Why Lower Inflation Won’t Rain on MLP/Midstream’s Parade

• Real assets, including energy infrastructure, offer a number of portfolio benefits, but may be best known for providing an inflation hedge.
• Beyond real asset exposure, MLPs/midstream typically have inflation-protected cash flows and generous yields that can also be helpful in periods of elevated inflation.
• With inflation expected to cool, it is important to keep in mind other MLP/Midstream performance drivers like dividend growth, free cash flow generation, and a strong outlook for natural gas demand. MLPs/midstream do not need high inflation in order to perform well.

While most investors allocate to the MLP/midstream space for its generous yields, real asset exposure can also appeal to investors. This has been topical given energy infrastructure outperformance amid elevated inflation in recent years. As inflation moderates, investors may be concerned that MLP/midstream performance will sputter. Today’s note discusses why inflation is often a tailwind for midstream and why energy infrastructure investors should not be spooked by expectations for moderating inflation.

Real assets, including energy infrastructure, can offer a number of portfolio benefits. These include diversification given lower correlations with stocks and bonds and potential defensiveness in periods of market volatility. Perhaps most notably, real assets are often used in portfolios as an inflation hedge and tend to outperform when inflation is elevated.

MLPs/midstream provide liquid real asset exposure given companies own and operate pipelines and other energy infrastructure. Beyond real asset exposure, midstream contracts tend to have annual inflation adjustments built into them, resulting in inflation-protected cash flows. For example, 90% of the long-term contracts for Enterprise Products Partners (EPD) include escalators to mitigate inflation impacts.

Midstream’s generous yields can also be attractive in inflationary periods as real yields decline. As of June 20, MLPs were yielding 7.4%, while a broader midstream index was yielding 5.4%.

Additionally, most interstate liquids pipelines follow the FERC Oil Pipeline Index, which sets a ceiling for annual rate increases based on the change in the Producer Price Index for Finished Goods. (Stay tuned for a separate note on this topic.)

Since 2000, there have been nine years when annual inflation was 3% or higher. MLPs/midstream generally outperformed in those years, as shown in the table below. MLPs, represented by the Alerian MLP Infrastructure Index (AMZI), modestly underperformed the S&P 500 in 2008 and 2023, but saw strong performance every year except 2008. MLPs also handily outperformed bonds every year, except 2008.

Midstream is represented by the Alerian Midstream Energy Select Index (AMEI), which is 75% U.S. and Canadian corporations and 25% MLPs. While the index history is more limited, AMEI outperformed the S&P 500 in five of the six years shown. The only exception was 2023.

Notably, MLPs and midstream have handily outperformed REITs and Utilities since 2021. Like MLPs/midstream, REITs and Utilities provide both real asset exposure and income. However, these sectors tend to be more sensitive to interest rates, with rising rates weighing on performance in 2022 and 2023. As of June 20, REIT and Utility benchmarks were yielding 4.1% and 3.0%, respectively.

With forecasts pointing to sub-3% inflation in 2026 and 2027 per Bloomberg, investors may be wondering if MLP/midstream’s strong performance run is coming to an end. While energy infrastructure tends to outperform when inflation is elevated, inflation is not the only performance driver for this space.

Notably, AMZI saw positive total returns each year between 2009 and 2014, but inflation was below 3% throughout that period, except for 2011. AMEI saw double-digit percentage gains each year from 2009 to 2014. Inflation is not necessary for MLPs and midstream to perform well.

In fact, a more important performance driver is likely dividend growth. Historically, this space has performed well when dividends are growing (read more). There has not been a cut to a regular dividend for an AMZI or AMEI constituent since July 2021. An improved dividend track record happened to coincide with higher inflation. Free cash flow generation and dividend growth represent important tailwinds for this space and can be supportive for performance going forward.

Another catalyst for midstream is the robust outlook for North American natural gas demand, driven in large part by liquefied natural gas exports (read more). Admittedly, some of this has been priced into the stocks, given the strong gains for natural gas pipeline names last year. However, with a wide range of forecasts for natural gas demand tied to power generation, there could be upside that has not been fully appreciated yet (read more). Continued project announcements could provide catalysts for the space. Even Northeast natural gas pipeline projects are potentially feasible amid a more supportive regulatory backdrop.

Finally, although the space has performed well in recent years, valuations have not become stretched as discussed last week (read more). Solid performance has coincided with EBITDA growth, which has limited multiple expansion, especially for MLPs. AMZI and AMEI are trading below their 10-year average forward EV/EBITDA multiples.

MLPs/midstream have performed well in recent years against a backdrop of elevated inflation. As inflation moderates, it is important to keep in mind that inflation is not the only performance driver for MLPs/midstream. The space can continue to be supported by ongoing free cash flow generation and dividend growth, as well as potential catalysts from natural gas growth opportunities. Importantly, valuations have not become expensive.

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AMZI is the underlying index for the Alerian MLP ETF (AMLP) and the ETRACS Alerian MLP Infrastructure Index ETN Series B (MLPB). AMEI is the underlying index for the Alerian Energy Infrastructure ETF (ENFR) and the ALPS Alerian Energy Infrastructure Portfolio (ALEFX).

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