Master Limited Partnership: More Going On Than Oil Price
MLPs can provide investors with exposure to a niche, yet vital, aspect of the energy production chain.
MLPs are sensitive to a number of factors, including the prices of oil and natural gas, interest rates, and the overall performance of the stock market. Yet at times, the performance of MLPs does not seem very connected to any of them.
Despite poor performance year to date, MLPs may seem well positioned going forward.
MASTER LIMITED PARTNERSHIP: MORE GOING ON THAN OIL PRICE
Master limited partnerships (MLP) appear to be a natural way to invest in the changing energy landscape. MLPs are exclusively focused on energy infrastructure in the United States and Canada. North American energy production has become a dominant factor in the price of oil and in the North American drive to be energy independent. Yet, the pricing and performance of MLPs can be complicated, influenced by systemic factors, such as the prices of oil and gas, interest rates, and movement in the equity markets. MLPs are also influenced by the degree of success of each individual partnership, in the same way that traditional stocks’ performances are determined by both market and individual factors. Despite recent performance, we believe that the sector may still represent a good long-term investment option to potentially profit from increased North American energy production.
WHAT IS AN MLP?
MLPs are technically partnership interests that issue units, instead of shares, that often trade on national stock exchanges. Partnerships are legal entities that by definition have a pass-through tax structure and do not pay federal or state income taxes. In order to qualify for this treatment, the partnership must generate more than 90% of its income as “qualifying income.” The definition of “qualifying income” has changed over the years, and has been largely limited to payments related to natural resources, commodities, and real estate. In practice, this means that MLPs are typically involved in transportation and storage of oil and natural gas. Unlike real estate investment trusts (REIT), MLPs are only required to pay out “available capital,” whereas REITs are required to pay out 90% of income received. Because the revenue of an MLP is determined by the amount of oil or gas flowing through the pipeline, not the price of that commodity, MLPs are often referred to as “energy toll roads.”
MLPs are required to pay out most of their income and that income is exempt from income tax. Furthermore, the actual distribution from the MLP is frequently characterized as a return of capital, as opposed to income, so the unit-holder does not pay income tax at the time of distribution. Consequently, MLPs historically have higher yields than the dividend yield on the broad stock market averages, or than the yield on investment grade bonds. As a result, MLP may be a potential play for investors seeking quarterly distributions, much like REITs. The tax component does present an element of uncertainty to MLP pricing; as a function of the tax code, their status could be removed by Congress. In addition, lower personal and corporate income taxes may make MLPs less attractive.
THE CHANGE IN ENERGY FORTUNES
Historically, the United States was heavily dependent on imported oil, with much of that oil coming from the Middle East. In 1981, after the two major oil supply shocks of the 1970s, Congress created the concept of the MLP to encourage private capital investment in U.S. energy production. Interest in MLPs, and their tax advantaged nature, grew substantially over the years, until Congress clarified rules in order to limit their use primarily to oil and gas-related companies. However, it was really the development of drilling technologies, most notably hydro-fracturing (fracking) that led to sustained interest in MLPs.
Primarily due to the changes in drilling technology, North America is largely energy self-sufficient. The United States has all the natural gas (and coal) it needs, quite possibly for generations. Due to increased domestic oil production, the U.S. only imports about 25% of its oil, and approximately 45% comes from Canada and Mexico, countries where U.S. based MLPs help facilitate movement of energy. As a result, almost all energy consumed in the U.S., quite literally all the natural gas, and over 85% of the oil has some connection to MLPs.
The prospective future of MLPs was enhanced after the 2016 election. U.S. oil and gas production increased significantly during the past five years, despite skepticism about the safety of fracking from the Obama administration and a number of state governments. The Trump administration promised to be much more energy friendly, with promises to roll back regulations and approve permits for additional energy development. According to Bloomberg, there is an estimated that there is about $50 billion in energy projects waiting permitting. Thus far, the Trump Administration has been unable to speed up the process or deal with this backlog. One reason for the delay is that the Federal Energy Regulatory Commissioner (FERC), the main regulatory body for energy infrastructure, only has two of its five commissioners seated, and one of those two announced she would not stay on after her term expires this June.
We view the current rebalancing of oil supply and demand to be very positive for domestic energy production, and therefore MLPs, going forward. Reduction in supply from OPEC has been met with increased production from North America. This should benefit Canadian and U.S. MLPs, some of which connect with pipelines into Mexico as well.
WHAT MOVES AN MLP?
Though conceptually, investing in MLPs should be straightforward, there are areas of confusion. While many factors drive MLP performance, different factors dominate at different times. Figure 1 details how much of the MLP index’s performance can be attributed to different factors. Overall, the most consistent factor determining MLP performance is still the broad equity market (as measured here by the S&P 500). The price of oil matters most to MLP performance when oil is at its most volatile, such as near oil’s peak price in mid-2008 and near the end of its price collapse in the beginning of 2016.
What is somewhat surprising is how seldom interest rates are a major factor in the performance of MLPs. One often hears MLP investors express confidence, or concern, regarding their investment based on movements in the bond market. Changes in yield on the 10-year Treasury bond are seldom the primary driver of MLP returns, though they were in parts of 2012 and 2013. But movement in the bond market is frequently a secondary driver. Therefore, we often look to yield to determine when MLPs are attractively valued. Figure 2 displays the yield of both MLPs and REITs relative to Treasury yields. With overall yields low, investors frequently look to alternative sources for income. At current levels, MLP yields should be attractive to investors, assuming stability in oil prices.
The performance of MLPs has been disappointing lately even as stock prices have increased, we believe due to the decline in oil prices this year. However, oil prices do not have to rise for MLPs to appear attractive, they just need some stability. We see a strong fundamental backdrop for MLPs with increased North American production and what is likely to be an easier regulatory environment going forward. Combined with attractive valuations, we believe MLPs have a role in a diversified investment portfolio.