A change in sentiment for MLPs?

by: , Managing Director, New York Life Investments; Nick Brown, Director, Client Portfolio Manager, Cushing Asset Management

Since 2016, MLPs have lagged both the broad market and the energy sector. But, with strong fundamentals, a move toward simplified corporate structures and an eye toward more prudent capital allocation, the tide may be turning for midstream energy MLPs. To gain further insight, we recently spoke with John Musgrave from Cushing Asset Management.

A positive fundamental backdrop

Fundamentals for midstream MLPs are compelling across the board. Production volumes for crude oil, natural gas, and liquefied natural gas in the U.S. are at all-time highs. Meanwhile, global demand for hydrocarbons are at record levels, and more countries are getting their base load supplies from the U.S. sources. Facilitating the movement of rising production and meeting increased overseas demand are U.S. midstream MLPs. This, in turn, ultimately drives MLP cash flows. Not surprising, a number of MLPs recently reported first quarter earnings that exceeded Wall Street expectations.

Global crude oil demand is expected to average approximately 100 mb/d in 2018

Global crude oil demand growth

Source: International Energy Agency, “Oil Market Report”, March 2018.

Simplified MLP corporate structures

Another factor that could support sentiment for MLPs is the move toward more simplified corporate structures. This is partially being driven by an increase in institutional investor ownership, which places more value on strong corporate governance, high returns on capital, and the ability to internally fund growth.

Self-reliant financing

Also related to more institutional ownership is the move by some MLPs to pursue more shareholder-friendly capital allocation strategies and reduce their leverage. For example, one high-profile MLP recently announced it would moderate its distribution growth rate to free up capital to internally fund its capital expenditures. We believe this could result in increased per unit growth and potentially lead to higher total returns for investors.

Midstream companies are continuing to reduce leverage and the reliance on public equity capital markets for funding, creating a healthier business model.

Average leverage ratios for the midstream sector

Source: Cushing Asset Management and Bloomberg data, as of 12/31/17. For the universe of publicly traded midstream companies. TTMEBITDA = Trailing twelve months EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization).

Attractive valuations

Another factor that could benefit MLP returns would be a rotation out of bond proxies, such as real estate investment trusts (REITs) and utilities. Rising interest rates have led to weak results for bond proxies thus far in 2018. MLPs have traditionally had a lower correlation to fluctuating rates and, therefore, should be less susceptible to higher rates as the Federal Reserve normalizes monetary policy. In addition, income-seeking investors may be drawn to the attractive yields offered by MLPs and more reasonable valuations versus traditional bond proxies.

MLPs vs. traditional bond proxies

Source: Bloomberg. Data shown as of March 31, 2018. AMZ is the Alerian MLP Index, S&P 500 Utilities is the S&P 500 Utilities Sector Index, S&P 500 REITs is the S&P 500 Real Estate Investment Trusts REITS Industry Index, S&P 500 Consumer Staples is the S&P 500 Consumer Staples Sector Index, S&P 500 Telecom Services is the S&P 500 Telecommunication Services Sector Index, Moody’s BAA is the Moody’s Bond Indices Corporate BAA Index. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

Potential headwinds

As with any asset class, there are factors that could result in periods of volatility for MLPs. While the Federal Energy Regulatory Commission’s (FERC) recent decision reduced some of the questions regarding the tax status for MLPs, certain details regarding these changes have yet to be resolved. As in the past, there are also environmental-related uncertainties. And, even though midstream MLPs are not directly impacted by falling oil prices, this can negatively impact investor sentiment, as could a decision by OPEC to increase production.

Conclusion

In recent years, we’ve seen a significant disconnect between midstream MLP fundamentals and returns. But, a number of headwinds for the asset class appear to be reversing course. What’s more, the strong fundamentals for MLPs, including robust hydrocarbons production in the U.S. and steadily rising exports, may result in improving investor sentiment and a rebound in the performance for MLPs.

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. Energy companies are subject to certain risks, including, the proposed elimination of specific tax incentives widely used by oil and gas companies, and the imposition of new fees on certain energy producers, could adversely affect energy companies in which the Fund invests and/or the energy sector generally.

MLPs are subject to certain risks inherent in the structure of MLPs, including tax risks. Energy companies are subject to certain risks, including, but not limited to the proposed elimination of specific tax incentives widely used by oil and gas companies, and the imposition of new fees on certain energy producers, could adversely affect energy companies in which the Fund invests and/or the energy sector generally.

Credit ratings agencies, such as Moody’s, Standard & Poor’s, and Fitch Ratings, have letter designations (such as AAA, B, CC) which represent the quality of a bond. Moody’s assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C, with WR and NR as withdrawn and not rated.

Standard & Poor’s and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, and D.

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.

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 “bond proxy” is shorthand to describe equities such as consumer staples and utilities with safe, predictable returns, but have higher yields than much of the bond market (and, crucially, yields which can grow over time)

Capital expenditures (CapEx) are funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment. It is often used to undertake new projects or investments by the firm.

EBITDA is essentially net income with interest, taxes, depreciation and amortization added back to it. EBITDA can be used to analyze and compare profitability among companies and industries as it eliminates the effects of financing and accounting decisions.

The Federal Energy Regulatory Commission (FERC) is the United States federal agency that regulates the transmission and wholesale sale of electricity and natural gas in interstate commerce and regulates the transportation of oil by pipeline in interstate commerce.

The Moody’s BAA Corporate Bond is an investment bond comprised of all companies that are rated BAA by Moody’s. BAA is the lowest rating within Moody’s top ‘Investment Grade’ category.

A real estate investment trust, or REIT, is a company that owns, operates or finances income-producing real estate.

The S&P 500® Utilities Index comprises those companies included in the S&P 500 that are classified as members of the GICS® utilities sector.

The S&P U.S. REIT Index defines and measures the investable universe of publicly traded real estate investment trusts domiciled in the United States.

The S&P 500® Consumer Staples Index comprises those companies included in the S&P 500 that are classified as members of the GICS® consumer staples sector.

The S&P 500® Telecommunication Services Index comprises those companies included in the S&P 500 that are classified as members of the GICS® telecommunication services sector.

New York Life Investment Management LLC engages the services of federally registered advisors. Cushing® Asset Management, LP is unaffiliated with New York Life Investments. New York Life Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. New York Life 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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Steve Sciortino

Managing Director, New York Life Investments

Steve Sciortino is Managing Director at New York Life Investments, responsible for the Product Management Group. In this role, Steve is responsible for driving product strategy and leading the product management efforts for the Funds and ETFs…

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Nick Brown

Director, Client Portfolio Manager, Cushing Asset Management

Nick Brown is the Client Portfolio Manager and Business Development Director at Cushing Asset Management. Prior to joining the firm in 2013, Nick was an Analyst in Bank of America Merrill Lynch’s Investment Banking Division in Houston

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