Are MLPs Still a Good Investment?
Alan Cole, President/Chief Investment Officer & Chris Engelman, Managing Director
Despite continuing to deliver solid earnings and dividend distribution growth, the prices of many Master Limited Partnerships (MLPs) have declined by about 20% over the past year. These publicly traded investments mainly focus on midstream energy infrastructure, such as pipelines. Here, President Alan Cole and Managing Director Chris Engelman discuss why MLP prices have been under pressure, as well as the steps Cedar Hill takes when investments like these fall out of favor to determine whether to hold, exit or add to the investment.
Why are MLP prices declining?
Engelman: Investor sentiment toward MLPs has been heavily influenced by the decline in oil prices that began last fall, along with more recent price declines in natural gas and natural gas liquids. To a lesser extent, fears of rising interest rates have also caused MLP prices to fall.
Should falling energy prices affect MLPs?
Engelman: While some MLPs have direct commodity exposure, most of them are not exposed to commodity prices. Energy producers sign contracts with midstream MLPs to pay a toll for using their pipelines to transport natural gas (66% of midstream MLP revenues), crude oil (11% of MLP revenues) and other energy products. As a result, midstream MLP performance is driven by the volume of the commodity, not the commodity’s price.
Cole: Over the past year, midstream throughput volumes have increased modestly, since lower natural gas prices have prompted utilities to convert more coal-fired units to natural gas power plants. Additionally, Americans are consuming more oil as people respond to low gasoline prices by driving more miles in bigger cars. As a result of this growing demand, most midstream MLPs grew their distributions over the past year.
What about rising interest rates? How do they affect MLPs?
Cole: If investors begin shifting funds from MLPs, real estate investment trusts (REITs), utility stocks and other income-oriented equities once interest rates increase, it could affect these securities. Despite fears of higher rates, however, the 10-year U.S. Treasury rate actually declined from 2.53% on June 30, 2014, to 2.35% on June 30, 2015.
Engelman: During this period, the spread between the dividend paid by the Alerian MLP index and the 10-year Treasury rate has increased to 3.94% from 2.58% and is now above historical averages. Given that the Fed will be raising rates at a tepid pace, investors are being more than adequately compensated for the imminent rise in interest rates.
Are midstream MLP dividends sustainable?
Engelman: Our research indicates that MLP dividends are not just sustainable, but also that distributions could grow by another 5% to 7% over the next 12 months.
Cole: Increased pipeline construction will drive this distribution growth, as energy shale basins require additional infrastructure to move oil and gas from the wellhead to the refinery and, ultimately, to the consumer. Although there is some concern that declining oil prices will lead to production cuts in some of the higher-cost shale energy basins, most MLPs have limited exposure to these regions. Instead, midstream MLP companies focus their capital spending on low-cost shale areas. Going forward, we expect significant dispersion between MLPs focused on low-cost basins, where production continues to grow, and MLPs focused on higher-cost areas, where production is expected to decline precipitously.
How is Cedar Hill approaching the MLP sector today?
Engelman: We are opportunistically increasing client exposure to MLPs, as our research indicates negative investor sentiment, rather than underlying fundamentals, has caused the recent decline in MLP prices. Our selective investment process includes evaluating which closed-end funds are selling at large discounts to net asset value and exploring other tax-efficient means to invest in the sector. We are cognizant that MLP prices could remain under pressure and fluctuate until investor fears of lower energy prices and higher interest rates begin to subside, however.
Cole: While there is no doubt MLP price declines have tested investors’ patience, our experience tells us this is often the best time to increase exposure to investments with strategic assets, strong balance sheets and sustainable cash flows.
