MLP, Third Quarter 2015
September 25, 2015
Written by Rick Daskin, the research and valuation sub advisor for the MLP strategy at Cumberland Advisors.
MLPs typically have lower market volatility than most US equity indexes. The one type of environment where this relationship breaks down is a market with an oil price collapse combined with a credit tightening cycle such as in 2008–2009. As in the credit-crisis-driven market in 2008–2009, oil prices have dropped dramatically. However, the credit picture is now somewhat different. Energy-producing companies have seen credit spreads widen, but there has not been a general credit-market collapse as during the 2008–2009 market panic. The MLP sector’s decline has been caused by a combination of lower energy prices coupled with investment tourists’ leaving the investment space and exacerbated by low trading liquidity in many partnerships. This manifests itself several ways. Closed-end MLP funds are trading at very wide discounts, indicating that investors are motivated sellers and that there are few buyers. And MLPs are selling off as much as are sectors such as energy exploration and production companies and oil service companies, which are far more exposed to commodity prices. However, MLPs’ results in general are less exposed to lower prices than the above sectors and should not decline as much. In fact, distributions for MLPs will probably grow this year in the range of 3–5% on average. Finally, MLPs are yielding well above historical averages when compared to other yield assets such as 10-yr US Treasury bonds, REITs, and high-yield bonds.
We are positive on the intermediate to long-term outlook for MLP returns. Valuations are attractive. Most partnerships will be able to continue to raise distributions, albeit at a slower pace. We also believe that at current prices demand for oil and petroleum-based products will catch up to supply and that there will continue to be demand for additional transportation infrastructure. The last leg down in the crude price, from about $75 per barrel for crude last fall to the current price of around $45 per barrel, was initiated by a decision by OPEC to produce at maximum capacity. This was a decision to sacrifice price for market share. There is an oversupply of oil currently, but the supply/demand imbalance is comparatively small. Some increased demand as a result of lower prices is now evident. In addition, long-run supply is not being replaced by new development, due to the lower prices. We are now seeing that expensive long-gestation projects, especially offshore developments, are being canceled or postponed. Oil derived from shale deposits in the US is presently in a gradual decline. If prices remain at these levels, you can expect to see US production roll over more quickly, in part because of the rapid decline rates of fracked oil wells. In addition, banks and other lenders will be evaluating collateral values of energy production company assets for redetermination of credit lines. Typically this process takes place in April and October, and the prices used are based on the trailing 12-month average. This October will capture most of the valuation decline. At that point we expect credit pressure on smaller producers especially. This may be the point where we see a washout in the exploration and production sector. While we do not expect prices to bounce back to previous highs, we do not believe present prices are high enough to meet increased demand in the intermediate to long term.
The catalyst for higher valuations of MLP partnerships will be the stabilization of energy prices and a bottoming out in the energy business generally. Once those conditions are in place, the combination of attractive tax-advantaged distribution yields combined with growing distributions should reward patient investors.
Richard S. Daskin CFA, CFP(R), RSD Advisors