Monday Mailbag: Commodity Prices, Hostile Alien Invasions, and Other MLP Investing Fears
What fears are keeping MLP investors pacing their bedrooms at 2am?
You mean besides commodity prices, commodity prices, and commodity prices? Here are the four (and a half) concerns we hear about the most as well as how to address them so that you can get some sleep at night.
1. Crude Contagion
Of course we’re beginning with commodity prices. When US oil production grew in 2012 by 852,000 barrels per day—the biggest year-over-year jump in US history—investors, management teams, analysts, and talking heads alike all couldn’t get enough of talking about the Energy Renaissance. No one expected that an eventual consequence of that supply increase would be crude prices falling 50% in a six-month span. With oil now trading below $50 per barrel, upstream MLPs have cut distributions, capex budgets, or both. While midstream MLPs generally have little or no direct commodity price exposure, they can be indirectly impacted as volumes fall or grow at a slower pace.
1a. NGL Prices
The following is from my colleague Emily Hsieh:
“Keep in mind that crude oil is not the only commodity impacted by crude oil prices. NGL prices are tied to crude oil prices as well. The entire processing and fractionation business is based off the idea that natural gas-based feedstocks are cheaper relative to crude-based feedstocks. Yes, natural gas-based feedstocks are still the cost-advantaged feedstock, but the magnitude has shrunk. We’re definitely not seeing 20-times-plus crude-to-gas ratios anymore. With frac spreads down, G&P MLPs could face some pressure. Yes, many are moving towards fee-based models, but there are still plenty of keep-whole and POP contracts outstanding.”
Solution: Carefully choose which MLP subsectors make sense for you in 2015. Research G&P names to find which have the highest fee-based percentages. If you choose to invest in supply-dependent energy businesses like gathering and processing, look for those companies with multi-year, fee-based contracts and/or minimum volume commitments. Companies operating closer to demand centers will also have an advantage.
2. Rising Interest Rates
Investors stopped fearing the impact of rising rates on MLPs as the 10-Year Treasury yield fell below 2%. Some assume rates will rise in 2015 and that any effect is already priced in, while others believe a rise in rates is too far off to worry about right now. History has shown that an unexpected rise in interest rates usually has near-term adverse consequences for MLP unit prices, both because they are considered by some to be fixed-income substitutes, but also because their growth is aided by cheap financing for acquisitions and organic growth projects.
Solution: MLPs with above-average distribution growth tend to do better in rising rate environments. MLPs with long-term, fixed-rate debt and/or the ability to finance a significant portion of their projects internally (via high distribution coverage ratios) are less likely to feel the consequences of more expensive credit. And in the event of a credit crunch, the 17 investment grade energy MLPs will still have access to capital. They are, in alphabetical order, Boardwalk Pipeline Partners (BWP), Buckeye Partners (BPL), DCP Midstream Partners (DPM), Enable Midstream Partners (ENBL), Enbridge Energy Partners (EEP), Energy Transfer Partners (ETP), EnLink Midstream Partners (ENLK), Enterprise Products Partners (EPD), EQT Midstream Partners (EQM), Magellan Midstream Partners (MMP), ONEOK Partners (OKS), Plains All American Pipeline (PAA), Spectra Energy Partners (SEP), Sunoco Logistics Partners (SXL), TC PipeLines (TCP), Western Gas Partners (WES), and Williams Partners (WPZ).
3. Keystone XL
The Senate will vote on this in the coming days. Republicans have the votes to pass it; Obama’s said he will veto it. (TransCanada (TRP) is throwing up its hands in exasperation.) While this is a frequently discussed topic, whether the pipeline is built or not is pretty neutral for the space as a whole. At this point, most analysts and investors have written it off entirely. So, if the project is cancelled, it will make news but not waves. If it does get built, the impact on the energy infrastructure investment marketplace will be marginal.
Solution: Just relax, man.
4. Black Swan
Personally, this is my biggest fear. The events that have moved the MLP space the most haven’t been anticipated, not even by the smartest guys in the room. Everyone talked about Peak Oil, right up until the day we talked about the Energy Renaissance. MLPs weren’t (and aren’t!) strongly correlated to commodity prices over the long term, but that hasn’t stopped investors from panicking since June. Other low probability, but potentially adverse developments could be: reduced capital markets access, dramatic fund flows away from energy infrastructure, breakthroughs in renewable energy technology, dissolution of the partnership structure in the US, heavy-handed environmental legislation, terrorist attack closing the entire Gulf of Mexico, or hostile alien invasion. Some of these are more likely than others.
Solution: Your overall portfolio should be diversified, but so should your MLP/midstream energy portfolio. Remember that MLPs are still equity securities, and that long-term investors have generally been rewarded for riding out periods of volatility.
Investors care about 2015, but midstream MLPs are a long-term investment in the build-out of North American energy infrastructure. It is an investment measured in years, not months. Even if 2015 is the intermission, it’s not the end of the show.