Energy market weakness has been persistent in recent months but, just as crude oil pricing appears to have demonstrated some resilience against the backdrop of a very negative broader market, MLP prices appear to have taken the baton and traded materially lower. Through Tuesday, September 29’s close, the Alerian MLP Index (AMZ) was down 39.2% and 36.3% year-to-date on a price and total return basis, respectively.1 This compares to crude oil and natural gas prices falling 15.1% and 10.5% year-to-date, respectively.2 Though we have tried, it is difficult to point to a fundamentally rational reason for the recent sector-wide decline and so we can only pass along the many rumors we’ve heard of involuntary selling (redemptions, deleveraging, etc.) to investors seeking an explanation.
Rationally, however, investors have also sought other answers, or narratives, to explain the weak performance. While the blogosphere is always full of wonderful and interesting opinions, typically few of these musings engender little attention. However, the volatility of late has increased the spotlight on a few such posts and as a result our inbox has been filled with investors worried that maybe, just maybe, some of these theories are right. So, without giving undue fanfare to any specific person or website, we thought we would address many of the commonly recurring misperceptions and “MLP short thesis” hot points.
Upstream, Midstream and Downstream Are Not the Same
The energy supply chain can be effectively cordoned off into three primary silos: upstream, midstream and downstream. Each of these silos carry substantially different business-level cash flow dynamics that should also be reflected, over time, in the stock prices of these entities. It is the upstream silo where distribution cuts (and eliminations) have occurred and many of the downstream MLPs employ variable distribution models to accommodate the inherent volatility of the “crack spread” (the difference between the price of oil and the products refined out of it, most notably gasoline and diesel).
The midstream silo holds effectively all the logistical assets that carry produced commodities from the upstream sector to the downstream sector and other end users. The midstream business model has evolved over the past decade to become increasingly fee-based; on average approximately 88%3 of the cash flow from publicly traded midstream MLPs is derived from fee-based business. However, using the oft-used toll road metaphor, fee-based business is sensitive to the traffic on the road (the volume of oil or natural gas moving through the system).
As midstream businesses are exposed to volumetric risk, focusing on oil and natural gas production volumes is a logical and appropriate practice. As we noted in our recent blog “Boring Can Be Good,” since crude oil prices peaked in July 2014, U.S. crude oil production has increased about 10%. However, new EIA data has indicated a 316 thousand barrels per day (Mbpd) decline in U.S. crude oil production from the peak month of April, with sequential monthly production declines in both May and June. This production decline is exactly what is ultimately needed in a market that has demonstrated a global supply-demand gap that has been estimated at between 0.5 million barrels of oil per day (MMbpd) to as much as 2.5 MMbpd, or between 0.5% and 2.7% of total demand.4
Interestingly though, many in the blogosphere have tried to steer production as both a positive and a negative for midstream MLPs; arguing in one paragraph that production declines are the death of midstream, while in another paragraph arguing that producers have gotten so efficient they keep growing production so prices will be low forever. It’s going to have to be one or the other.
If production declines persist, prices will have to go higher to stimulate production to meet a global demand base that is growing at 1.0 to 2.0 MMbpd per year. Reasonable demand growth expectations would suggest the need for 5 to 6 million barrels per day of additional crude over the next five years. Further, given the global decline rate of approximately 5% (roughly 4 million barrels per day per year),5 limited OPEC supply growth potential, and massive capital spending cuts or deferments across the globe, production growth will likely fall to North America and largely the U.S .shale basins that have become incredibly competitive and efficient over the past year.
Negative Free Cash Flow
Negative free cash flow (defined as cash flow generated by operations less capital spending) also gets a lot of negative blogosphere commentary, though, interestingly, it is actually an indicator of the huge growth underway.
When the midstream MLP was created it was in a world of no production growth. Midstream was a low risk asset with harvestable cash flow. So the midstream MLP was structured to do just that: capture the throughput fee, maintain the assets in good condition, and pay out the excess, or free, cash flow. Then came the energy renaissance and the need to develop new infrastructure to handle the increasing volumes being produced from new and existing basins. These assets are the same, long-term, cash flow harvestable assets, they just require capital to construct. Therefore, at its essence, the negative free cash flow is actually highlighting the growth opportunity itself: the energy renaissance.
You can equate this dynamic to any business in growth mode: you have to build the plant or factory or restaurant or store, in order to generate new cash flow. You can retain cash flow from existing assets to fund the new projects (which would mean less or no dividends) or you can raise capital. In the case of midstream, the size of the infrastructure opportunities present in recent years would have, in many cases, required external capital regardless of the dividend payout level. To argue that MLP management teams should avoid attractive growth opportunities in order to avoid the capital markets is absurd.
Debt, Credit Risk and Project Funding
The “borrowing base redetermination” is an upstream phenomenon and generally does not directly impact the midstream entity. Additionally, even if debt at an upstream entity were to force the producer into bankruptcy, in order for the producer to generate cash flow, its production will need to get to market, which requires the midstream logistical system. Midstream is a preferred provider in almost all bankruptcy proceedings.
Debt at the midstream entity level is often higher than in the other energy silos. This is because the business profile carries much less cash flow volatility, and lenders are willing to lend more against it and at lower rates. As we noted in the aforementioned “Boring Can Be Good” blog, midstream EBITDA has continued to grow, cash flows have continued to grow, and distributions have continued to grow.
In fact, despite equity market weakness, the midstream debt market has been wide open and midstream debt has generally traded well. While many midstream entities are loath to use equity to fund growth projects in the current environment, most midstream companies are not over levered and have the luxury of flexibility in timing their equity market needs. Further, many MLPs benefit from supportive sponsors that can aid in these financing needs and, as was exhibited during the financial crisis, should all other measures fail, management teams can access the currently very well-funded private equity capital providers at the project level.
Let’s All Just Take a Deep Breath
In 2008 there was a widespread assumption the midstream model was dead. In fact, this notion was nearly the consensus view for a short period rather than just the “unique” notion proffered by a few bloggers. The AMZ declined 41.5% and 37.1% on a price and total return basis, respectively for the year.6 Of course, this opinion proved to be far from prophetic as MLP prices in 2009 recovered 61.9% on a price basis and 75.6% once distributions are considered.7 Today, cash flows in the sector are far less commodity-price exposed than they were in 2008, the capital markets are under much less strain, leverage is lower, debt markets remain very accommodating, and companies are generally larger and more diversified.
While we certainly have no window as to when the energy markets, or the MLP space in particular, will begin to normalize, we know that when momentum is driving a market, seeking a rational explanation usually fails. However, history tells us momentum trading patterns eventually peter out and that fundamentals eventually come back into focus. Unfortunately, the timing of these turns only seems obvious in retrospect. We are sure the blogosphere will then be filled with commentaries declaring how clearly they saw the turn was coming but just forgot to tell us.
1 Bloomberg, 9/29/15↩
2 Bloomberg, 9/29/15↩
3 Wells Fargo, August 2015↩
4 U.S. Energy Information Administration, 4/1/2015↩
5 U.S. Energy Information Administration, 4/1/2015↩
6 Bloomberg, 9/29/15↩
7 Bloomberg, 9/29/15↩
Investing in MLPs involves additional risks as compared to the risks of investing in common stock, including risks related to cash flow, dilution and voting rights. Each Fund’s investments are concentrated in the energy infrastructure industry with an emphasis on securities issued by MLPs, which may increase volatility. Energy infrastructure companies are subject to risks specific to the industry such as fluctuations in commodity prices, reduced volumes of natural gas or other energy commodities, environmental hazards, changes in the macroeconomic or the regulatory environment or extreme weather. MLPs may trade less frequently than larger companies due to their smaller capitalizations which may result in erratic price movement or difficulty in buying or selling. Additional management fees and other expenses are associated with investing in MLP funds. Diversification does not guarantee profit or protect against loss.
The Oppenheimer SteelPath MLP Funds are subject to certain MLP tax risks. An investment in an Oppenheimer SteelPath MLP Fund does not offer the same tax benefits of a direct investment in an MLP. The Funds are organized as Subchapter “C” Corporations and are subject to U.S. federal income tax on taxable income at the corporate tax rate (currently as high as 35%) as well as state and local income taxes. The potential tax benefit of investing in MLPs depends on them being treated as partnerships for federal income tax purposes. If the MLP is deemed to be a corporation, its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution which could result in a reduction of the fund’s value. MLP funds accrue deferred income taxes for future tax liabilities associated with the portion of MLP distributions considered to be a tax-deferred return of capital and for any net operating gains as well as capital appreciation of its investments. This deferred tax liability is reflected in the daily NAV and as a result a MLP fund’s after-tax performance could differ significantly from the underlying assets even if the pre-tax performance is closely tracked.
The Alerian MLP Index is a composite of the 50 most prominent energy MLPs. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results.