Oil and natural gas MLPs in the midstream sector generate returns by transporting the commodities, so they are much less affected by the price of oil. Still though, market speculators have overreacted to the decline of MLPs this year, despite their steady returns, thus putting many midstream companies to be on sale.
Comparing the performance of midstream and upstream sectors
Midstream companies are the MVPs of the MLP sector because they operate on long-term fee-based contracts that act as toll-roads. This business model enables them to not only get paid, but to make steady distributions. In turn, as midstreams are removed from oil prices, they are concerned with the volume and distance oil travels through pipelines. Oppositely though, upstream companies are not as resistant to oil commodity prices. According to a Rig Zone interview with Hinds Howard, CBRE Clarion Securities’ vice president and senior financial analyst, upstream companies have higher volatility.
“Hedges rollover and higher levels of debt catch up with cash flow,” Howard explained. “Reserve redeterminations based on lower commodity prices create more cash flow constraints. All of that leads to distribution cuts. After almost every upstream MLP cut its distribution, it will be hard for any MLP to regain the confidence of the market. So, I would say they are structurally challenged and increasingly irrelevant for MLP investors.”
Further, Howard noted that the midstream companies that experienced the oil rout have as good a chance of recovering nicely after rebounding but without the same level of risk as upstreams.
Two prime examples of midstream companies performing well are Enbridge Energy Partners LP and Plains All American Pipeline LP. Enbridge Energy Partners has underperformed in the last 12 months, as it dropped 15 percent over the previous month. Despite these dropps, though, Enbridge is still offering unitholders an 8 percent yield. Two advantages Enbridge has on the midstream market are that it can deliver both light and heavy crude through its pipelines, and it has a vast network of pipelines that afford it the opportunity to transport oil to a wide range of markets including eastern Canada, the Northeast U.S., the Midwest and the Gulf Coast. So while it is down 25 percent this year, the company generates 80 percent of its income from fee-based contracts, and the rest of its revenue is hedged with storage facilities. These factors combine to ensure steady cash flows for investors.
On the other hand, Plains All American Pipeline is down 14 percent this month, but still offers a 7.6 percent yield. One of the primary benefits Plains All American has in the midstream sector is that it transports crude oil and natural gas through its pipelines from the most productive basins in North America. Although, it also has a diversified revenue stream by storing oil and natural gas, which positions it for a competitive advantage in a market with a glut of cheap energy supplies. In turn, Plains All American benefits from volatility in oil prices because it generates revenues on the spreads between commodities prices in North America.
Cramer sees bullish markets for midstream MLPs
Mad Money’s Jim Cramer speculated recently that midstream MLPs were attractive, even as the Alerian MLP ETF Index hit four-year lows. Cramer commented that a combination of stabilized oil prices and the slowing world economy – that could force the Fed to hold off on rate hikes – have made midstream MLPs an intriguing investment opportunity now. One of the reasons for MLPs is that they offer generous returns as compared to bonds, as the average yields are 7.8 percent. Although Cramer noted that MLPs, even midstream companies, rebound strong after they drop. For instance, since the recession, midstream MLPs have provided a 40 percent return after hitting lows. So, while midstream companies are significantly undervalued, it is important to pick the right companies. Fortunately for investors, the sector has plenty to offer.
Bottom line for investors
Ultimately, investing in high-yield securities may seem to have an excess of risk attached to the assets, especially when they are in volatile markets like energy commodities. But there is no shortage of market overreactions when it comes to the midstream MLP sector. Particularly when most companies have steady cash flow and expect to continue to cover distributions in the near-term. This is why some market analysts are turning bullish on MLPs because even as upstream and midstream companies melted down, there was still plenty of value in the midstream sector. In fact, it is expected that the higher performing midstream MLPs will benefit from rate hikes, which makes the low prices they are trading at now look like bargain buys. The reason for this continued profitability of midstream companies is that as the economy gets healthier, these MLPs will transport and store higher volumes of crude oil and natural gas, thus passing down higher income to investors from their increased cash flows. This is not a benefit that bonds, with fixed coupons, can provide.