MLPs: Attractively Valued, Yet Misunderstood
A conversation with Jerry V. Swank of Cushing Asset Management
Charlie: When we last spoke in June, you stated that oil had reached its bottom. Since then, oil has had a bumpy ride as it increased to around $50 a barrel. The Organization of Petroleum Exporting Countries (OPEC) has proposed production cuts starting in November. What is your energy outlook now?
Jerry: We think Brent/West Texas Intermediate (WTI) crude oil could reach $55 a barrel this year as the supply and demand calculus continues to balance out and sentiment improves. Next year, oil could spend time in the $60s.
We have seen a flattening out in production through a reduced number of drilling rigs for oil and natural gas. Additionally, we have the proposed OPEC production cuts which should act as a temporary put on crude oil prices. Meanwhile, natural gas—a large portion of our midstream portfolio—appears to be at its trough following a nearly two year bear market and is poised to see price gains. For the first time in four and a half years we have a positive price outlook for natural gas.
Charlie: What does this mean for midstream master limited partnerships (MLPs)?
Jerry: For midstream MLPs, we are in a sweet spot as volumes are increasing and the exploration and production companies enter a position where they feel comfortable to go forth into new geographic areas and basins.
Charlie: This sweet spot came after a rough and tumble adjustment process. Can you explain it?
Jerry: A large, seven quarter decline in oil prices forced a number of flagship MLPs to curtail their capital spending, renegotiate contracts, and lower distributions to more sustainable levels. It was painful. But the result was an attractively valued and terribly misunderstood asset class.
Charlie: Misunderstood in what way?
Jerry: MLPs are now up 61% from their February 11 lows and yield 7.09%, as of September 30, 2016, but they continue to move in tandem with crude prices rather than their cash flows and revenues.
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.
Charlie: What should we be looking for when investing in MLPs?
Jerry: MLPs as an asset class yield near 7.20% with an enterprise value (EV)/earnings before interest, taxes, depreciation, and amortization (EBITDA) multiple of 17.7 according to Bloomberg. But not every MLP will be a winner. We 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.
Charlie: What is your take on the growth outlook?
Jerry: Opportunities are created as the transportation of energy changes. In 2013–2014, a large focus was on crude delivery by rail. Since that time, an emphasis has been placed on liquefied natural gas (LNG). As the number of facilities exporting natural gas grows to five in the next four years, shipping could be an increasingly interesting form of transportation to utilities around the world. Generally speaking, if one follows the supply chain and identifies potential bottlenecks, there are often investment opportunities in the companies possessing the capabilities to relieve those bottlenecks.
Charlie: As investors weigh the pros and cons of active versus passive investing, what are some things to consider with respect to MLPs?
Jerry: The pros and cons largely depend on one’s investment goals, tax sensitivity, and holding period. The most notable advantage of an active fund in this space concerns its ability to maintain distribution levels. When you owned an index fund earlier this year, yields fell as certain MLPs cut dividends. In an actively managed portfolio, managers are able to position the portfolio to avoid a big cut—maintaining its distributions. Additionally, volume growth may be larger or smaller in certain basins and geographical favorites. Active management can monitor these factors and track fundamentals and valuations. That said, a rising tide tends to raise all boats.
Active management is an investment strategy involving ongoing buying and selling actions by the manager. Active managers purchase investments and continuously monitor their activity in order to exploit profitable conditions. Active management typically charges higher fees than passive management.
Brent/West Texas Intermediate crude is a major trading classification of sweet light crude oil that serves as a major benchmark price for purchases of oil worldwide.
Brexit is an abbreviation for “British exit,” which refers to the June 23, 2016, referendum whereby British citizens voted to exit the European Union.
CME Group Inc. is an American futures company and one of the largest options and futures exchanges.
A commodity is a basic good used in commerce that is interchangeable with other commodities of the same type; commodities are most often used as inputs in the production of other goods or services.
Correlation is a statistic that measures the degree to which two securities move in relation to each other.
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
Build America Bonds (BABs) are taxable municipal bonds that feature tax credits and/or federal subsidies for bondholders and state and local government bond issuers.
Earnings-per-share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. Earnings-per-share serves as an indicator of a company’s profitability.
The EBITDA/EV Multiple is a financial ratio that measures a company’s return on investment (ROI).
A master limited partnership (MLP) is a type of business organization that exists in the form of a publicly traded limited partnership. There are two classes of partners in a master limited partnership: limited partners and general partners. Limited partners are investors that purchase units in the MLP that provide the capital for the MLP’s operation and that receive periodic income distributions from the MLP’s cash flow, whereas the general partners are responsible for managing the day to day operation of the MLP and that receive compensation based on the performance of the MLP’s business venture.
The Organization of Petroleum Exporting Countries (OPEC) is an organization founded in 1960 to coordinate the petroleum policies of its members, and consists of the world’s major oil exporting nations.
The price-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.
The price/earnings to growth ratio (PEG ratio) is a stock’s price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period.
Proposition 53 was a California ballot proposition on the October 7, 2003, special recall election ballot, which failed to get passed.
A real estate investment trust (REIT) is a type of security that invests in real estate through property or mortgages and often trades on major exchanges like a stock. REITs provide investors with an extremely liquid stake in real estate. They receive special tax considerations and typically offer high dividend yields. Investment in REITs carries with it many of the risks associated with direct ownership of real estate, including decline in property values, extended vacancies, increases in property taxes, and changes in interest rates.
The S&P 500 Forward Price-to-Earnings (P/E) Ratio uses estimated net earnings over next 12 months. Estimates are typically derived as the mean of those published by the analysts at S&P.
A share repurchase is a program by which a company buys back its own shares from the marketplace, usually because management thinks the shares are undervalued, reducing the number of outstanding shares.
Standard deviation is a measure of the dispersion of a set of data from its mean.
The S&P 500 Energy Sector is a category of stocks that relate to producing or supplying energy. This sector includes companies involved in the exploration and development of oil or gas reserves, oil and gas drilling, or integrated power firms.
Sovereign debt refers to bonds issued by a national government in a foreign currency, in order to finance the issuing country’s growth.
Valuation is the process of determining the current worth of an asset or company.
The Bloomberg Commodity Index (BCOM) is a broadly diversified commodity price index distributed by Bloomberg Indexes. The index tracks prices of futures contracts on physical commodities on the commodity markets.
The IA SBBI U.S. Large Stock Total Return Index was created by Ibbotson as a broad based, capitalization-weighted index which measures the total return performance of U.S. equities.
The IA SBBI U.S. Corporate Total Return Index was created by Ibbotson as a market value weighted index which measures the performance of long-term U.S. corporate bonds.
The IQ Global Resources Index uses momentum and valuation factors to identify global companies that operate in commodity-specific market segments and whose equity securities trade in developed markets, including the U.S.
The MSCI EAFE Index serves as a benchmark of the performance in major international equity markets as represented by 21 major MSCI indexes from Europe, Australia, and Southeast Asia.
The MSCI Emerging Markets Index is a float adjusted market capitalization index that consists of indices in 23 emerging economies designed to measure equity market performance in global emerging markets.
The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. As of June 2007 the MSCI World Index consisted of the following 23 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States.
The Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector.
The S&P 500® Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock market performance.
The S&P GSCI Index (formerly the Goldman Sachs Commodity Index) serves as a benchmark for investment in the commodity markets and as a measure of commodity performance over time.
Past performance is no guarantee of future results. An investment cannot be made directly in an index.
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