Dewitt Capital Management Blog

Recent activity in the MLP energy infrastructure space is showing a lessening of the correlation between MLPs and the price of oil.   This correlation with oil created a dramatic drop in the Alerian MLP index, from August of 2014 into the middle of February this year, when the prevailing thinking on Wall Street was that MLPs were a surrogate for oil.

What has changed is that investors are starting to realize that MLPs are more than just about the price of oil.  They are beginning to recognize that these are operating business involved in the ongoing and necessary transportation, distribution, fractionation, and storage of natural gas, natural gas liquids, and oil.  Cheap oil only increases the use of oil.  As one of my baby boomer clients noted, RV sales are going through the roof as baby boomers set across the country in their gas guzzling Winnebagos because gas is cheap.  That means it would only be natural to process and transport more refined products, not less.

In addition to that, the use of natural gas is rising as a fuel for electrical generation.   Natural gas is rapidly replacing coal and nuclear, as exports to Mexico continually increase, and LNG exports build to Europe and Asia.  Coming up is a dramatic increase in the use of ethane as billion dollar petrochemical plants get built and placed into service in the Southeast, Northeast near Pittsburgh, and all the way up in Ontario, Canada. Business is looking better for MLPs.

-Dave

MLP earnings season has been very positive for the vast majority of companies. Volumes across many pipeline systems held up better than many observers expected. The rig count has increased for 7 straight weeks as producers are starting to drill again. Many of these rigs have been placed in the Permian Basin in Texas, as it’s very profitable in this basin for many producers at the current oil prices. The MLPs that operate in the Permian also fared well during earnings calls. On the natural gas side, the Marcellus and Utica shales also showed strong volume growth for several of the companies we are invested in. The recovery in natural gas liquids (NGLs) prices was discussed by many MLP management teams and they believe NGL pipelines will see strong volume growth and increased earnings over the next several years. Much of the NGL recovery will be driven by increased ethane pricing due to numerous petrochemical facilities coming on-line that will significantly increase demand for ethane.

Another notable development is that several MLPs have entered into joint ventures on major pipeline projects. This helps fund other projects and also improve the balance sheet, which the market has viewed as favorable. Another benefit of joint ventures is that it helps prevent overbuild in certain shale plays as other projects are cancelled. The largest deal occurred when Sunoco Logistics and Energy Transfer sold a 36.75% stake in their Bakken pipeline for $2B. This move repaired balance sheets and a competing pipeline was cancelled as a result of the deal. All in all, we view this earnings season as very positive.

DeWitt Capital focuses on MLPs that benefit from the increased production and use of natural gas (methane). This weekend over 200 million Americans will experience temperatures over 90 degrees.  This means electrical generatation will have to rise to meet the need for air conditioning.  Natural gas is the one fuel that represents a path forward that is both readily available and reduces carbon emissions versus the other readily available resource, coal.

Exports of natural gas to Mexico is are growing quickly, tripling  over the last three years with expectations of doubling over the next two years.  Liquified natural gas is beginning to ramp up as import facilities have been converted  to export facilities!

Although MLP stocks prices have largely traded in line with oil over the last twenty four months, that correlation is beginning to break down. We have noticed lately that MLP prices are starting to chart their own path. Natural  gas and natural gas liquids (ethane and propane) are seeing a resurgence in both demand and pricing.  DeWitt continually researches the energy infrastructure universe to discover those companies that benefit from these trends. Eventually the market will reward the increasing cash flow generated by these companies while investors enjoy the ample distributions they provide.

When I read and hear people complaining about getting a miserable 2 percent on their money and struggling to find a livable cash return on their income portfolio, I wonder why they don’t add Master Limited Partnerships that are yielding on average 8 percent. Here is the good and the bad:

First the good: as I just stated, the average yield is about 8 percent and the dividends on most MLPs have risen every year for the last three decades. Not only is it rising, but the dividend is about 80 percent tax sheltered on average, varying for the different MLPs. The investment is in America’s energy infrastructure so it has no foreign competition. The business is composed of hundreds of thousands of miles of pipelines, along with storage facilities, processors, and other related businesses. It is an investment in the management of the fuel that runs America. It provides reliable steady income and this should be no surprise.

Now the bad news: Today the prices of MLPs have been wildly volatile. The whole sector has traded as if it were a biotech stock. It all depended on the price of oil. And over the last year, some actually eliminated their dividends and some went bankrupt. And those MLPs gave the whole sector a huge black eye.  In 1991, MLPs were businesses engaged in the transportation business (pipelines.) Today, there are MLPs that drill for oil and dig up sand for fracking. The oil drillers have gone bankrupt and investors lost almost all of their money.

DeWitt Capital Management invests in the companies that manage the throughput. So whether the price of oil was up or down, we still had to move oil and gas and get it to the consumer. Did you stop driving your car when oil was cheap? Did jets stop flying? Did the 18-wheeler pull off the road? No, there is still energy demand and so the MLPs managing the throughput keep paying out dividends.

An MLP portfolio can be designed for people at various stages of life. Pre-retirement, post retirement, and later retirement portfolios can be crafted for every need at every stage of life.  Someone who is still working but looking for more capital appreciation could invest in a professionally selected portfolio of MLPs that could potentially raise their distributions quickly and thereby drive the price of those MLPs quickly. By the time the investor reaches retirement age, the portfolio should be paying out rising income at a higher level.

An investor who has recently retired and who is invested in a portfolio of low yielding municipal bonds or government bonds and stocks, could switch part of their portfolio to higher yielding MLPs that have the ability to raise distributions over time.  Because of the tax deferred nature of those distributions, their tax could be lowered while at the same time, have spendable income increased.

Someone further on in life may want to spend more time with the grandkids and family members at a vacation home or engage in travel.  However, the yields on government bonds and municipals being as low as they are could cause some discomfort.  The solution:  Invest in a portfolio of high yielding and conservative MLPs that provide high income with most of the income tax sheltered.  The retiree can enjoy years of tax sheltered income, enjoying time with their friends, family and grandchildren.  When the client passes these MLPs onto their children, the deferred tax bill is eliminated.

After 25 years of investing and tracking Master Limited Partnerships, DeWitt Capital knows the MLP world inside and out.  We can build an MLP portfolio to suit each individual at every stage of life.  See what you and your clients are missing by not investing in America’s energy infrastructure!

The business of America’s energy infrastructure is not subject to competitive threats from overseas and will not be outsourced to China! It is everywhere around you, operated by Americans, and keeps America moving.  This sector belongs in everyone’s portfolio.

New investors reviewing the recent performance of MLPs might be scared off for good. But the reality is that market volatility is not quite what it seems, because MLPs have maintained or boosted distributions despite a collapse in oil prices. According to a Think Advisor interview with Jeremy Held, director of Research & Investment Strategy for ALPS Portfolio Solutions, to the patient go the spoils.

“Long-term investors, if can they can withstand the volatility … will be rewarded for staying the course in the asset class,” Held explained.

What new investors need to look for in MLPs
The most important thing to keep in mind for new investors looking into the MLP space for the first time is that fundamentals matter more than oil commodity price volatility. In the long term, the fundamentals for MLPs, particularly midstream companies, will remain intact because demand for oil will continue to be prevalent. So too will the growing need for energy infrastructure.

This is the reason why midstream MLPs have withstood oil price drops in the last two years. For instance, oil prices ranged from $92 to $117 a barrel and distributions increased by 7.3 percent in 2013, while oil prices dropped to between $59 to $106 per barrel and distributions improved by 6.8 percent in 2014. This has been further evidenced in the last 12 months as oil has dipped to about $43 to $60 a barrel, but distributions have increased by 7.5 percent. In fact, midstream distributions have increased by 1.9 percent in Q2 2015, up from 1.5 percent Q1.

Therefore, new investor concerns about declining oil commodity prices need to be put into context. What matters most is the stability of the distribution, something midstream MLPs have maintained in all market conditions.

MLPs as a hedge for savvy investors
MLPs offer investors real assets that act as a great hedge against inflation and market conditions. This is due to the fact that most midstream MLPs have long-term contracts that are indexed for inflation. In fact, MLPs operating pipelines were allowed to raise their fees 4.58 percent. In July, federally-mandated tariff increases were implemented for pipelines, which include the Producer Price Index. Therefore, with oil prices likely to stabilize with the domestic production boom combined with the increasing demand for oil, midstream MLPs are positioned for growth in the next few years.

The bottom line is distribution growth
MLPs are down by over 18 percent since January, making many lose faith in the sector. New investors see the record lows in oil prices, and may be scared off from the energy sector as a whole. But it is important to note that the Alerian MLP Index has grown by 4.3 percent this third week of August, showing that the sector has recovered a substantial portion of the losses it incurred with the price collapse.

Supporting this rebound is Darren R. Schuringa, chief investment officer for Yorkville Capital, who explained that midstream MLPs are yielding 7.5 percent. What this means is that the pullback in the sector was not related to the fundamentals of these midstream companies. So with these midstreamers unaffected by market volatility, distributions have been maintained and exceeded.

For context among new investors to the sector, the spread between MLPs and U.S. Treasuries is a good comparison. This is due to the fact that historically, when spreads between MLPs and U.S. Treasuries have been wider than 5 percent, MLPs produced positive returns over the next twelve months 100 percent of the time. This is what makes the current market conditions a great entry point for new investors.

But when infrastructure MLP distributions are put under review, it is clear that with 11.5 percent growth year-over-year, investors are provided with high yielding assets that are volatility resistant.

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.