Oil and gas master limited partnerships (MLPs) have not been spared the broader pressures on the energy sector this year. The S&P 500 Energy Index has underperformed the S&P 500 by 25% so far this year, and the Alerian MLP Index has dropped 6% over the same period (and is currently yielding 8.0%).
For investors looking to buy and sell MLP stocks, daily swings in crude oil prices appear to be driving trades. This marks a big change from the past. Once considered boring yield instruments, MLPs (U.S.-based publicly traded partnerships that typically manage oil and gas pipelines) historically demonstrated higher correlations to utility stocks than to crude oil prices. This made sense, given that MLPs earn tolling fees based on volumes transported and are thus not affected significantly by the underlying price of the commodity. But today, the MLP sector’s correlation to utilities has actually turned negative, dropping to the lowest levels of the past 15 years (see Figure 1).
So what happened, and when can we expect this trend to reverse?
Looking back: An equity funding gap begets dividend cuts
From 2003 to 2007, the Alerian MLP Index and S&P 500 Utilities Index closely tracked each other, with near-identical total returns of about 165%. As the outlook for energy infrastructure spending grew increasingly positive over the following six years (ending 2013), MLPs consistently outperformed utilities, generating roughly 113% excess returns. MLPs had essentially become “utilities with better growth prospects.”
This began to change starting in 2014, when the dramatic oil price correction hurt sentiment toward companies exposed to the energy sector. With stock prices coming under pressure, MLPs found it difficult to raise the capital they needed periodically in order to execute on their growth projects. As it became difficult to raise equity capital from MLPs’ predominantly retail investor base, the outlook for distribution growth became less certain, causing stock prices to contract. This process gave rise to an adverse feedback loop: As share prices fell, equity needs grew, thereby further penalizing the dividend outlook.
Unfavorable equity markets and stretched credit metrics left many MLPs with little choice but to trim their expected distributions, resulting in a 25% cut to 2018 dividend expectations over the past three years (see Figure 2). For investors seeking utility-like returns, the sustainability of dividends is sacrosanct, and many understandably abandoned the sector.
The result has been that since 2014, utilities have benefited from the global hunt for yield securities, while MLPs have not: The Alerian MLP Index has corrected 21%, while the S&P 500 Utilities Index has gained 64%. As MLPs traded off, the spread between MLPs and utilities – which averaged 2.0% after the financial crisis – has now widened to 4.25% currently.
MLPs are becoming more “utility-like” again
In other sectors, it’s typically a sign of distress when companies cut dividends or trade at elevated dividend yields. In our view this is not the case for MLPs, which have rather paused dividends to preserve capital. More importantly, we believe MLP management teams’ mindsets have changed: They now prioritize cash retention. This is a break from the traditional MLP model, which relied on consistent equity issuance to fund growth projects. By lowering dividends to preserve cash, MLPs are evolving into stronger franchises with better credit metrics, higher dividend coverage ratios and less reliance on capital markets – actions that should make MLPs more attractive to discerning investors.
Improved confidence that the current distributions are sustainable should also help bring back yield-hungry investors. After all, 8% dividend yields would be hard for investors to ignore today – especially when supported by 88% fee-based cash flows, improved balance sheets and attractive coverage ratios. And as fundamentals continue to strengthen, we expect the MLP sector to be less susceptible to daily oil price gyrations, which would further magnify the sector’s attractiveness relative to other yield asset classes.
We don’t deny that volatility related to oil prices may persist in the MLP asset class for some time. However, conditions have fundamentally improved compared with two years ago, suggesting investors will likely embrace a more “range bound” rather than “uncertain” crude price outlook. This could make it easier for new investors to dip their toes into the sector.
Some risks bear watching
Despite the recent improvements in the MLP sector, energy markets are cyclical and subject to unpredictable swings in both supply and demand. In a recession, global demand for energy can drop significantly, leading to lower prices and reduced transport volumes, which can hurt MLPs. Geopolitical risks are also an ongoing reality, given the outsize influence of OPEC and the Middle East on the energy markets.
Additionally, proposed pipeline projects in North America require approval from the Federal Energy Regulatory Commission (in the U.S.) or the National Energy Board (in Canada) to proceed. This process can take a year or more, and pipeline projects have faced increasing opposition given environmental concerns.
These risks bear watching even as MLP fundamentals continue to strengthen.
Many investors understandably lost confidence in the MLP sector amid the changes over the past few years, but we believe patient investors willing to look past the recent volatility will likely have the opportunity to benefit.
In our view, with dividend cuts nearing an end, balance sheet repair gaining momentum and long-term prospects looking favorable, MLPs’ current valuations do not yet reflect the healing that is taking place and represent an overly negative outlook on the sector – and this creates potentially attractive investment opportunities for select MLPs. According to our analysis, MLPs as a group are trading at a material discount to historical valuations and offer potential for total returns in the low to mid-teens, supported by an 8% dividend yield. While there is no guarantee, this represents one of the most attractive secular growth stories in the market, in our view.
Value-oriented investors seeking higher-yielding opportunities may want to take a fresh look.