Some master limited partnerships have business models that support distributions and expansion, even in challenging times. To best grasp the diverse factors affecting midstream MLPs today, we spoke with three leading industry observers for their analyses and outlook.
This year’s panel includes:
Kenny Feng, president & CEO of Alerian in Dallas;
Brian Kessens, managing director and portfolio manager, Tortoise Capital Advisors in Leawood, Kansas; and
Quinn T. Kiley, managing director with Advisory Research in St. Louis
Which subsectors of the midstream-MLP field have the most favorable short- and medium-term outlooks, and why?
Kenny Feng, Alerian: We do not believe that short- and medium-term MLP performance will be primarily divided along subsector lines. Absent a sooner-than-expected recovery in the macro environment, the companies that are best positioned for 2016 outperformance are those with the lowest degree of uncertainty and highest margin for error, i.e.:
high distribution coverage,
an investment grade credit rating,
a supportive sponsor,
favorable contract structures, and
asset, counterparty, and geographic diversification.
That can come in the form of a mid-cap refinery logistics MLP with a clear path to multi-year, double-digit distribution growth; a small-cap gathering and processing MLP with a well-capitalized upstream sponsor in a low-cost basin; or a large-cap diversified MLP with limited financing requirements.
Brian Kessens: Tortoise Capital Advisors: Natural gas pipelines, as measured by the Tortoise MLP Natural Gas Pipeline Index, declined 31% in 2015 despite a favorable growth backdrop.
We estimate approximately $26 billion in natural gas pipeline capital expenditure from 2015-2017 and expect this investment to drive distribution growth in the sector. The majority of this investment targets the Northeast, where production from the Marcellus and Utica shale now tops 20 billion cubic feet per day (Bcf/d), with expectations to reach 30 Bcf/d by 2020.
Wide basis differentials continue to indicate the need for more takeaway capacity in this geography. Furthermore, we believe an additional 10 to 15 Bcf/d of natural gas demand will emerge between now and the end of the decade in the form of exports via LNG and to Mexico, coal to natural gas switching in the power sector and increased industrial activity.
Quinn Kiley, Advisory Research: Infrastructure that is tied to demand-driven volumes should fare well even in the “lower for longer” commodity price environment. This will include those liquids MLPs tied to a refiner parent.
As demand for refined products grows, albeit at a slower pace than GDP growth, the volumes handled by infrastructure supplying crude to the refiners or taking refined products away from the refineries should be flat to growing. Natural gas pipelines that are tied to major demand centers, i.e., the Northeast, Southeast, and the West Coast should fare better than others as our economy grows and natural gas prices remain low.
Which factors are likely to most influence the performance of midstream MLPs in general over the next year or so, and why?
Feng: We believe the most influential factor on overall midstream MLP performance in 2016 will be certainty. If the path to a recovery in commodity prices becomes clear, production volumes stabilize and distributions are convincingly secure, then the pace of investment dollars flowing into MLPs will increase from current anemic levels and provide valuation support.
The absence of one or more of those drivers will allow uncertainty—and the volatility that comes with it—to persist. In other words, we expect finicky investor sentiment to again play a meaningful role in 2016 alongside midstream fundamentals.
Kessens: We believe that crude oil prices will be key to a turnaround in market sentiment, and that prices will improve once supply and demand are in better balance, but we expect them to be “lower for longer.” In the meantime, we believe there are tremendous values in the pipeline energy space, as there seems to be a market assumption of “no growth” priced into current valuations.
Additionally, we believe MLP distribution sustainability is another key factor. In our view, distribution cuts within the midstream space will be the exception, as companies have multiple levers to pull to weather this downturn, including reducing capital expenditures.
We maintain a view that midstream MLPs will continue to have stable to growing cash flows.
Kiley: The obvious answer here is crude oil pricing, as this impacts investor sentiment for MLPs more than the other factors. We don’t expect a meaningful rebound in crude oil prices in 2016.
Therefore, the ability of MLP management teams to support the long-held view that midstream assets provide stable cash flows and this stability supports stable distributions could be more impactful over the next year. If midstream MLPs are able to defend their distributions, investors may be rewarded even without an oil price recovery.
What new developments (like exports) could push midstream MLPs in new directions over the next year or two? And how about in the immediate and long term?
Feng: We continue to observe with interest the evolution of the Northeast from a natural gas demand center into a prolific source of supply. These new volumes will need to go to Mexico, on carriers for export as LNG (liquefied natural gas), to domestic power plants, and to new ethane crackers built by foreign-domiciled petrochemical companies.
We expect MLPs to again provide the necessary infrastructure to connect the wellhead to the end user. We also expect technological advances upstream to continue to lower breakeven costs for producers, indirectly providing volume and cash flow support for fee-based midstream assets.
Kessens: We think the recent exportation of liquefied natural gas will have a significant impact over the long term, though LNG export facilities do not come online in a meaningful way until 2020; and exports to Mexico will be incremental as the country builds additional natural-gas-fired power generation.
We think another long-term opportunity will be crude oil exports. Currently, West Texas Intermediate (or WTI) and Brent trade near parity. Over the longer term, production growth from U.S. shale rock should return, and there is a need for this additional production to be exported.
The breakevens from shale continue to decline as costs decrease and efficiencies improve. We’ve continued to underestimate the technological improvement in the production sector.
Over the more intermediate term, we expect exports of propane and butane to continue in a bigger way and ethane to be exported from the Northeast to European chemical facilities this year. We believe this need to move additional volume increases the strategic value of coastal infrastructure.
Kiley: While the advent of crude oil, lease condensate and LNG exports in recent months has been interesting for energy industry watchers, we do not think there is ultimately a huge impact on MLPs as a result.
These new markets for volumes are helpful, on the margin, but longer-term demand growth and commodity price stability would go further to advancing MLP security prices going forward.
Is now a good time to invest, given recent price declines? Why or why not?
Feng: Whether or not now, or any given point, is a good time to invest depends on an investor’s investment objectives and risk tolerance. Longer-term investors seeking low-double-digit returns and participation in the build-out of North American energy infrastructure may find current prices appealing.
That said, those investors will be asked to stomach continued volatility in the near and medium term given weak commodity prices, volume uncertainty, limited capital markets access, counterparty concerns, higher interest rates, and project deferrals and rationalization.
Kessens: We think a no-growth yield for MLPs is 9 to 10%. The current yield on the Tortoise MLP Index is more than 10%, which implies no or even negative growth in the sector. We don’t think that’s the case.
We believe growth in 2016 will be in the mid-single digits as cash flow from ongoing and recently completed internal projects are put into service. We calculate nearly $140 billion in midstream MLP and C-Corp pipeline projects between 2015 and 2017.
While current investor sentiment is driven by the direction of crude oil prices, our long-term conviction in the cash flow growth from additional pipeline infrastructure needs and existing assets remains.
When investors appreciate this, we think market participants will look back on the existing period of capitulation and recognize the opportunity that was at hand. Warren Buffett’s mantra to “be greedy when others are fearful” seems very apt.
Kiley: Investors with medium- to longer-term investment horizons may find many opportunities to initiate new positions or add to existing allocations as current valuations look attractive for many midstream MLPs. However, we expect continued volatility in the MLP space.
Investors with shorter investment horizons might find this unsuitable, given their tolerances. As with the financial crisis, MLPs underperformed the broader energy sector.
We expect MLPs to outperform the broader energy industry going forward, as commodity prices are unlikely to recover to previous levels any time soon.
What other trends in midstream MLP investing would you like to highlight, and why do you see them as important for the industry’s future success?
Feng: We expect merger and acquisition activity to ramp up in 2016. As the saying goes, in a downturn, first you sell your bad assets, then you try to find a joint venture partner for your slate of growth projects, and finally, as a last resort, you sell your good assets or the whole company.
There are many illiquid, small-cap MLPs with private equity sponsors who did not sign up for a macro environment that necessitates additional post-IPO cash investment at the limited partner level as a show of support to the marketplace. As management expectations begin to incorporate lower-for-longer pricing, well-capitalized MLPs should have opportunities to consolidate.
We also expect companies that stick around to seek alternative sources of financing, including preferred equity, payment in kind (or PIK) units, converts and second lien debt.
Kessens: Capital market access, whether traditional equity or non-traditional structured deals, continues to be important for MLPs to meet growth financing needs. While overnight equity capital market access is currently challenged, there are several ways for MLPs to access equity capital including Private Investments in Public Equity or PIPEs, parent/sponsor support, using excess cash flow for funding needs and accessing private capital.
Kiley: Over the last three years, we have seen a shift in how investors gain exposure to the MLP space. Closed-end funds were the first exchange-traded products to offer MLP exposure. In recent years, more and more retail flows are coming in through open-end products like ETFs (exchange-traded funds), ETNs (exchange-traded notes) and mutual funds.
It is likely that the investors exiting these positions in the fourth quarter are tax-loss selling and switching between investment vehicles, and therefore increasing volatility in the space. Higher volatility going forward as a result of these structural changes in the market should be expected, although not likely as severe as what we experienced in 2015.