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February 02, 2015 at 07:00 PM
It was a tale of two markets for midstream master limited partnerships (or MLPs) in 2014. The energy markets were calm for the first part of the year, and the midstream and infrastructure indexes moved steadily higher. As the price of oil started dipping below $100 per barrel for West Texas Intermediate (WTI) in late summer, however, prices for midstream MLPs become more volatile, and this trend continued through year-end.
Midstream MLPs are service-oriented businesses that focus on the distribution of energy from the wellhead to end use. Given the critical job they have in moving energy through an infrastructure, referred to as their toll-road model, they typically have the highest degree of cash-flow stability within the broader MLP sector.
We asked several leading MLP experts for their thoughts on the sector’s recent performance and their outlook for the energy industry overall. This year’s panel includes the following industry experts:
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David Chiaro, partner and co-head of MLP strategy, Eagle Global Advisors LLC, and co-advisor of the Eagle MLP Strategy Fund, Houston;
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Kenny Feng, president and CEO, Alerian, Dallas;
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Quinn T. Kiley, managing director and portfolio manager, Advisory Research Inc., St. Louis;
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Matt Sallee, CFA, managing director and portfolio manager, Tortoise Capital Advisors, Leawood, Kansas;
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Darren Schuringa, CFA, chief investment officer, Yorkville Capital Management, New York.
How did midstream MLPs perform in 2014?
David Chiaro, Eagle Global Advisors: Since early 2012, there has been material variance in performance amongst the MLP sub-sectors. Total return for 2014 was 4.8% for the broad universe of MLPs, if you use the Alerian MLP Index as a benchmark; however, refined product pipeline MLPs and the larger-cap diversified MLPs were the better performers in 2014.
Sectors that have more direct commodity-price sensitivity, which we typically avoid or underweight, performed poorly. The exploration and production (or E&P) MLPs were by far the worst performing sub-sector in the index, followed by, although to a much lesser degree, shipping MLPs and gathering and processing (or G&P) MLPs.
Kenny Feng, Alerian: The Alerian MLP Infrastructure Index (AMZI), a composite of energy infrastructure MLPs, returned 2.0% on a price return basis and 7.6% on a total return basis in 2014. Performance dispersion for individual midstream MLPs was wide, with price returns ranging from -79.9% to 86.7%.
Quinn Kiley, Advisory Research: 2014 was a very volatile year for MLPs and energy equities in general. Midstream MLPs, which typically have long-term contracts and limited commodity price exposure, were caught up in the energy sell-off during the second half of the year.
In our view, the fundamentals for crude oil, natural gas, natural gas liquids and refined products remain constructive over the long term, but may face some headwinds near term. For the long-term investor, many midstream MLPs look[ed] attractively valued as we enter[ed] the New Year.
Matt Sallee, Tortoise Capital Advisors: The broad energy sector, including midstream MLPs, had a strong performance for much of the year, benefitting from robust oil and natural gas production out of North American shales. However, energy stocks retreated significantly in the fourth quarter as investors reacted to the drop in crude oil prices.
West Texas Intermediate started the year at $98.42 per barrel, peaked at $107.62 per barrel on July 23, and then closed 2014 at $53.27 per barrel, more than a 50% drop from peak to year-end (moving even lower into the new year).
As can be the case in the short term, the market did not necessarily decipher quality, and energy-related stocks across the value chain were affected. As such, midstream MLPs also pulled back later in the year, but to a lesser extent, as they typically are not directly affected by commodity prices and tend to have more steady, fee-based revenues.
Midstream MLP performance for 2014 as a whole was solid. The Tortoise Midstream MLP Index posted a 15.4% total return for the year, slightly outpacing the broader equity market as represented by the S&P 500 Index’s 13.7% return. This number includes the retreat in the fourth quarter, when midstream MLPs returned -7.9%, compared to the 4.9% gain for the S&P 500 for the same period.
Darren Schuringa, Yorkville Capital Management: At Yorkville, we follow and analyze every single energy master limited partnership. For 2014, the Yorkville MLP Infrastructure Index (our benchmark index, YINFUX, which is a market-capitalization index that includes all midstream MLPs) achieved a total return of 14.4% and price return of 9.0%.
Of the five sectors that comprise midstream or infrastructure MLPs, general partners and refined product MLPs led, gaining 32.6% and 24.5%, respectively.
Were these 2014 results what you expected?
David Chiaro, Eagle Global Advisors (left): We expect total return for any 12-month period to be approximately equal to the distribution yield plus distribution growth of the portfolio, or about 11-13%. In 2014, MLPs exhibited more volatility relative to history. Both positive and negative factors relative to our own expectations drove some very interesting price action.
For the first eight months of the year, MLPs outperformed this scenario as the result of the very strong growth in oil and natural gas production.
The torrid pace of drilling activity exceeded some of our more optimistic expectations, resulting in record volumes on pipeline assets and spurring increased infrastructure capital spending during the year. In addition, the activity helped to bolster investor expectations for longer-term scenarios of robust capital investment in energy infrastructure.
It was perhaps the sharp increase in drilling and production that contributed to a sharp decline in oil prices in the fourth quarter of 2014, as markets became focused on the potential for oversupply of the commodity globally. MLP equities also suffered a sharp decline in tandem with the oil price, showing a negative total return for the year of approximately 4% at its lowest point.
While the index finished the year with a positive 4.8% total return, Eagle MLP separately managed account strategies were able to outperform the index.
Feng: At the beginning of last year, Alerian’s base case estimate was that MLPs’ 6% yield plus distribution growth of 4-6% would net a total return of 10-12%. While full-year performance was more or less in line with our base case estimate, the journey there was rather bumpy.
MLPs returned more than 21.2% during the first eight months of the year, due to continued valuation expansion. Unit prices then plunged alongside the drop in oil prices, from more than $100 a barrel in June to roughly $50 by the end of December.
The AMZI had given back all its year-to-date gains by Dec. 15 and had a yield north of 6% for the first time since January 2013. Investors redeployed capital during the last two weeks of 2014 to bring returns back into positive territory.
The most unexpected deviation from our expectations was not how much MLPs did or did not return in 2014, but rather how violent the unit-price movements were during the fourth quarter, even for companies with healthy leverage and distribution coverage ratios, long-term fee-based contracts and stable or growing volumes.
It was an important reminder to stakeholders that MLP volatility tends to spike in periods of uncertainty related to tax legislation, interest rates, and/or commodity prices.
Kiley: We expected higher-growth MLPs to outperform higher-yield MLPs in 2014, and that is what we saw play out during the year. While we were expecting some weakness in commodity prices, the speed and depth of the sell-off surprised us.
Fortunately, we were well positioned, as we had focused on owning those MLPs with fixed-fee contract exposure. That said, virtually every MLP subsector was hurt in the sell-off.
Sallee: We anticipated midstream companies would do well in 2014, with production continuing to drive infrastructure buildout. We were not disappointed in this regard.
The project backlog, as we anticipated, remained strong in 2014 and into 2015, with projects underway for crude oil and liquids pipelines in various plays across the country. We also thought natural gas pipeline companies would benefit from additional buildout in the Marcellus, which has certainly been the case for those with strategically placed assets in that basin.
While we did not necessarily expect the magnitude of the decline in oil prices, we were not entirely surprised either. Several factors developed throughout the year to drive oil prices lower, including increasing global supply, particularly out of Libya, where until fairly recently production had been offline due to political strife; slower growth in global demand, especially out of Europe and Asia; and a strengthening U.S. dollar.
Although the Organization of the Petroleum Exporting Countries’ (OPEC) announcement on Thanksgiving Day that it would not cut its current crude oil production levels was not a surprise to us, the effect on pricing was both swift and dramatic.
: After midstream MLPs returned 32.4% in 2013, it wasn’t surprising to see returns below historical averages in 2014. M&A transactions within the asset class boosted returns. Most notably, the Kinder Morgan consolidation increased returns by approximately 2.6% for the year.
The volatility experienced along the way was certainly unlike anything we had seen since 2008-2009 and was not expected coming into 2014.
While many midstream MLPs and entire sectors are largely insulated from commodity-price volatility, there is no question that the 40%-plus decline that occurred in West Texas crude oil from $105 a barrel to $55 had a negative effect on MLP unit prices.
The best comparison for 2014′s steep decline in the price of oil was 2008-2009, when the price of WTI crude declined by over 70% from $140 to below $40. During this period, approximately 90% of midstream MLPs maintained or increased distributions, and 100% of the cuts occurred in one sector, gathering & processing.
In 2009, MLPs popped 80%, recouping their losses in less than 12 months due to the aforementioned strong fundamentals. Every midstream MLP maintained or increased its distribution in 2014 [with one exception].
Since 2009, MLPs have had 10 pullbacks of 5% or more and recouped their losses entirely in an average of 24 trading sessions. As a result, we advised and continue to advise investors to buy MLPs on pullbacks, as long as the fundamental story remains intact.
What short-term upside do you see for midstream MLPs?
Chiaro: While dramatic swings in commodity prices could again add to the volatility of MLP equities over the next year, we still expect total return for the 12-month period to be approximately equal to the distribution yield plus distribution growth of the portfolio, or about 11-13%.
A recovery of commodity prices would likely facilitate better performance. While MLP equities have reacted negatively to declining crude prices, there are still many reasons to stay positive as it pertains to the fundamentals.
Crude oil prices have dropped significantly; however, it should take some time for reduced drilling activity to materially impact production. Many E&P companies have cut their capital investment programs for 2015 vs. 2014, yet are still forecasting some amount of production growth.
While the pace of hydrocarbon production growth will slow, existing volumes will utilize existing infrastructure to get to market. Hence, the underlying assets that support MLP cash flows and distributions to limited partners will still remain highly utilized.
Geographically, some oil basins will experience greater changes in production growth rates than others, and as a result, the effect on the midstream companies that own infrastructure will also vary.
However, midstream companies are not only geographically diverse, but also have contract diversity and product diversity, which also will vary the degree to which specific MLPs are impacted by lower oil prices. Natural gas, liquefied natural gas (LNG), refined product pipelines/storage, and shipping are good examples of asset types that likely will be materially less affected by lower crude oil prices.
We also believe that merger and acquisitions (or M&A) and sponsor relationships could represent upside potential for select securities in 2015. Many companies whose equity prices have outperformed on a relative basis are in a stronger position to acquire assets or other companies.
Many energy companies that own MLP general partners are continuing to realize value by selling assets to their respective MLP, augmenting its organic growth profile. The incremental growth related to asset purchases from a sponsor can greatly benefit select MLPs, especially in an environment where organic growth is more difficult to achieve.
Kenny Feng, Alerian (left): We view midstream MLPs as a long-term investment in the buildout of North American energy infrastructure and believe holding periods should be measured in years, not months. In the near term, we expect MLPs to be highly correlated to oil prices, as has been the case during previous periods of crude oil volatility.
Assuming oil prices don’t fall another 50% from here, we believe the vast majority of midstream MLPs will be able to grow or at least maintain their distributions in 2015. Total returns above 10-12% could come from stabilized or higher oil prices, M&A activity or strong fund flows from new investors.
Kiley: This past summer, we lowered our longer-term outlook for MLP asset class returns to 5-9% annually. With the recent weakness, exacerbated by tax- loss selling in the fourth quarter, 2015 could see a better return if the outlook for higher commodity prices, from here, holds.
Midstream MLPs should have minimal cash flow impacts from the recent commodity price weakness, and as such, we expect the majority to maintain or grow their distributions during 2015.
Not surprisingly, commodity-price exposed MLPs recently started announcing distribution cuts for 2015. As is always the truth with MLPs, stable to growing distribution leads to rising prices over the long term, while distribution cuts destroy equity value.
Sallee: In our view, the outlook for midstream companies remains positive over the course of the next year, as the need for midstream transportation infrastructure remains critical. We project capital investment in MLP, pipeline and related organic growth projects of approximately $135 billion from 2014 through 2016.
The visible growth from these projects underway provides clarity to cash flows and growth potential in 2015 and even into 2016.
These capital expenditures are largely already supported by shipper commitments, including crude oil projects to debottleneck along the Gulf Coast refining complex and to add capacity out of the Permian Basin. There also are natural gas projects to relieve takeaway constraints in the Northeast. Natural gas infrastructure needs could even increase, to connect growing Marcellus gas supply to developing demand sources.
Pipelines carry a variety of products, so it’s worth noting that some types of pipelines will be affected more by lower crude oil prices than others.
Natural gas pipeline companies should be the least affected, as their performance isn’t directly tied to crude oil prices, and natural gas production is still on the rise the rise, though we continue to monitor recontracting rates. Crude oil pipelines earn fees based on the volumes they transport, so the price of oil does not directly impact these companies.
If the low price of oil persists, it is possible that volumes may be affected over time. In this scenario, companies transporting from areas with higher breakeven prices will be more affected than others.
And, while lower crude oil may be a headwind for some energy companies, we expect it to benefit refined product pipeline companies, as we see the potential for increased consumer demand thanks to lower prices at the pump. We also anticipate some consolidation within the pipeline space.
Finally, we expected headwinds from lower crude and NGL prices to affect natural gas processing and crude oil marketing businesses. Gathering and processing pipeline companies could see some pressure, as this group takes on more commodity price exposure due to the nature of certain contracts within the space.
However, many of these companies’ contracts have become more fee based over the past several years. We anticipate distribution growth may slow, if crude oil and NGL prices remain low for an extended period.
Schuringa: We forecast a 12-month total return estimate of 11-15% for midstream MLPs, based on 6-8% distribution growth combined with current yields of 5-7%. If we see compression in MLPs yields, the potential for price appreciation becomes even greater.
On a relative basis, MLPs as an entire asset class are currently trading at an approximate 390 basis points spread to the 10-year Treasury, compared to a historical average of 340 basis points. When spreads have been these levels, MLPs have historically offered a next 12-month total return of 15%.
MLPs are also cheap relative to investment grade and high-yield bonds, trading at spreads of 130 basis points and -60 basis points, respectively. Given historical spreads, these levels imply a potential total return of 25%-plus based on consensus estimates for 2015 distributions.
What is your intermediate- and long-term view of midstream MLPs?
Chiaro: Our intermediate- and long-term outlook for MLPs is very positive and is supported by the view that: (1) stable, fee-based assets with long lives and inflation escalators, which are key to North American infrastructure, should be attractive investments over time, and (2) the asset class will benefit from additional growth opportunities as it becomes more closely aligned with growing demand centers, such as LNG export facilities, natural gas liquids export facilities and expanded/new facilities related to the petrochemical, chemical or utility industries.
As the potential resource base continues to grow, new markets and ancillary businesses will develop along the infrastructure chain to support this activity.
MLP equity performance has generally exhibited low correlations to commodity prices and other asset classes over the long run. However, in the second half of 2014, MLP equities traded down in conjunction with the price of crude.
While we expect the energy industry will undertake reduced drilling and production activity due to lower crude prices, we see an opportunity to invest in companies that have traded lower on negative sentiment rather than on changes in business fundamentals. And when commodity prices stabilize and rebound, the sentiment that contributed to lower valuation will be replaced by fundamental analysis.
We believe in the asset class [and] our portfolio-management process, remain focused on the companies that have the best fundamental stories, and see ample opportunity to support a mid-teens return proposition.
Feng: If $50 oil is the new normal, we expect to see rigs in higher-cost plays eventually laid down and domestic production growth to pull back, which will likely force MLPs to reevaluate some of their infrastructure projects.
That said, like most businesses, the energy industry self-corrects over the long term. Lower pricing reduces supply, creating an imbalance with higher demand that is corrected by an increase in prices.
It’s also worth noting that producers continue to make efficiency gains each year in faster-growing plays like the Eagle Ford and Bakken. And if higher-cost areas see a reduction in drilling activity, it also creates a supply glut in the oilfield services and equipment markets, which would further lower the marginal cost per barrel in prolific, lower-cost basins.
Ultimately, continued crude oil, natural gas and NGL supply growth from unconventional sources necessitates the repiping of North America, and MLPs will house the vast majority of the infrastructure that is built to that end.
: Our long-term view is 5-9% annualized returns for the asset class. The midstream portion of the MLP asset class should do better than that over the long term.
Over longer periods of time, it seems highly likely to us that we will see interest rates rise. This will be a headwind for MLPs, and those MLPs that can grow their distributions will likely outperform the group.
Sallee: Our long-term expectation for midstream companies remains generally positive, though we note some challenges exist.
Matt Sallee, Tortoise Capital Advisors (left): We’d also like to mention that this is an interesting time in the energy market and particularly in the closed-end fund market, where opportunities for value may exist. Over the past year, discounts have felt pressure across the closed-end fund market, we believe in part due to some concerns about rising interest rates.