MLPs declined sharply in the second quarter due to Federal Reserve tightening and declining oil prices. The equity income market has been under pressure since the Trump election with the Federal Reserve continuing to unwind its unprecedented financial crisis stimulus. Oil prices dropped following the May 24 OPEC meeting as market concerns shifted to stubbornly high inventories and growing incremental supply from the US, Libya and Nigeria. This weakness presents a déjà vu buying opportunity for MLPs because their cash flows and distribution yields are not directly tied to oil prices. During the oil bear markets of 2009 and 2016, we watched oil prices drag MLPs down before they had impressive yield reversion-snapback rallies. While oil’s recent 20% decline is a fraction of the historic 2008 and 2015 declines, many MLPs offer significant total return prospects because their high yields will buoy high returns. We view this pullback as an opportunity to build portfolios of growing high yield energy infrastructure assets. This decline offers a similar opportunity, since in 2009 and 2016, those investors who used weakness in oil prices to buy MLPs, experienced returns on the order of 50-100% when MLP yields reverted to their historic yields.
To fully appreciate the weakness in the MLP sector, the chart below shows the relative strength of MLPs versus the S&P 500 and the pronounced weakness in MLPs in an otherwise strong equity market.
The under-performance of MLPs to the broader market should reverse in the coming months as MLPs report solid earnings and the oil market comes into balance. The chart below shows the persistent outflows from equity income funds since the November election. In May the added pressure of declining oil prices led to outflows in MLPs funds.
On a day to day basis, midstream MLPs prices are correlated to oil prices. Over longer periods, MLPs are correlated to production and transportation volumes on which midstream MLPs generate their fees. The US fracking boom led to robust growth in US oil production and MLP performance from 2006 to 2014. With the collapse in oil during 2014-2015, US production volumes declined as high cost producers and overly leveraged MLPs were wiped out. Following oil’s bottom in January 2016, US oil production began to recover as did MLPs. This recent decline offers an opportunity to buy these stable high yielding partnerships knowing that US production is expected to grow. US fracking technologies are helping domestic producers grow their share of the global energy market.
Below is a one year chart of the Alerian MLP Index, which shows how weakness accelerated in the second quarter.
Below is a five year chart of the Alerian Index which shows the decline related to the collapse in oil from July 2014 to January 2016, the snapback rally and current base building behavior.
Below are some of our favorite yield names.
American Midstream Partners, LP (AMID, $13.25)-is a midstream MLP focused primarily on natural gas processing, gathering and transportation. Following its March 8th merger with JP Energy, AMID has experienced a 30% decline despite indications it will raise its distribution in the second half of 2017. With a yield of nearly 12.85%, we think AMID could generate a 50% total return over the next 12 months.
Teekay Offshore Partners, LP (TOO, $3.02)- is an international specialized shipping provider of marine transportation, oil production, storage services and floating accommodation. The contract cancellation of the Arendal Spirit, prompted a negative Morgan Stanley report that appears to have had some large analytic oversights, led to a 61% decline (4.39 to 1.67) in the last two months and followed by a 80% bounce (1.67 to 3.02) in the last two weeks. As concerns of a distribution cut or liquidity event dissipate, this 15% yield partnership could also generate a 50% total return. We will watch this carefully.
Crestwood Equity Partners, LP (CEQP, $23.65)-is an integrated midstream partnership with operations spanning across the United States. Their operations include gathering and processing, storage and transportation and marketing, supply and logistics. Crestwood is recovering from a distribution cut in 2016 and a balance sheet restructuring. Operations appear solid and its 10.8% yield suggest this could be a solid total return MLP.
Energy Transfer Equity, LP (ETE, $18.14)- is one of the largest and most diversified investment grade master limited partnerships in the United States. Under the direction of industry icon Kelsey Warren, this more levered MLP is a favorite aggressive blue-chip choice. ETE yields 6.35%.
Kayne Anderson MLP Investment Co. (KYN, $19.11)- is our favorite closed end MLP fund. We know the management of KYN and they are top tier professionals. Given that it uses leverage and yields 9.4%, I think this is an excellent retirement plan investment.
We could own all five for an aggressive portfolio yielding nearly 11%.
Our performance shown below demonstrates consistent outperformance to the MLP benchmark and significant long term outperformance to the S&P 500. We believe recent under performance is due to our more aggressive portfolios and general MLP weakness. From these levels we anticipate attractive returns, as MLPs snap back from recent underperformance.
Separately Managed Accounts (SMAs) versus MLP Funds:
To best capitalize on MLPs’ investment attributes, we recommend investing in separately managed accounts (SMAs) and avoiding MLP mutual fund structures. MLP mutual funds and ETFs are subject to taxation of approximately 30% defeating the unique benefit of the corporate tax-free structure of Master Limited Partnerships. This out-performance is illustrated below and in our attached presentation.
The Case for Separately Managed MLP Accounts
The 9.83% performance differential (10.64% vs. 0.82%) between our MLP SMAs to the Alerian MLP (AMLP) illustrates a compelling reason to invest with Income Growth Advisors, LLC. Our meaningful out-performance is not unique to the $10.3 billion dollar Alerian ETF but all MLP funds.
For basic income and total return minded investors, we offer our MLP SMA strategy through our prime brokers US Trust/Bank America/Merrill Lynch, Interactive Brokers and Folio Institutional. Given the improving domestic energy market, this is an excellent time to allocate to MLPs. Income Growth Advisors, LLC offers a clear pathway to an attractive, growing and tax advantaged income stream which is ideal for retirement and investment diversification.
If you have any interest in discussing specifics regarding the strategies outlined in this letter, please feel free to contact us.
Tyson Halsey, CFA