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The Best Way To Play The Energy Sector Sell-Off

Last week I received a news alert that highlighted the extent of the current bear market in energy stocks. Typically, late in a business cycle and with a potential recession on the horizon, some sectors that tend to fare well are utilities, real estate, and energy. That has been the case with the utilities and real estate sectors, as they are two of the top-performing S&P 500 sectors over the past year.

But the sell-off in energy has been brutal. Market data provider FactSet sent an alert last week that showed how many companies in various sectors were setting new 52-week highs and lows. The energy sector, in particular, stood out:

Source: FactSet alert on August 27, 2019.

Note that while 95 percent of the 52-week marks in the utilities and real estate sectors were highs, that mark was 0 percent in the energy sector. Further, the energy sector had far more new 52-week lows than any other sector, with 42.

The most recent sell-off in the energy sector is a result of a plunge in oil prices brought on by the latest threats of tariffs in the ongoing trade war with China. The energy sell-off has been indiscriminate, taking down healthy and unhealthy companies and segments alike. It has even hit one of the healthiest sectors this year — the master limited partnerships (MLPs) — which consist largely of the companies that transport and store oil and gas.

Alerian is an independent provider of energy infrastructure and MLP market intelligence. Its benchmarks are widely used to analyze relative performance of the MLP sector. Alerian’s latest research note looks at distribution coverage for the 22 constituents of the Alerian MLP Infrastructure Index (AMZI). For context, the AMZI represented 94 percent of the total midstream MLP market capitalization as of the end of July.

Distribution coverage is one of the most important metrics for determining an MLP’s financial health. Distribution coverage compares distributable cash flow (DCF) generated in a period to the total cash distributions paid for that period. A coverage ratio below 1.0x means that a company didn’t generate enough cash in the period to cover its distribution. If coverage consistently falls below 1.0x, the MLP may have to cut its distribution. Related: Saudi Aramco Boosts Oil Investment In China’s Downstream

Alerian’s recent research note compared distribution coverage for the 22 AMZI constituents in the second quarter of 2018 versus the second quarter of 2019:

Source: Alerian

In contrast to much of the energy sector, this analysis shows a segment that is generating enough cash to cover its distributions, as well as one that has improved year-over-year. In 2018, these companies generated on average about 30 percent more cash than necessary to cover their distributions. A year later, that excess has risen to 40 percent. Notably, several of the companies that were on the lower end of last year’s distribution coverage announced distribution cuts — which is exactly the kind of warning signal a low distribution coverage can provide.

The AMZI Index presently yields 8.8 percent compared to its five-year average of 7.3 percent and ten-year average of 6.8 percent. With the bond markets at historic lows and investors desperately seeking yield (as evidenced by the performance of utilities and real estate), MLPs are presently extremely attractive. Their coverage ratios are healthy and getting better, yields are above normal, and the recent sell-off means the sector is on sale.

As the Alerian research note concludes, “Improving distribution coverage should give MLP investors confidence when it comes to the quality of the distributions being paid, even as yields remain elevated.”

By Robert Rapier

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