Commentary

MLPs Commentary Q1 2017

03/31/2017

For the first quarter of 2017, master limited partnerships (MLPs), as measured by the Alerian MLP Index (AMZ), were up 2.2% on a price basis and up 3.9% on a total return basis, or including the impact of distributions. As measured by the Alerian MLP Infrastructure Index (AMZI), a more concentrated measure of midstream MLPs, the sector gained 2.4% on a price basis and 4.1% on a total return basis. For context, the broader market, as measured by the S&P 500, gained 5.5% on a price basis and 6.1% on a total return basis.

Correlation of price performance between midstream equities and crude oil remained elevated over the period at 63% versus the 10-year average of 47%, and a late quarter period of crude oil price weakness was accompanied by midstream price weakness. This crude oil price weakness appeared to stem primarily from continued U.S. inventory builds as well as fears that U.S. shale producers may ramp production more quickly than previously anticipated. However, storage builds over the first-quarter are normal and likely provide little indication of the current crude oil supply and demand balance (we provided further insight in our March 13th blog Energy Markets Have Turned Choppy but We Like the Horizon). Further, while a quicker than expected resurgence of U.S. shale production may serve to temper the crude price recovery we note midstream assets should benefit through the resultant volume improvements regardless.

The influence of Washington remained topical over the quarter. In contrast to the challenging energy regulatory environment of the prior presidential administration, President Trump signed multiple midstream related executive orders in late January designed to expedite current and future midstream projects. Two orders were individually specific to the Keystone XL and Dakota Access Pipelines, each directing respective authorities to take all actions necessary and appropriate to facilitate the implementation of the projects. Additionally, President Trump signed an order to expedite the review and approval of high priority infrastructure projects. Separately, three large natural gas pipeline projects, representing a collective $7.5 billion of growth capital spending, received Federal Energy Regulatory Commission (FERC) approval in early February, just ahead of FERC’s loss of a quorum due to the resignation of a FERC commissioner. The commission now lacks a quorum to vote on project approvals until at least one new commissioner can be nominated and confirmed which is not likely to be accomplished until mid-2017.

Most midstream, or energy infrastructure, subsectors provided positive performance over the reporting period. On average, the Gathering and Processing and Marine subsectors provided the best performance over the quarter, buoyed by improving commodity prices supporting improved volumetric projections. Conversely, the propane subsector was the only group to experience negative performance over the reporting period as warmer than normal weather and propane price volatility added idiosyncratic headwinds.
Fourth quarter operating performance was reported during the period and was, on average, better than consensus expectations with EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, coming in 2.1% better than consensus estimates and 7.3% higher than the third quarter of 2016. Midstream entities announced 46 distribution increases and 31 distributions that were unchanged from the third quarter.

Approximately $5.9 billion of new MLP equity was issued over the quarter via marketed transactions and we estimate an additional $2.0 to $3.0 billion was issued through “at-the-market” programs in which primary units trade into the market anonymously throughout the normal trading day. An added $9.9 billion of capital was raised via the debt capital markets. We estimate MLP-focused investment vehicles, including closed-end funds, open-end funds and index-linked products, experienced approximately $2.8 billion of inflows over the quarter.
MLP capital investment over the quarter included approximately $9 billion of announced asset acquisitions and we estimate $6 to $7 billion of organic capital spending. New midstream project opportunities to alleviate localized capacity constraints, meet demand from new industrial capacity, and to fulfill export demand remain abundant, particularly in premier basins such as the Permian, Midcontinent, and Appalachia as well as Gulf Coast port, refinery, and petrochemical facilities.

West Texas Intermediate (WTI) crude oil priced at the Cushing hub ended the quarter at $50.60 per barrel, down 6% from the end of the fourth quarter and 32% higher than the year-ago period. Domestically, most regional and quality crude pricing differentials held true to recent norms. The differential between crude oil priced in Midland, TX and WTI priced at Cushing, OK that had moved to a modest premium in late 2016 reversed to a modest discount potentially indicating that Permian pipeline utilization rates were normalizing after several pipes were placed into service in recent months, and as Gulf Coast pricing continued to improve relative to Cushing thereby incenting Permian barrels to move to the coast rather than inland. Late in the quarter Canadian differentials improved significantly following a facility fire and maintenance activity in the region. The spread between Brent crude, a proxy for international crude prices, and WTI ended the quarter near $2 per barrel, narrowing back to recent normalized levels and providing modestly less incentive for U.S. refiners to run domestic crudes as international barrels became incrementally less expensive.

Henry Hub natural gas spot prices ended the quarter at $3.10 per million British thermal units (MMbtu), down 16% from the end of the fourth quarter and 60% higher than the year ago period. Natural gas priced in certain areas of Appalachia continued to tighten relative to benchmark pricing over the period as incremental capacity from new pipelines continued to debottleneck the region. For instance, natural gas pricing near Leidy, PA exited the quarter at approximately $2.82 per MMbtu, a very modest 9% discount to Henry Hub as compared to the 38% discount a year ago and the very wide 86% discount at the end of the third quarter of 2016. Additionally, natural gas prices in the Permian basin relative to benchmark pricing continued weakening as available takeaway capacity has tightened; highlighting the midstream debottlenecking opportunity.

Natural gas liquids (NGL) priced at Mont Belvieu ended the quarter at $23.75 per barrel, down 18% from the end of the fourth quarter but 35% higher than the year-ago period. Butane pricing exhibited the weakest performance, down 46% over the quarter as tightness from seasonally higher demand in Northeast Asia and lower supply from the Middle East, eased as winter came to an earlier than normal end. Frac spreads, a measure of natural gas processing economics, weakened over the quarter to settle at $0.29 per gallon, down 21% from the end of the fourth quarter but 17% higher than the year-ago period. Generally, the greater the frac spread, the greater the incentive for producers to seek natural gas processing capacity.
Notably the backwardated structure (in which future prices are lower than near-term prices) of both the crude oil and natural gas futures curves steepened over the period as near term pricing declined less than longer-dated prices. Generally, for any commodity, a backwardated futures market acts to deter storage by removing the ability for traders to purchase and store the commodity today to sell at a higher hedged price in the future. Generally, providers of storage services prefer a contango market and, therefore, market structure over the period was unfavorable for contracting available storage.

Please note, though we routinely review the pricing environments for the major energy commodities in our commentaries, we do so primarily to provide investors a more nuanced understanding of the broader energy markets. However, we choose to seek to exploit the logistical needs surrounding these products primarily through energy infrastructure MLPs that we believe are not overly exposed to changes in these prices.

Over the quarter, the ten-year Treasury yield declined six basis points to end at 2.39%. The MLP yield spread at quarter-end, as measured by the implied yield of the AMZ index relative to the 10-year Treasury bond, narrowed by three basis points to 4.63%. The long-term average (2000-1Q2017) spread is 3.54%, which continues to suggest that 10-year treasury rates could increase materially before this spread approached its historical average. At period-end, the AMZ’s indicated yield was 7.02%.
Over the first quarter of 2017, REITs and utilities posted total returns of +1.2% and +6.6%, respectively, versus the AMZ’s 3.9% gain. Price strength for these yield-oriented sectors likely reflects the modest decline in interest rates over the period. Although MLPs are often associated with interest rates, given the yield-oriented return component, the energy market recovery has recently exerted a stronger influence on midstream equities.

We expect midstream operators to benefit from the reflation of domestic hydrocarbon production and the more efficient use of existing assets going forward, in contrast to the widespread need to construct new assets over the first years of shale production growth. We believe current market valuations underestimate the potential for renewed business growth going forward and we remain optimistic on the sector’s prospects. Consequently, we believe midstream MLPs continue to offer attractive total return potential based on the potential for price appreciation and stable or growing distribution streams.

1Q17 Sector Commentary

Despite late quarter midstream price weakness which accompanied a period of crude oil price weakness, the midstream sector outperformed the more commodity sensitive sectors of the broader energy market. Midstream subsectors with exposure to volume growth or other idiosyncratic drivers led the pack, while more commodity exposed subsectors declined.

Outperformers

Natural Gas Pipelines partnerships led the midstream sector during the quarter and likely benefited from a lack of exposure to crude oil fundamentals. Further, firming expectations for natural gas demand likely aided the subsector with the completion of a major export facility and strong subscription results for new pipeline capacity.

Marine partnerships also outperformed during the quarter, driven primarily by investor interest in LNG shipping companies. While the majority of vessels are on long-term contracts, spot rates moved higher as global export facilities began operation, increasing the volumes of LNG traded and improving long-term prospects for the group.

Underperformers

Refining partnerships underperformed during the quarter, as persistent product inventory fears weighed on sentiment, despite refining margins moving higher during the quarter.

Propane partnerships underperformed during the quarter which likely reflects the expected impact of the warmer than expected winter heating season on delivered volumes.

E&P partnerships underperformed during the quarter as oil prices declined during the last month of the period.

Contributors

ONEOK Partners, LP (OKS)

• OKS outperformed over the period following an announcement that the partnership and its sponsor, ONEOK, Inc. (OKE) would merge, eliminate incentive distribution rights (“IDRs”), and enhance dividend growth prospects.
• As a result of the transaction, ONEOK provided dividend growth expectation of 9% to 11% annually through 2021.

Tallgrass Energy Partners LP (TEP)

• TEP shares outperformed over the period after announcing better than expected operating and financial results as well as new long-term contracts on the Rockies Express Pipeline.
• TEP management expects to grow its distribution by 20% in 2017.

Holly Energy Partners, L.P. (HEP)

• HEP outperformed over the quarter as its stable business profile likely attracted additional investor interest during late quarter commodity price weakness. The partnership’s recent financial performance demonstrated continuing stability as EBITDA continued to grow and distribution coverage remained robust.
• The partnership is on pace to achieve continued mid-to-high single digit distribution growth and carries reasonable leverage.

Detractors

Enbridge Energy Partners, L.P. (EEP)

• EEP underperformed over the quarter as the company provided disappointing financial projections for the upcoming fiscal year, with the expected weakness primarily due to EEP’s natural gas business and North Dakota rail terminal.
• Enbridge Inc. (ENB), EEP’s sponsor, having recently completed its acquisition of Spectra Energy (SE), is now evaluating strategic options in order to address EEP’s financial and operating profile. Though the results of the strategic review could result in various financial, operating, and management directives, ENB remains a supportive sponsor and continues to reaffirm its intent to provide strategic backing. Further, EEP benefits from a large network of crude oil pipelines in the U.S. and Canada, most of which benefit from strong contractual cash flow regardless of commodity prices or throughput volumes.

Genesis Energy, LP (GEL)

• Despite strong results in the Offshore pipeline segment, GEL units underperformed over the period on weaker results in its Supply & Logistics, Marine, and Onshore pipeline segments due to a combination of lower volumes and margin compression.
• However, we expect improving sequential quarterly results as new projects recently placed into service demonstrate increased utilization.

Summit Midstream Partners, LP (SMLP)

• SMLP underperformed over the period after the partnership’s general partner (“GP”) sold a portion of its holdings via an overnight equity offering that transacted at an 8% discount to the previous day’s closing stock price.
• Following the sale, the GP continues to hold 36% of the outstanding units of SMLP and expects to receive additional units via the deferred payment mechanism which facilitated the sale of assets to SMLP in 2016.

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