Master Limited Partnerships -- Keeping the Faith
Feb. 8, 2016 Commentary

Master Limited Partnerships -- Keeping the Faith

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Today’s piece is a continuation of last week’s release. The format remains the same, a conversation with a fictitious client – Client “X”. Client X comes into my office about once every six months, during which he asks questions of me as we discuss the overall macroeconomic and capital market outlook. We also cover specific action items for his consideration.

Last week we covered my macroeconomic outlook. Basically, I continue to believe the U.S. and global economy are not going to experience a formalized economic recession this year. The weight of the evidence does not point to this event – yet. Consequently, we started talking about taking advantage of the recent market weakness by initiating a position in short-duration, actively managed high-yield investments. This week, we will cover another investment which has been under tremendous downward pricing pressure over the last year – Master Limited Partnerships.

Client X: Now that we have covered the macroeconomic and capital market outlook, in which you stated your thought that an outright economic output recession is probably not in the cards this year, I decided to initiate a position in a downtrodden asset class – high yield bonds. Bill, is there anything else I need to consider?

Bill: Yes, I would like to talk about your current position in MLPs.

Client X: Well, if nothing else, you have courage to bring this asset class up. I followed your advice to add to my MLP exposure in the second half of last year – a move which has yet to bear fruit. As a matter of fact, I think MLPs were about the worst performing asset class in my balanced portfolio last year.

Bill: Yes, you are right.  During the third quarter last year, I wrote that MLPs were positioned as a good “buy” for many investors to consider. Since that time (July 20, 2015 – Jan. 29, 2016), MLPs have declined in value significantly. The Alerian MLP index was down more than 30 percent over that period of time.  Proposing the purchase of MLPs was in hindsight a poor recommendation – one that should eventually bear fruit, but the downside has been greater than anticipated.

Client X: Bill, what did you miss?

Bill: As you know, MLPs own petroleum product pipelines. These pipelines’ sensitivity to oil and natural gas price shifts has historically been very muted, but still present. For example, over the long term, the rolling “beta”, or price sensitivity of MLPs to oil prices has been around half that of oil prices. Over rolling periods if oil prices rose or fell by 20 percent, MLP prices have risen or declined by about 10 percent. This time around, over the short term, that relationship has broken down. Since July 20, 2015, oil prices are down 36 percent while MLP prices are down 33 percent. In my outlook for 2015, I suggested oil could decline to the $40 per barrel range. As we know, oil prices declined into the $20 per barrel range.

Client X: Since the decline in oil prices is the main factor of why MLP pricing has been so weak, do you see any evidence as to when oil prices will stop declining?

Bill: First, let me say that forecasting oil prices is tough. That being said, in the past I have explained that the current decline in oil prices is primarily a supply problem rather than a lack of demand. For example, global oil consumption is up 2 percent over the last 12 months. On the other hand, due to improvements in oil field drilling and capture technologies, fracking activities led to a huge increase in the supply of oil to the marketplace. This increase in supply led to lower prices, as the market became oversupplied.

Our sources tell us that U.S. oil production has been reduced by about 400,000 barrels per day (on a base of about 10 million barrels per day) since last summer. Those same sources have confirmed the view that oil production will probably decline by another 400,000 barrels per day by this coming summer. Along with other high-cost production cuts, it now appears oil supply/demand will be back in balance and the oversupply will be absorbed within the next 3-4 months.

Client X: What about other producers? What about the Iranians? Could the Saudi’s ramp production further?

Bill: It appears the Saudis, the Russians and most OPEC producers, save Iran, are currently producing pretty much flat out. So I don’t expect to see massive additional supply coming in from the Saudis or other OPEC members. This view includes the Russians. The Iranians will be bringing additional oil onto the market this year. Sources tell me that the up ramp for Iranian oil will be gradual, due to a lack of capital investment over the last number of years by the Iranians. By the end of this year it is assumed the Iranians should be bringing about 600-800,000 barrels per day to the market. Assuming the world stays out of economic recession, increases in demand should absorb the majority of this increase.

Client X: Bill, that’s all fine and good, but I am becoming discouraged with MLPs. Due to the technological shift you mentioned, it appears the oil game has changed as compared to how the energy world has worked in the past. As you have said, technological change begets technological change. I suspect the cost of lifting oil out of the ground will do nothing but decline as we move forward. If this is the case, what is to say that oil prices won’t remain extremely low for the long term?

Bill: I suspect you are correct, that over the long term, lifting costs will decline. I believe the days of $100+ oil prices are behind us for a long period of time. This, however, has nothing to do with the amount of oil – and natural gas – we use. Demand is the long-term key for growth for the pipeline business. Per my piece dated July 20, 2015, MLP’s – An Opportunity, I reached the conclusion that growth of demand had slowed, but should remain positive over the long term; this is particularly true for the natural gas utilization. Supply/demand factors tell me that oil prices should stay in the $30 to $60 per barrel range for the majority of the time over the next business cycle.

Remember, over the long term, pipelines receive their revenue from volume throughput, not oil or natural gas prices per se. Now, it is correct that oil prices drive drilling activity, which influences oil pipeline throughput. But the long-term driver of pipeline utilization tends to be demand, rather than actual supply. 

Client X: I hope you are right for the long term, but following this massive downward shift in MLP market values, I sense we may be on the verge of some significant dividend cuts. At least that is what the market is “telling” us. As you highlighted in the conversation on high-yield bonds, we may also be on the verge of some weaker oil companies declaring bankruptcy. Why should we hold our current MLP exposure? 

Bill: As you know, I take historical comparative information into account when thinking about valuation and factor relationships. The last time oil prices collapsed, as they have over the last 18 months, was the period of June 2008 to February 2009 – during the Great Recession. Oil prices declined by 70 percent over that period, similar to the environment we are currently experiencing. During the previous decline, less than 25 percent of MLP companies reduced their dividends. Capital was extremely scarce during the Great Recession – much tighter than the current environment. So I believe using the previous cycle may be a good “worst case” comparison when thinking about the potential for dividend cuts.

Client X: Ok, I buy that thought process. Using that thought process, what is your “worst case” scenario for dividend cuts this cycle?

Bill:
Recently, Kinder Morgan, a highly levered pipeline company cut their dividend by 75 percent due to cash flow problems. The Alerian MLP index carries a dividend yield of 11.4 percent. If 25 percent of all MLP’s cut their dividends by 75 percent the index would then yield 9.3 percent, following the cuts at current market prices. This is my current “worst case” scenario given known factors. Think about it this way – you may earn 9.3 percent or better on your money with MLPs if you can stand shorter term rice volatility levels, which will undoubtedly occur if dividend cuts commence.

Client X: Those are strong yields. My financial plan is calling for an average annual return of 8 percent. Under your analysis, I can make that return simply by holding MLPs – even through projected potential dividend cuts. But the changing landscape and price volatility continue to concern me. What are my alternatives?

Bill:
Well, we talked about the high-yield bond arena last week. But let’s take a look at yield comparables given the potential lower dividend yield from MLPs.

 

 

Current Yield

Current Yield Spread of MLP

Historical Yield Spread of MLP

S&P 500 Index

11.4%

N/A

N/A

MLPs – following potential div. cuts

9.3%

N/A

N/A

10-Year U.S. Treasury Notes

1.9%

7.4%

3.1%

Real Estate Investment Trusts

5.2%

4.1%

1.7%

 

A little explanation. The “spread” data above compares MLP yields following the outlined dividend cuts mentioned above to 10-year Treasury notes and to REIT investments. Even including these dividend cuts, MLPs would still yield more than double the historical relative yield compared to both 10-year Treasuries and REITs than has been the case on average over the long term (1996 – 2015). It seems a lot of bad news has been built into this market.

Client X: Dare I ask – since your analysis is suggesting potential further downside in MLPs as dividend cuts occur, should I sell my MLPs at this stage?

Bill: My answer depends on your ability to absorb further price volatility and your time horizon. If my “worst case” scenario comes to pass, price volatility (declines) may be in store. On the other hand, MLPs own oil and gas pipelines – these are solid, real strategic assets. Our economy can’t function without them. They are somewhat irreplaceable – think of the political hurdles placed in front of the Keystone pipeline buildout. So, if you are a buyer of strategic, irreplaceable assets which are crying out for capital, then MLPs are an asset class which need attention. Bottom line, price volatility will probably continue, but if you have a longer-term investment time horizon, MLPs appear to be very cheap assets.

Client X: Ok, I will hold my current MLP position. What are the factors which will indicate that the smoke is clearer from the battlefield – that the risks you have outlined have lessened?

Bill: First, oil price volatility should lessen. If the Saudis make an announcement that they are cutting production, I suspect MLP prices (and oil prices) could spike on the upside. If we see some stability towards China’s economic growth, oil prices may stabilize. If U.S. production rates slows more rapidly than my outline, prices may stabilize. In other words, there are a number of variables which could change the oil supply/demand picture fairly quickly. In those scenarios, MLP prices should move to the upside, and possibly fairly quickly.

Client X: Ok – it seems there are a number of reasons MLP prices may stabilize and increase. On the other hand, if broad-based dividend cuts are in the offing, MLP prices may suffer further. Is that the scenario?

Bill: Yes, but remember current values, as expressed by current dividend yields, are discounting some very bad news.

Client X: Bill, I appreciate your views and time. At the end of the day you believe the current market volatility has led to some real potential investment opportunities.

Bill: Yes. Given the expectations for continued near-term volatility, now may not be the time to add to your existing positions. That of course depends on the size of your current allocation and risk tolerance. Importantly though, and assuming you can tolerate what is likely to be a bumpy ride for the next few months, it doesn’t seem to be the time to sell either, as MLPs have been pretty well beaten up. I would say to those investors that have remained on the sidelines with MLPs that I sense there are some real opportunities to initiate positions in the high yield and MLP spaces. As always, I appreciate your time, patience and business.


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