Master Limited Partnerships (MLPs) are about as fashionable as hot pants. Like the skimpy shorts of the seventies they retained a hard core of fans and have even seen various moments when it looked like they were coming back, but mainstream opinion has remained negative. Now, however, there are three factors that suggest that at the very least the worst could be over, and which may actually result in MLPs seeing a resurgence in popularity.
The argument against MLPs is obvious and well known. The big drop in oil a few years ago and subsequent cost-cutting by energy companies is still hurting. Pipelines are made from steel, a product that looks set for price hikes as the Trump trade wars begin. The rising rate environment, long-signaled and now being enacted by the Fed, makes the yield that is the basis of MLP’s appeal for investors less attractive. And, last but by no means least, a recent rule change by the Federal Energy Regulatory Commission (FERC) sparked another sharp selloff as it was seen as potentially having a negative impact on pricing and/or margins for the pass through partnerships.
That is a depressing list, so it is little wonder that the performance of MLPs has been dismal. In February of last year, the Alerian MLP ETF (AMLP) was at its two-year high. Since then, while the S&P 500 has gained around fifteen percent, AMLP has lost over thirty. The chart isn’t pretty…
(Click to enlarge)
Regular readers will know that, to me, a chart like that often looks more like a potential opportunity than a warning, so I set out to see if there was a bull case to be made for the untrendy and unloved asset class. My first call was to Jay Hatfield, a thirty-year veteran of financial markets with vast experience in the yield space who is now CEO of InfraCap, and CIO of, among other funds, their actively managed, leveraged MLP ETF, AMZA. Obviously, Jay is somewhat biased, but that doesn’t mean that what he said can be discarded and he certainly knows his stuff. He made some interesting points.
On the interest rate influence, he pointed out that long-term yields have not been sky-rocketing as the Fed’s course has become clear. The long bond (US 30-Year T-Bond) yield did jump early in 2018, but never got above 3.25 percent and has since dropped back to below 3 percent. 10-year yields have stayed below 3 percent in that time, and also dropped recently. His reasoning for that counterintuitive move makes perfect sense. Many have focused on the Fed’s changes to short-term rates but yields at the longer end of the curve are market driven, and demand for Treasuries remains high.
The reason is simple. Pension funds around the world often need, and in others would prefer, to hold a certain percentage of bonds and “risk-free” U.S. sovereign debt in particular. As their equity portfolios grow and they rebalance there is therefore a steady and growing demand for Treasuries. Some of those funds are required to hold a certain percentage of U.S. Government debt, but it is those that aren’t that are really driving rates down and will continue to do so. Interest rates around the world have been at historic lows since the recession, driving money into stocks. As a result, many funds have what is, for them, an overly risky asset mix and are gradually adjusting. In other words, the Fed can do what it likes, but the global market mitigates against a big jump in long term interest rates, and it is a fear of that that has influenced MLPs.
We then turned to the subject of the asset underlying the pricing of MLPs, oil. Hatfield echoed what I have been saying for a while; that in the long-term, oil will most likely be range-bound. Jay’s point was that technology improvements in drilling, particularly in shale fields, have increased supply but what it is often overlooked is they have also increased the elasticity of that supply. Production is now more easily adjusted to price changes which makes a range-bound market more likely.
That relative price stability is an obvious plus for pipeline operators, but there are things that suggest that it will come in tandem with an increase in demand for their services. The Trump administration may be imposing tariffs on steel, but they can hardly be accused of being anti-oil. The EPA and other regulatory agencies have moved from being opponents of pipeline developments to bodies that are there simply to rubber-stamp applications. Add in the usual retracement of a Trump policy announcement that has now excluded the U.S.’s largest steel suppliers and on this front too the selling of MLPs is hugely overdone. I would add that for pipeline operators, the opening of LOOP, a Louisiana deep-water port that can handle supertankers and therefore boost U.S. oil exports, is also a positive.
Thirdly, as the above-referenced article points out, as worrying as the FERC ruling looked at first an examination of the details and probable real-world effects suggests that it won’t be that bad. The ruling only applies to interstate pipelines and won’t have much of an effect on negotiated or market-based rates. Enterprise Products Partners (EPD) was one of the first MLPs to react officially and said in in a press release that the changes “…are not expected to have a material impact to the earnings and cash flow of Enterprise.” As the Forbes article put it “Investors clearly shot first, then asked questions later, which created good opportunities for dip-buying.”
So, with both long-term interest rates and oil facing conditions that suggest a range-bound immediate future and with what is clearly an overreaction to some news, a strong case can be made that picking up some MLP exposure at these levels is not as risky as it may seem on the surface. Jay’s fund has a yield of around 20%, but AMZA is, because of leverage and other factors, probably too risky for most investors. However, the 8.32% yield of AMLP is tempting for those who need income from their portfolio, and would still provide a decent cushion should we have not quite seen the bottom.
On reflection, it seems MLPs are not exactly like hot pants; they have some chance of regaining mainstream popularity. You may think that buying them now will make you look foolish but, in a few months, it could make you look like a fashion leader. The difference though is that, unlike with clothing, if you buy MLPs, you will get paid for your rejection of conformity.