Attractive Income in a Yield-Starved World
MLP Prices Have Diverged from Their Cash Flows
Master Limited Partnerships (MLPS) are now up 25.89% from their February 11th lows and yield 7.51% as of September 20th 2016 but they continue to move in tandem with crude prices rather than their cash flows and revenues, says Libby Toudouze, a MainStay portfolio manager (see chart below).
WTI Oil Prices versus MLP Cash Flows
Source: Cushing Asset Management and Bloomberg, 9/20/16. Represents rolling Last Twelve Months Earnings Before Interest Taxes Depreciation and Amortization (LTM EBITDA) as reported by the issuer. Note: Midstream EBITDA represented by midstream companies with at least a $10 billion market cap. Upstream EBITDA represented by members of the S&P 500 Oil & Gas Exploration and Production Sub Industry Index (S5OILP). The index comprises stocks in the S&P Total Market Index that are classified in the GICS oil & gas exploration & production sub-industry. Oilfield Service EBITDA represented by members of the Philadelphia Stock Exchange Oil Service Sector Index (OSX). The Index is a price weighted index designed to track the performance of companies involved in the oil services sector. Midstream is a term used to describe one of the three major stages of oil and gas industry operations. Midstream activities include the processing, storing, transporting and marketing of oil, natural gas and natural gas liquids.
This dynamic was especially challenging during a seven quarter period where oil prices corrected from $91.66 a barrel for West Texas Intermediate crude to $34.10. A number of flagship MLPs had to curtail their capital spending, renegotiate contracts, and lower distributions to more sustainable levels. The result is an attractively valued and misunderstood asset class.
MLPs are a volume business but the market often treats them like a price times volume business. Demand actually grew for cheap refined products during the energy swoon of 2014-2016 and MLPs move energy products or their feedstock to where they are needed. Another misconception is that MLPs, which offer attractive yields in a yield-starved world, are a substitute for bonds. They are not. But they do offer a potential opportunity for investors seeking income to source it from outside the bond portion of their portfolios.
The Big 3
Today, MLPs as an asset class yield in excess of 7% with an EV/EBITDA multiple of 16.78 according to Bloomberg, as of 09/20/16. But not every MLP will be a winner. Libby and her colleagues focus on three important determinants for success: (1) distribution sustainability, (2) contract sanctity and (3) access to capital for growth. Because MLPs pay out most of their cash flow in the form of distributions to investors, they need access to capital to expand their pipeline infrastructure to connect new supply centers with refiners and ports.
MLP prices have diverged from their cash flows. For those who take the time to understand this asset class, this pricing disconnect may provide a worthwhile long-term opportunity.
All investments are subject to market risk, including possible loss of principal.
MLPs and other natural resources sector companies are subject to certain risks, including, but not limited to fluctuations in the prices of commodities; the highly cyclical nature of the natural resources sector may adversely affect the earnings or operating cash flows of the issuers; a significant decrease in the production of energy commodities would reduce the revenue, operating income, and operating cash flows of MLPs and other natural resources sector companies and, therefore, their ability to make distributions or pay dividends.
Midstream MLPs gather, process, and transport natural resources.