MLPs: Has the Baby Been Thrown Out with the Bathwater?
Until about a year ago, investors were clamoring to invest in Master Limited Partnerships (“MLPs”). These companies, which engage in the transportation, storage, processing, and production of natural resources, stand to profit from the energy renaissance taking place in the U.S. The fervor for MLPs was further buoyed by the favorable tax benefits of owning MLPs due to their tax-deferred dividends, and by their relatively high yield in this low rate environment.
However, MLPs have fallen out of favor. The Alerian MLP Index is down over 37% from its peak in August 2014 through mid-November. This decline is primarily due to investor anxiety over falling oil prices, which have crashed nearly 60% since June 2014. The bear thesis holds that MLPs will suffer across the board, as lower prices for oil and gas negatively impact demand for the energy-related services that MLPs offer. MLP price declines have also been exacerbated both by retail MLP investors exiting MLP ETFs and ETNs and by short selling from funds trying to manage their energy-related exposures. Moreover, the prospect of an interest rate rise has weighed on MLPs, as it would make their yields less attractive on a relative basis.
This striking change in sentiment, along with a continued poor outlook for energy demand, begs the question: is the case closed for MLPs?
We believe that the sell-off has been overdone. In particular, certain sectors of the MLP market, primarily those related to energy infrastructure, continue to have excellent mid-term and long-term prospects. While MLPs have largely sold off in tandem, there is in fact a significant bifurcation in business models between upstream MLPs, which are mainly energy-price-sensitive exploration and production assets, and midstream MLPs, which provide energy infrastructure and are much less correlated to oil and gas prices. As one example, pipeline MLPs function like toll takers: they generate stable cash flow from long-term contracts that pass-through energy costs, insulating them from price volatility.
Even in this low commodity price environment, infrastructure MLPs are forecasted to grow distributions by 4-6% in 2016, and the yield for the Alerian MLP Infrastructure Index currently stands at 7.8%. A potential return stream next year in the low teens looks attractive to us, especially as it is tax-advantaged. MLPs also offer diversification benefits as they have been negatively correlated to bonds (-0.50 correlation to the Barclays U.S. Aggregate Bond Index), and only modestly correlated to stocks (0.56 to the S&P 500 Index).
While equity prices have fallen for MLPs over the past year, debt markets are still largely accommodative. Large cap MLPs still have access to capital as most are investment grade or strong ‘BB’ credits and can issue debt in the 4% to 7% range. The debt market for smaller MLPs that rely on bank financing is becoming more expensive, but the silver lining is that this may make them attractive acquisition targets for large companies. Certainly there are worries that MLPs will feel additional pain if the Fed raises rates and borrowing costs go up, but the current outlook is for a steady rise in rates, giving MLPs time to adjust.
With all of these positives for infrastructure MLPs – sound business models, steady revenue streams, continued distribution growth, access to the capital markets and the potential for consolidation – we believe that midstream MLPs might be a case of the baby being thrown out with the bathwater.
Source: Alerian MLP Index Factsheet. Correlation data is for the trailing three year period ending September 30, 2015.