Oil and MLP Prices – Upward Push Sustainable?
As most know, I have been a proponent of investments within the MLP space. I wrote on the subject twice over the last year – on July 20, 2015, and again recently on February 8. In both cases I urged clients not to sell shares, and instead, if appropriate, to think of purchasing additional exposure. Since July 20, 2015, MLP prices declined by a whopping 30.2 percent, but have risen by 20 percent in value since my latest piece reiterating my positive stance on the asset class.
Now, both oil and MLP prices have rebounded sharply from the lows seen last month. Through close of business last Friday, March 11, the Alerian MLP Index had rebounded by 24.7 percent from its closing low on February 11. In like fashion, oil prices have also rallied upwards over that period, by 28.8 percent, moving back above $40 per barrel (Brent).
Question: Is this the start of a new, sustainable upward push in commodity prices and oil related share prices, or is this a big head-fake with eventual downside pricing pressure reasserting itself sometime in the near future?
I am going to throw out a few factoids and attempt to create a weight of the evidence approach to answering this question. Also, I am fully aware of the fact that MLP dividends are not driven by commodity prices – but the perception of future growth of those dividends to one degree or the other is related to petroleum prices. Ergo, the tie between oil and MLP prices.
The Bullish Argument for Oil and MLP Pricing
On the bullish – or positive side of this question for continued higher prices:
- Smart money has been moving into the MLP space over the last few months. For example:
- Warren Buffett, the “Oracle of Omaha” announced that Berkshire Hathaway was purchasing shares in several MLPs. This purchase program also included shares in Kinder Morgan. Additionally, the Oklahoma Teachers Retirement System also announced the purchase of various MLP shares.
- SL Advisors has announced that by their calculations, almost half a billion dollars of insider purchases have taken place within the MLP space over the previous 12 months. I have long held the view that insiders sell stocks of their own company for various reasons – estate planning, tax payments, etc., but they typically buy shares for only one reason – they believe the stock is undervalued. Of course, it is widely believed insiders, by definition, know their own company’s status more thoroughly than outsiders.
- Plains All American issued $1.6 billion in convertible preferred units to a group of private equity investors that were already invested in Plains and therefore knew the business well. The purchasing group included EnCap Investments, First Reserve and Stonepeak Infrastructure Partners.
- During the fourth quarter of last year, various other knowledgeable investors or insiders increased their MLP holdings – including Crestwood Equity Partners, Energy Transfer Equity and Tallgrass Energy GP.
- The huge decline in oil prices since the fourth quarter of 2014 has been driven by a supply/demand mismatch. U.S. producers had ramped oil production to about 10 million bbls per day. New Oil was threatening the Saudi’s global market share. Since that time, most OPEC members have been producing flat-out, driving prices downward as supply was swamping demand. Everyone knows in commodity-land when this occurs, prices are going to fall.
- U.S. production (and other, non-OPEC producers) has throttled back production over the last nine month period. U.S. production alone has declined by 400,000 bbls per day since last summer. The chart below (courtesy of our friends at Ned Davis Research) shows the stunning reality – current global demand growth for oil is now in balance with supply gains. This isn’t to say that the total market’s supply/demand picture is in balance – there is still too much inventory left on the market, but the overall supply/demand picture has become brighter.
- There is an old saw which states if you find yourself standing in a “hole” which you do not wish to be in, the first rule in “hole” management is to stop digging. It appears global production growth has stopped “digging”.
Historically, when these markets come back into balance (currently the market appears to be heading in the right direction) what have oil prices done?
- Note the next chart. The blue line represents oil prices while the red line is the change in demand relative to the change in supply. When the red line is moving upwards, it indicates a period when demand growth is outstripping supply growth. This change in supply/demand dynamics normally leads to an increase in the commodity price – in this case oil.
- In regards to MLP cash flow generation rates, the stuff from which dividends are paid, first quarter results are not yet in. However, few MLPs cut dividends during the fourth quarter of last year. Since then, oil prices have pushed upwards by more than 10 percent. It is also good to know that oil prices traded at an average price of $54 per bbl during the first quarter of last year. Now at $41, the “comparable” oil price decline has become less blistering than was the case during most of last year.
- The largest single-country economy in the world, the United States, has shown signs of GDP growth acceleration. Consumption spending, housing and the jobs market are all pointing towards possible GDP growth acceleration as 2016 unfolds. Demand for petroleum products in the United States should continue to show a nice uptick.
So, there are a number of indicators suggesting the majority of the current upward move may indeed be sustainable, and MLP pricing may hold as we move forward.
The Bearish Argument
On the bearish – or negative side of the oil price and MLP price question, I can list the following factors:
- Global economic growth, the stuff which drives oil demand and prices, is weak. Indeed, the International Monetary Fund, (IMF), normally a cheerleader of economic optimism, is warning that global growth is going to be weak this year. Indeed, China’s export growth rate has declined, Europe’s and Japan’s economies look flat and the emerging (non-China) economies are struggling to maintain some semblance of growth. Of the major economic powers, only the United States is showing a renewed upward push in economic activity.
- Iran is coming back on-stream. Few know how rapidly their production is going to ramp to the upside. Some believe Iran will bring an additional 800,000 - 1,000,000 bbls per day to the marketplace by the end of 2016. If this happens, much of the rebalancing between supply and demand growth would evaporate and the world would be back in a well-oversupplied basis once again.
- China’s economic growth is an unknown in the analysis. China’s appetite for oil and other commodities is unknown as they have acted as a major “swing” driver of marginal demand for oil over the last few years. We suspect their banking system is highly levered, with bad debts which need to be rationalized (written off) and the banks overall need to be recapitalized. China has experienced significant capital flight from domestic investors, which has acted as a dampener to overall monetary policy. China is truly a wildcard which can’t be accurately measured. This leads to the inability to truly measure future demand trends for many commodities, including oil.
- From a technical standpoint, oil prices may be struggling with severe overhead exposure between $42 and $47. While I’m not a slave to technical analysis, it is good to understand investor psychology and possible selling pressures if the current upward trend starts to reverse.
- Longer term, it is apparent to most that commodity prices in general, and oil prices in particular, have entered a new secular bear market – which probably started in 2011. This bear market is now almost five years old. Counter-trend rallies are part of secular bear markets of all types. The current upward move in oil prices could simply be a technical rebound. In which case, the upward move probably doesn’t contain longer term legs.
I’m sure there are other lucid arguments on both the bullish/bearish side of this discussion. But I believe the outline above covers most current arguments both for and against higher oil and MLP prices over the short/intermediate term.
MLP investments – particularly long haul midstream pipelines, are strategic assets. What I mean by that is they are assets without which our economy would struggle. They are irreplaceable. Witness the political brouhaha which occurred recently when considering the Keystone pipeline.
MLP investments pay handsome dividends. The Alerian MLP ETF has paid 11.24 percent dividends given current market value and trailing 12-month dividend payments. The real question which I have come to grips with is the sustainability of the dividend payments on high quality, lower levered MLP pipeline operations.
If we see MLPs cut dividends going forward, given what I know today, I suspect those dividend cuts shouldn’t be terribly corrosive. In 2008-2009 less than 25 percent of MLPs cut dividends. Assuming the MLP space is facing a challenge at the same magnitude as was the case in 2008-2009 (oil price collapse combined with a lack of financing availability) I think we could see dividend cuts so MLPs on balance could yield +8 percent following the dividend cuts.
I know of few investment alternatives which yield +8 percent and hold strategic, irreplaceable assets. I remain bullish on MLPs.
I have taken a week vacation – when you read this my family and I are in the Caribbean, soaking up some sun. I will be back in two weeks.
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