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MLP Insights: Q4 2019

Jan 8, 2020

View all Rohan Reddy's ArticlesRohan ReddyRohan Reddy

In recent years, Q4 has not been kind to midstream energy, and 2019, so far, has not been an exception. Yet despite shorter term headwinds, like tax loss selling pressure, we remain optimistic for the asset class over a longer time frame as fundamentals and valuations continue to contradict recent price trends. In this piece, we discuss a variety of relevant near- and medium-term topics affecting the midstream energy space, including:

  • Seasonal Q4 selling pressure affecting near term returns: the energy sector’s underperformance made it a prime target for tax loss harvesting, leading to near term headwinds
  • Fundamentals show strong corporate performance that defies price movements: industry fundamentals like revenues, coverage ratios, & earnings remain on solid footing, but certain basins and upstream counterparties could introduce challenges
  • Outlook for 2020 remains optimistic: A variety of improving macro factors, receding technical pressures, and solid operating results leads us to a positive 2020 outlook

Seasonal Q4 selling pressure affecting near term returns

The decade-long bull market left few sectors behind, but Energy was the outlier, with the sector underperforming the S&P 500 by over 82% the last five years.i Strong performance across broad equity indexes and fixed income left little opportunity to tax loss harvest, or sell investments at a loss to offset realized gains in other areas of one’s portfolio. With Energy underperforming, however, much tax loss harvesting was concentrated on the sector and its sub-industries like midstream oil & gas, amounting to substantial selling pressure on the sector around year end.

mlp midstream performance

Related to tax loss harvesting, negative fund flows in the MLP space also applied selling pressure to the space. Over $3 billion left MLP funds in the trailing 12-month period, including more than $1 billion in outflows over the past 3 months.ii Considering MLP funds manage $45 billion in assets for an asset class with ~$450 billion in free float market cap, fund flows can impact share prices in the near term.iii Flows are not being felt equally across the industry, though. At Global X, our two MLP ETFs saw a combined $114 million in net inflows during this timeframe.iv Investors may be growing increasingly wary of underperformance from active managers, high fees, or exposure drift.

mlp fund flows

Fundamentals show strong corporate performance that defies price movements

Despite near term selling pressures, the midstream energy complex’s fundamentals have routinely defied price movements. US oil production grew by 10%, crude exports grew by 6%, and liquified natural gas exports nearly doubled, utilizing nearly all pipeline capacity to transport oil and gas around the country.v Dividend coverage ratios for the asset class are cushioned by 30% on average and price-to-cash flow valuations are trading at early-2016 levels of 5x when oil prices were hitting rock bottom.vi This leaves room for potential multiple expansion, but sentiment is detracting from the operating results.

With strong cash flows and low valuations, private equity firms are circling the space for buyout opportunities. But these seemingly positive catalysts have not resulted in a sustained rally.

Midstream fundamentals enjoyed a sustained boost from increasing US energy production, but there’s evidence the hypergrowth period of production may be subsiding. Shale production experienced outsized technological gains in this period that enabled oil & gas to be drilled more economically. As with any maturing industry, however, growth was bound to level off at some point, and we believe this is contributing to some of the share price declines in midstream.

oil production

natural gas production

Certain basins were challenged too, with rig counts falling more drastically in those regions. The Oklahoma plays were hit by reduced capital spending and a rig drop off exceeding many of the other basins. Oklahoma midstream companies were hit harder than their peers in the index. Devon Energy (DVN) is no longer running any rigs in the STACK play in Oklahoma, crippling midstream entity, EnLink Midstream (ENLC), in the process. Enable Midstream (ENBL), another Oklahoma focused midstream company, took the brunt of this reduced Oklahoma activity too, and is underperforming its peers. These challenges seemingly overshadowed positive basin stories like the Permian, where nearly 4.7 million barrels were produced in November versus just 4 million the same time last year. Marcellus shale gas production grew 5% from last November.vii This illustrates the importance of diversifying midstream exposure across firms and basins.

rig count

Outlook for 2020 remains optimistic

In light of the fourth quarter jitters, and a rocky year overall, it’s easy for investors to become disenchanted with midstream. But the valuations and fundamentals continue to paint a compelling picture.  Midstream is one of the most undervalued asset classes across the equity universe. And the strength of the cash flows and dividend coverage makes for a more positive asset class outlook in 2020.

Upstream counterparty risk & commodity prices remain our top concerns, but we’re optimistic for multiple reasons. A drilling slowdown appear already priced in and financiers are limiting capital issuance to upstream producers in search of free cash flow and returning capital to shareholders. Drillers will be forced to live within their means and take more prudent economic steps. Breakeven drilling levels keep falling, which helps support higher production. Most new wells can run profitability with oil trading between the high $40’s and low $50’s, and existing wells can cover operating expenses at $27-$37 a barrel across basins.viii The Saudi Aramco IPO also supports higher oil prices, as evidenced by the additional 500,000 barrel cut by OPEC+. Between a stabling global economy, a weakening dollar, a bottoming interest rate cycle, and limits on output, there are many reasons to believe the commodity markets will support stable oil prices, potentially providing the much needed confidence to revalue the MLP and midstream space higher.

 

Related ETFs

MLPA: The Global X MLP ETF invests in some of the largest, most liquid midstream Master Limited Partnerships (MLPs).

MLPX: The Global X MLP & Energy Infrastructure ETF is a tax-efficient vehicle for gaining access to MLPs and similar entities, such as the General Partners of MLPs and energy infrastructure corporations.

Please click the fund names above for current fund holdings. Holdings are subject to change.

Category: Articles

Topics: MLPs

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The information presented here is for informational purposes only. It was prepared on information and sources that we believe to be reliable, but we make no representations or guarantees as to the accuracy or the completeness of the information contained herein. All expressions of opinion reflect Global X’s judgement as of the date set forth above and are subject to change. This information is not intended to be individual or personalized investment or tax advice. Please consult a financial advisor or tax professional for more information regarding your tax situation. Global X Management accepts no responsibility for the conclusions and decisions clients make utilizing this information.

Investing involves risk, including the possible loss of principal. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Investments in securities of MLPs involve risk that differ from investments in common stock including risks related to limited control and limited rights to vote on matters affecting the MLP. MLP common units and other equity securities can be affected by macro-economic and other factors affecting the stock market in general, expectations of interest rates, investor sentiment towards MLPs or the energy sector, changes in a particular issuer’s financial condition, or unfavorable or unanticipated poor performance of a particular issuer (in the case of MLPs, generally measured in terms of distributable cash flow). The Global X MLP funds invest in the energy industry, which entails significant risk and volatility. The funds invest in small and mid-capitalization companies, which pose greater risks than large companies. MLPA and MLPX are non-diversified.

The potential tax benefits from investing in MLPs depends on the MLPs being treated as partnerships for federal income tax purposes. If the MLP is deemed to be a corporation then its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution to the fund which could result in a reduction of the fund’s value.

MLPA has a different and more complex tax structure than traditional ETFs and investors should carefully consider the significant tax implications of an investment. MLPA is taxed as a regular corporation for federal income tax purposes, which differs from most investment companies. Due to its investment in MLPs, the fund will be obligated to pay applicable federal and state corporate income taxes on its taxable income, as opposed to most other investment companies. The fund expects that a portion of the distributions it receives from MLPs may be treated as tax-deferred return of capital. The amount of taxes currently paid by the fund will vary depending on the amount of income and gains derived from MLP interests and such taxes will reduce an investor’s return. The fund will accrue deferred income taxes for any future tax liability associated certain MLP interests. Upon the sale of an MLP security, the fund may be liable for previously deferred taxes which may increase expenses and lower the fund’s NAV.

Carefully consider the Funds’ investment objectives, risks, and charges and expenses before investing. This and additional information can be found in the Funds’ summary and full prospectuses, which may be obtained by calling 1-888-GX-FUND-1 (1.888.493.8631), or by visiting www.globalxetfs.com. Please read the prospectus carefully before investing.

Global X Management Company LLC serves as an advisor to the Global X Funds. Global X Funds are distributed by SEI Investments Distribution Co., which is not affiliated with Global X Management Company or any of its affiliates. Solactive Indexes have been licensed by Solactive AG for use by Global X Management Company LLC. Global X Funds are not sponsored, endorsed, issued, sold, or promoted by Solactive AG nor does this company make any representations regarding the advisability of investing in the Global X Funds. Neither SIDCO nor Global X is affiliated with Solactive.