The MLP business model
At its most basic level, the MLP business model is volume-based and focuses on the transportation, storage and processing of hydrocarbons like crude oil and natural gas. According to the US Energy Information Administration, crude oil production levels in both the United States and Canada have nearly doubled over the past 20 years thanks to technological advances in exploration and production (see chart below). Concurrently, US natural gas volumes have swelled by more than 60%, as many utilities see natural gas as a more economical and environmentally friendly alternative to coal.
Source: US Energy Information Administration. Past performance does not guarantee future results.
With hydrocarbon volumes booming, why are MLP prices down?
Despite this favorable backdrop for oil and gas production volumes, the MLP asset class is currently trading at relatively modest valuations. The Alerian MLP Index ended July trading nearly 50% lower than its peak price in August 2014.1 Furthermore, multiples for the MLP space have contracted significantly, with price/cash flow and price/earnings ratios 41% and 24% cheaper since the market peak.2
Let’s take a closer look at what may have created this deep value opportunity in MLPs and why there may be room for a rebound.
The Invesco Real Estate team believes that the biggest catalyst for soft MLP prices (and low valuations) has been commodity price declines since the MLP market peak in 2014. In the last four years, the price of West Texas Intermediate crude oil has declined by 35%, falling from $107 per barrel to $70 recently.1 Additionally, New York Mercantile Exchange natural gas prices have fallen by 41%, dropping from $4.72 per thermal unit to $2.80 at the end of July.1
This trend is significant because, since the global financial crisis (GFC), we have seen a generally higher correlation between commodity indices and MLP prices. Prior to the GFC, the correlation of the S&P GSCI Energy Index was quite low (and sometimes negative) relative to the Alerian MLP Index. Following the GFC, the correlation between these two indices settled into a range of 0.4 to 0.6.1
We believe a dislocation has developed between MLP prices, commodity volumes and commodity prices. In our opinion, given the volume-based MLP business model, MLP prices should be moving much more in line with commodity production volumes (rather than with commodity prices). Improved oil and gas extraction efficiencies have dramatically lowered the breakeven point for exploration and production companies as compared to 10 years ago, which may give them the ability to grow volumes at lower prices than they could in the past.
Surprise FERC ruling supports the MLP space
In addition to attractive valuations, pipeline MLPs recently received a surprise regulatory boost. On July 18, the Federal Energy Regulatory Commission (FERC) issued a final rule on the Income Tax Allowance Policy for these MLPs. This included changes from the original ruling on March 15 and were viewed positively by the market. Specifically, FERC included two major concessions to MLP pipeline owners:
- MLPs may include a tax allowance in their cost of service pricing under certain circumstances for a three-year period.
- FERC eliminated accumulated deferred income tax balances for MLPs instead of requiring these to be refunded to customers.
The net impact of these concessions will vary from company to company, but we believe they likely will result in less rate pressure on cost-of-service pipelines than was originally projected several months ago.
The July FERC announcement also explicitly granted MLP pipeline owners the opportunity to explain why including a tax allowance does not lead to a double-recovery of income taxes. This clarification was a surprise positive outcome and could create a more stable operating environment for those MLPs most impacted by the original March announcement — if they are successful in arguing their case for pipeline rates. Overall, the final ruling delivered clarity for the MLP industry and may help investors refocus on company fundamentals.
Fundamentals appear positive for the MLP investment case
Despite the recent ups and downs of the MLP market, Invesco Real Estate remains optimistic on the MLP space.
- Consensus estimates point to 20% earnings growth in 2018 followed by a further 11% earnings growth in 2019.3
- Furthermore, we believe that OPEC’s agreement to limit crude oil production will be beneficial for North American production growth as global supply and demand appear to be in balance.
- We also believe the MLP sector continues to enjoy political support given the Trump administration’s focus on reducing energy regulation. This could benefit MLP companies currently seeking approval for new North American projects that may prove accretive to long-term earnings growth.
- Lastly, we believe that relaxed restrictions on US exports on oil and natural gas should provide a tailwind for select companies in the MLP space.
Where do we see opportunity?
The two production basins currently attractive to us are the Permian and the Marcellus given their strong underlying economics and resilient production volumes. We also believe that companies focused on refining and storage remain in strong positions given their stable contractual cash flows coupled with significant project backlogs. Another of our high-conviction views is a focus on companies geared to the natural gas liquids segment, specifically those involved in ethane and propane (where prices have been surging).
Within the MLP universe, there are many high-quality companies with strong fee-based cash flows capable of growing their asset base via organic capital expenditures or acquisitions, in our view. According to the American Petroleum Institute (API), there is currently a need for significantly more investments in North American energy infrastructure. API estimates that from 2018 through 2035 an additional $521 billion will need to be invested in oil-related pipelines, and $481 billion more will be needed for natural gas pipelines.
As always, we believe the key to successfully investing in the MLP space involves strong fundamental research, selectivity and an institutional mindset. We see 2018 as providing a ripe environment for active management in the MLP space and we believe the opportunity for outperformance may continue given the inefficiencies in the MLP asset class.
About Invesco Real Estate
Invesco Real Estate has nearly 475 employees in 21 different markets worldwide with current assets under management exceeding $64 billion as of June 30, 2018. Our focus areas include US real estate, global real estate, global real estate income, infrastructure and MLPs.
Learn more about Invesco MLP Fund, as well as our broad range of real estate and real asset solutions.
1 Source: Bloomberg L.P., data as of July 30, 2018
2 Source: Bloomberg L.P., data as of June 30, 2018
3 Source: Bloomberg L.P., data as of June 25, 2018
A master limited partnership (MLP) is a publicly traded limited partnership in which the limited partner provides capital and receives periodic income distributions from the MLP’s cash flow and the general partner manages the MLP’s affairs and receives compensation linked to its performance.
Energy infrastructure MLPs are subject to a variety of industry specific risk factors that may adversely affect their business or operations, including those due to commodity production, volumes, commodity prices, weather conditions, terrorist attacks, etc. They are also subject to significant federal, state and local government regulation.
Hydrocarbons are organic compounds (such as acetylene or butane) containing only hydrogen and carbon — these commonly occur in petroleum, natural gas and coal.
A multiple is any ratio that uses the share price of a company along with some specific per-share financial metric to measure value. Generally speaking, the higher the multiple, the more expensive the stock.
The price-to-cash-flow ratio measures a stock’s valuation by dividing its share price by its cash flow per share outstanding.
The price-to-earnings ratio measures a stock’s valuation by dividing its share price by its earnings per share.
Correlation is the degree to which two investments have historically moved in relation to each other.
The Permian Basin is an area rich in recoverable hydrocarbons located in western Texas and southeastern New Mexico.
The Marcellus Basin is an area rich in recoverable hydrocarbons (primarily natural gas) located in the Allegheny Plateau in the eastern US.
Natural gas liquids (NGLs) are components of natural gas that are separated during refining. Examples of NGLs include propane, ethane and butane.
The Alerian MLP Index is a composite of the 50 most prominent energy master limited partnerships calculated by Standard & Poor’s using a float-adjusted market capitalization methodology.
The S&P GSCI Energy Index is a benchmark for investment performance in the energy market.
This article is brought to you courtesy of Invesco.