Editor’s Note: Nate Conrad, my eldest son, recently left to spend the summer in China as part of Princeton in Beijing, an intensive language study program. To share his experience with our family and organize his thoughts about life in China’s capital city, Nate started a weekly blog chronicling his summer abroad. We’re hosting the blog on the Capitalist Times website; readers interested in learning more about everyday life in Beijing can check out Nate’s Beijing Diaries.
Over the past half-decade, the Alerian MLP Index has delivered impressive outperformance, fueled by growth opportunities created by the shale oil and gas revolution and investor demand for above-average yields in a low-rate environment.
The Alerian MLP Index has held up better than most energy subsectors since oil prices began to tumble last summer, giving up only 20.8 percent of its value, compared with the 54.1 percent loss posted by the Bloomberg North American Independent E&P Index and the Philadelphia Oil Service Sector Index’s 37.7 percent drop.
This resilience relative to other energy equities stems in part from the perceived safety of long-term, fee-based contracts that predominate in the midstream industry.
Nevertheless, this basket of 50 prominent master limited partnerships (MLP) has underperformed thus far in 2015, posting an 12.2 percent loss after factoring in distributions.
This recent downside reflects a number of factors, including the Alerian MLP Index’s outperformance relative to other energy stocks last year, the market’s growing concern about rising interest rates and worries that the slowdown in drilling activity will limit future growth opportunities.
Long the province of individual investors seeking a reliable income stream, the upsurge in US oil and gas production driven by the shale revolution transformed this niche security class into more of a growth vehicle.
Although buy-and-hold investors income historically have gravitated toward MLPs for their above-average yields, the huge growth opportunity created by the shale oil and gas revolution shifted the focus from accumulating growing payouts to yield compression—or price appreciation that outstrips distribution increases.
Given investors’ negative sentiment toward the energy patch and the diminished growth outlook for many MLPs, faster money that entered the space in search of outsized price appreciation may head for areas that offer more lucrative returns.
The March 23 issue of Energy & Income Advisor warned that much of this technical downside would focus on Enterprise Products Partners LP (NYSE: EPD) and other blue-chip names that figure prominently in the more than 80 fund products that offer significant or pure-play exposure to MLPs. (See Risk Check.)
The outperformance of midstream giant Kinder Morgan’s (NYSE: KMI) stock relative to Enterprise Products Partners underscores this technical risk.
Since June 30, 2014, Enterprise Products Partners’ units have pulled back by 21.9 percent, in line with the Alerian MLP Index’s 20.8 percent drop.
As the largest MLP by market capitalization, Enterprise Products Partners has a 17 percent weighting in the Alerian MLP Index and features prominently in the more than 80 long-oriented mutual funds, closed-end funds, exchange-traded funds and exchange-traded notes that offer significant exposure to this security class.
In contrast, Kinder Morgan, which last fall consolidated the two MLPs under its auspices, has generated a total return of 8.1 percent over this same period. And as recently as April 24, Kinder Morgan’s shares were up almost 30 percent, at which point the stock had outperformed the Alerian MLP Index by about 40 percentage points.
As a C corporation, Kinder Morgan no longer appears in the Alerian MLP Index or many strategies that focus exclusively on this group.
We would argue that much of the recent weakness in Enterprise Products Partners LP and Energy Transfer Partners LP (NYSE: ETP) reflects industry tourists rotating out of broad-based MLP strategies because of negative sentiment toward the energy sector, uncertainty about commodity prices and worries about rising interest rates.
This technical weakness belies Enterprise Products Partners’ robust distribution coverage, high-quality management team, low cost of debt and equity capital, extensive backlog of organic growth opportunities and arguably the best visibility regarding post-2017 growth opportunities.
Meanwhile, Energy Transfer Partners has a number of levers at its disposal to unlock value for unitholders and offers exposure to some of the most exciting growth opportunities in the midstream patch: the need for takeaway capacity in the Marcellus Shale and Mexico’s surging demand for inexpensive US natural gas.
With a distribution yield of almost 7.8 percent, Energy Transfer Partners LP offers one of the best combinations of growth and value in the MLP space. (Read more about Enterprise Products Partners and Energy Transfer Partners in MLP Portfolio in Review.)
Although we regard much of the weakness in Enterprise Products Partners and Energy Transfer Partners as technical in nature, the ongoing re-rating of the midstream industry could result in further downside as investors adjust their growth expectations.
We had considered adding ETRACS 1XMonthly Short Alerian MLP Infrastructure Total Return Index (NYSE: MLPS), an exchange-traded note (ETN) that tracks the inverse performance of the Alerian MLP Infrastructure Total Return, to the MLP Portfolio as a hedge.
Unfortunately, this ETN doesn’t trade with sufficient volume after UBS Group (Zurich: UBS, NYSE: UBS) called a significant portion of these notes.
In lieu of this hedge, investors should continue to take advantage of additional weakness to buy MLPs with best-in-class growth stories that don’t hinge on energy prices. Focus on names that stand to benefit from an extensive inventory of potential drop-down transactions.
Roger's favorite utilities for investors seeking superior price appreciation by taking calculated risks.
Harness the tried and true wealth-building power of rising dividends.
Nothing compounds wealth like reinvesting a rising stream of dividends.
Warning: Falling Dividends.
Roger's current take and vital statistics on more than 200 essential-services stocks.