With oil and gas prices slipping, rumors among the investment community about the demise of MLPs have surfaced. However, after an exciting windfall of recent transactions in the MLP market, there is a clear signal to investors that there is money to be made in the midstream MLP energy sector.
The current environment has presented a prime opportunity for investors focused on long-term assets, as fear and uncertainty in the investment community have left many scrambling out of the energy sector. This market irrationality has opened up opportunities to buy key assets at great discounts compared to other asset classes. Therefore, the 2015 energy market has favored MLPs because an oversupply of crude oil and natural gas will mean a greater need for transportation pipelines and storage terminals in the near future.
Although following 20 years of steady growth, MLPs are no longer the emerging assets of the investment landscape. With attractive distribution growth from six years of very low interest rates, MLP investors have now come to expect not just yield, but yield plus growth.
Transactions raise optimism
After the recent deal-making on the MLP market, there is a clear indication of low valuations. Among these deals, the most notable included MPLX’s acquisition of MWE, which offered a 32 percent premium, WMB’s rejection of a takeover bid from ETE, and rumors of several smaller-scale deals, the MLP sector is booming.
This recent flurry of M&A illustrates an undervalued sector due to the drop in energy prices in 2014. Although the energy sector has rebounded somewhat in recent months to lift MLP prices, these recent large acquisitions have gotten the attention of investors. Particularly considering that even when the price dropped last year, the Alerian MLP ETF yielded 7.3 percent compared to a 2.2 percent average for 10-year U.S. Treasuries.
Low valuations and low prices
With recent increases in the prices of larger MLPs, most entities on the market are still trading at historical discounts. There is still an abundance of discounted options that could get even cheaper with increasing interest rates. As MLPs are a step removed from price volatility of the energy sector, they do not feel the hit of price volatility. For instance, between 2014 and 2015, crude prices dropped 60 percent while MLP prices only fell 20 percent. Although MLP yields increased because production did not slow down. With production expected to increase, M&A in the midstream MLP market is will accelerate. This is due to the fact that the larger firms are using the short-term economic downturn to buy assets at discounted rates and consolidate their positions.
With prices falling last year, production did not drop as companies identified cost-effective production strategies. This meant that cap-ex remained at healthy levels, which is expected for the next three years. Furthermore, with the rumored rate hikes, MLPs are more likely to experience short headwinds that will not significantly affect future performance as it will for higher-yielding equities and equity-like securities.
The primary reason for its low volatility to rate hikes is that most MLP dropdowns have minimum volume commitments, which offer investors a clear outlook on future cash flows. However, MLPs are also attractive because GPs will continue to collect incremental cash flow from MLPs, and as the MLP grows, it will generate a multiplier effect on distribution growth.
Market volatility is a short term risk for MLPs as opposed to other high yield asset classes because they are not directly tied to oil exploration and production. So for long-term investors, the midstream market is in the in-between stage with many entities expected to have record distributions within the next two to three years. Prime examples of this buy-low growth potential include WMB, which has a forecast three-year CAGR expected to be 15 percent, ETE is expected to raise distributions by 31.2 percent within three years, and a new company like ENLC is expected to grow dividends by 16 percent per year for the next three years.
Reason for optimism
The MLP pull-back has created significantly lower valuations for high quality firms. As the U.S. shale and natural gas industries continue to become a game-changer in global energy, there will need to be more infrastructure build-out. So with the recent sub-par performance of MLPs, there are opportunities in steep discounts to net asset value for income-oriented investors. Ultimately, between the high dividends, tax-deferred status and capital appreciation of MLP units, MLPs should continue to be among the top performing asset classes.