Income Growth Advisors’ MLP Separately Managed Accounts (SMAs) rose 3.47% for the trailing twelve months ended this past May. Although MLPs, oil and oil stocks have declined since late January, MLPs remain an excellent income and total return investment that have significantly outperformed the S&P 500 since 2000. Since 2000, our SMA MLP strategy has returned 14.22% and beaten the S&P 500 by 8.86% annually. Our returns have beaten our benchmarks and have exceeded MLP funds by an impressive margin.
This month’s letter will highlight our historic performance and the yield opportunity provided by our portfolios. We will review the MLP markets, their correlation to oil and other assets and the case for separately managed accounts over MLP funds.
IGA’s SMA MLP Investment Performance:
Since inception on December 31, 2000, our separate accounts have returned 14.22% annually after fees outperforming the S&P 500 by 8.86% and the Alerian MLP Index by 1.98%. On a 10 year, 5 year and 3 year basis, we have outperformed the Alerian MLP Index by 4.15%, 4.00%, and 5.06%, respectively. In May, our accounts declined 12.18% compared to a decline of 4.52% for the Alerian (AMXZ) index. This disappointing performance was due to a contract cancellation for one of Teekay Offshore Partner’s ships, which we will detail later.
When our separate account performance is compared to popular MLP mutual funds and ETFs, our out-performance is exceptional. Our SMA strategy has outperformed the industry leading Alerian MLP ETF—AMLP by 9.52% on an annual basis after fees–since its August 2010 launch.
IGA MLP SMA Account Yields:
Our largest account is managed for a family office and has a combination of large and small capitalization MLPs and yields 9.54%. This account holds Enterprise Products Partners, LP (EDP), Magellan Midstream Partners, LP (MMP), EQT GP Holdings (EQGP), Tallgrass Energy Partners, LP (TEP), Teekay Offshore Partners, LP (TOO), American Midstream Partners, LP (AMID) and Antero Midstream Partners, LP (AM).
Smaller accounts typically are a few hundred thousand dollars and own three or four MLPs with portfolios yielding today in the 10-13% range.
We believe that the recent weakness in the energy space will end and the high yields that many of these MLPs offer will attract new buying. 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. Below are some of our largest MLP positions and their yields:
- American Midstream Partners, LP (AMID) 13.07%
- Teekay Offshore Partners, LP (TOO) 14.05%
- Enterprise Products Partners, LP (EPD) 6.19%
- Antero Midstream Partners, LP (AM) 3.47%
- Magellan Midstream Partners, LP (MMP) 4.80%
American Midstream Partners (AMID) and Teekay Offshore Partners (TOO) have been particularly weak, offer unusually high yields and have put pressure on our portfolios this year. AMID has pulled back 34% since its January 23rd peak of $18.30/share. The last quarter’s earnings report highlighted the merger with JP Energy as being absorbed well and its distribution coverage is forecasted to be between 110-120%. We believe that recent weakness is related to general weakness in the energy complex.
For TOO, the situation is not so pristine. In its quarterly report on May 18, the company disclosed a contract cancellation for one of its ships, the Arendal Spirit. Since the company is heavily leveraged, fears of a distribution cut are weighing heavily on the company’s stock. TOO stock declined 41% last month and closed at $3.13. It is a now speculative turnaround opportunity. With the recovery in oil prices, which bottomed last January, offshore drilling economics have improved. TOO has ships which provide support services to the offshore drilling business. TOO is due to have two other ships–the Gina Krog and Libra–return to income producing status in the coming months and contribute to $200 million in additional annual cash flow from vessel operations. The investment is a turnaround from deep value levels. The company is evaluating options with potential replacement customers, its lenders, and asset transactions. If they can manage through this and our basic thesis of a cyclical recovery holds, then the company could have significant upside.
In terms of pure operating momentum, Antero Midstream Partners (AM) is a delivering great growth due to its positioning in the Utica Marcellus shales where the natural gas drilling economics are outstanding and the company appears to have several years of high growth ahead of it. Its production growth rose 22% last year and its distribution growth rose 28% on a year over year basis with 1.4 times coverage. However, their pristine story comes at a price, AM yields 3.47% which does not compare to the 13% or 14% yields of AMID or TOO. Also, within the Utica Marcellus, there are several other companies we own that are also enjoying the positive operating returns. Rice Midstream Partners, LP (RMP) and the EQT Corp., EQT Midstream Partners, LP and EQT GP Holdings, LP family of companies all benefit from the same attractive Utica Marcellus shale economics.
Market Commentary:
MLPs have been under pressure along with the entire energy complex since early February. The so-called “Trump Trade” has almost fully retraced impacting MLPs, oil and energy stocks. While this pullback has been frustrating, we expect that a bid will soon emerge and MLPs will again prove a top performing asset. The consensus opinion has been that the Trump administration will be good for the energy business. However, issues regarding OPEC production cuts and weakness in commodity prices globally have been a headwind since February. There is also concern that longer-term growth for the hydrocarbon business will be challenged by the increased use of alternative fuels and from disruptive technologies like electric cars and ride sharing technologies. However, these factors should not have a noticeable impact on oil prices until the mid-2020s.
The chart below of the Alerian MLP Index (AMJ) shows the “Trump Trade” from November 8 to early February. The Trump Trade retracement is from February about 13.7%
The five year Alerian MLP Index chart below gives a broader picture; it shows the oil collapse from 2014 through January 2016, the recovery, the Trump Trade and its retracement. MLPs look oversold in a US equity market that is extended and expensive.
We believe that MLPs’ 7.2% yields will soon attract capital and, as issues surrounding surplus oil and commodity deflation dissipate, MLPs will resume performing as a leading total return investment.
MLPs have also seen a weakening of fund flows as expectations of high interest rates and Fed tightenings have slowed demand for equity income investments sharply and to a lesser degree, MLPs.
Source: Barclays.
Over the coming months as we move through the Federal Reserve’s anticipated tightens, inflows should return to equity income investments and MLPs, in particular.
How MLPs Correlates with Oil, Equities and Treasury Notes:
Until 2008, MLPs 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 has increasingly correlated with oil prices.
In the financial crisis of 2008, oil prices declined from $145/bl to $31/bl and MLPs dropped 50.6%. At the same time, 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. Then, the shale boom’s success led to a surplus in oil in 2014 as the United States began producing oil at rates comparable to Saudi Arabia’s 10 million barrels per day. This led to a paradigm shift in the oil markets and disrupted the fundamental drivers of MLPs.
The table below shows that:
⦁ The correlation with oil is now 0.59 and up from 0.40 over the last 15 years.
⦁ MLPs are closely correlated to the S&P 500 at .60 to .65 over the last 10 to 15 years.
⦁ There is little correlation to the 10 year US Treasury Note.
Source: Barclays.
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 improving domestic energy market, this is an excellent time to allocate to MLPs. MLPs offer a clear pathway to an attractive, growing and tax advantaged income stream 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.
Sincerely,
Tyson Halsey, CFA