July 2015: A Tough Month for Energy Investments

Master Limited Partnerships performed poorly in July as weakness in energy prices and concerns about the Federal Reserve tightening in September contributed to continued weakness in this sector. Financial concerns with Greece, Puerto Rico, and China’s equity market collapse exacerbated the market decline. Lastly, a number of leveraged MLP closed end funds had to liquidate MLPs to manage the risk of their leveraged positions creating a feedback loop of forced selling into a panicked market.
Benjamin Graham famously wrote, “In the short run the market is a voting machine, in the long run, it is a weighing machine.” Presently, the MLP market is concerned about a number of factors and the intrinsic value of MLPs is being overlooked. On one hand, we on Wall Street say, “Never try to catch a falling knife.” On the other hand, Warren Buffet’s buying strategy is “be greedy only when others are fearful.” Considering all these fundamental and psychological factors, now is a very good time to buy MLPs.
There are three fundamental factors weighing on Master Limited Partnerships. First is the declining price of oil. Second is weakness in natural gas prices. Thirdly is the prospect of higher interest rates as the Federal Reserve contemplates ending its near zero rate interest rate policy in September.
• On oil, we believe the major decline in the price of oil is over, but that the current weakness in oil prices is related to Saudi Arabia’s increasing production and fears of Iranian oil hitting the world market with the end of sanctions following the Iranian nuclear deal. More importantly, however, like all commodity cycles, low prices shut down inefficient producers and current prices will start reducing global production, as it did earlier this year.
• Natural gas has been weak for a while, but as 2015 ends, the US will begin to export LNGs and the surplus supply will begin to shrink as consumption increases from power companies, chemical factories, and foreign demand.
• Lastly, interest rate tightening cycles often see the bulk of their market impact in the early stages of the cycle. This time is no different. Bonds, utilities, REITs, and MLPs have seen declines in the 10-20% range thus far this year. That suggests a market adjustment for greater than a quarter point on the short end of the yield curve has already been priced in.
MLPs are a compelling income story. Currently, they yield 6.8% and that yield will grow! Our basic valuation case is: Expected Returns = Current Yield + Dividend Growth. Due to weakness oil and gas prices, there is a pause in the growth of the US shale boom which collapses the Dividend Growth factor. Historically, MLPs have enjoyed 10% distribution growth, but in this current energy bear market, confidence in distribution growth is hard to quantify. Nevertheless, a 6.8% tax advantaged yield is quite attractive relative to a taxable 10 year US Treasury Note yielding 2.17%.
We believe that the US will repeal the ban on exporting oil. Combined with the build out of LNG export capacity, growth in the shale boom will return following this current slowdown. It is particularly important to appreciate that the US has driven the shale boom with improved extraction technologies like horizontal drilling and hydraulic fracturing a.k.a “fracking”.

Consequently, we believe that production costs will continue to decline and that the US will resume growing its production capacity relative to other global producers, as it has in recent years.
Our MLP Separately Managed Account returns for July were down 8.39% and year-to-date performance is down 7.77%. We are still measurably outperforming the Alerian Total Return Benchmark which is down 13.89% for the year.

History has shown that years following a correction like this one tend to be exceptional for investment performance. The problem is human nature leads investors to chase performance and often prompts selling during periods like this, when methodically accumulating the out-of-favor asset class in question is the prudent investment policy.
Consider the following: in 2002 the MLP index was down 3.36% but in 2003 it was up 44.54% and in 2008 the index was down 36.92% and in 2009 the index was up 74.41%. When fears leave the market, the attractive yield leads to a sharp snapback in performance which we expect over the next two years.
It is worth noting again that leveraged MLP funds have added fuel to the fire as several large funds had bought MLPs on margin. This strategy is great when MLPs are going up; however, when they go down, it leads to indiscriminate selling which belies the compelling opportunity in this current challenging market environment.
Adding insult to injury, mutual funds, closed end funds and exchange traded funds must pay taxes which are deferred and/or avoided through direct ownership of MLPs. The return differential between MLP Separately Managed Accounts (SMAs) and MLP funds is remarkable. Consider the differential between our return history compared to the index and the ETF by the same name.

MLPs are a logical allocation in plans or portfolios needing income. MLPs offer tax advantaged growing streams of income which may be particularly appealing in retirement planning. MLP investments should be made through separately managed accounts for large taxable allocations. While recent price weakness may be disconcerting, this is the time to add high quality income producing assets to your portfolio and focus on the long term.
Sincerely,

Tyson Halsey, CFA