We believe crude price volatility has overshadowed positive lower 48 crude oil production trends for the Master Limited Partnership (MLP) asset class and expect that, as crude price volatility begins to ebb, investors may begin to focus on these production trends.
Historically, the correlation between changes in crude oil prices and midstream equities – most of which are organized as MLPs – has been relatively low. However, as crude oil prices began to collapse in September 2014, the correlation between the commodity price and the equities increased.
Between 2011 and September 2014, the correlation of weekly price performance between crude oil and the Alerian MLP Total Return Index (AMZX) averaged approximately 0.40 but increased to 0.64 between September 2014 and March 2016.1 Since March 2016, correlations have returned to historical levels, although with episodes of higher correlation.
What Caused Correlation to Increase?
Notably, at the same time crude prices were falling, crude oil producers were drastically cutting drilling budgets. As a result, the rig count collapsed from a high of over 2,000 to a low of 404, signaling that production was likely to moderate as well.
In fact, crude oil production in the lower 48 states began to moderate approximately six months after crude prices bottomed, hitting a monthly low of below 8 million barrels a day (bbls/d) in October 2016, representing a 13% decline from the peak (Exhibit 1).
While the margin earned on certain midstream services is directly affected by commodity pricing, it is much more common that midstream assets earn a set fee, or fee-like margin, for the volume transported or handled. Therefore, this volume decline had an impact on the operating performance of certain midstream companies.
Further, many midstream operators went from touting robust growth expectations when the rig count was high, to fears of a prolonged period of cash flow contraction due to uncertainty about a rebound in production growth. This reversal of growth expectations clearly contributed to the midstream and MLP equity price correction experienced since September 2014.
Where Are We Now?
Significant improvements in drilling efficiencies and production performance have lowered the crude price required by production companies to profitably drill (Exhibit 2).
As a result, since 2016, rig counts and production trends continue to improve even though crude pricing has generally been range-bound between $45 and $55 per barrel. In fact, crude oil production in the lower 48 states is poised to surpass 2015 highs and production growth expectations going forward have improved as well.
We believe this production trajectory should be healthy for midstream operators. Historical patterns appear to bear out this relationship (Exhibit 3).
Notably, from 2011 until September 2014, crude pricing was stable, but crude production in the lower 48 states grew steadily and the AMZX delivered healthy total returns. We believe we may be in a similar period. Though recent crude price volatility suggests market anxieties about the direction of oil prices, rig-count data and lower-48 production have been increasing steadily.
Do MLP Valuations Reflect Expected Production Growth?
As production trends have improved, so have midstream growth expectations. In fact, Wells Fargo’s five-year median distribution growth expectation for its midstream coverage has rebounded to 5.4% as of May 31, 2017, from 3.4% at February 29, 2016.2
Despite the improving outlook for volume and distribution growth, midstream companies are trading at historically attractive levels. According to Wells Fargo research, Midstream MLPs are trading at an estimated 2018 price-to-distributable cash flow (DCF) of 10.7x, versus the five-year average of 12.9×.3
We believe recent crude price volatility has overshadowed fundamental improvements for the MLP asset class and expect that as crude price volatility begins to ebb investors may begin to focus on these production trends once again.
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1 Source: Bloomberg.↩
2 Source: Wells Fargo Research, as of 6/3/2017.↩
3 Source: Wells Fargo Research, as of 6/3/2017.↩
The Alerian MLP Index is a float-adjusted, capitalization-weighted index measuring master limited partnerships, whose constituents represent approximately 85% of total float-adjusted market capitalization.
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. 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.
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These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.