The recent stock market weakness began on September 19th with the initial public offering of Alibaba Group Holding Limited. The stock market has been overvalued for some time and the tape has been poor — breadth has been deteriorating and foreign markets have been sinking. Psychology peaked with Alibaba and has soured with ISIS and Ebola. Weak economic numbers out of Europe and other economic concerns culminated with last week’s sharp selloff. Energy stocks have been particularly hard hit.
One sector we have argued would be relatively safe has been Master Limited Partnerships (MLPs). The MLPs we favor have outperformed. On the other hand, those caught shopping for big yields were hurt if they owned Exploration and Production (E&P) MLPs because these E&P MLPs’ profits are closely tied to the price of oil. Oil prices have collapsed in recent weeks leading some to wonder if we are in for deflation and an economic slowdown. Others believe Saudi Arabia is trying to hold onto its OPEC market share and is increasing its production to lower oil prices with the intent of hurting Russia, Iran and the United States.
Approximately 80% of US oil production is profitable above $65/barrel. This means domestic drillers could endure lower prices, but as we approach $65/barrel, drillers will stop producing and prices will firm. Last week witnessed panic in the oil trading pits and volatility in options on oil futures spiked. Panic like this suggests a bottom in the price of oil. It means many E&P companies hedged their production for fear that their profits might be lost. E&Ps or upstream MLPs which took the brunt of the decline in the MLP space (upstream MLPs down 26% since June 30, versus NYMEX down 21%) are due for a bounce. But tying ones investment fortunes to a commodity price is speculative. While a tradable rally in E&Ps is tempting, the better opportunities in the energy sector are in the logistics and natural gas.
Logistics MLPs, whose businesses are not tied to oil prices, experienced surprising weakness and then a sharp rebound last week. Logistics companies are involved in the transportation, processing, storage and refining and have long term contracts which lead to predictable earnings profiles. In this group, we like Rose Rock Midstream, L.P. (RRMS), Sunoco Logistics Partners, L.P. (SXL), Tesoro Logistics Partners, L.P. (TLLP), Western Refining Logistics, L.P. (WNRL), and Valero Energy Partners, L.P. (VLP). Another subsector not linked to oil prices is the natural gas space. Companies focused on natural gas transportation and logistics also offer stable earnings and distribution growth profiles. In this group, we like Cheniere Energy Partners, L.P. (CQP), EQT Midstream Partners, L.P. (EQM), and Tallgrass Energy Partners, L.P. (TEP).
We continue to believe Master Limited Partnerships offer solid total return prospects that should outperform stocks and bonds in the years ahead. Stocks, in general, are richly priced and bonds offer historically low yields. MLPs offer stable business models and attractive growing tax advantage distribution yields which will rise along with interest rates in the future. Their growing distributions and stable earnings profiles are what make MLPs good defensive investments in an uncertain environment.
For retirement plans, we recommend MLP C corporations and natural gas producers which have seen sizeable corrections. MLP C Corporations are companies tied to MLPs and are benefitting indirectly from the tax advantages of MLPs. We think natural gas producers and MLP C corporations are a smart way to participate in the US shale boom and recent market correction in energy stocks. Southwestern Energy Co. (SWN), Pioneer Natural Resources, Co. (PXD), and EP Energy Corporation (EPE) are attractive natural gas producers. Kinder Morgan Inc. (KMI), Targa Resources Corp. (TRGP), and Williams Companies, Inc. (WMB) are solid MLP C corporations we recommend.
How you invest in MLPs can be more important than MLP security or subsector selection. For taxable accounts, we recommend separately managed accounts as MLPs in mutual fund products lose substantial tax benefits, which is obvious in their long term performance. For qualified or nontaxable accounts, a portfolio of MLP C corporations makes sense. We think the recent volatility in the energy sector offers an opportunity to pick up some good energy companies at reasonable prices.