by Energy master limited partnerships, most of which are in the business of storing and transporting oil and natural gas, have had a rough time of it since energy prices started falling in mid-2014. The Alerian MLP index has fallen 38 percent since its August 2014 peak and is down 27 percent year to date. The 22 percent loss in the third quarter is the worst quarterly decline since the index’s inception in 1998. In September, the asset class was down 15 percent, though it regained all of that ground and more in the first week of October. To say that MLPs have been challenged is to state the obvious. But is it finally time to also call them cheap? There’s no arguing with the fact that MLPs, which contain both debt and equity, have seen their distribution yields go up as their prices have gone down. The market cap-weighted yield on the Alerian index is 8.3 percent, their highest level since 2011. By comparison, 10-year Treasury notes are paying just 2.05 percent. Analysts pay close attention to that spread between MLP yields and 10-year Treasury notes — MLPs have historically outperformed when spreads are wide. Historically, when they’ve reached these levels, the total return on MLPs has been roughly 30 percent over the following 12 months.
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Ashley Kindergan considers the following as important: Credit Suisse, Crude Oil, Energy, income, infrastructure, Investing: Features, master limited partnership, MLP, natural gas, Oil, pipeline, storage terminal, yield
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Energy master limited partnerships, most of which are in the business of storing and transporting oil and natural gas, have had a rough time of it since energy prices started falling in mid-2014. The Alerian MLP index has fallen 38 percent since its August 2014 peak and is down 27 percent year to date. The 22 percent loss in the third quarter is the worst quarterly decline since the index’s inception in 1998. In September, the asset class was down 15 percent, though it regained all of that ground and more in the first week of October. To say that MLPs have been challenged is to state the obvious. But is it finally time to also call them cheap?
There’s no arguing with the fact that MLPs, which contain both debt and equity, have seen their distribution yields go up as their prices have gone down. The market cap-weighted yield on the Alerian index is 8.3 percent, their highest level since 2011. By comparison, 10-year Treasury notes are paying just 2.05 percent. Analysts pay close attention to that spread between MLP yields and 10-year Treasury notes — MLPs have historically outperformed when spreads are wide. Historically, when they’ve reached these levels, the total return on MLPs has been roughly 30 percent over the following 12 months. While a 30 percent return expectation seems lofty, those healthy yields (not to mention distribution growth averaged 7 percent in the second quarter of 2015) offer a compelling entry point, assuming continued growth in production and M&A activity. What’s more, many MLPs generate significant free cash flow – 20 to 30 percent higher than what they need to make their distributions – and are unlikely to need to turn to the capital markets for funding. That provides some insulation from market sentiment about the asset class.
Which brings us to the longer-term horizon. The outlook for the U.S. energy industry is still encouraging, even though it may seem rather dismal at the moment. Credit Suisse’s energy analysts believe persistently low prices have resulted in a decline in U.S. oil production that started in the second quarter of this year and could continue through the middle of 2016, while its MLP analysts predict the partnerships will cut capital expenditures in both 2015 and 2016. Neither trend will be particularly helpful for MLPs, which earn most of their revenues from customers who pay to use their infrastructure. On the other hand, analysts still expect MLPs to spend approximately $40 billion in 2016, which is more than in any year prior to 2013 and close to double 2011 levels.
There are good reasons that MLPs haven’t stopped betting on their own futures. Oil prices should soon begin to creep higher, which would support renewed increases in production. Credit Suisse energy forecasters expect global oil demand to outrun supply in the fourth quarter of 2015, leading the price of West Texas Intermediate to rise from an average of $43 that quarter to $59 by the end of 2016. As oil prices rise, producers will pump more oil, creating more demand for the new wells, storage facilities, pipelines, and refineries through which MLPs earn their keep.
So, while the huge boom in energy production may slow in the coming year, American energy is still a growth industry in the long term. Oil is still the fuel that keeps the global economy running, and the U.S. has bountiful supplies, the technology to get at them, and the deep, liquid capital markets to finance exploration and production. The same goes for gas. Already the world’s largest natural gas producer, the U.S. is in the process of building export terminals to ship liquefied natural gas to Asia and Europe. All told, the U.S. Energy Information Administration has said the country could become energy-independent by 2028.
That’s not to say investing in MLPs comes without risk. Many partnerships are tied into long-term contracts and receive fixed revenues for the use of the infrastructure they control, such as pipelines or storage terminals. Low oil prices could yet spur customers to renegotiate these deals at lower prices, which could negatively impact distribution yields. Since MLPs are essentially high-yield fixed-income products, there’s also the potential volatility caused by any future Fed rate hike. (That said, given the sharp re-rating of the sector, it might be less vulnerable to a spike in interest rates than it otherwise might have been.) Though a full recovery in MLPs may take some time, the combination of currently cheap valuations and a still-encouraging long-term outlook make it a good time to reconsider their investment potential.