MLP Insights: Q1 2016
Following a nearly 33% downturn in 2015, MLPs have started off the new year down another 12%1. Many funds that invest in MLPs have experienced dramatic increases in volatility, as they no longer have the benefit of a buffer from accrued taxes. In addition, midstream MLPs, which typically operate toll road business models to insulate themselves from modest changes in commodity prices, have now become highly correlated to oil. While many investors are understandably concerned about their MLP holdings, we believe the underlying real assets that comprise a midstream MLP can ultimately withstand the cyclicality of energy markets, and even continue to generate strong cash flow despite a distressed environment for oil and natural gas.
- Asset heavy industries such as pipelines tend to perform poorly when business conditions are unfavorable
- The longevity of these real assets help them retain long term value across business cycles
- Investors who wait out the current volatility could be rewarded with high yields and normalization of value for these assets
In this volatile energy environment, it is common for investors and analysts to obsess over daily energy prices and extrapolate their impact on future MLP cash flows. As many have pointed out, low oil and natural gas prices can close wells and put energy producers out of business, resulting in lower supply and therefore less business for infrastructure MLPs. At distressed levels, such as we are seeing now, each tick in oil prices can heavily influence the supply stream, as producers teeter between covering their variable costs and falling short. But it’s important to remember what midstream MLPs fundamentally are: real assets, often pipelines and storage facilities, with long-term operational lifespans, and often local monopolies.
Entities comprised almost entirely of tangible assets such as factories, infrastructure, or real estate, often struggle to adapt in a slowing business cycle. While a software company can quickly pivot or scale its business, a pipeline cannot change course without huge amounts of capital expenditures. This means that investments with high tangible assets are often hit harder in adverse economic conditions than more malleable firms. Stocks with very low price-to-book ratios, which tend to have higher tangible assets as a percent of their overall market cap, fell by 89% during the financial crisis, while high price-to-book stocks (those with less tangible assets) fell 44%2. MLP investors have now witnessed this first hand as we reach the lowest energy prices in nearly a decade, and there is little MLPs can do about it.
While the rigidity of tangible assets can be a weakness in downturns, it can also be one of their greatest strengths. Often, their long operational lifespans allow them to ultimately endure the ups and downs of business cycles. Unlike a software company, which can quickly become obsolete or watch its value leave with a top programmer, a pipeline requires only some baseline maintenance to remain operational and ready to reap the rewards in a turnaround. Since the low point of the recession, stocks with very high tangible assets returned 1176%, while companies with very low assets returned 149%3.
Therefore, for investors with longer time horizons, we believe holding on to high quality durable assets and outlasting the current turmoil is a more desirable approach than taking losses and leaving the asset class in the midst of a downturn. More specifically, we believe focusing on the large cap midstream MLP space will position investors in the highest quality infrastructure assets with lower leverage and more diversified businesses, making them in our opinion, the best positioned to withstand a prolonged energy glut.
Moreover, even at these distressed energy levels, midstream MLPs have largely been able to maintain high yields and strong operating performance despite adverse market conditions. Midstream MLPs have an indicated yield of 9.49%, representing over a 750 bps spread over 10-year treasury bonds4. This high yield can provide a source of income when most yields still remain low, as well as ease the pain of waiting for a recovery in energy prices. In addition, the spread looks attractive from a valuation perspective, when compared to its five-year average of 421 bps5. From an operating perspective, midstream MLPs continue to outperform expectations. In Q3 2015, market-capitalization weighted earnings before interest, taxes, depreciation and amortization (EBITDA) averaged 2.6% higher than consensus expectations, and 7.8% higher than the Q2 2015 figures6. While some midstream entities have cut distributions to shore up their balance sheets, the average distribution increased by 2% in Q3 2015 versus Q2 20157. While EBITDA and distribution growth could come under pressure with a prolonged cycle of cheap energy prices, we believe the real assets underlying a midstream MLP will ultimately recover their value, and the historically high yields delivered from the MLP business model are an attractive form of compensation while waiting.