This fierce bear market in oil, energy stocks and Master Limited Partnerships is showing more and more signs of bottoming. While our initial timing has been early, we have been suggesting allocating funds over a period of time so one can invest through the cycle bottom. Our experience from the 2008-9 decline was that those who tried to pick the precise bottom, ultimately, were discouraged when they missed the bottom, and, then, never made the allocation and missed the whole new bull market. During this subsequent bull market, our client MLP composite returned 469% or 38.5% annualized from November 2008 to September 2014, before management fees.*
Midstream MLPs are tax advantaged utilities that own and operate transportation, storage, and processing assets. These are stable fee based businesses whose earnings historically have been largely insensitive to commodity prices. As an asset class, MLPs are quite similar to real estate. Both are hard assets which generate income through rents or fees. Both provide attractive stable income, income growth and capital appreciation with long term attractive return profiles. However, like all assets, neither real estate nor MLPs are immune to market cycles. This current 75% decline in oil–where West Texas Intermediate oil declined from $107/bl to $26/bl–has led to a boom-bust cycle in US shale production which has driven a 58% decline in MLP total return performance.
The energy industry has been aggressively cutting capital expenditures, head counts, and dividends to adjust operations to the new oil price environment. As the energy industry continues to downsize, earnings will stabilize and production will decline. The oil surplus will begin to abate. This retrenchment is the bust side of a boom-bust cycle. In addition to production capacity reductions, demand will begin to rise driven by new export markets for liquid natural gas and oil. MLPs will increasingly experience price appreciation and capital inflows, creating a virtuous circle of lower cost financing which will help to grow MLP operations, earnings and distributions.
We see similarities in the current MLP cycle with the boom-bust cycles during the financial crisis of 2007-9. Following the technology bubble and bear market of 2000-2003, the Federal Reserve lowered interest rates leading to booms in housing, stocks and commodities. Back then, housing had a nationwide boom which ended in a bust between 2006 and 2010.The stock market had a boom which ended in a 55% decline in the S&P 500 from 2007 to 2009. Oil prices peaked at $145/bl in June of 2008 before collapsing to $31/bl in December of 2008. MLPs peaked in July 2007 with a yield of 5.37%–based on the AMZX capitalization weighted index–before declining 50.6%. When MLPs bottomed on November 27, 2008, in the wake of the Lehman Brothers bankruptcy, their yields had risen to a peak of 15.25% up from, the aforementioned, 5.37%.
On February 11th, when rumors that Chesapeake Energy Corp. (CHK) had retained bankruptcy counsel caused a panic in the MLP sector, the MLP index traded to a bottom at 792.80 and a yield of 12%. As we wrote on January 25th, oil bottomed on January 20th at $26.55/bl days after Iran began exporting more oil, as a result of sanctions relief as part of the Iranian nuclear deal. Increased coordination among OPEC members in capping production suggests higher oil prices in the second half of 2016, when lower US production combines with a more constrained international production environment.
In 2009, oil prices rebounded to $80/bl in December of 2009, up over 158%, over the trailing twelve months. During that time, the capitalization weighted MLP index rose 74% and Income Growth Advisors’ asset class composite rose 97%. MLP yields are currently 9.43%, down from 12%, on February 11th. A simple return to 5% yields on MLPs would lead to nearly a doubling from today’s prices. Whether that takes 12 or 24 months is academic, investors should enjoy a very high return either way. If investors fail to start allocating to this sector, we believe they may miss a great opportunity to accumulate a growing tax advantaged income investment at compelling prices.
From a market timing stand point there are several positives that suggest we are now bottoming and investors should be allocating money to the sector:
• Warren Buffet’s Berkshire Hathaway Inc. (BRK-A) reported that it had invested in Kinder Morgan, Inc. last December. Also during the fourth quarter of 2015, Alan Tepper of Appaloosa Management took stakes in several MLPs and oil stocks. Both are billionaire value investors who have demonstrated great skill in identifying distressed asset prices and have world class investment records.
• January 20th appears to have been a low in oil prices at $26.88/bl. This occurred when Iran had begun shipping unrestricted oil and rumors swirled that oil prices would plunge to the teens based on fears of full US storage capacity. With no place to store oil, there would be no commercial bidders, and this would lead to a sudden plunge in prices. This event would be short lived, however, because the collapsed oil prices would lead to a sudden shuttering of production capacity, which would then lead to the market rebalancing.
• On February 11th, rumors that Chesapeake Energy, Corp. (CHK), the second largest natural gas producer in the US, would file for bankruptcy sent shock waves through the market. The Chesapeake rumor hit Williams Companies, Inc. (WMB), which is being bought by Energy Transfer Equity, LP (ETE). Both have been an enormous disappointment since the deal was announced this fall, with both stocks off 56% and 65.5% for WMB and ETE, respectively, and leaving Williams Partners, LP (WPZ), orphaned in a brutal environment.
• On December 8th, 2015, Kinder Morgan, Inc. cut its dividend 75% shocking the market and leading to a stunning capitulation. With this draconian dividend cut from the iconic midstream energy leader, the market came to fear the worst in this “safe” sector.
• The rate of decline in oil has abated as has the rate of decline in MLP prices. Individual stock price patterns appear to be bottoming, too. When securities cease to decline in the face of bad news, it suggests that the worst case has been discounted. As the fourth quarter’s earnings are reported for MLPs with their soft earnings, reduced distribution growth rates, and widespread capital expenditure cuts, the bad news appears to be fully priced in.
• Lastly, the yield spread between MLPs and the 10 year US Treasury notes is near historic highs last seen near the market bottom in 2008-9. MLPs currently yield 9.43% versus 10 year US Treasuries which yield 1.74%. You need six times as many US Treasuries as MLPs to generate the same income! This differential significantly overcompensates for the additional risk of a wisely selected MLP portfolio.
Another method of evaluating cycles examines capital inflow and outflows in a sector, as well as, trends in assets under management (AUM). Under this methodology we have seen a boom bust cycle in MLPs, and now, are on the cusp of growing capital inflows on a monthly basis, after a huge decline in inflows.
The boom in MLP funds over the last seven years illustrates huge growth in aggregate assets under management in MLP ETFs and mutual funds. In the period from 2009 until 2014, MLP fund AUM grew from $4 billion to $63 billion in 2014, and then subsequently dropped to $36 billion.
Quarterly MLP inflows grew from about $1 billion to nearly $5 billion per quarter before inflows started dropping in 2014. In the third quarter of 2015 MLP funds were experiencing net outflows.
The chart below suggests that we saw an uptick in inflows in January.
The chart below overlays net MLP inflows annually with the corresponding price charts for MLPs and oil.
We believe today’s corporate restructurings are giving give way to operating normalcy. This brutal period of weak MLP prices, tied to declining oil prices and MLP outflows, is starting to reverse. The negative feedback loop of lower oil prices, driving weaker economics, earnings, and MLP prices is turning to a new positive market cycle. One certain factor to help drive this phenomenon is the unusually high yields which MLPs offer relative to 10 year US Treasuries. With more inflows into the sector, the cost of capital will decline which will reduce MLP operating expenses. Lower capital costs will help earnings, which will help MLP prices, which will attract more capital and provide financial options that have been prohibitive in recent months. All of these factors point to the beginnings of a new bull market cycle for Master Limited Partnerships.
As always, we recommend investing through our separately managed accounts (SMAs), and not through funds or ETFs. While funds are popular, they do not offer the transparency of our SMAs nor do they capitalize on the tax advantaged structure of MLPs. Our direct MLP or SMA investment structure provides nearly a 30% return differential between our MLP separate account aggregate performance and that of MLP funds. Our primary custodians are Interactive Brokers and US Trust Bank America Merrill Lynch.
Sincerely,
Tyson Halsey, CFA
- see performance dislaimer
- *See SMA performance versus AMLP.