For the past decade, energy master limited partnerships (MLPs) have found themselves of growing interest to investors. The vehicles—publicly traded entities that contain both debt and equity—saw their total market capitalization rise nearly ten-fold between 2003 and 2014, from less than $50 billion in 2003 to $450 billion in 2014. Much like real estate investment trusts, the partnerships generate income from infrastructure assets such as pipelines, and pay out the bulk of their income as dividends each quarter. Yields have been solidly above 5 percent – a rare thing in the post-2008 near-zero world. They were even on track to beat the S&P 500 in 2014 until the bottom fell out of the oil market.
Although their business models aren’t always directly tied to the price of crude oil, MLPs have not been spared from the rout in energy-related assets over the last several months. The Alerian MLP index, which tracks the total returns of 50 large and mid-cap partnerships that comprise 75 percent of the total energy MLP market, peaked in August at $1,896.22, with yields at a record low of 5.14 percent. It then fell 15 percent during the broader market selloff in the first two weeks of October, exacerbated by concerns over falling oil prices. After nearly making up its losses over the next few weeks, it then plummeted again in mid-December to its lowest point all year – 21 percent down from the August peak. By early January, the index was 16 percent off its peak, with yields at 6.07 percent – 395 basis points higher than the yield on 10-year Treasuries. That’s well above the 10-year average spread of 344 basis points.
While increased volatility in the asset class is unlikely to abate any time soon, Credit Suisse analyst John Edwards says the December selloff created some interesting buying opportunities. In previous instances when the yield spread was between 350 and 400 basis points, investors enjoyed an average 21 percent return over the following 12 months. Given the overall weakness in the energy market this time around, however, Edwards expects a total return between 12 and 20 percent over the coming year.
To understand the relatively calm outlook in the context of still-falling oil prices, it’s important to understand MLPs are not simply a play on the price of oil. MLPs also make money by charging fees for the use of pipelines or storage terminals, and for those with meaningful infrastructure exposures, oil prices can matter less than the outlook for future energy infrastructure spending. Of course, infrastructure spending is also tied to oil prices, but it is significantly less elastic. Capital spending has been rising 14 percent a year since 2007, and the pace is likely to slow next year. Credit Suisse expects a $45 billion increase to $563 billion in capital expenditures in 2015, down from a $48 billion bump in 2014. In 2016, they expect capex to fall back to 2014 levels. Still, as Barbara Reinhard, Credit Suisse’s Chief Investment Officer – Americas for the Private Banking & Wealth Management Division points out in a recent note, “While shale growth may slow, it is unlikely to stop, and infrastructure still needs to be built.”
Besides, oil prices aren’t expected to stay quite this low forever. As of early January, WTI was trading at about $50, but Credit Suisse expects prices to grind higher over the next two years. U.S. production is expected to grow by just 600,000 barrels per day over that time period, rather than the 2 million previously forecast. Those missing 1.4 million barrels are roughly the equivalent of the 1.3 million barrel imbalance between demand and supply in 2014 that resulted from falling Chinese demand in the face of higher-than-expected U.S. production and the reopening of Libyan oil fields. And the shrinking output from U.S. shale beds should stabilize prices. By year-end 2015, analysts expect WTI at $75 and Brent at $80 (from $51 in early January).
But investors need to be selective, and should be particularly wary of highly leveraged partnerships as well as those with minimal dividend cushions. Of course, their level of direct exposure to commodity energy prices matters, too. Reinhard notes that low oil prices will deliver a direct hit to margins for MLPs with upstream assets – those heavily invested in extraction-related assets. The midstream-focused MLPs that own the infrastructure and systems that transport and store oil, are buffered by long-term contracts. Those with downstream assets – refining and distribution operations – may see very little impact at all. Geography matters, too. Edwards notes that the Permian and Eagle Ford basins in Texas, as well as the Marcellus/Utica natural gas liquids plays in Pennsylvania, Ohio, and New York have very low break-even prices and are best positioned to weather a couple years of low energy prices. North Dakota’s Bakken formation is a tale of two sub-regions, with wells in the core play profitable at $61 a barrel and those at the fringe requiring $74 to break even. Finally, Edwards says the MLPs that have grown their distributions the fastest outperformed their more sluggish peers during the recent selloff, and will probably continue to offer up the best performance in the sector going forward.
Growth in both oil and gas infrastructure spending and MLP dividend distributions will surely slow in the next two years. That said, Credit Suisse expects Alerian index dividends will grow between 5 and 8 percent next year. For longer-term investors, too, the underlying rationale for investing in MLPs hasn’t changed. The U.S. still needs more pipelines and other infrastructure to move natural gas and oil from new shale beds to consumers, while the rapidly expanding middle class in China and India ensure that higher energy demand is part of our global future. Despite the recent selloff, choosing the right MLPs can still provide a path to an attractive source of income.