Income Growth Advisors’ MLP Separately Managed Accounts (SMAs) rose 22.09% for the trailing twelve months ended this past April. This performance declined with oil’s price from the exceptional 79.05% or 57.08% annualized returns posted in February and March. This month’s letter will describe the decoupling of MLP prices to oil prices and what will drive MLP performance in the future. We will also touch on why MLPs are an attractive asset class, why their investment prospects remain compelling, and why MLPs are especially attractive in this investment environment when compare to other asset classes.
Our SMA MLP Investment Performance:
People invest with us and in MLP for investment performance. Since inception on December 31, 2000, our separate accounts have returned 15.21% annually after fees outperforming the S&P 500 by 9.92% and the Alerian MLP Index by 2.59%. Over the last 10 year, 5 year, 3 year and one year periods, we have outperformed the Alerian MLP Index by 4.98%, 5.90%, 5.64% and 8.01% respectively. When our separate account performance is compared to popular MLP mutual funds and ETFs, our out-performance is even more impressive.
How MLPs and Oil Correlate:
MLPs historically enjoyed the reputation of stable utilities with toll road business models that were immune to changes in the price of oil. This perception was dismantled in the 2014-2016 oil crash. Until 2008, MLP’s performance have been driven by their high distribution yields and the distribution growth rates. The sum of these two drivers closely correlated with MLP returns. This formulaic relationship explains the consistent mid-teens MLP returns since 2000. However, with the 2008 financial crisis and the boom and bust cycle of the US shale industry, MLP performance started to correlate with oil prices.
In the financial crisis of 2008, oil prices declined from $145/bl to $31/bl and MLPs dropped 50.6%. The shale or fracking boom in the United States drove growth in US oil production and high single digit distribution growth rates in the MLP sector. However, the shale boom’s success led to an over capacity in oil in 2014 as the United States began producing oil at rates comparable to Saudi Arabia’s 10 million barrel per day. This led to a paradigm shift in the oil markets and disrupted the basic drivers of MLPs.
The chart below shows US oil production through its boom and bust cycles. MLP prices closely tracked US oil production and oil prices during this boom bust cycle.
The chart below shows the US MLP aggregate market capitalization which tracked the growth of the US shale industry. Over-capacity and over-production led to a decline in oil prices, reduced production and a bottom in oil and MLP prices in February 2016.
Our Outlook for Oil and MLPs:
We expect that the Trump administration’s pro-energy policies will lead to solid oil production growth which drive distribution growth. Currently, MLPs yield on average about 7% and their distribution growth is in the 3-5% range implying an industry wide return potential of 10-12% annually. We see more attractive opportunities with higher yields and greater distribution growth prospects which can drive 20-30% annual returns. Additionally, MLPs’ current yield spread to US Treasuries suggest 10-15% appreciation potential over the next two years as yield spreads normalize.
At Income Growth Advisors, we focus on MLP selection to outperform our benchmarks. As the oil patch heads to full recovery and we see many smaller capitalization companies and special situations where we anticipate significant upside as these opportunities are, again, priced as bankable income securities.
We continue to focus on smaller names and MLPs that are more leveraged to the most productive and efficient shales including the Permian Basin and the Utica Marcellus. We also see opportunities in MLPs whose distributions have been cut, but whose MLP price has been unfairly penalized relative to their distributable cash flow profiles. We also research specific companies whose operations appear to be poised for a healthy recovery in cash flows.
MLPs Offer Attractive Return Prospects:
MLPs yield in the 6-8% range. In this historically low interest rate environment, MLPs’ high yields will continue to drive solid returns. In a world with $8 trillion in negative interest rate debt, capital will flow to high yielding securities with stable or growing franchises like MLPs.
US equity markets are expensive based on Nobel Laureate Robert Shiller’s work. While his Cyclically Adjusted Price Earning or (CAPE) valuation metric is not a precise timing tool, it does show that the stock market is near peak valuation levels similar to 1929 and 2008, though not as high as its historic peak during the technology bubble of 2000.
Consequently, MLPs with their attractive yields and growth prospects offer an compelling return proposition, especially when compared to today’s expensive stock and bond markets.
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 outperformance is illustrated below and in our attached presentation.
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 still improving energy market, this is a good time to allocate to this income sector. MLPs offer a clear pathway to an attractive, growing and tax advantaged income stream for retirement and investment diversification.
If you have any interest in discussing this letter or investments, please feel free to contact us.
Tyson Halsey, CFA