. To point, the U.S. Department of Energy’s 1998 Annual Report echoed the nation’s hopeless outlook:
“
Low prices imply poor economics for oil producers, and poor economics leads to low drilling levels. Only twice in over 100 years have fewer oil wells been drilled than in 1998…The onshore lower 48 States is a mature exploration and development area where, in the absence of enough exploratory and development wells drilled,
”
it is next to impossible to add sufficient new fields, new reservoirs, and positive revisions to replace production.1
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However, the most recent data from the U.S. Energy Information Administration (EIA) shows that the United States had more proven reserves of crude oil and natural gas in 2010 than it did 25 years prior, despite population growth of approximately 30% and the requisite increases in energy consumption that accompanied it.2 (Not to mention the 45% increase in vehicle miles traveled over the same period.) Further, to the surprise of the 1970s energy doomsday pundits, the imported share of petroleum into the United States has fallen every year since 2005, when the country reached its import zenith of 60% of consumption. Today, the EIA estimates that the United States imports nearly half of that at 35%.
0.08 0.07 0.06 0.05
Consumption per capita
0.04
Imported petroleum per capita
0.03 0.02 0.01
14 20
10 20
06 20
02 20
19
19
98
0
94
Energy efficiency gains account for reductions in oil consumption and import.
Million Barrels of Oil Equivalent Per Day (mmboe/d)
Chart 1: Reductions in oil consumption and imports
Sources: U.S. Energy Information Administration and U.S. Bureau of the Census Note: 2013 and 2014 values are projections from their respective sources.
The most shocking revelation of America’s energy trajectory, however, is the prediction that the United States could become a net exporter of petroleum products and natural gas in the foreseeable future. How did an entire country go from waiting in the 1970s’ odd/even gas lines to being a potential exporter of energy? This is the remarkable story of North America’s energy revolution.
Energy in America: Yesterday and tomorrow Historically, North America has been viewed as highly dependent on imported energy. In 2010, the United States consumed 19,148 million barrels of oil equivalent per day.3 Producing only 8,593 million domestically, the country was importing 55% of its fuel to meet demand, primarily in the form of oil. That percentage has already decreased to an estimated 48% in 2013, and is forecast to continue its steady decline.4 It is an epic confluence of efficiency and technology that is attributable to this growing independence from imported oil. The United States has become significantly more energy efficient over the last 25 years, and is projected to continue increasing its efficiencies over the next 25. Increases in consumer awareness of energy conservation, energy efficiency of household appliances, and fuel economy standards are all accountable for the marked decrease in American energy consumption. This is despite healthy population growth and rising affluence during the same period.
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Investing in the North American Energy Revolution
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Chart 2: Shifting interactions of growth and consumption
3
Population (hundreds of millions) 2.5
Vehicle miles traveled (trillions of millions)
2
Consumption per vehicle miles traveled (thousands of millions of barrels and miles) 14 20
10 20
06 20
02 20
19
19
98
1.5
94
Fuel efficiency gains account for reductions in oil consumption despite population and driving growth.
Growth of Population and Vehicle Miles Traveled
3.5
Sources: U.S. Energy Information Administration, U.S. Bureau of the Census, U.S. Department of Transportation Federal Highway Administration Note: 2013 and 2014 values are projections from their respective sources.
Yet at the same time that energy demand per capita has been decreasing, cheaper renewable energy has been contributing more power to the grid. Additionally, advancements in drilling techniques have allowed access to existing oil and gas reserves that were previously unreachable or unfeasible. Offshore drilling has increased the energy potential of the United States, while the utilization of energy from Canadian oil sands is facilitating a reduction in crude oil imported from overseas. The continent’s most notable advanced drilling technique, however, is hydraulic fracturing (more commonly known as “fracking”) in conjunction with horizontal drilling.
What is fracking? The fracking process involves injecting fracturing fluid (a combination of water, chemicals, and proppant) at high speed into a wellbore and through the underlying hydrocarbon rock below. This cracks the rock with enough pressure to create spin-off fractures that permeate through the formation and allow trapped pockets of oil and gas to escape back up the wellbore. Once the injection process is stopped or the pressure is reduced to allow the oil and gas to surface, the proppant (generally any particulate material such as grains of sand or ceramic) prevents the fractures from closing. The advancement into horizontal drilling has allowed existing wells to branch into such rock formations from the side, reducing the number of costly wellbores needed to be drilled to access entire parts of the formation.
Fracking and other advanced drilling techniques are unlocking a significant supply of oil and gas reserves throughout North America. While some observers speculate that America will account for a third of new oil supplies over the next five years, the real potential for energy independence lies in natural gas. It is not easily transported overseas without being liquefied, and so large domestic supplies have pushed North American prices down, providing the continent with some of the lowest-cost natural gas in the world. Attractive prices and excess supply have the potential to make natural gas a viable alternative to oil as the energy that powers North America. Combined, the continent’s oil and natural gas reserves can be significant enough to supply the United States for an entire century.
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Chart 3: North American oil and gas reserves HORN RIVER OIL SANDS MONTNEY DUVERNAY CARDIUM
New drilling technologies, such as fracking, have unlocked reserves throughout North America.
UTICA
SHAUNAVON
CODY
BAKKEN JONAH
ANTRIM
NIOBRARA
MANCOS MONTEREY
PIERRE
MISSISSIPPI LIME
LEWIS
CHATTANOOGA
GRANITE WASH
WOODFORD AVALON
MARCELLUS
UTICA
PICEANCE
CLINE
FAYETTEVILLE FLOYD
HAYNESVILLE
BARNETT
TUSCALOOSA
WOLFCAMP EAGLE FORD
Source: Kayne Anderson Capital Advisors, L.P.
Infrastructure expansion needed for energy independence New infrastructure will be required to transport, store, and distribute the resources harnessed from North America’s newly accessible reserves. Technically, all of the infrastructure development and energy processing that falls between the actual extraction of oil and gas (termed “upstream”) and the refined end product delivered to the consumer (termed “downstream”) is collectively referred to as “midstream.” Midstream process elements include the construction of pipelines and storage tanks, the processing of oil and gas, and the ground and sea transportation channels, amongst others.
Chart 4: Shifts in U.S. oil and gas movements
Shifts in oil and gas movements are occurring that will require new infrastructure construction.
OIL OIL & GAS
Projected Movement
GAS GAS
OIL
Present Movement
OIL & GAS OIL & GAS
GAS
OIL
OIL OIL
Source: Kayne Anderson Capital Advisors, L.P.
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OIL & GAS (LNG)
OIL & GAS OIL
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For years, domestic energy production in the United States has revolved around the Gulf of Mexico and California coasts, and refineries near Chicago and Philadelphia. The reserves from newly accessible shale formations, however, are being extracted in areas of the continent far from existing energy infrastructure. Therefore a shift is occurring in the direction of oil and gas movements across the continent from midstream processing and storage points—one that will require new pipelines and vehicles/barges capable of safely and securely transporting various energy commodities to market. In all, the Interstate Natural Gas Association of America estimates that companies in the United States will spend more than $251 billion on oil and gas midstream infrastructure through 2035,5 with the build-out of the infrastructure expected to span at least two decades. Further, upon build-out, midstream infrastructure will continue to generate steady income by levying tariffs on the products it transports. Users will contract with infrastructure companies to guarantee a defined price paid for a defined amount of flow, and pay additional tariffs if and when that flow is exceeded. Such midstream infrastructure, then, is well poised for investing in North America’s energy revolution. It is less sensitive to changes in commodity prices than upstream or downstream segments and is instead more reliant on flow/volume (which may actually increase if energy needs are met domestically and regulations allow for additional exports).
Investment opportunities in energy infrastructure To date, energy companies have made substantial amounts of capital expenditures in North America, but more investment is needed to fully unlock the energy revolution’s potential. Much of the country’s energy infrastructure is being built and operated by publicly traded entities, many of them structured as publicly traded partnerships. A common investment is ownership of master limited partnerships (MLPs), as many of these companies focus exclusively on the midstream energy sector. Energy-related MLPs offer diverse investment exposure to pipelines, storage facilities, and marine tankers as well as a broad representation of raw energy materials such as crude oil, natural gas, propane, coal, and other petroleum products. Debt and equity of other non-MLP energy related companies—servicers and suppliers to the energy sector—may also prove to be beneficiaries of the energy revolution in much the same way that Levi Strauss made his fortune outfitting the “49ers” during California’s Gold Rush instead of prospecting himself. But it’s energy-related MLPs that are garnering attention today. Required by law to receive at least 90% of their income from specific “mineral or natural resources
What is an MLP? Master limited partnerships (MLPs) are publicly traded limited partnerships that consist of a general partner and limited partners. Although they share many of the same characteristics of a traditional limited partnership, MLPs are more liquid because they trade on major exchanges like shares of a public corporation. As in most partnerships, however, operating earnings of an MLP are allocated among all partners in proportion to their ownership interests and are taxed at the investor level at the investor’s applicable income tax rate.6
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activities” as defined by the U.S. Tax Code, MLPs are a natural vehicle for investing in the North American energy revolution as they eliminate the double taxation found within the traditional corporate structure. This gives them a cost-of-capital advantage enabled by their ability to distribute more of their earnings to their limited partners, typically in the form of quarterly cash distributions. Compared to direct commodity investments, many MLPs can be less volatile due to their ownership of real assets and a revenue model focused on transporting raw commodities instead of the discovery and sale of the commodity. Also, midstream assets without direct commodity price sensitivity have historically received higher valuations in the market than those exposed to the variability of commodity price cycles. Perhaps most notable, though, is the fact that MLP distributions have grown by 7% (annualized) each year for the last five years in a row.7 Chart 5: Average MLP cash distribution growth rates
Cash Distribution Growth Rate (%)
10 8%
8
7.5-8.5%
6.2%
6 4.5% 4
3.1%
2
E 13 20
12 20
11 20
10 20
20
09
0
Source: Kayne Anderson Capital Advisors, L.P.
Past performance does not guarantee future results. There are no guarantees that MLP distributions will continue to grow.
The North American energy revolution is here now, and is expected to shape our economic landscape into the foreseeable future. With the increase in proven reserves and the advancements in technologies necessary to harness them, North America’s energy trajectory is poised to continue its upward trend. The investment in required midstream infrastructure is estimated in excess of $251 billion dollars and is expected to be spread over more than 20 years. MLPs offer a value proposition unique in the energy space that includes growth potential coupled with income distributions and indirect commodity exposure. If the energy infrastructure demand trends are an indication of the future, investors should be prepared. American energy independence is not just a pipe dream.
1. U.S. Energy Information Administration, U.S. Crude Oil, Natural Gas, and Natural Gas Liquids Reserves 1998 Annual Report (Washington, DC: GPO, 1999), ix. 2. Estimate based on U.S. Bureau of the Census data for July 1 of 1985 and 2010 3. Technically defined as million barrels of oil equivalent per day (mmboe/d) and estimated by the U.S. Department of Energy’s Energy Information Administration 4. Kent Wosepka et al., “The U.S. Energy Revolution: How Shale Energy Could Ignite the U.S. Growth Engine,” Perspectives, June 2012, 5, http://www.goldmansachs.com/gsam/docs/fundsgeneral/general_education/economic_and_market_perspectives/ps_us-energyrevolution-tpd.pdf 5. The INGAA Foundation, Inc., North American Natural Gas Midstream Infrastructure Through 2035: A Secure Energy Future, Executive Summary (June 28, 2011), 15, http://www.ingaa.org/File.aspx?id=14911 6. Kayne Anderson Capital Advisors, L.P., “Master Limited Partnership Primer ‘MLP 101’ ” (Internal Presentation, Fourth Quarter 2012), 3. 7. Alerian, Frequently Asked Questions (April 30, 2013), 2, http://www.alerian.com/wp-content/uploads/Alerian_MLP_FAQ.pdf transamericainvestments.com
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Terms & Definitions Canadian oil sands: The largest deposits of bituminous sands in the world. Bitumen is the heaviest and thickest form of petroleum—it is often referred to as tar because of its similar smell, appearance, and uses—and does not flow freely unless heated or diluted. It is heavier than water and more viscous than molasses. Loose sand and partially consolidated sandstone saturated with bitumen exists in large deposits around the world, with the largest deposits in Alberta, Canada. Downstream: The part of the energy infrastructure value chain that delivers a refined product to the consumer. Energy Information Administration (EIA): The principal agency of the U.S. Department of Energy responsible for collecting, analyzing, and disseminating data and information on coal, petroleum, natural gas, electric, renewable, and nuclear energies. Environmental Protection Agency (EPA): The agency of the U.S. federal government created for the purpose of protecting human health and the environment by writing and enforcing regulations based on laws passed by Congress. It conducts environmental assessment, research, and education, and is responsible for maintaining and enforcing national standards under a variety of environmental laws through fines, sanctions, and other measures. General partner: The party responsible for managing an MLP’s affairs. They receive compensation that is linked to the performance of the MLP. Horizontal drilling: The process of accessing underground hydrocarbon reserves horizontally from an existing wellbore. When used in conjunction with hydraulic fracturing, it reduces the number of wellbores needed to be drilled to access entire underground shale rock formations. Hydraulic fracturing (“fracking”): The process of injecting fracturing fluid at high speed into a wellbore and through the underlying hydrocarbon rock below. The process cracks the rock with enough pressure to create spin-off fractures that permeate through the formation and allow pockets of oil and gas to escape back up the wellbore. In conjunction with horizontal drilling, it is the primary process of harvesting hydrocarbon reserves from underground shale rock formations in North America.
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Hydrocarbon: The organic compounds consisting entirely of hydrogen and carbon that create energy when burnt. The majority of hydrocarbons found on earth occur naturally from decomposed organic matter in the form of crude oil. International Energy Agency (IEA): The autonomous intergovernmental organization dedicated to responding to physical disruptions in the supply of oil and serving as an information source on statistics about the international oil market and other energy sectors. It was established in the framework of the Organisation for Economic Co-operation and Development (OECD), and acts as a policy advisor to its member states and other non-member countries. Limited partner: The person or persons that provide capital to an MLP—also known as investors—and receive periodic income distributions from the MLP’s cash flow. Master Limited Partnership (MLP): A type of limited partnership that is publicly traded. There are two types of partners in this type of partnership: a general partner and a limited partner. Midstream: The part of the energy infrastructure value chain that is responsible for moving energy products from their wellheads to consumption. Barrel of oil equivalent (boe): A unit of energy based on the approximate energy released by burning one barrel of crude oil. It is often expressed in millions of barrels per day (mmboe/d) to measure daily production and consumption, and is used by energy companies as a way of combining oil and natural gas reserves and production into a single measure. Proppant: A particulate material, such as grains of sand or ceramic, that keeps a hydraulic fracture in a rock formation open so that oil or gas may escape. It is an additive to the fracturing fluid used during the hydraulic fracturing process. Upstream: The part of the energy infrastructure value chain where raw energy product is sourced, often known as the wellhead. Wellbore: A hole drilled for the purposes of exploration or extraction of natural resources. It is a part of the process of hydraulic fracturing.
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Mutual funds are subject to market risk, including the loss of principal. Investments in MLPs involve risks that differ from investments in corporate issuers, including risks related to limited control, cash flow risks, dilution risks, and risks related to the general partner’s right to require unit holders to sell their common units at an undesirable time or price. The energy industries can be significantly affected by fluctuations in energy prices and supply and demand of energy fuels, energy conservation, the success of exploration projects, and tax and other government regulations. Sector funds can be more volatile because of their narrow concentration in a specific industry. Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, economic, or other developments. The fund is subject to certain MLP tax risks. Risks associated with accounting for deferred tax liability could materially impact the net asset value. An investment in the fund does not offer the same tax benefits of a direct investment in an MLP. The potential tax benefits from investing in MLPs depend on them being treated as partnerships for federal income tax purposes. If the MLP is deemed to be a corporation, then its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution to the fund, which could result in a reduction of the fund’s value. The fund is classified as “non-diversified,” which means it may invest a larger percentage of its assets in a smaller number of issuers than a diversified fund. To the extent the fund invests its assets in fewer issuers, the fund will be more susceptible to negative events affecting those issuers. Shares of the fund may only be sold by offering the fund’s prospectus. You should consider the investment objective, risks, charges, and expenses of the fund carefully before investing. The prospectus contains this and additional important information regarding the fund. To obtain the prospectus and/or a summary prospectus, please contact your financial professional or go to transamericainvestments.com. The prospectus should be read carefully before investing. Transamerica Funds are advised by Transamerica Asset Management, Inc., and distributed by Transamerica Capital, Inc. Not insured by FDIC or any federal government agency. May lose value. Not a deposit of or guaranteed by any bank, bank affiliate, or credit union.
Transamerica MLP & Energy Income Class A: TMLAX Class C: TMCLX Class I: TMLPX
Ask your financial advisor about Transamerica MLP & Energy Income or visit our website for more information.
MWPMLP0713
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