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We don’t think so. Investors with allocations to energy MLPs (master limited partnerships) may want to maintain existing allocations, despite their recent poor performance and the proposed regulatory changes impacting interstate pipelines. The industry enjoys reasonable valuations, improving (if weak) fundamentals, and positive dynamics in energy commodities.
Two weeks ago, the Federal Energy Regulatory Commission (FERC) unexpectedly announced proposals to no longer allow MLPs to recover an income tax allowance on cost-of-service rates. On the same day, the FERC separately announced a proposal on the impact of recent tax legislation on all regulated pipelines, regardless of whether the pipeline is structured as an MLP or a C corporation. Taken together, these proposals sent benchmarks tumbling, with the Alerian MLP Index closing roughly 5% lower on the day of the announcements.
This regulation-linked decline followed a difficult February for the industry, when changing inflation expectations contributed to a spike in market volatility. Although the spike didn’t impact just MLPs, investors were nonetheless rattled—over $800 million left MLP vehicles, which is the largest recorded monthly net outflow since August 2015, according to the financial intelligence firm EPFR. In all, the Alerian MLP Index is down 12% this year, even as near-month WTI crude oil futures are up 8% and the S&P 500 Index is down around 1%.
Still, investors may want to maintain existing MLP allocations. After letting the dust settle since the announced regulatory proposals, the initial sell-off almost certainly had little to do with fundamentals, as even those who closely follow this sector lacked complete data on the market’s exposure to regulated cost-of-service rates. Now, with better information available, the proposed regulatory changes appear to materially impact only a handful of names, and those impacts have likely been priced into the market.
At a sector level, MLPs appear fairly valued. The Alerian MLP Index offers a dividend yield of 8.9%, which ranks in the top quartile of historical observations since 2000 and has typically been associated with attractive subsequent returns. Although prices as a multiple of free cash flow aren’t signaling the same degree of cheapness, they do not appear to be signaling that the industry is expensive either. Moreover, both of these metrics look attractive relative to richly priced US equities and comparable credits.
The industry’s fair pricing compensates for its less-than-enviable fundamentals. Leverage, as measured by net debt to EBITDA, stands at an elevated 5.7 times. Although high, MLPs are typically leveraged 4.0 to 5.0 times to support its high-cost infrastructure investments. Further, this metric has steadily fallen in recent quarters, as net debt stabilized and EBITDA rose. Unlike leverage, profitability ratios have been stronger—the industry’s EBITDA margin has been above its long-term level for the last couple years, as MLPs reined in costs.
The recent poor performance has taken the Alerian MLP Index to below the average level reached during first quarter 2016, a remarkable fact considering the change in outlook for crude oil production. Government forecasts at the time—with prices of key energy commodities cratering—indicated 2017 US oil production would decline by more than a half a million barrels per day (mb/d) to 8.0 mb/d. One year later, the United States is expected to produce a whopping 10.7 mb/d, with more growth forecast to follow.
Having said this, there’s no doubt that MLPs have been frustrating of late, with unexpected regulatory announcements saddling already poor performance. And, with interest rates headed higher, it’s understandable that some worry about possible earnings weakness. Yet, the industry’s pricing looks reasonable, fundamentals are trending positively, and underlying commodity dynamics appear supportive. For those investors that can hunker down and tolerate this industry’s swings, rewards may be in their future.
Kevin Rosenbaum is Deputy Head, Capital Markets Research at Cambridge Associates
Originally published on March 27, 2018
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