December 31, 2015
Written by Nathan Erickson, CFA®, CAIA, Chief Investment Officer
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As we look back over the last year, one of the investments we’ve received questions on the most has been MLPs. MLPs have been a part of Miller Russell Associates’ client portfolios since 2012 and help diversify portfolios beyond traditional stocks and bonds. However, over the past year and a half MLPs are down 33% as oil prices have plummeted in the face of rising oil supplies and increased oil production across the globe. Looking ahead to 2016, we want to revisit why we own MLPs and discuss the outlook for the asset class moving forward.
What are MLPs?
MLP stands for Master Limited Partnership, which refers more to their tax structure than what they invest in. There are two partners in the partnership: the general partner and the limited partner. As investors, we are the limited partners. We provide capital to the MLP and receive periodic income distributions from the MLP’s cash flow. For a partnership to be legally classified as an MLP, it must derive 90% or more of its cash flows from real estate, natural resources, or commodities. We invest almost exclusively in companies that are considered midstream energy MLPs. Within the energy value chain, there are three components: upstream focuses on the extraction of natural resources; midstream focuses on the transportation of natural resources; and downstream focuses on the refining and usage of natural resources. Since midstream MLPs focus on transportation, their earnings depend more on volume of natural resources than price. For readers who would like additional detail on the energy value chain, this link provides a great overview: https://www.alerian.com/education/energy-value-chain/.
Why do we own MLPs?
When our investment department evaluates asset classes, we begin with a focus on the attributes of the asset class and how it may incrementally improve a client’s portfolio. As the investment landscape grows and evolves over time, the opportunity set of asset classes continues to expand. However, in the late 70’s and early 80’s, commodities were the only real alternative asset class to complement traditional stocks and bonds and became a staple of diversified portfolios. Even today, many portfolios contain some allocation to commodities, either through a diversified basket or a direct holding in metals or natural resources. The justification for owning commodities, and really any diversifying asset class, is that its return characteristics have a low correlation to, or relationship with, traditional stocks and bonds and can therefore reduce overall portfolio risk.
As we began evaluating MLPs in 2011, we identified that from a portfolio standpoint MLPs and commodities provide similar diversification benefits. This is primarily measured through correlation, which is a measure of how related one asset’s returns are with another on a scale of -1 (completely inversely related) to +1 (completely positively related). As correlation approaches zero, the two investments’ returns have no relationship with each other, or said another way, one investment’s returns can’t be explained by the other.
Relative to the S&P 500 index from 1996 (the inception of the MLP Index) to present, the Alerian MLP index has a correlation of 0.39, and the Bloomberg Commodity Index has a correlation of 0.32. Relative to the US Aggregate Bond Index, the Alerian MLP index has a correlation of 0.05 and the Bloomberg Commodity Index has a correlation of 0.04. From a diversification standpoint, the two asset classes provide similar benefits.
Aside from correlation, we consider the return and risk characteristics of the asset class, as well as the investment thesis to ensure it is logical and persistent. One of the key differentiating factors between commodities and MLPs is the yield component. Commodity returns are based on price only. Investors make money if the commodities they invest in can be sold for more than they paid for them. MLPs on the other hand are required to pay distributions to investors based on their earnings and have fairly consistent yields. Since both MLPs and commodities provide similar portfolio benefits (from a correlation standpoint), we have chosen to only own one of them, and we have chosen MLPs because they pay a yield. Since 2012, MLPs have returned approximately 10% more per year than commodities.
Why Have MLPs lost so much recently?
As mentioned previously, MLPs are down approximately 33%, from their peak at the end of August 2014 to the end of November 2015. Over that same time period oil prices have dropped approximately 50%, suggesting that the drop in oil prices is causing losses in MLPs. Given that MLPs make money based on the volume of oil and natural gas transported through pipelines and not on how much the goods sell for at the end of the pipeline, there shouldn’t be a relationship between returns in MLPs and the price of oil. As we dig deeper fundamentally and statistically, we find little evidence that MLP returns are directly related to oil prices.
We analyzed earnings estimates for the top 90% of the index, which represents 28 of the 50 companies in the index. Despite the drop in oil prices, on a weighted average basis 2016 earnings for these companies are expected to grow 8-10% over 2015 earnings. Not a single MLP in the top 90% has cut its dividend, which is one of the main concerns of investors who are bearish on the sector. In fact, last week’s rally of nearly 13% for the index can be attributed to one of the more well-known MLPs, ONEOK Partners (OKS), maintaining their dividend in their most recent earnings release. ONEOK Partners represents 2.88% of the Alerian MLP Index. From a fundamental perspective, we have yet to see evidence that MLPs should be valued at this level based on current and near-term expected earnings. If the drop in oil prices had a direct impact on MLP earnings, they should be declining at the same rate as the energy sector, which are down more than 50% over the last year.
When we run a regression analysis between MLPs and the price of oil since 1996, the results show that statistically none of the return of MLPs is related to oil prices. However, running the same analysis over the past year and a half, 27% of the return of MLPs can be explained or is related to the price of oil. Since the fundamental business model of MLPs hasn’t changed in the last year and a half, this number implies more of a behavioral relationship between the two.
We continue to believe that what began the downturn in MLPs was a reaction to falling oil prices by investors in the sector who did not have a full understanding of the business model. MLPs have become a very attractive sector over the last several years as bond yields have declined and investors shifted fixed income allocations towards the higher yielding MLP asset class. Over the last several years the energy sector has also done well with the onset of fracking and discovery of new oil reserves in the U.S. As oversupply has plagued the energy sector and driven down oil prices, we believe investors have unfairly linked MLPs to the energy sector and sold them indiscriminately, despite the fact that they remain profitable.
There are some arguments that decreased production in the U.S. as a result of lower oil prices could lead to lower volumes for pipelines. While reduced production may slow development of future projects, most MLPs’ existing cash flows are linked to long-term, fee-based contracts which support relatively stable cash flows despite challenges in the market. As noted earlier, after a year and a half of low oil prices, the large majority of the MLP index has been unaffected from an earnings or yield standpoint.
Outlook for 2016
From a portfolio perspective, the diversification benefits of owning MLPs as an asset class have not changed. Nor do we find evidence that the fundamental business model of MLPs has permanently changed, as oil continues to be produced and needs to be transported. In our view, fundamental changes to the asset class would either be a substantial reduction in demand for oil (a wholesale shift to clean energy) or a change in the tax advantaged status of MLPs. Neither of those changes appear to be feasible in the near term.
If investors are linking oil prices and MLPs, a rise in the price of oil should result in renewed interest in the asset class. Exploration and production companies have cut their capital expenditure budgets by 20% in 2016. This follows a 20% cut in 2015 from 2014. In a way, OPEC countries who continue to produce oil at unprofitable prices are succeeding in forcing public corporations to cut production. As a result, there could be a shortfall in crude oil as early as the 3rd quarter of 2016. While we currently have an excess of supply relative to global demand, demand continues to grow. A drastic reduction in supply could drive oil prices higher sooner than investors expect.
From a valuation perspective, MLPs are now trading just above the trough valuations experienced during the 2008 financial crisis. With yields hovering around 8-10% we see current valuations as an opportunity to rebalance portfolios to target and buy the asset class when prices are low. As we near the end of the year we will be using some of the cash distributions from other investments to take clients’ MLP allocations to their full 5% target.
As investors, we will always experience periods of time where some asset in the portfolio is disappointing, and another asset is doing so well that we wished we owned more of it. We need only look to 2013 when MLPs were up nearly 28% to recall when it was the darling of the portfolio. As your advisor, our goal is not to find investments that only deliver positive returns, because they don’t exist. Our goal is to construct a well-diversified portfolio so that the winners and losers balance out in a way that leads to long-term returns that are reasonable for the overall risk taken. At this time, MLPs continue to be a part of that solution and, as we’ve seen in the past, could very well move from the worst performing asset class to one of the best in the near future. As always, if you have any questions or would like to discuss in more detail, please reach out to a member of your engagement team.
 A regression analysis is a way of measuring the relationship among variables. In this example, it is a statistical method of evaluating the relationship between a dependent variable (MLP returns), and an independent variable or “predictor” (oil prices). The outcome is called a beta coefficient and measures the strength of the relationship. The beta coefficient can be stated as a percentage, representing the amount of the dependent variable that can be explained or predicted by the independent variable. The beta should also be tested for statistical significance. In this example, the 27% or 0.27 is statistically significant.