MLPs: When Energy Sentiment Goes down the Pipe(line)
Master Limited Partnerships (MLPs) are typically midstream energy businesses that pay out a significant component of operating earnings to investors in the form of distributions. As of the end of July, the Alerian MLP Index had a yield of 7.2%, making the asset class an attractive option for income seeking investors. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Despite being in the energy business, commodity prices are not the primary driver of MLP fundamentals. The most important metric for MLP companies is volume, and more specifically, growth of volume. With respect to oil prices, the only question for MLPs is, “Are prices high enough for producers to grow volume?”
During the energy crisis, crude oil prices fell below U.S. producer break-even prices (the cost oil producers incur to extract crude oil), causing rigs to be laid down, capital expenditures to be halted, and exploration and production (E&P) companies to struggle. As many E&P companies faced possible bankruptcy, investors worried that the contracts between the movers and producers of oil and gas may be at risk.
What’s in the Midstream?
Is the MLP Market Struggling because Oil Prices Are Below Break-Even Prices Again?
No. The U.S. has become very successful at producing crude oil at prices that no one ever thought possible, with current prices at $45-$55. At this price point, U.S. rig counts are increasing substantially, which has led to significant growth in crude oil production volume. The U.S. is currently producing around 9.3 million barrels per day and is on pace to exceed the mid-2015 peak of 9.6 million barrels per day.
As illustrated in Figure 1 below, as oil prices have plummeted, recovered, and remained range-bound, the EBITDA of representative MLPs within the midstream universe actually continued to trend upward. Despite lower oil prices and struggling upstream energy producers, MLPs increased their cash flows due to projects coming online, increased demand, and the volume of hydrocarbons being transported through the midstream infrastructure.
Figure 1: Midstream MLP Universe Kept Strong amid Oil Plummets
Source: Bloomberg. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. The chart depicts rolling last-twelve-month (LTM) EBITDA as reported by the issuer. Midstream EBITDA is represented by midstream companies with at least a $10 billion market cap. WPZ represents Williams Partners LP; SXI represents Standex International Corp; SEP represents Spectra Energy Partners LP; PAA represents Plains All American Pipeline LP; OKS represents ONEOK Partners LP; MPLX represents MPLX LP; MMP represents Magellan Midstream Partners LP; KMI represents Kinder Morgan Inc; ETP represents Energy Transfer Partners LP; EPD represents Enterprise Products Partners LP; EEP represents Enbridge Energy Partners LP; BPL represents Buckeye Partners LP. Chart created by Cushing Asset Management. West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a domestic benchmark in oil pricing.
Other considerable drivers of MLP cash flows are the natural gas and natural gas liquid (NGL) businesses, which are doing phenomenally well. The U.S. has already started exporting propane, ethane, and liquified natural gas (LNG). Because natural gas producers in the U.S. have become so efficient at producing natural gas, we have way too much of it, and our prices are low, making LNG dynamics worldwide very attractive. So, there is growing demand for export outlets for U.S. hydrocarbons, and midstream companies will build out the infrastructure to facilitate that growth.
Why Have MLP Unit Prices Declined Despite Favorable Fundamentals and Increasing Volumes?
“Investor sentiment for energy securities is absolutely horrific,” according to John Musgrave, Co-CIO and Portfolio Manager at Cushing Asset Management. As Figure 2 below shows, the energy sector as a whole represents approximately 6% of the S&P 500 Index, which is really at an all-time low. It has only been lower once, briefly in January of 2000, near the peak of the tech bubble. Due to valuations, we are in rare territory, as energy typically represents approximately 9% of the index.
Figure 2: Energy Has Typically Been a Heavier Weight in the S&P 500
S&P 500 Energy Weight as a Percent of S&P 500
Source: Bloomberg, 1/1/07 – 6/30/17. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. S&P 500 is the S&P 500 Index; S&P 500 Energy is the S&P 500 Energy Sector GICS Level 1 Index (S5ENRS). Chart created by Cushing Asset Management.
The problem global markets are having with crude oil prices is the U.S. supply growth. While this doesn’t have the same implications for the midstream space as the upstream space, MLPs have traded with a much higher correlation to oil prices than may be warranted.
Musgrave added, “If we have one overall theme for 2017, it’s that despite improvements in rig counts, production volumes, MLP balance sheets, and cash flow, MLPs continue to get caught up in the negative energy sentiment, which unfortunately impacts their equity unit prices.” Interestingly, while equity capital markets are caught up in a risk-off environment, debt capital markets are actually very healthy – spreads, which widened out to 1,600 bps (basis points), have collapsed to be in line with the broader market, indicative of a sector without outsized credit risk.
What Does this Mean for Investors?
According to Musgrave, “We think right now is an amazing entry point. I truly believe in this opportunity, because the opportunity is about volume. I can’t stress that enough – volumes in the U.S. are growing, and there will be an increased need to transport these volumes.”
This information is provided as a resource for information only. Neither New York Life Insurance Company, New York Life Investment Management LLC, their affiliates, nor their representatives provide legal, tax, or accounting advice. You are urged to consult your own legal and tax advisors for advice before implementing any plan.
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; and 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.
Commodities are investments in instruments and companies that are susceptible to fluctuations in certain commodity markets. Any negative changes in commodity markets (that may be due to changes in supply and demand for commodities, market S‐4 events, regulatory developments or other factors) could have an adverse impact on those companies.
The Alerian MLP Index (AMZ) is a composite of the most prominent energy master limited partnerships.
Basis points (bps) refer to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument.
The Cushing® 30 MLP Index (MLPX) is an equal weighted index that tracks the performance of 30 publicly traded MLP securities that hold midstream energy infrastructure assets in North America.
Midstream MLPs gather, process, and transport natural resources.
The Philadelphia Stock Exchange Oil Service Sector Index (OSX) is a price-weighted index composed of 15 companies that provide oil drilling and production services, oil field equipment, support services and geophysical/reservoir services.
The S&P 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The S&P 500 Energy Index (S5ENRS) is a capitalization-weighted index comprised of those companies included in the S&P 500 that are classified as members of the GICS energy sector.
The S&P 500 Oil & Gas E&P Sub Industry Index (S5OILP) is a capitalization-weighted index. This is a GICS Level 4 Sub-Industry group.
The S&P 500 Real Estate Investment Trusts REITS Industry Index (S&P 500 REITS) is comprised of stocks in the S&P 500 Index that are classified as members of the GICS REITs sector.
The S&P 500 Utilities Index is comprised of those companies included in the S&P 500 that are classified as members of the GICS utilities sector.
West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a domestic benchmark in oil pricing.
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