Lower oil prices might lubricate the economy, but they’re proving slippery for midstream master limited partnerships.
Midstream companies don’t explore or drill for oil and natural gas; they process, transport and store the extracted commodities. Their business results are often tied contractually to the volume they transport, rather than oil and gas prices. Because midstreams avoid the hit-or-miss results that drillers produce, their cash flows, market values and distributions (which are similar to dividends) have been more stable than those of other energy stocks.
But they’re not immune to the energy markets, and it has been a bumpy ride recently for investors. For the 12 months ended mid-September, the Alerian MLP Infrastructure index (AMZI) dropped 31 percent, from 3,537 to 2,434, on a price-return basis.
Large and growing distributions to investors have been the midstreams’ good news so far this year, and the AMZI’s constituents currently pay a 7.85 percent distribution. That’s an attractive yield for clients seeking higher income, but are the MLP distributions’ growth and sustainability at risk?
Here’s the downside scenario. Energy prices remain low, and producers leave their oil and gas in the ground until prices rebound. Less production means less demand for transport infrastructure and reduced volume through pipelines. MLPs’ cash flows suffer, they can’t increase distributions as they have historically, and eventually they reduce payouts.
It’s a widespread concern, according to Quinn Kiley, managing director and senior portfolio manager with Advisory Research’s MLP and energy infrastructure team in St. Louis: “The question everyone is asking today is, Are we in a scenario where crude oil is so low that there’s going to be a shrinkage of volumes and it’s going to negatively impact fundamentals of MLPs?”
Kiley, whose $11.45 billion firm manages $5.6 billion in MLP assets, recognizes the skeptics’ point but argues that oil and gas producers are responding to low prices by drilling larger wells on core positions, which is allowing them to maintain production. Pipelines have always been the cheapest, safest and most efficient way to get product to market, he says. “So if a producer is going to produce and they have a pipeline available to them, typically they’re going to use it,” he adds.
Several other factors make a strong business case for midstreams, Kiley maintains: Demand for energy transport infrastructure in the U.S. has never caught up to the recent growth in production, so there’s still strong demand for existing pipelines and “a need for some new infrastructure.” Also, the majority of midstream MLPs’ assets are tied to natural gas production. That industry segment has been dealing with the “lower prices for longer” scenario for several years, he says, and it has adjusted well. Volumes are at all-time highs, and although the current trend is relatively flat, they’re projected to grow.
Darren Schuringa, founder of Yorkville Capital Management, a $176 million MLP investment manager based in New York, points to 11 percent year-over-year MLP distribution growth through the most recent quarter as evidence that lower commodity prices haven’t hurt the firms’ businesses. The industry’s positive prospects should continue for the long run, Schuringa believes, because the U.S. has ample oil and natural gas reserves that will require transport.
But investors need to analyze midstream MLPs individually, he warns. In a low-price environment, the exploration and production companies will allocate their resources to areas in which they can earn the highest profits. High-cost fields will suffer from a lack of funding, and their output and demand for transport services could drop. “If you’re investing in MLPs, you need to know who your counterparties are within the given fields,” he says. “What is your contract exposure to the counterparties? What percentage of revenue and cash flow do they represent?”
Schuringa cites several other reasons why MLPs are attractive investments, despite the recent downturn. Coverage ratios, which measure distributable cash flows versus current distributions, are healthy. Most firms’ ratios range from 1-to-1 to 1.5-to-1, he says, which gives investors some protection against distribution cuts.
He also notes that MLPs as an asset class are trading at a spread of 500 basis points over Treasuries, an event that has occurred less than 10 percent of the time in MLPs’ trading history. Whenever that has happened, Schuringa says, “MLPs have posted positive returns in the next 12 months.”
These points make sense to at least some advisers. Jim Pratt-Heaney, founding partner with $1.6 billion LLBH Private Wealth Management in Westport, Connecticut, says his firm has been investing in MLPs for years; most of its clients have an allocation to the partnerships. LLBH doesn’t make tactical trades in clients’ accounts, but it will consider working with the firm that manages its MLP positions to increase investments in specific firms when a portfolio allocation is below its target level, such as during the recent sell-off, Pratt-Heaney explains.
If Kiley’s and Schuringa’s assessment of midstreams’ business case is correct, MLPs’ currently depressed prices will prove to be a bargain for buyers willing to step in. If they’re wrong, though, MLP prices are likely to keep slipping until oil and natural gas prices stabilize.
