Much of the discussion about MLPs in recent months has revolved around the sharp declines in oil prices. But beyond oil-price volatility, what’s affecting the MLP market? What trends should investors watch out for, and what opportunities are available now? We spoke with two MLP experts: Jeff Jorgensen, director of research for Center Coast Capital Advisors, and Matt Sallee, portfolio manager with Tortoise Capital Advisors. The following is an edited transcript.
Q: What trends are you currently seeing in the MLP space?
JEFF JORGENSEN: From the beginning of 2013 to August of 2014, everything went right for MLPs. A lot of asset managers flooded into the space, and a lot of new MLPs were created. People were picking any MLP investment and netting a nice return.
But MLPs are not all created equal. The MLPs based in more marginal drilling regions or formed by marginal sponsors have gotten punished as commodity prices have fallen. Those are the ones that benefited the most from the ideal market conditions in previous years. Now they don’t have the fundamental quality to perform without them.
MATT SALLEE: Many MLPs are likely to lower their capital budgets in response to lower oil prices. You’ve already seen the number of rigs actively drilling for oil and gas in the U.S. decline by about 40% in recent months. Some drilling just doesn’t make economic sense at $50 a barrel. In the near term, that will result in the leveling off of domestic oil production. We still believe the U.S. energy production growth story is intact, but it’s taking a pause.
In some cases, that means MLPs may defer programs such as building a processing plant, whether in the Permian Basin or in the Bakken shale. Companies are likely to defer activity for a year or so until they’re confident that oil prices have bottomed. This also may mean lower distribution growth as some MLPs hold some cash flow back and wait until the environment turns back to growth.
Q: What trends do you expect to see in the MLP market in the coming years?
JORGENSEN: I think in the short term, MLP performance will be driven more by commodity prices than it has been in the past. We’ve seen an increased correlation between MLP market performance and crude prices in recent months, and I think an MLP recovery will be governed in part by a rebound in oil prices.
Over time, though, I think you’ll see the quality names differentiate themselves. As investors realize that cash flows are stable regardless of commodity prices, they’ll come back into the MLP market and help drive a recovery. But it’ll be a cautious re-entry, as opposed to the flood of investors we saw entering the MLP space in 2013.
SALLEE: I believe we’ll see higher crude prices, higher drilling activity and a resumption of the production growth story—but not for a year or two. The growth story is not over for MLPs. When I look back at historical distribution growth of midstream MLPs, distributions grew in 2009 and grew a lot in 2010. So MLPs grew their distributions even through a financial shock that was more severe than what we’re going through now. I think this is likely to play out in a similar fashion.
If oil prices stay in the range of $50-$60 per barrel, I think M&A activity will increase among MLPs. We could see healthy midstream MLPs acquire assets from exploration-and-production MLPs that are trying to live within their cash flows. If the upstream companies have midstream assets they can part with, they may do that to fund their drilling budgets. And we also may see large energy companies like Kinder Morgan and Plains All American Pipeline looking for acquisition targets in the midstream space.
Q: Where can investors find opportunities?
JORGENSEN: MLP sectors have recovered across the board after a very irrational response this fall and winter. But so many people threw the baby out with the bathwater that there are still names within each subsector that I think remain unfairly beaten-up. I think now it’s more about looking for value on a name-by-name basis than looking at sectors as a whole.
The good news is that investors are finally starting to dig in and do the research that they should have been using all along. From looking at contract structures to their management teams, it takes real due diligence to identify how these companies are different—which ones are quality partnerships and which are not.
SALLEE: I see opportunities among high-quality MLPs in the gathering and processing sector. These MLPs trade at attractive valuations, though they do face headwinds as oil prices remain low. I also believe MLPs involved in refined products such as gasoline, diesel and jet fuel are interesting as lower prices are stimulating higher demand. So far this year, demand for refined products is up 5 percent over the same period last year. More flows through the pipelines means greater cash flows for these companies.
Ultimately, I believe that investing in midstream MLPs is the way to go. Investments in other sectors, such as upstream MLPs, need to be done with caution, and investors must understand that these offer a very different risk proposition than investing in a pipeline MLP.