A change in sentiment for MLPs?
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.
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).
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.
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.
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.
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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.
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Standard & Poor’s and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, and D.
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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.
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