The outlook for MLPs continues to strengthen. After two dismal years, MLPs bounced back in 2016 and the Alerian MLP Index generated a total return of 18.3%. It was an especially notable performance when considering the Alerian Index’s plunge of -28.2% to start the year. Higher commodity prices drove the strong performance, investors moving back into the energy sector and the widely held view that the Trump administration will emphasize developing energy infrastructure. We expect the same factors to provide a tailwind to MLPs as we move into 2017. The underlying business fundamentals have improved significantly over the last several months as commodity prices have rallied and US producers have added rigs and increased drilling budgets for 2017. This bodes well for the MLP sector as more drilling will lead to additional volumes in the pipelines without much capital investment from the MLPs. A major driver behind the increase in oil prices was a deal among OPEC members and Russia which agreed to cut global production by 1.8 million barrels a day or nearly 2% of global production. This cut led to oil surging to over $50 a barrel and is expected to accelerate the rebalancing of global inventories. Natural gas prices also enjoyed a strong 2016 driven by increased domestic demand, the startup of a Liquefied Natural Gas (LNG) export facility, and increasing exports to Mexico. With the improvement in underlying fundamentals and MLPs trading at a discount to historical valuation metrics, we believe this represents a great entry point for long-term investors.
What happened in 2016?
MLPs bounced back as underlying energy fundamentals improved over the course of the year. U.S natural gas exports by pipelines into Mexico and LNG export and a slight production decrease bolstered the outlook for natural gas prices. Oil price strength was driven by speculation of an OPEC deal and then rallied more as an actual deal came to fruition. Natural Gas Liquids (NGLs) prices increased significantly as petrochemical companies have invested billions of dollars in new facilities that will use NGLs, specifically ethane, as a feedstock. All the above are very positive for U.S energy production, and 2017 should see energy production back on a growth track. Expectations of production growth is a major benefit for MLPs as volumes/profits will increase and demand for new pipeline projects will rise. MLPs positioned in low-cost shale basins (Permian, Marcellus/Utica, SCOOP) generated strong returns as production continued to increase despite the low price environment. The Permian Basin in West Texas now produces over 2 million barrels of oil per day, and many industry insiders think production can easily double from these levels. All the new production will flow through existing pipelines, and we expect to see demand for additional infrastructure.
There were seven mergers announced during the year, and four MLPs eliminated their incentive distribution rights (IDRs). IDRs are essentially a management fee which the MLP pays to their general partner. By eliminating IDRs, MLPs lower their cost of capital which enables them to see a better investment return on projects. Distribution growth slowed in 2016 as most MLPs opted to strengthen their balance sheets by retaining more cash and paying down debt. We view the choice to reduce leverage rather than increase distributions as a positive that will ultimately make the sector stronger in the long run. MLPs got back on track in 2016, but they have a long way to go to get back to 2014 highs.
The Trump Effect
The Trump administration is shaping up to be one of the most pro-energy administrations in decades, if not ever. While information regarding exact policy is scant, many executives in the energy industry are very encouraged with recent appointments. These include former Exxon Mobil CEO Rex Tillerson for Secretary of State and former Texas Governor Rick Perry for the Department of Energy. Rick Perry was involved in unleashing the shale boom in Texas, and until his appointment, he sat on the board of Energy Transfer Partners (ETP), the owner of the delayed Dakota Access Pipeline (DAPL). The Trump Administration is adamant about developing domestic natural resources, and to properly develop them, additional energy infrastructure is essential. We believe a significant amount of red tape will be cut away with projects like DAPL (and perhaps the Keystone XL pipeline) able to move forward. President-elect Trump frequently discussed infrastructure investments during the campaign, and it is evident he understands the importance of energy infrastructure.
What to expect in 2017
United States oil and gas producers won the war against OPEC. Technological improvement in drilling led to lower breakeven costs as the United States becomes one of the global low-cost producers of hydrocarbons. Energy infrastructure will continue to play a key role in developing US Shale. We expect MLPs to continue their move upwards in 2017. Supportive policies from the Trump administration will open up drilling and create additional demand for infrastructure. MLPs with assets in the Permian and Marcellus/Utica will continue to deliver strong distribution growth with robust distribution coverage ratios.
Several MLPs are completing significant pipeline projects throughout 2017, and as they come on-line, we expect to see increased volumes as producer’s ramp up production for the new pipelines. MLPs with gathering and processing assets will benefit from the significant uptick in demand for ethane. Ethane rejection occurs when ethane is left in the natural gas stream instead of processing it; this has been a major problem over the last 5yrs as ethane prices were low and it was uneconomic to process. Nearly 700,000 barrels per day of ethane were rejected in 2016. Those rejected barrels will find new demand centers as chemical companies complete their facilities which use ethane to produce ethylene, the building block of plastics. MLPs with NGL pipelines should benefit from these increased ethane volumes.
Exports will continue to be a major theme in 2017. In the coming years, demand for natural gas exports (pipelines to Mexico and LNG) will rise to nearly 8 billion cubic feet per day, nearly 10% of current domestic production. The chart above shows the growth in natural gas exports since the beginning of the shale boom. Additional production from the Marcellus/Utica region is needed to meet the export demand. MLPs with natural gas assets in this region will benefit from the supply growth. Industry consolidation and the elimination of IDRs will continue to be a theme in 2017. It’s been a tumultuous road for MLPs since 2014, but the future remains bright as we return to growth in the energy sector. DeWitt Capital Management strives to put its clients in the MLPs participating in the growth areas and provide index-beating returns to its investors.
We remain optimistic on the MLP sector in 2017. Several major pipeline projects coming on-line in the next 12-18 months will further enhance cash-flow for many of the MLPs we invest in. Midstream management teams learned valuable lessons throughout the downturn which should lead to better capital decisions and ultimately a stronger sector overall. We are long-term bullish on the future of natural gas. The INGAA, a natural gas association, recently released a report that estimated over $500B in new natural gas infrastructure would be needed to meet supply growth through 2035. We are equally bullish on the growth in natural gas liquids such as propane and ethane. With commodity prices stabilizing and the Alerian Index yielding 7.1%, we believe MLPs off a compelling opportunity for the long term investor.