“You know nothing, Jon Snow.”
Fans of the HBO show Game of Thrones will be familiar with the memorable and often-heard quote directed to one of the show’s most popular characters. It’s entertaining to see the character’s reaction to being told that he knows nothing – a mix of confusion, anger and curiosity. Investors often feel that they are getting the same message from the “market,” and have the same reaction as Jon Snow to being told that they “know nothing.”
The downturn in energy Master Limited Partnerships (MLPs) provided that sort of message in the latter part of 2014, as investments that were thought to be somewhat insulated from falling commodity prices fell sharply during the oil bust. After the initial reaction to the downturn – confusion and anger – many investors moved on to the curiosity stage and asked whether the downturn created a buying opportunity.
The Asset Class
Energy MLPs have long been of interest to investors for their yield, capital appreciation potential and inflation-hedging characteristics. Distributing 90% of their income by law, MLPs have been a popular alternative for investors starved for yield in a low interest rate environment.
Energy MLPs are engaged in the production, transport, and refining of energy products such as crude oil, natural gas and natural gas liquids (NGLs) such as ethane, propane, and butane found in natural gas.
Those three main business activities – production, transport, refining – define the three segments of the energy MLP space.
- Upstream MLPs are mainly involved in production of oil and natural gas. These firms should do well in times of increased energy production, such as occurs with an expanding economy. They are sensitive to low energy prices, which reduce the profitability of their projects.
Oil price sensitivity tends to make upstream MLPs more cyclical than other energy segments – creating expectations of more volatile market prices and dividend payouts.
- Midstream MLPs supply the infrastructure to transport, process and store energy products. They are classically known as “pipeline” businesses, but their business activities can include gathering, treating, processing and logistics. Midstream MLPs thrive when they can expand cost-effectively into new infrastructure projects and when activity volumes are stable or increasing. Midstream MLPs have benefited greatly from the U.S. energy renaissance created by unconventional energy production techniques. Midstream MLPs are considered to be relatively insensitive to energy prices, because they primarily are paid fee-based prices based on volume rather than on the price of the energy. More than half of MLPs are in the midstream segment.
Many investors consider midstream MLPs to be a hedge against inflation, because their fees often increase in line with inflation, while their volumes tend to rise in tune with a growing economy.
- Downstream MLPs convert basic energy materials into value-added products. Downstream MLPs operate refineries and their products include NGLs as well as heating oil, gasoline and other fuel products.
As buyers or users of basic energy commodities, they may be adversely affected by high energy prices and fluctuations in demand. This is a diverse group with idiosyncratic performance drivers.
Major direct influences on performance include recent energy price declines caused by global over-supply as well as the current increase in energy production within the United States. MLPs are also an interest-rate sensitive investment, so the outlook for interest rates is an additional factor behind MLP performance.
The oil glut and resultant pressure on oil prices hit upstream MLPs the hardest. (See Chart 1 below) Almost all upstream MLPs cut their distribution rates in recent months; the average reduction of distributions was 50%. Industry observers warn that the highly leveraged nature of upstream MLPs make further distribution cuts almost inevitable should energy prices remain low.
Midstream MLPs held up comparatively well during the downward spiral of oil prices, though they’ve been laggards relative to the broad equity market. Short-term demand has picked up in the face of lower price levels. However, low prices have caused upstream MLPs to cut investment in extraction projects, which could have an adverse effect on future volumes.
The longer-term demand picture looks bright for the midstream segment, though. The energy renaissance means that the U. S. is still in need of major infrastructure projects to transport energy, and a further boost may come from increased demand caused by improving economic activity, though the economic picture is far from clear.
Downstream MLPs have benefitted from lower energy prices, but that has been balanced with sluggish economic activity. Results have been mixed.
Oil Decline Period is 7/31/2014 – 12/31/2014 Oil Trough Period is 12/31/2014 – 3/31/2015
Full Period is 7/31/2014 – 3/31/2015 Broad MLPs is defined by the Alerian MLP Index
Downstream MLPs is defined by the Yorkville MLP Downstream Index
Midstream MLPs is defined by the Alerian MLP Infrastructure Index
Upstream MLPs is defined by the Cushing Upstream Energy Income Index
Source: Bloomberg, index company websites.
M&A / Consolidation Activity
MLPs have been on center stage in the merger and acquisition parade in recent months. Three recent stories stand out in the news – Sunoco, Kinder Morgan and Williams.
In March 2015, Sunoco spun off its logistics business to form Sunoco Logistics Partners. Sunoco’s motivation was to “unlock” the value of low-volatility assets that were perceived as underpriced by the stock market. Hess has publicly stated that they plan a similar MLP spin-off.