Opportunities in MLPs and Energy Infrastructure

by: , Portfolio Manager, Cushing Asset Management

Despite a solid fundamental backdrop, midstream energy infrastructure, including Master Limited Partnerships (MLPs), was one of the few asset classes to stumble in 2017. Midstream energy companies are energy infrastructure businesses that are involved in the transportation, storage, and processing of oil and gas. Or, put more simply, midstream companies are the movers of energy, as opposed to upstream companies which are producers (drillers). Many of these midstream companies structure themselves as MLPs, which are pass-through entities that pay out a significant component of operating earnings to investors in the form of distributions.

The lackluster performance of 2017 was driven by several factors, including weak investor sentiment, fluctuating energy prices, contagion from some company-specific headlines, and concerns regarding the impact from the tax reform bill. It appears that many of these clouds have lifted, as evidenced by the strong start for midstream energy, thus far, in 2018. We see more tailwinds for MLPs and midstream energy stocks going forward.

Relief Regarding Tax Reform as It Relates to MLPs

One overhang for MLPs in 2017 was tax reform and if MLPs would be stripped of their tax-advantaged status. Despite those concerns, MLPs maintained their tax-advantaged status over C corps, primarily due to the 20% pass-through deduction that was included in the new tax reform bill. In addition, tax reform is a positive for energy infrastructure companies that are structured as C corps. While these companies are generally not cash taxpayers, it extends their ability to be non- or extremely low-cash taxpayers going forward.

A Constructive Backdrop for Energy Infrastructure

Energy pricing is not the primary driver of midstream energy fundamentals—it is volume growth. Despite this, when energy prices weakened last year, midstream energy companies were dragged down with them. From a volume perspective, as long as commodity prices provide a stable backdrop—let’s say $45 to $75 for crude oil and $2 to $4 for natural gas—a normally functioning energy supply chain usually follows. With the synchronized global economic expansion, we believe the pricing environment will provide a positive backdrop for midstream energy companies (including MLPs) in 2018.

Less Uncertainty

While midstream energy fundamentals were solid last year, investor sentiment was challenged. This extended beyond concerns surrounding tax reform and energy prices. The asset class as a whole was negatively impacted by other issues, including corporate governance issues and distribution cuts by several midstream energy companies. To be sure, investors don’t like these types of headlines and uncertainty. We believe these issues are largely behind us, which should cause investors to once again focus on individual company fundamentals. As Figure 1 below illustrates, valuations are particularly attractive, given the negative sentiment of last year.

Figure 1: MLP Valuations

Current 5-Year Average Premium (Discount) 10-Year Average Premium (Discount)
Midstream MLP Yield 8.3% 7.0% (16%) 7.2% (14%)
Price-to-DCF 9.9x 12.0x (18%) 12.1x (19%)
EV-to-EBITDA 11.0x 13.7x (20%) 12.8x (14%)
Spread to 10-Year – Discount (Premium) 591 475 422
Spread to IG Bonds – Discount (Premium) 413 216 165
Spread to HY Bonds – Discount (Premium) 294 112 (20)  –

Source: Midstream Monthly Outlook: January 2018, Wells Fargo Securities, 1/18. Midstream MLP Yield represented by Alerian MLP Index; IG Bonds represented by BLP Active IG Corporate Bond Index; HY Bonds represented by BLP Active High Yield US Corporate Bond Index. Index definitions can be found at the end of this blog post. Past performance is no guarantee of future results, which will vary. It is not possible to invest in an index.

Validating a Solid Foundation

In our view, the foundation for midstream energy is rock solid on several fronts. Consider the following:

  • The U.S. has validated that it can be energy independent, and is setting up to be the world’s largest energy exporter.
  • MLPs have validated that they can survive a low commodity price environment, as energy technology can make production economical at low price levels.
  • Current metrics validate that volume growth is going to increase across almost all shale basins.
  • There has been validation that demand has picked up—a trend that we believe will continue for the foreseeable future.

Collectively, we believe this will lead to improved investor sentiment for energy infrastructure in general and, more specifically, energy MLPs.

Outlook

In our view, the stage is setting up nicely for a multi-year—if not longer—run for the energy infrastructure universe. In a market that has stretched valuations and low yields, the attributes for MLPs look compelling. Not only are MLPs’ valuations relatively attractive and fundamentals sound, they also offer growth potential, which historically has provided a cushion in rising interest-rate environments. Furthermore, they offer a compelling income stream for investors.

Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.

Neither New York Life Investment Management LLC, its affiliates, nor its representatives provide tax, legal, or accounting advice. Please contact your own professionals.

About Risk

All investments are subject to market risk, including possible loss of principal. There is no assurance that the investment objectives mentioned will be met. Diversification cannot assure a profit or protect against loss in a declining market.

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.

 

The Alerian MLP Index is the leading gauge of energy Master Limited Partnerships (MLPs). The capped, float-adjusted, capitalization-weighted index, whose constituents represent approximately 85% of total float-adjusted market capitalization, is disseminated real-time on a price-return basis (AMZ) and on a total-return basis (AMZX).

A C corporation, under United States federal income tax law, refers to any corporation that is taxed separately from its owners. A C corporation is distinguished from an S corporation, which generally is not taxed separately.

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.

FINRA – BLP Active High Yield US Corporate Bond Index  – In the March 2012 rebalancing a significant number of bonds that were eligible for the index but were being excluded because of a technical error were added to the index. A measure of the average price change of all bonds in the index weighted by par amount. Individual bond prices are derived from the volume weighted average price of all trades reported by TRACE from the prior days trading. Prices calculated do not include accrued (clean price). FINRA – Bloomberg Active US Corporate Bond Indices are comprised of the active (most frequently traded) fixed coupon bonds represented by FINRA TRACE, FINRA’s transaction reporting facility that disseminates all over-the-counter secondary market transactions in these public bonds. The indices are rebalanced on a monthly basis. Type NBBHTR <index> MEMB <GO> for constituent information. Index launch date: October 17, 2005.

FINRA – BLP Active Investment Grade US Corporate Bond Total Return Index – In the March 2012 rebalancing a significant number of bonds that were eligible for the index but were being excluded because of a technical error were added to the index. Measures the total amount earned by owning a security over the time period. It incorporates the accrued interest on the bond during ownership, coupons paid out on the bond, and rise and fall of the bond’s price. It is the most complete measure of the amount of money made on holding fixed income issues in the index. FINRA – Bloomberg Active US Corporate Bond Indices are comprised of the active (most frequently traded) fixed coupon bonds represented by FINRA TRACE, FINRA’s transaction reporting facility that disseminates all over-the-counter secondary market transactions in these public bonds. The indices are rebalanced on a monthly basis. Type NBBITR <index> MEMB <GO> for constituent information. Index launch date: October 17, 2005.

New York Life Investment Management LLC engages the services of federally registered advisors. Cushing® Asset Management, LP is unaffiliated with New York Life Investments. MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, New Jersey 07302.

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Libby F. Toudouze

Portfolio Manager, Cushing Asset Management

Libby F. Toudouze has over 30 years of experience in investment management and 15 years of Energy and MLP specific portfolio management experience. Before joining Cushing Asset Management, she established and ran a family office where her responsibilities included

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