Energy infrastructure started off 2018 on a positive note, gaining 10.3% through January 23 (and up 20.3% from the recent low on November 29, 2017) but subsequently declined 15.1% through the end of February and another 6.9% in March.

This bout of trading weakness has caused investors to ask what issues may be affecting current sentiment. We believe the issues affecting midstream master limited partnerships (MLPs) are predominately shorter-term, technical overhangs that are likely to fade over time. At the same time, we believe the fundamentals of the asset class are set to continue to strengthen.

Factors Affecting Midstream MLPs

Several factors and industry developments are currently affecting the midstream MLP sector environment. These include:

  • The elimination/simplification of incentive distribution rights (IDRs) by a growing number of MLPs. IDRs are a complex structure that allow an MLP’s general partner (GP) to receive an increasing share of the cash flows disbursed by the MLP as the distribution rate increases (similar to a progressive tax mechanism). However, alignment of interest and cost-of-capital concerns has led to a trend of partnerships eliminating this mechanism. Approximately 62% of the sector, by market capitalization, has already announced IDR eliminations with varying effects on equity price performance. As additional announcements are made, we expect market anxiety to improve.
  • The impact of rising interest rates, which has affected equity markets in general. Historically, short-term periods of MLP sector weakness have occasionally occurred in response to dramatic interest rate moves. However, over long-term periods, midstream equities and MLPs specifically have not demonstrated meaningful correlation to interest rate changes.
  • The changes announced in March by the U.S. Federal Energy Regulatory Commission (FERC) related to pipeline tariffs. FERC’s announcement came in reaction to a federal court’s previous remand that cost-of-service tariffs on interstate natural gas and oil pipelines owned by MLPs would no longer receive an income tax allowance (ITA). This shift in FERC’s long-held position caused significant market confusion and volatility across the sector, though we believe the ultimate outcome is likely far more nuanced and any revenue impact will be much less widespread.

Sector Fundamentals Firming

Overall, we believe the midstream MLP sector’s fundamentals are strong and firming for the following reasons:

  • The energy industry macroeconomic outlook is much healthier relative to the past few years.
  • Most midstream providers are likely to experience growing volumes, and therefore margins, across their assets.
  • Sector participants have taken important steps to reduce cost-of-capital concerns by addressing the IDR mechanism and through lowering dependence on external equity capital.
  • Valuations are attractive, in our view.

While we cannot discern what the future may hold for energy markets or the MLP sector, history tells us that momentum and technical trading patterns eventually come back into focus and ultimately prevail.