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Energy sector funds snap two year outflow streak on the back of ‘great rotation’ into MLPs

EPFR Global-tracked energy sector funds look set to post full-year inflows for the first time since 2010 despite the mixed outlook for oil prices and the eroding state support for alternative energy subsidies.

Going into 2013 the outlook for many energy plays was lacklustre at best. Fair value estimates for oil prices had dropped to around USD80 a barrel in the face of rising US production, weak demand from Europe and questions about China’s appetite for energy.
The nuclear industry remained on the defensive in Japan, Germany and other key markets. Cash-strapped governments were reviewing their support of alternative energy producers. The stage seemed set for energy sector funds tracked by EPFR Global to post a third consecutive year of outflows.
With 2013 almost over, however, those energy sector funds are on course to post inflows for the first time since 2010. Oil prices have proved resilient, holding around USD100 a barrel for most of the year, as macroeconomic data from Europe, the US, Japan and China more often than not met or exceeded expectations as the year progressed.
But fundamentals, while increasingly supportive, are not the driving force behind this year’s inflows. They real key has been an aggressive rotation – now in its third year -- from traditional funds to those investing in Master Limited Partnerships (MLPs), a vehicle so far confined to the US that allows investors to take tax deferred distributions and, in the case of MLP funds, gives them the option to trade their investment like a stock.
Through mid-December the energy MLP funds tracked by EPFR Global had attracted a net USD8.73bn in new inflows, more than offsetting over USD3.5bn in redemptions from conventional energy sector funds.
The appetite for energy MLPs is consistent with the hunger for yield that has gripped investors since central banks started crushing interest rates in 2008-09. Over that period emerging markets, high yield, floating rate and mortgage backed bond funds have attracted significant inflows, as have dividend equity funds, as investors searched for higher returns. Heading into the New Year, however, only floating rate bond and energy MLP funds still have momentum when it comes to attracting fresh money.
The interest in energy MLPs has had the effect over the past three years of concentrating energy sector portfolio capital flows in US ‘mid-stream’ assets such as gas and oil pipelines and storage facilities while Europe-domiciled energy sector funds have seen over USD6bn redeemed since the beginning of 2012.
“These mid-stream assets tend to generate stable revenue streams that are not highly correlated to the prices of oil, gas and coal,” says Mark Wildermuth, co-founder of MLP Data which tracks and analyses this asset class. “Demand for them, thanks to the US energy boom, is also strong.”
MLPs, according to Wildermuth, are also not as interest-rate sensitive as some investors believe because their income streams tend to be based on long-term contracts. But the US Federal Reserve’s recent announcement that it will start winding down its current quantitative easing programme – QE3 – in the New Year raises questions for the sector as a whole, ranging from the effects on demand and the costs of future capital expenditure to the cost-benefit analysis for investors who have used the sector as a hedge against the dollar weakness many anticipated when the Fed launched the first of its QE programmes.
Retail investors, who started committing fresh money to energy sector funds in 3Q13 as industrial production picked up around the world, have begun to pull back again. Managers of funds with geographic mandates have, with the exception of China equity funds, been cautious about increasing their exposure to energy plays. In early November Japan equity fund allocations for the sector were at more than four year lows and those for Europe equity funds at levels last seen in 1H07.
Investors also face new supply considerations when making decisions about the energy sector’s prospects in 2014 and beyond. Mexico’s reform push, reduced tensions between Iran and the developed nations and the recovery of Iraq’s oil sector all have the potential to boost supply in the short run while the development of Brazil’s offshore oil fields could be a factor later this decade.
Bigger supplies of cheaper oil represent another headwind for alternative energy plays, which will also be under pressure from the new German government’s clear shift in policy that puts more emphasis on economic competitiveness and could result in less state support for renewable energy sources . But investor demand for the sub-sector rebounded this year as oil prices held firm, Japan kept nuclear capacity off line and President Obama’s administration kept the pressure on coal-fired generators.
Among the factors that may help at least some alternative energy plays outperform in the coming months is a push to modify the existing legal framework for MLPs in the US so that they cover alternative energy projects which, because they are not “depletable” sources, are currently excluded. A bill, The MLP Parity Act, has attracted bi-partisan sponsorship but is yet to be voted on.

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