Income Growth Advisors’ MLP Separately Managed Accounts (SMAs) rose 1.67% in July, beating our MLP benchmark and matching the S&P 500. This month’s letter analyzes the fundamental value proposition of MLPs by examining MLPs’ growing tax advantaged distribution yields and comparing those to other income alternatives. We review the tightening interest rate environment and the oil market and how these factors are impacting MLP prices. And, most importantly, to facilitate portfolio construction for our clients’ unique objectives we introduce four MLP portfolio profiles. These MLP portfolio profiles are: Blue Chip Total Return, Highest Quality, High Growth and Aggressive Growth.
MLPs are an attractive investment because their tax advantaged yield is considerably higher than other income investments. MLPs’ yield currently more than doubles that of REITs, utilities, US Treasury Notes and the S&P 500, which yield 3.81%, 3.48%, 2.19% and 1.88%, respectively. Additionally, MLPs can grow their distributions at unusually high rates, that provides a hedge against rising interest rates and inflation. This distribution growth makes MLPs less vulnerable to a rising rate environment than most income alternatives. Lastly, MLPs offer compelling expected returns. MLPs expected returns are generally calculated as the sum of an MLP’s yield plus its estimated three-year distribution growth rate. For example, today the MLP index yields 7.78%2 and has a distribution growth rates of about 5% which add to a 12.7% expected total return. In today’s historically low interest rate environment and expensive equity market, this near teen return prospect, with its high growing and tax advantaged income profile, is an attractive yield and total return option for investors.
MLP Distribution Growth Prospects:
The MLP industry is recovering and distribution growth prospects look attractive. MLPs offer an attractive combination of high current yields with potentially high distribution growth profiles. This combination will drive higher future yields and MLP prices. One reason for our confidence in the sustained growth of the US energy market is that the US has benefitted from technological advancements like horizontal drilling and fracking. These innovations have brought our energy production costs down so that we now compete with Saudi Arabia and Russia as a leading producer of hydrocarbons. The chart below shows how the US nearly doubled its oil production between 2008 and 2014, before the recent bear market and industry consolidation. Now, US oil production is returning to historic highs of 10mm/bpd with good growth prospects as it US emerges as a cost efficient and leading producer of hydrocarbons.
Additionally, the boom in fracking is producing tremendous growth in natural gas as illustrated in the chart below. Natural gas is a clean low carbon source of energy replacing coal and petroleum fed utilities. NGL production has doubled in the US since 2005.
Growth in US production of natural gas and petroleum leads to growing fees for the MLP industry which provides the infrastructure to explore, develop, gather, process, transport, refine, store and market hydrocarbons globally.
The benefit of a growing distribution is shown in the chart below where a 7% yield compounding at 5% annually per year doubles in 15 years.
MLP Headwinds–Oil and Interest Rate:
Though the value case for MLPs is compelling, the market is not recognizing their value. As Benjamin Graham famously stated, “In the short run, the market is like a voting machine…. In the long run, the market is like a weighing machine….” We believe the opportunity in MLPs is a short-term mispricing which will reward investors over the longer run. The chart below of AMJ, the Alerian MLP Index ETN, shows the MLP’s weak performance this year.
The current undervaluation of MLPs and their recent poor performance are the result of two headwinds: the 2014-2016 crash in oil prices and the current Federal Reserve policy to reversal of the unprecedented accommodation following the 2008 Financial Crisis.
Below is a five-year chart of oil prices.
The oil market, which is now stabilizing at levels more than fifty percent below its 2014 highs, is caught between the unpredictable actions of the OPEC cartel and the United States’ resurgent energy industry. Over the last decade, technological innovation, has made the US a leading oil producer. This success is stifling Saudi Arabia’s cartel discipline by replacing OPEC production cuts. This complex dynamic leaves a market that is unsure what the proper price of oil should be. Investors are perplexed by volatile OPEC policy and increasing US rig counts and stubbornly high petroleum inventories. For example, in June and July, oil prices rebounded to the $50/bl range, following a 22% decline to the low $40/bl range. Open interest for oil futures’ contracts shows that US producers are aggressively hedging oil prices in the low 50s and high 40s to lock in attractive investment returns. This institutional behavior has spawned the phrase “lower forever” and affirms the United States’ emergence as the new global swing producer. These complex oil market dynamics are keeping MLP prices low.
The other factor compressing MLP valuations is the Federal Reserve reversing its historic accommodation by reducing its massive $4.3 trillion balance sheet and tightening short term interest rates. Federal Reserve tightening cycles are a familiar process–after a few tightenings, a correction in the stock market typically results. However, the consequence of unwinding the Federal Reserve’s $4.3 trillion balance sheet, presents a unique risk to the capital markets. Due to the scale and unprecedented nature of this massive balance sheet, market reaction is far less predictable. In both Federal Reserve actions, income generating vehicles like MLPs, REITs, utilities and Treasuries will decline to align their yields with the higher rates offered in the Treasury and mortgage markets. This bearish interest rate environment should persist for about 6 years. This should be a headwind for MLP, but their distribution growth profile will help MLPs outperform other income assets since MLPs should increase their distribution yields more rapidly than any income vehicles.
The Tide is Changing:
The chart below shows the massive decline in long term interest rates since 1981, 36 years ago. We believe, as does DoubleLine bond guru Jeffrey Gundlach, that long term treasuries should revert to 6% over the next decade. During this time, the distribution growth profile of MLPs should lead to their significant out-performance compared to fixed income and equity income investments.
More ominously, we believe the extraordinary 36 years of declining rates helped drive an enormous boom in real estate prices. If rates rise as we expect, the rewardingly high real estate returns of the last four decades will decelerate and potentially lead to declining real estate values in some markets. More broadly, all global asset and securities pricing will be impacted if US Treasury notes return to a 6% yield. As we have reiterated throughout this letter, MLPs will be one of the top performing income vehicles and retirement focused investors should allocate to this unique sector while valuations are attractive.
IGA and Benchmark Performance:
IGA’s SMA returns continue to significantly outperform MLP funds and ETFs, like the Alerian AMLP ETF as shown in the performance table below:
While MLPs and our performance are down this year, we believe this is a relative performance aberration which will correct. During the 2014-2016 oil price crash, the S&P 500 has steadily moved higher to record prices and high valuation levels. Now that oil prices have stabilized and the energy industry is recovering, recent MLP underperformance to the S&P 500 should reverse as valuations revert to their respective means.
Our year-to-date performance has been disappointing due to our over weighting in smaller cap MLPs which underperformed larger MLPs. This underperformance is shown in the chart below, where the Global X Junior MLP index is plotted against the Alerian ETF.
Further, the merger of our two top performing MLPs last year, JP Energy Partners, LP (JPEP) and American Midstream Partners, LP (AMID), led a significant overweighting in AMID. AMID declined from $18.45 to $11.11/share (40%) in the first half. Additionally, Teekay Offshore partners, LP (TOO) disappointed us due to a contract cancellation which triggered a restructuring and a distribution cut. While we sold all our TOO before the distribution cut, the concerns about the distribution and a seemingly biased research report, caused our TOO holdings to also impact our performance. While, July saw a healthy rebound in AMID, much of it benefit was offset by TOO.
Second Quarter Earnings:
Now that the energy industry has had 18 months to restructure itself, since oil bottomed at $26/bl, this second quarter reporting season for MLPs appeared normal in that there were few major shocks and the sector, as a whole, appeared to be returning to normal. We saw generally uninspiring earnings in the largest capitalization MLPs like Enterprise Products Partners, LP (EPD), Kinder Morgan, Inc. (KMI) and Plains All American Pipeline, LP (PAA) as the law of large numbers is making growth more challenging. EPD’s earnings were solid and make it one of the safest MLPs investors can own. KMI impressed shareholders with aggressive distribution guidance, up 60% in 2018 and 25% in 2019 and 2020, but after its stunning distribution cut and stock crash in 2015, one would like cash flows in hand before celebrating KMI’s distribution recovery. PAA disappointed by announcing its intent to reduce its distribution so that it, too, can start directing surplus cash flows to new growth projects. PAAs distribution reassessment reflects the lingering broad impact of the collapse in oil prices and its impact on the sector.
However, several MLPs reported truly impressive earnings reports. Antero Midstream Partners, LP (AM) is the premier growth company benefitting from the Utica and Marcellus shales extraordinary natural gas economics. AM projects its distribution growth to be between 28-30% for 2018-2020 off a 3.78% yield after reporting net income up 75% and adjusted EBITDA up 59% with distribution coverage of 150%. MPLX, the MLP under Marathon Oil, reported adjusted EBITDA up 35%. It has robust growth opportunities in the Marcellus, Permian and STACK and forecasts 12-15% distribution growth in 2017 off of its 6.56% distribution yield. Noble Midstream Partners, LP looks to be another great growth MLP. It yields 4.14% and reported its adjusted EBITDA up 28% q/q (sequentially) with 190% distribution coverage. NBLX has premiere holdings in the Permian Basin and DJ Basin and Barclays forecasts its EBITDA to grow at 119% CAGR from 2016 through 2019.
Our higher yielding small cap MLPs reported promising operating results. AMID which yields 11.96% announced several transactions consolidating its acquisition of JP Energy and disposing of low growth businesses, like its sale of its propane business to fund higher growth investments like Panther and the Cayenne Pipeline with Targa. AMID forecasts a material increase in EBITDA in 2018. Crestwood Midstream Partners, LP (CEQP) yields 9.66% is continuing its asset and balance sheet restructuring by expanding its Delaware Permian partnership with First Reserve with Shell Midstream Partners, LP (SHLX). Crestwood raised earnings guidance for 2017 and is positioned to resume distribution growth in 2018.
MLP Portfolio Profiles:
In response to client interest, we began creating MLP portfolios profiles to facilitate constructing client portfolios and models with the risk and return objectives that they desire. As different clients have risk tolerances, these MLP portfolio profiles help us construct individual portfolios in a manner that best suits our clients. This process has provided some valuable insights into the whole range on MLPs we cover and should help our performance going forward.
The four models’ objectives are:
- Blue Chip Total Return-which are large MLPs with high distributions and growth prospects,
- Highest Quality-the safest MLPs with the lowest risk profile,
- High Growth-those MLPs most likely to benefit from growth in natural gas and petroleum over the next five to ten years.
- Aggressive Growth-the riskier MLPs with the highest return profiles, but may include those MLPs with significant balance sheet and business risks.
Our profiles allow us to more effectively review the MLP universe. By imposing different investment disciplines across our coverage universe and then comparing those MLPs within the same profile, we get fresh ideas to help security selection for our clients’ objectives. For example, our Highest Quality analysis refreshed the Boardwalk Midstream Partners (BWP) story. BWP is the Lowes Corporation MLP which cut its distribution in 2014, but now appears to have restructured its operations such that they should be able to increase their distribution in upcoming quarters. Likewise, our High Growth profile refocused our attention on Shell Midstream Partners, LP (SHLX) whose IPO pricing was priced for perfection due to the massive portfolio of assets Royal Dutch Shell would be able to push down to the MLP when it went public in 2014. Now, two years later with a 4.54% distribution, SHLX’s income growth prospects can finally drive this MLP higher now that the bear market in energy is over and its income and growth profile look competitive.
Warren Buffet once compared his investment philosophy to hockey’s great Wayne Gretsky, who said, “I skate to where the puck will be.” In the years ahead, the odds suggest interest rates will rise and those who look to their investments for income would be well advised to look to MLPs whose prospective distribution growth will allow those investors to collect an attractive tax advantaged income stream while holding onto an income asset that will likely significantly out-perform fixed income and equity income investments. A portfolio of MLPs with growing distributions should lead to comfortable income and significantly better prospects for capital preservation than traditional income vehicles.
Tyson Halsey, CFA
- FTSE NAREIT All Equity REITS 3.81%: http://www.ftse.com/Analytics/FactSheets/temp/7ec30af0-a3e9-4a0e-b248-b129371dc8ec.pdf S&P Utility Index Yield 3.48%: http://us.spindices.com/indices/equity/sp-500-utilities-sector US Treasury 10 year note 2.19%
- S&P 500 yield SPY distribution 1.88%.