Source hits the spot with new US energy infrastructure play

Jun 13th, 2013 | By | Category: Equities

By David Stevenson

I think I owe readers an apology right at the beginning of this column – I am, I freely admit, something of an energy bore. In my Financial Times, MoneyWeek and Investment Week columns I’ve been banging on for what seems like an eternity about my structural bias towards the energy sector and, in particular, the energy infrastructure niche.

Source hits the spot with new US energy infrastructure play

Source hits the spot with new US energy infrastructure play

Only this weekend, for instance, there I was regaling poor old MoneyWeek readers about the massive opportunity presented by the developed world’s need to retool and re-engineer its energy supply infrastructure.

So, given this tireless campaigning for energy-focused ETFs and funds, it won’t come as a great surprise to ETF Strategy readers that I think that Source, a London-based ETF provider, has done us all an enormous favour by listing Europe’s first MLP tracker structure.

In fact, I think it’s such a good idea that I’ve already bought a nice long line of shares in the fund. The fund in question is called the Source Morningstar US Energy Infrastructure MLP UCITS ETF and it is linked to an index of leading US-based energy infrastructure companies tracked, surprise, surprise, by Morningstar!

What may come as a greater surprise to ETF Strategy readers – given this rampant enthusiasm – is that I’m also willing to concede that now may not be the best time to actually buy this innovative new fund. In fact, I have a sense that this hugely popular sector in the US has probably overreached itself and could be due a small correction fairly soon. But my crystal-ball-gazing gifts and my abilities in market timing are so utterly lamentable that I’m willing to swallow any short-term volatility (over the next few months I’d guess) in pursuit of what I think should be a relatively steady long-term gain.

So, why the long-term bet on energy infrastructure? This isn’t the most appropriate space to bore you yet again with my views on energy, but I would make five simple arguments.

1. Everything that will happen for the good in the next few decades in the developing world will require an energy input of some sort and energy consumption will vastly increase

2. Alternative energy sources will emerge and US shale gas will make a huge impact on power generation and industrial use, BUT for the foreseeable future oil will remain the energy of choice for transport-based users, especially in the third world

3. Oil prices are volatile but they are trending higher over the long term as the cheap and easy-to-access stuff starts to run out. After every economic crisis, oil prices have reset to a higher level

4. New reserves of oil will emerge – no doubt about that – and I would argue we are not at the peak oil inflection, but new energy sources will require massive capital investment, especially in infrastructure, and will keep energy input costs high, requiring a decent profit margin for oil producers

5. As climate change rears its ugly head, we will desperately need a new energy infrastructure that will involve retooling our ‘soft’ knowledge about how to consumer energy (cue lots of innovations around energy usage). But it will also require a massive expansion in hard infrastructure, based largely around new grids, and massive new pipeline and storage networks

Given these long-term views – which, I will add, many very intelligent people violently disagree with – I think that a bias towards both a) strategic energy reserves owned by key companies as well as b) energy infrastructure build out and ownership makes sense!

There’s also the realty that in the core US market, tax-efficient income-orientated funds and structures such as Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs) (that own pipelines) and royalty trusts (which collect an income from oil and mining assets) are perhaps the DOMINANT equity income strategy for local investors. In other words, whereas here in the UK we buy shares in the likes of Vodafone or BAT to produce a growing dividend income, over in the US MLPs and REITs are the default structures for progressively growing equity income over time.

Cue the Source product based on the Morningstar index. The fund tracks the major companies in the sector based on their distribution yield, but the fund structure has an important and novel twist – it appears to be tax efficient for UK investors. One of the key drawbacks for UK investors in MLPs (or REITs for that matter) is that in order to implement an energy infrastructure strategy, we actually need to invest in US shares that pay a dividend. Those dividends are in turn subject to a withholding tax which is at either 30%, or 15% if you sign a US waiver form. That means the US Treasury gets a decent slug of your money even before you get it into a tax-efficient SIPP plan.

The Source structure does away with this tax treatment and in effect you receive the income as gross. The twist, of course, is that this is a total return swap, so the big investment banks behind the product do away with all that tax withholding nonsense and provide you with a total return IOU or swap i.e. we, the undersigned enormous investment bank, promise to pay you, the little investor, the total return on the index (including that income stream of growing dividends) in return for a swap fee (which was 0.75% the last time I looked) plus an annual fund fee of 0.50% per annum.

Obviously, that makes this structure a tad more expensive than your mainstream equity market tracker (total charges amount to 1.25%) but that treatment of the US tax is a big plus, giving UK-based investors a really simple structure to access this huge US sub-market. There’s also the obvious counterparty risk plus currency risk, as the underlying assets are US denominated – but, then again, I’d rather take dollar assets any day given the buoyancy of the US national economy.

All in all, the US energy infrastructure sector is an important play for ALL UK-based investors, so let’s hope that Source’s competitors now come up with new twists on the same idea!

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