The Case for Energy MLPs
Since hitting a five-year low in January 2016, the energy sector has experienced a meaningful recovery. That being said, there have been several periods of heightened volatility. This year’s price swings in the S&P 500 Energy Index are perhaps one reason why retail investors remain wary of this space. While bouts of volatility are expected at this stage of the economic cycle, the outlook for energy remains attractive.
Within energy, master limited partnerships (MLPs) seek to provide a compelling combination of attractive yields and exposure to the recovering energy sector. As global demand for crude oil and natural gas grows, we believe midstream MLPs that are focused on gathering, transporting, storing, and delivering these commodities are well-positioned.
We recently sat down with John Musgrave, Co-Chief Investment Officer for Cushing Asset Management, to help us uncover the opportunities in energy and MLPs.
Oil Recovers, While MLPs Have Lagged
Despite West Texas Intermediate (WTI) crude oil prices increasing more than 40% since mid-2017, the Alerian MLP Index is down 3% over the same period. While crude oil prices have very little direct impact on MLP earnings, they have a significant impact on investor sentiment for the MLP asset class. This has been particularly evident over the past few years. As crude oil prices declined from $107 to $26 per barrel, the ratio of the Alerian MLP Index compared to the S&P 500 Index plummeted from over 0.50 in August 2014 to 0.24 in February 2016.
Over the past two years, crude oil prices have risen 147%, returning to a price level that incentivized increased U.S. production. As expected, rising production has led to increased pipeline volumes which, in turn, have boosted MLP cash flows. Despite crude oil prices more than doubling and now well above the U.S. average breakeven price of $37, the ratio of the Alerian MLP Index to the S&P 500 Index is currently 0.23. This is even lower than when crude oil prices were $26 per barrel and U.S. crude oil production was more than one million barrels lower per day than current levels. Historically, MLP performance has followed the movement of oil prices very closely, which can be seen in the chart below. If the ratio reverts back to its historical level of 0.50, performance for MLPs could improve.
The Disconnect between Oil Prices and MLP Performance
Source: Bloomberg. Data shown for the period January 1, 2010 through December 31, 2017. AMZ represents the Alerian MLP Index; S&P 500 represents the S&P 500 Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest in an index.
Increase in Oil Production Benefiting Midstream MLPs
According to the International Energy Agency, the U.S. is now the second largest crude oil producer globally, second only to Russia. The U.S. is expected to establish new record levels of production for crude oil, natural gas, and natural gas liquids. As global demand for crude oil grows, midstream MLP companies that engage in the transportation and storage of crude oil stand to benefit, with increased volumes flowing through their systems.
Growing U.S. Crude Oil Production
Source: U.S. Energy Information Administration, as of 12/31/17, “Weekly Petroleum Status Report” and “Petroleum Supply Monthly.”
A Shift in the MLP Investor Base Driving Better Outcomes
Despite a positive outlook for commodity prices and dramatic improvements in energy fundamentals, investors’ reaction to (and the possible misunderstanding of) the ongoing shift in midstream corporate strategy has contributed to disappointing performance of the asset class. Historically, MLPs have been primarily owned by retail investors. However, institutional ownership has grown to 40% and continues to rise.
Retail investors, who tend to be more focused on the attractive and stable income generated by MLPs, often place significant value on yield, distribution sustainability and distribution growth. Against this backdrop, they’re more accepting of the external distribution model historically used by MLPs. This is very different than institutional investors, who are typically more focused on total return than yield. They also place more value on strong corporate governance, high returns on capital, and the ability to internally fund growth.
The push from institutional investors for reform on MLPs’ corporate structure, capital allocation, and funding models has led to MLP management teams paying more attention to these concerns. The shift from the historic model of growing distributions to one with more internally funded growth capital expenditures has not been easy. While some retail investors may feel betrayed by this shift, institutional investors find the new total-return-focused model much more attractive. And, we’re encouraged that significant advancements have been made. These actions are leading to a simpler, healthier midstream asset class that is more palatable to a wider group of investors.
Institutional Investor Ownership on the Rise
Source: “Midstream/MLPs: Positive Outlook for ‘18,” Wells Fargo Securities, January 11, 2018.
While risks remain in this space, we believe MLPs provide investors with a highly compelling combination of high yields, attractive valuations, and exposure to the recovering energy sector. While oil prices have little to do with midstream MLP fundamentals, investor sentiment for the asset class could improve, should the recovery continue and production levels rise. At the same time, reforms being driven by institutional investors could result in even stronger fundamentals for MLPs. We expect positive volumetric and sector fundamentals will ultimately return to the forefront of investors’ focus and bring positive stock performance from the current discounted levels.
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.
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).
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.
S&P 500 Index is an index of 505 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion.
The S&P 500® Energy Index comprises those companies included in the S&P 500 that are classified as members of the GICS® energy sector.
West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a benchmark in oil pricing. This grade is described as light because of its relatively low density, and sweet because of its low sulfur content.
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.