The surge in oil and natural gas production over the past few years have made pipelines, storage and associated energy infrastructure master limited partnerships (or MLPs) attractive bets in the energy midstream space. This is because these network providers derive a major portion of their revenues from fee-based contracts based on volume and are largely insensitive to commodity price fluctuations.
The Business of MLPs
MLPs differ from regular stocks in that interests in them are referred to as units and the unitholders (not shareholders) are partners in the business. Importantly, these hybrid entities bring together the tax benefits of a limited partnership with the liquidity of publicly traded securities.
Finally, the assets that these partnerships own – oil and natural gas pipelines and storage facilities – typically bring in stable fee-based revenues and have limited, if any, direct commodity-price exposure. This enables these MLPs to pay out fairly growing distributions.
Advantages of the MLP Structure
Higher Returns: MLPs represent an attractive investment option for income-focused investors in the current environment. In addition to high yields, MLPs are structured as pass-through entities.
This means that they typically distribute nearly all of their cash flows back to unitholders. The MLPs are not required to pay a corporate income tax as the tax liability of the entity is passed on to its owners (or unitholders) in the form of a cash dividend (distribution). This allows the MLPs to offer very attractive yields to the investors.
Low Risk: Most MLPs are involved in processing and transportation of energy commodities such as natural gas, crude oil and refined products, under long-term contracts. As such they have relatively consistent and predictable cash flows, unlike exploration and production (E&P) companies, whose profits are highly correlated with commodity prices.
Like all high-income products, MLPs also tend to react negatively to rise in interest rates initially. But research shows there is no material correlation between 10-year treasury rates and Alerian MLP index performance in the longer-term.
One of the reasons is that many MLPs use fixed rate debt for majority of their borrowings. Another reason could be that investors hold MLPs for a long time due to tax consequences and thus they do not have a significant adverse reaction to rising interest rates unlike other rate sensitive assets like utilities and REITs.
Further, MLPs have low correlations with many other asset classes including equities and commodities and thus add diversification benefits to the portfolios.
Less Sensitive to Commodity Price Fluctuations: These midstream operators are not direct oil and gas plays as they derive a major portion of their revenues from fee-based contracts depending on volume and are largely insensitive to commodity price fluctuations. Therefore, volatility should be low with this asset class.
MLPs Have Done Poorly in 2017
But so far, this year, they are doing worse than the broader market. We note that The Energy Select Sector SPDR, a popular way to track energy companies, has logged a return of -4.9% year to date, while the benchmark Alerian MLP Index is currently down a punishing 8.3% over the same period – at a time when U.S. stock markets are hitting all-time highs on a daily basis. The slide has been primarily triggered by a host of negative distribution surprises – cuts and moderations.
Of late, capital market access has remained tough and credit metrics stretched, making it difficult for the oil and gas transporters to execute on their growth projects. As a result, the distribution outlook became uncertain with a number of MLPs left with no choice but to trim their expected payouts.
And with most investors owning MLPs for the benefit of generous, periodical distributions, many have understandably abandoned the sector. A recent case in point is Genesis Energy L.P., which lost more than 3% after slashing its distribution to 50 cents per unit from 73 cents.
Fundamentals Suggest Rebound in 2018
While this year's decline in midstream MLPs unit prices has been frustrating, some investors are predicting a recovery in 2018 based on the following factors.
Strong Production Volumes Driving Cash Flows: We believe that the primary driver for the midstream operators' unit performance lies with the pace of U.S. oil production growth. And with output in the lower 48 states soaring to levels close to those from top producers Russia and Saudi Arabia, the environment looks bullish for partnerships engaged in transportation and storage of the commodity. As per EIA's latest weekly report, U.S. output rose by 73,000 barrels per day to 9.8 million barrels per day – the most since the EIA started maintaining weekly data in 1983.
Looking ahead, EIA forecasts total U.S. crude oil production to average 9.2 million barrels a day in 2017, rising to 10.0 million barrels per day next year - the most since the 1970s. The healthy production trajectory is expected to drive midstream volumes and cash flows. Cash flows should improve further with a number of high capital expenditure projects starting to come online and generate revenues.
The Trump Factor: Making good on his campaign promises to rev up infrastructure spending, President Trump signed executive orders to smooth the way for TransCanada Corp.’s (TRP - Free Report) Keystone XL Pipeline and Energy Transfer Partners L.P.’s Dakota Access Pipeline just a few days into his new Administration. With the U.S. government indicating that it will expedite approvals of future developments as part of new energy infrastructure projects.
Tax Reform: Expectations that the Trump administration’s proposed tax and regulatory reforms will allow the publicly traded partnerships to retain their current status and take the pass-through business deduction, have given investors further reasons to put their money in MLPs. Per an eleventh-hour amendment proposed by Senator John Cornyn of Texas, unitholders will be eligible to deduct 23% of the attributable income, prior to being taxed. This will effectively mean a lower tax rate for MLPs.
Attractive Valuations: The midstream sector is currently trading at their cheapest valuations in years with the high-yield securities appearing inexpensive from almost every metrics - from distribution growth to EV/EBITDA. Together with robust fundaments, the discount pricing seems to be the perfect excuse for investors to indulge in some bargain buying.
The strong fundamentals do not necessarily indicate that all energy MLPs would be wise picks. Moreover, with a wide range of partnerships thronging the investment space, it is by no means an easy task for investors to arrive at stocks that have the potential to deliver attractive returns.
While it is impossible to be sure about such outperformers, this is where the Zacks Rank, which justifies a company’s strong fundamentals, can come in really handy. In particular, we have shortlisted 5 midstream operators having a Zacks Rank of #1 (Strong Buy) or #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
CVR Refining, LP , a #1 Ranked stock, is our first pick. Sugar Land, TX-based CVR Refining is an independent downstream energy partnership with refining and associated logistics properties in the Midcontinent United States.
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Our second choice is Holly Energy Partners, L.P. (HEP - Free Report) . This Dallas, TX-based Zacks Rank #1 MLP is engaged in the ownership, operation, development and acquisition of crude oil and refined products logistics assets that support the refining operations of sponsor HollyFrontier Corp. (HFC) and other downstream operators.
Then we have Spectra Energy Partners, LP . Headquartered in Houston, TX, this Zacks Rank #1 partnership is one of North America’s largest fee-based midstream operators, primarily in the eastern U.S.
Enable Midstream Partners, LP is another MLP we recommend. Headquartered in Oklahoma City, OK, Enable Midstream – carrying a Zacks Rank of 1 – owns, operates, develops and acquires gathering and processing assets in the Anadarko, Arkoma, Tex-La and Williston basins.
Finally, there is Summit Midstream Partners, LP (SMLP - Free Report) . The Zacks #2 Ranked operator is focused on gathering, treating, and compression services in the Marcellus Shale, Williston Basin, Piceance Basin, and Barnett Shale regions.
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