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MLPs: Patience is a Virtue

No matter the time frame, whether daily, weekly, or even monthly, a chart of the Alerian MLP Index paints a picture of a sector that has gone nowhere over the past three years. As investors and believers in this sector, we can tell you first hand this ride has not been easy and certainly not fun. We can talk about fundamentals all day long and how America is on track to become the largest energy producer in the world. Imagine that, the USA being the undisputed king and leader of fossil fuels. Energy stocks, and MLPs in particular, trade at valuations that suggest this story of the Shale Revolution 2.0 is a façade, something that is only a remote possibility.

 

MLP Valuations March 2018

 

MLPs trade at valuations that only make sense if you were to disregard every action by management teams to shore up balance sheets and increasingly rely on internal cash flows. These valuations make sense if you ignore the outlooks of distribution growth that many MLPs are guiding to and assume there will be none. In fact, to make our models fit current valuations for several MLPs we follow, we have to make assumptions for distribution growth to be zero or even negative. And this so blatantly is in violation of what is happening on the ground. For example, fitting our dividend discount model to Buckeye Pipeline’s (BPL) current price requires us to plug in -3% distribution growth per year in perpetuity. With coverage currently at 1x and multiple large cash generating projects expected to come online shortly, it is obvious this negative growth assumption is ludicrous, not to mention Buckeye has never cut its distribution in its history.

Looking at Wells Fargo’s most recent figures at the top of this blog, you can see the extremely large discounts to historical averages that MLPs are currently trading. With fundamentals continuing to improve and unit prices continuing to remain stagnant, these discounts will only increase, making what is a compelling value proposition all the more compelling. Fourth quarter earnings came in very strong overall, and this is yet more evidence that fundamentals continue to improve. 

Before the start of the new year, the feeling was that a lot of fresh capital was going to flow into space. We wrote a blog in December of last year detailing the evidence that suggested that generalist investors, investment advisors, as well as some banks, saw value in the space and wanted a part of it. The feeling was confirmed when MLPs started off the year on a tear, moving up 10.4% in two weeks. Fund flows were strong, and a downtrend that defined all of 2017 was broken. Since then, almost as fast as we went up, we gave up nearly all the early year gains. 

So, the question is, what is going to trigger fresh capital into the space? We know how quickly MLPs can rebound. ETF fund inflows for January were $248MM according to Wells Fargo. During that time the index outperformed, but easily surmounting that number were February (through 2/21/2017) outflows of $322MM. We still see anecdotal evidence that generalist investors are paying attention. At a recent investor conference, Morgan Stanley noted that global infrastructure investors had US midstream pegged as the best relative value in their investable universe. Wells Fargo’s most recent weekly update wonders, “where is the generalist cavalry?” They surmise that generalists are still shying away due to volatility, the possibility of more distribution cuts, and restructurings. Wells Fargo appears just as bullish as we are on the space and are also just as confused about the lack of buyers. In our view, it is only a matter of time before we see the fund flows we have all been waiting for. With the businesses performing well on the ground and an outlook for growth, sentiment can only stay this low for so long. From here, the risk is to the upside, and you get paid handsomely while you wait.

 

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2017 4Q Earnings Recap

Quarterly earnings from the MLP sector are out with generally positive results. In this article, whether the company is structured as an MLP or a C Corp, I will use the term MLP to refer to both. Out of 29 MLPs and energy infrastructure companies we follow that have reported, results were a little better than expected.

The areas of growth-supporting increased distribution coverage are the following: 1. Increasing oil exports. 2. The increasing use of ethane and propane to support the massive build-out of chemical plants located primarily on the Gulf coast to make ethylene and propylene. 3. Increasing use and exports of natural gas in the form of liquified natural gas (LNG) as well as continuing exports of natural gas to Mexico.

None of these positive results seem to be reflected in the price of the MLPs. Investors are more focused on growth stocks and not paying much attention to the strengthening fundamentals of the MLP sector, the high level of tax-deferred income they offer, or the fact that the industry is moving toward a self-funding model, far less dependent on equity (dilutive) financing. The investor base of MLPs has been going from retail dominated to being dominated by value-oriented institutional investors who are looking for long-term sustainable investments that have not been caught up in the runaway stock market.

Therefore, we recommend putting a portion of your portfolio in this undervalued sector and in the top names that will benefit most from the long-term trends. These trends again are clear: 1. Rising production and exports of LNG and natural gas. 2. Increased production and use of ethane. 3. Increasing production and export of U.S. produced oil.

In the meantime, here is what we have seen so far from 29 MLPs that have reported that we include in our universe that we would invest or consider investing in:

  • 51.7% raised their distribution
  • 48.3% kept the distribution steady
  • 22 MLPs met earnings expectations
  • 5 MLPs beat earnings expectations
  • 2 MLPs missed earnings expectations
  • Average EBITDA growth was 13.2%

The markets have been volatile. MLPs have not been immune to this. However, by investing in a growing sector with solid fundamentals, good growth projections, strengthening balance sheets and coverage ratios, you can diversify now and get paid 8% to do it. Let us help you select those MLPs that will profit most from these positive trends and be prepared when investor sentiment shifts!

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Jeffrey Gundlach, Touted as Today's "King of Bonds", has a Change of Heart on MLPs

On April 19th, 2015 Jeffrey Gundlach made a cautionary investment call on high yield bonds, REITS, and MLPs. He warned investors about master limited partnerships (MLPS) saying that they are massively leveraged and risky if interest rates rose.

Gundlach is widely followed on Wall Street because of his timely investment calls over the years.

However, on January 20th, 2018 in a Barron’s roundtable, he is quoted saying this: “What is interesting as a bond-surrogate investment is master limited partnerships, which don’t need oil to go up. You just don’t want it to go back down to $20, so you don’t worry about a bankruptcy situation. MLPs have tremendously underperformed the XLE. We aren’t looking to triple our money here; we are looking for an income vehicle that has a lower risk profile. I’m having a hard time finding more-traditional bond investments that look good, but I like a particular closed-end fund that owns MLPs. " Click the link below to see one of the interviews where Gundlach talks about MLPs.

Jeffrey Gundlach Interview

We like the idea that a well-known market genius is changing his opinion about master limited partnerships. It is difficult today to find yield that is not overpriced. However, we are not so sure that buying a leveraged fund, as Gundlach suggests, which tends to duplicate the index is the best way to invest in MLPs.

By selecting individual MLPs, you avoid the fees embedded in the fund. Also, MLP funds have to reduce the MLP’s net asset value by the amount of the holdings that are above their cost basis and pay a tax on that differential. If you want to beat the index, it is better to select and advisor with years of experience and a strong track record to actively manage a portfolio of individual MLPs. A fund may be fine for investors with limited capital to invest in MLPs. However, if you have $250,000 or more to dedicate to the sector, you may be better off investing in individual MLPs to get the full tax benefits that come with owning the actual MLP.

4Q17 MLP Commentary

 

4q 2017 mlp

  Investor sentiment for MLPs and midstream energy companies is turning positive. While 2017 was a difficult year for MLP prices, the outlook has rarely looked better. Crude oil production is closing in on 10 million barrels/day, natural gas production is booming, and new pipeline projects are being developed. The Alerian MLP index bottomed in early December as the sector was the victim of significant tax loss selling, but since the bottom they have bounced back nearly 15% and are poised for further gains. Crude, natural gas, and NGL volume increases will result in “free” cash flow growth for midstream companies with available pipeline capacity. MLPs remain an attractive investment for many reasons including; improving underlying energy fundamentals, valuation metrics towards historical lows, cash flow that is rising, and volume growth in the coming years. MLPs with assets in the low-cost basins such as the Permian and Marcellus will benefit from rapid volume, and cash flow growth as producers focus on those locations. Another tailwind for MLPs is the expected completion of up to seven world-class petrochemical facilities that will significantly boost demand for ethane and propane. After a difficult three years for energy markets, it is a welcome development to have multiple tailwinds at the back of MLPs once again.

What Happened in 2017

MLPs peaked in late January 2017 and then entered a downtrend until they broke above the trendline in mid-December. The negative performance was driven by too much new MLP equity coming to market, concerns about oil prices, tax-loss selling and uncertainty surrounding the MLP business model. Historically the MLP business model was to fund growth capital expenditures with 50% equity and 50% debt. The market has soured on this model so the MLP companies are adjusting to a new normal. Enterprise Product Partners (EPD) addressed this new normal in the 4th quarter when they announced they were cutting their distribution growth rate from 5% to 2.5% and using the excess capital to develop new growth projects. They have the goal of being self-funded on the equity side of the equation by 2019. We view this as a very positive development for the midstream world as it demonstrates better capital discipline and will increase per/unit earnings in the years to come. This move to the self-funding model and a focus on return on invested capital should attract more institutional capital to the sector. 

Another theme that continued to play out in 2017 was the elimination of incentive distributions rights (IDRs). IDRs are rights held by the general partner that entitle the GP to an increasing percentage of excess cash flow as the MLP raises its distribution. By eliminating IDRs, MLPs have a lower cost of capital which makes growth projects more profitable. We expect to see this trend continue in 2018. As the sector waned, some management teams lowered their cost of capital by cutting distributions. Five years ago, the thought of cutting the distribution was a death wish, but as the sector moves towards self-funding, some MLPs that cut distributions have traded up on the news. We believe we are moving out of the phase of distribution cuts and look forward to growth in 2018.

2018 Outlook

We are very excited for 2018. Underlying energy fundamentals are rapidly improving as the oil markets tighten, the global LNG trade is accelerating faster than analysts predicted and U.S. energy production will be at all time highs. We believe we are currently seeing a sector rotation into energy as investors look for sectors that have underperformed. Technological advancements in drilling have enabled producers to significantly increase efficiency and decrease break-even costs which gives midstream companies further confidence that volumes will be there even in oil prices stall. We expect to see more consolidation in 2018 as larger MLPs use M&A as a tool to pursue growth. As many of the major pipeline projects from previous years are completed and placed into service, we will see a significant boost in cash flows and a decrease in growth capital expenditures. 

Demand for ethane is expected to increase by nearly 700,000 barrels/day in the next three years. This demand is driven by seven new world-class ethane steam crackers coming online in the coming years. This petrochemical boom is driven by low-cost feedstock that U.S shales produce. They are now competitive or superior to Middle East petrochemical facilities.

U.S crude production has increased by over 15% since the lows of 2016. According to Goldman Sachs, crude is expected to grow a further 6% in 2018. Natural gas production is also expected to grow by 6%. Natural gas liquids supply is expected to grow by 40% by 2040. Consensus analysts estimates expect the Alerian MLP Index EBITDA to increase by a remarkable 18.5% in 2018. All this growth flows through pipelines and associated infrastructure to demand centers.

Tax Plan

2017 4q MLP blog pic.png

The recently passed tax bill is a positive for midstream infrastructure companies. According to Wells Fargo and Latham Watkins LLP, pass-through income could be taxed at an effective max rate of 29.6%. The bill provides for a 20% deduction (or a lower max income tax rate of 29.6% vs 39.6% currently) for income earned from pass through entities for tax years through 12/31/25. For C-corp midstream companies, the corporate income tax has been permanently lowered to 21% from 35%. This is a positive and will likely be recognized as a longer-term benefit as many of the midstream C-corps don’t pay full cash taxes. One potential negative in the bill was the limitations on deduction of business interest. The bill limits the amount allowed as a deduction to 30% of annual EBITDA for tax years through 12/31/2021 and 30% of EBIT thereafter. Wells Fargo estimates that only 5 midstream companies under coverage would incur an interest expense in excess of 30% of EBITDA. Another feature of the bill is accelerated depreciation. Businesses are able to fully and immediately expense 100% of the cost of qualified property acquired and placed into service between 9/27/17 and 1/1/23. The percentages decrease in 20% increments over the following 5yr period. However, the bill excludes natural gas pipelines, which would not be able to fully expense depreciation in year one. As most MLPs are diversified, there will be assets that certainly benefit from this deduction. Another likely benefit of accelerated depreciation is that it will increase the tax shield for MLP income, so less of your distributions will be taxable. 

Conclusion

We are very optimistic that midstream energy infrastructure will have a strong 2018. Most of the question marks surrounding MLPs during the downturn have been answered. MLPs are primed to benefit from improving operational economics, growing volumes and a supportive regulatory environment. Several major projects that are coming on-line in the coming months will enhance cash-flows and drive earnings growth. Management teams shifting towards the self-funding model will create a healthier sector over the long term. The United States has emerged as an energy super-power, and the buildout of infrastructure is vital to the success of shale. With a 7.5% yield, and valuations at significant discounts to historical metrics, we view the asset class as one of the few great values in the market. It’s been a tumultuous road for MLPs since 2014, but the future remains bright as we return to growth in the energy sector. DeWitt Capital Management strives to put its clients in the MLPs participating in the growth areas and provide index-beating returns to its investors.

 

 

 

 

 

 

 

 

Tax Plan Implications on MLPs

A question that is increasingly weighing on our clients’ minds is how the proposed tax legislation will impact MLPs. We called the Master Limited Partnership Association (MLPA) this morning, which is the lobbying group for MLPs based in DC, and spoke with Lori Ziebart, its Executive Director. She updated us with what she expects to be the implications for MLPs when the House Committee on Ways and Means reveals their final plan tonight at 5:30 PM EST.

The two largest sources of uncertainty for MLPs were whether they would maintain their status as a pass-through entity and whether or not they would be eligible for the 20% ordinary income tax deduction that initially looked to exclude MLPs. Last week, the senate added a provision last minute to ensure MLPs would be eligible. This means that unitholders effective tax rate would go from 39.6% to 29.6%, a definite win for MLP investors. The MLPA strongly believes that MLPs will maintain their current status as a pass-through entity and that the provision allowing MLPs the 20% deduction will be in the final bill.

Below is a chart showing the before and after effects of the likely tax plan.

Tax Table

 

Tax Table 2

 

Breaking News: MLPs Closed above Long-Term Trendline

Little did MLP investors know, but back on February 16, 2017, MLPs began facing strong southerly winds and began sailing south. From the close on 2/15/17 to the close 11/29/17, MLPs gave up 26% in what turned out to be a textbook downtrend. It was a painful and at times confusing period.

However, MLPs may have just begun to tack north. On 11/30/17, MLPs rose 4.1%, its largest one-day gain in almost two years. Over the last ten trading days, MLPs have closed green seven times. Over this period, the chart has formed the classic “1-2-3” reversal pattern (see below) on strong volume. In fact, over the last ten trading days, as compared to the previous ten trading days, average total volume for the ten largest MLPs in the Alerian Index is up 16%, helping to lend credibility to this breakout. The index has broken through its 50-day moving average and is knocking on the door of the 100-day moving average.

Finally, MLPs have closed today above its long-term trendline for the first time since it started back in February. While a few more trading days above this trend line would help to confirm this breakout and trend reversal, it’s looking pretty good, and we expect momentum to continue.

MLP Trend

MLPs: The Contrarian Case

Master limited partnerships have been the worst performing sector this year. Of the ten SPDR sectors, only one is negative year-to-date, and that is energy, which has slid 8% this year. The Alerian MLP Index (AMZ) has more than doubled that decline, down 17% year-to-date. MLP money managers have remained remarkably bullish throughout this period, repeatedly brushing off the weak performance as merely being a market that is behaving irrationally while telling investors that it won’t be long before the market stabilizes. They remind prospective investors that the fundamentals paint a much different picture than the stock price performance suggests.  Looking at the chart of the AMZ index tells us these managers have been dead-wrong all year. MLPs have time and time again failed to sustain any meaningful momentum. Every time there has been a glimmer of hope that the AMZ was setting up to break out of the prevailing downtrend, sellers have stepped in to ensure investors were going to have to sit through more pain.  And again, MLP money managers tell the same story, that fundamentals are strong and that we are on the brink of a great recovery in the stock prices of MLPs.

I am writing today to tell you that the above is good news if you are considering an investment in this sector. As much as it feels like a lie, the story MLP managers have been telling is far from one. Fundamentally, there is a scarcity of reasons why MLPs are performing so poorly in the market. Rather than sound like a broken record listing all the fundamental reasons MLPs should be moving up, I want to talk about some different reasons why investing in MLPs right now is a compelling opportunity.

One of my favorite investor types is the contrarian investor. Contrarian investors look for opportunities that most other investors would not even consider. They look to invest in securities and sectors against their prevailing sentiment and trend. Simply, they believe that herd mentality often results in securities that get mispriced, presenting an opportunity for outsized gains when the dust settles. For example, one sector that has been under pressure this year is retail, particularly those companies operating in malls. Several mall-focused retailers are facing an existential threat from the likes of Amazon and Walmart, and indeed, there have been several bankruptcies over the last few years. A contrarian investor may look to purchase a high-quality retail stock that, due to herd mentality, was the baby thrown out with the bathwater. Now that there are signs in the market that Amazon is not going to be putting everyone out of business, many retail stocks have bounced back violently, and it is the contrarian that is reaping the rewards.

MLP stock prices, as defined by the AMZ index, have performed far worse than retail, as defined by the SPDR Retail ETF (XRT). However, there certainly has not been any midstream MLP bankruptcies this year, and there certainly is not any talk of that as even a possibility. MLPs are performing quite well as companies, and management teams have remained very optimistic. In fact, management teams have frequently expressed frustration and confusion over how their stocks are trading. In contrast to the retail example, there have been several retailers that have expressed doubt over their ability to continue as a going concern (I am looking at you, Sears). My point here is that MLPs are not facing any major operational or existential threats, yet they trade as if they are all going to zero. MLPs fit the bill as a contrarian opportunity that are mispriced in the wake of relentless, yet severely misguided, negative sentiment. Sentiment, however, is starting to shift.

There is growing reason to believe that getting into MLPs sooner rather than later should be a strong consideration for any investor. Signs that sentiment is shifting are starting to appear. Below are some recent headlines that show people are starting to pay attention to the compelling value MLPs are currently offering.

Sentiment.png

On top of this, we have seen private equity buying MLP managers. For instance, Blackstone bought Harvest Fund Advisors, the largest MLP manager around. It follows that Blackstone is expecting positive fund flows into MLPs.

Another incentive to move into MLPs is an expected rebound as tax loss selling abates. Over the past five years, the Alerian MLP index has managed considerable gains from mid-December to year end. Further, in three out the last five years, MLPs have had strong Januaries per the screenshot below. There is a narrative taking hold that 

mlp december effect.gif

new money will flow into MLPs in 2018, and the first-derivate action to that trade is to get in ahead of the new year and take advantage of the weakness caused by tax-loss selling. 

MLPs are yielding a fully covered 8% yield,  they are performing strongly on the ground with improving fundamentals,  they still trade at a steep discount to their historical averages, and crucially, there are signs that sentiment is starting to shift. While the rest of the market is notching new all-time highs seemingly every day with increasingly stretched valuations, why wouldn’t you put some money to work in MLPs?

 

MLPs: Time to Buy?

Is now the right time to begin to allocate money to master limited partnerships? After many false starts, we might be at a point where investing in master limited partnerships and energy infrastructure makes more sense than ever. There are a number of reasons for this listed below:

  1. The average yield on an MLP is around 8%.
  2. MLPs have restructured over the last three years and are now exhibiting more conservative balance sheets.
  3. Their coverage ratios (the amount that they pay out versus what they could pay out) is getting stronger.
  4. The United States is producing, transporting and exporting record amounts of oil.
  5. Projects designed for the export of liquefied natural gas are underway, and liquefied natural gas exports are increasing.

In the past, when master limited partnerships have underperformed, prices have risen dramatically in the following years. This occurred in 2000, 2001, 2009 when the index rallied 44%, 45%, 75% respectively. I’m not saying that the future will duplicate the past, however, in an era of low interest rates and baby boomers looking for income in retirement, an 8% yield certainly is attractive. The stability of that yield is stronger than it has been in the past, and investors will inevitably give this sector a second look.

There is no question about the fact that this sector has been underperforming for the last three years. During times of market enthusiasm for growth stocks, value stocks tend to languish. MLPs are the ultimate value stock as investors have shunned them because of the following reasons: 1. Volatility due to the correlation to oil when the oil prices collapsed. 2. Distribution cutbacks designed to strengthen balance sheets and increase coverage ratios. 3. The perception by many that fossil fuels are on the way out and that renewables are on the way in. However, economic growth throughout the world is higher than it has been in over a decade and this is occurring in nearly all areas of the world. The demand for oil should continue to increase. Since mid-February, comparative inventories of crude oil and refined products have dropped by 120 million barrels, driven mostly by strong domestic demand and increased exports.

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 In conclusion, MLPs are currently a value proposition for which one can receive a large cash distribution while waiting for the inevitable revaluation of the sector.

Technical Analysis and MLPs: A Look at the Charts

While we do not claim to be expert chartists, we do like to use technical analysis to get a sense for where we might be headed. Looking at the charts of master limited partnerships (MLPS) alongside those of crude oil and the broad energy sector, we think there is a reason to believe MLPs may be on the verge of picking up positive momentum.

Below we have three charts, the AMZ MLP index, the XLE, an ETF that tracks S&P 500 energy stocks, and finally a chart of crude oil. Each chart is stacked evenly going back to the beginning of 2017. Looking at the AMZ and XLE charts, you notice that since February their charts look nearly identical, and both feature a pristine downtrend as defined by the yellow line. Each chart’s 50-day moving average (light blue line) also closely track the trendline. Looking at the crude chart, it also closely resembles the other two, forming a neat downward trend.

oil chart.png

 In mid-June, oil took a turn up and after initially looking like it might yet again fail to break through resistance (50-day moving average for this analysis), it took another shot at it and successfully broke through. Since then, the 50-day moving average (DMA) has turned into support and oil has been forming an uptrend, as seen in the chart. After this occurred, the XLE reacted positively and broke through its 50 DMA. It did not last long though, and confirmation of a breakout failed as the XLE quickly retreated back into downtrend territory. Its next attempt, however, was emphatically successful. The XLE screamed through its downtrend line, then it 50 DMA, and as of this writing, it is even trading above its 200 DMA (pink line). From the breakout of the trendline to today, the XLE as returned just about 10%. From the breakout of oil’s trendline to today, crude oil has returned about 8%.

 XLE USENEW.png

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Then there are MLPs. MLPs have hardly budged since oil began recovering. In fact, since oil began recovering off the low 40s, MLPs have been roughly flat. This performance has been disappointing and quite perplexing considering that MLP fundamentals are as strong as they have been in years. However, hope is not lost. Looking back at the charts, we can see that the AMZ is trading above its downtrend line which is the first time it has done that since it was formed on the chart. It is also above its 50 DMA. Remember, while liquid, MLPs are far less so than the broad energy stocks that make up the XLE. This often results in a slower moving and less reactive market. The AMZ index is also heavily weighted towards a few big name companies. One of those, Energy Transfer Partners, recently did a large secondary that hurt the sector’s performance and further dented investor confidence. Another event that has been hanging over the sector was a disappointing earnings result from a large member of the AMZ, Plains All American, that led them to cut their distribution for the second time in the past year. This bruised investor sentiment even more.

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While the rest of the energy sector was busy breaking out, MLPs needed time, as they always seem to need, to digest, deliberate and move past these negative outcomes. These are some of the reasons we think MLPs haven’t reacted to the improving investor sentiment that is taking place across the broad energy sector. That said, and taking the optimistic view, it is easy to see why we think MLPs may be set up to “catch up” to the performance of the rest of the energy sector. Of course, charts can only give us clues about where we may be headed, and there is no guarantee this scenario will play out.

 

 

Master Limited Partnerships: 2Q17 Review

Master Limited Partnerships: 2Q17 Review

2017 is shaping up to be a transition year for midstream MLPs. Domestic production of hydrocarbons has reversed trend and is once again on a growth trajectory. Crude oil production is up 910,000 barrels/day in the last 12 months and is expected to cross 10 million barrels/day of production in 2018. Demand for natural gas continues to grow driven by exports and new gas-fired electricity power plants. Natural Gas Liquids (NGLs) demand is set to spike as new petrochemical facilities begin operations. The large capital investments in pipelines and associated infrastructure from previous years are coming on-line and hydrocarbon volumes through pipelines are set to see growth in the second half of the year. MLP price performance has been challenged so far due to a 19% decline in crude oil prices this year. The elevated correlation between crude prices and MLPs remains, but we believe this will begin to dissipate as the OPEC production cuts begin to lower global crude oil inventories in the coming months. MLPs continue to trade at a discount to historical valuation metrics. As of June, 30th 2017, Wells Fargo calculates a price to distributable cash flow (P/DCF) ratio for 2018 of 10.7x, this compares to the 5yr average P/DCF ratio of 12.9x, a 17% discount to historical levels. This discount exists despite the improved balance sheet health and renewed growth outlooks for the sector. We believe this elevated short term correlation with crude oil is presenting extremely attractive investment opportunities for long-term investors. MLP earnings are driven by volumes moving through the pipelines, not the price of the commodity. As volumes return, many MLPs will see earnings growth just by filling underutilized assets. As the market starts to recognize the strong fundamentals underlying MLPs, the crude correlation will go down. MLPs have several tailwinds that will play out in the coming months.

 

MLP Q2 Update

MLP prices were under pressure in Q2 as oil/energy sentiment turned negative due to bloated global crude inventories. The short-term volatility in crude prices does not impact most MLPs business operations and is obscuring the long-term value of the midstream sector. During the quarter, we traveled to Orlando for the MLP Association Conference where we met with management teams to get a feel for their view on their business and the sector. Many management teams expected 2017 to be a transition year as strengthening balance sheets and building distribution coverage are priorities. Many were bullish about greater utilization of their existing assets, and potential growth projects. The predominant view was MLPs will eventually break out of the high correlation with crude oil as the market sees additional data on improving fundamentals. We discussed reasons for possible weakness with fellow MLP investors at the conference. The prevailing view on weakness pointed towards the oil price correlation, low retail fund flows into the sector and too much equity issuance. The rig count, which counts the number of rigs drilling for oil and gas in the U.S has increased by over 100% in the last year. This increase is a leading indicator on volume growth, which is why we fully expect to see significant volume increases in the back half of 2017. Another tailwind for the MLP sector is the positive legislative support from the Trump Administration. Under President Obama, many pipeline projects were delayed or cancelled, Trump has reversed this and wants to capitalize on our domestic resources as we march towards energy independence. MLPs that operate in key shale basins such as the Permian and Marcellus continue to announce strong earnings and guidance surrounding growth. Permian production continues to rise and several new pipeline projects for natural gas, NGLs, and crude have been announced in recent months. The midstream industry continues to see opportunities to optimize our energy infrastructure system. Another positive for the sector, is we are entering a phase of massive new domestic energy demand from exports, petrochemical and manufacturing facilities.

 

 

Growing Demand

Volume growth is coming for natural gas, natural gas liquids (NGLs) and crude oil pipelines. Demand for natural gas continues to grow driven by LNG exports, pipeline exports to Mexico and increasing investment in natural gas-fired electricity power plants. The Energy Information Agency (EIA) projects gas-fired generating capacity to increase by 11.2 gigawatts in 2017 and 25.4 gigawatts in 2018. That is enough capacity to power over 20 million homes. Many of these new electricity plants are in the mid-Atlantic and being powered by Marcellus Shale gas. We like MLPs that deliver gas to these facilities as the contracts are typically 10-20yrs with minimum volume commitments from investment grade counterparties. We expect natural gas to play a significant role in electricity generation for decades to come as coal and nuclear plants are phased out. MLPs are playing a vital role in the buildout of infrastructure to support LNG exports. The U.S is currently exporting roughly 2 billion cubic feet (bcf) of gas from Cheniere Energy’s Sabine Pass facility. By 2021, the EIA projects exports will reach 9.2bcf as new facilities come online. MLPs actively participate in building and operating these facilities along with the pipelines that feed the facilities gas.

 

 

Another industry reaping the benefits of shale is the petrochemical industry. According to the American Chemistry Council, domestic chemical companies have invested $161B in 264 new projects since 2010. Domestic chemical manufacturing is on the verge of a renaissance due to the low-cost and abundant shale gas that has lowered feedstock prices and energy costs for chemical companies. Two of the primary natural gas liquid feedstocks being used by domestic petrochemical companies are ethane and propane. These feedstocks are processed into ethylene and propylene, both building blocks of plastics. As demand for natural gas liquids continues to grow, we wouldn’t be surprised to see chemical companies becoming joint-venture partners on associated pipeline projects. Enterprise Product Partners (EPD), the largest MLP by market cap, estimates demand for ethane is estimated to grow by 340,000 barrels/day in 2017 as petrochemical plants come on-line. Additional demand growth of 430,000 barrels/day is expected through 2020. MLPs that operate natural gas liquids pipelines and processing facilities stand to benefit from this increasing demand.

Oil Upside?

In the beginning of 2017, OPEC announced production cuts of 1.8 million barrels/day. The market rewarded OPEC by pushing the prices towards $55 per barrel as it was believed global inventory levels would begin to rapidly decline. At that point, domestic oil companies used the strength in prices to hedge their production at higher prices. Since then, oil prices have drifted to the mid $40s. The negative oil price action has been driven by two factors; rapidly increasing oil production in the U.S (good for MLPs) and global inventory levels remaining frustratingly high. We think some energy investors are failing to see the forest through the trees. Before the cuts were implemented, many OPEC countries boosted their production so they would be able to cut production from a higher baseline. This ramp in production delayed inventory withdrawals for a few months. However, in the past month, we have seen inventory levels begin to decline at an accelerating pace. While U.S production continues to increase, the increases are not enough to offset the OPEC cuts, natural declines in oil fields and the lack of investment in new oil projects for the last 3 years. The lack of investment in new oil projects has some industry observers concerned that we could see a violent price swing to the upside as demand continues to increase and supply can’t keep up. Low oil prices continue to spur demand growth. Global oil demand is slated to increase by 1.3 million barrels/day in 2017 and an additional 1.4 million barrels/day in Source: International Energy Agency
2018. That would put global demand at 99.3 million barrels/day. Much of the new demand is being driven by developing countries such as China and India. The chart above illustrates that global supply/demand balance is finally flipping towards a supply deficit. We believe the trend continues in the coming months which should push down inventories enough to see oil rally towards $50-$55 by year end.

 

Conclusion

With our expectation of improving energy fundamentals in the coming months, we believe MLPs have rarely been more attractive as an investment. A shift in sentiment will drive positive fund flows into the MLP sector as valuations remain very discounted versus historical levels. In recent weeks, we have seen strong insider buying, positive dividend announcements, and several new growth project announcements. MLPs continue to place multi-billion dollar projects into service, enhancing their cash flow and growth visibility. The increasing utilization of existing assets will drive earnings and distribution growth with minimal investment needed. Midstream management teams learned valuable lessons throughout the downturn which has led to better capital decisions and ultimately a stronger sector overall. The growing sources of demand for energy due to manufacturing and petrochemical companies moving back to the U.S creates demand for additional infrastructure investment. With commodity prices stabilizing and the Alerian Index yielding 7.3%, we believe MLPs offer a compelling opportunity for the long-term investor.

Best Regards,

Dave DeWitt

Bob Milnes

 

 

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