US MLPs – It is hard to get too bearish at depressed levels and these yields
US MLPs suffered in 2017 with the Alerian MLP Index, the primary benchmark, down 13% without dividends, and 6.5% with dividends. Despite the price of oil recovering strongly, MLPs lagged as there were concerns about balance sheets, distribution cuts, poor earnings guidance and uncertainty about the impact of tax reform. Additionally, years of underperformance made MLPs obvious candidates for retail tax loss selling at the end of December.
The biggest stress emanated from their inability to raise capital to execute, or bid on, oil and gas projects. Both debt and equity raisings dried up as banks shied away from the distressed sector and falling share prices made it difficult to issue secondaries to institutions or retail investors. This created a vicious cycle because as share prices fell, capital raising became uncertain, leading to distribution cuts and retail liquidation.
This year has been more of the same with MLP’s joining utilities as one of the worst performing sectors in the SPX. This is despite value investors finding opportunities in individual companies betting that distribution cuts have peaked, balance sheets have been repaired and the US production outlook for oil and natural gas has improved dramatically with the expected removal of environment regulations. Also, with the passage of President Trump’s tax bill, uncertainty over the tax treatment of these vehicles has been dispelled.
Bulls are particularly optimistic about, what they see as, a fundamental change in the companies’ approach to capital management after years of excess debt or equity issuance to fund investment spending. They believe that more attention to self-funding through internal free cash flow will translate into lower leverage, higher dividend coverage and more disciplined investment. Barron’s estimates that capital restructuring over the past 18 months has increased dividend coverage ratios to an average of 1.2x and lowered leverage to approximately 4.0x.
Investors are also encouraged by the opportunity for these companies to diversify their projects. Traditionally, they were solely focused on pipelines, but many firms are expanding into gas processing, fractionation, petrochemical projects and marine terminals. This not only allows them to spread out their risk, but also gives them other avenues of growth.
Another longer-term positive is the outlook for both crude and natural gas production. The Energy Information Initiative (EIA) estimates that the average annual U.S. crude production will increase from 9.33 million b/d in 2017 to 10.6 million b/d in 2018 and to 11.2 million b/d in 2019. This would be a 50-year high, potentially surpassing production of both Russia and Saudi Arabia. Much of this production will come from the Permian Basin which is experiencing strong volume growth and a lot of proposed pipeline infrastructure to extend to Corpus Christi, Texas, where it will be shipped. There is also the potential for more offshore production as the White House’s new leasing plan would allow drilling to the outer continental shelf. Currently, offshore drilling accounts for only 15% of total U.S. crude production.
There is also the potential for export markets, for both oil and liquefied natural gas (LNG), to expand from here with crude exports recently surpassing 7.2 million b/d and new LNG export facilities coming on-stream in the next few years. However, companies on the ground report that the infrastructure to achieve these increasing levels of production is simply not there with shortages of pipelines and facilities and a lack of skilled labor becoming an increasing hurdle. This provides an opportunity for MLPs that have restructured and have cash to spend.
Another factor that could bring retail and institutions back into the sector is the clarification on how MLPs will be treated under the new tax law. For MLP investors, tax reform is a clear positive. According to Forbes, MLPs are already highly tax-efficient, with about 80% of distributions deferred until the vehicles are sold. For the remaining 20%, the ability to apply the new pass-through tax rate (of about 29.6%) versus the roughly 37% marginal will increase the tax benefits of owning MLPs. For companies, the changes are more nuanced, but a net positive, with the reform providing capex incentives and a lower corporate tax rate.
The biggest risks to these companies is a sharp fall in the oil prices or a change in regulations. While MLPs were traditionally viewed as utilities, they are now viewed as a play on commodity prices. Also, there is still a segment of the industry that has not restructured, with their cost of capital, and leverage, still high. Headlines on these companies could impact the whole sector.