Commentary

MLPs Q1 2016

04/01/2016

Market Overview

OFI Steelpath

For the first quarter of 2016, master limited partnerships (MLPs), as measured by the Alerian MLP Index (AMZ), were down 6.5% on a price basis and down 4.2% 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 fell 8.0% on a price basis and lost 5.6% on a total return basis. For context, the broader market, as measured by the S&P 500, gained 0.8% on a price basis or 1.3% from a total return perspective.

Crude oil and natural gas prices continued to drive sentiment over the period. Technical influences, such as the U.S. Dollar’s relationship with crude oil prices, exerted heightened influence on trading during the first quarter. Further, energy related equities and energy commodity prices remained highly correlated over the period. Despite resilient operating performance, midstream equity performance was negative over the quarter and significant volatility was pervasive. In fact, intra-quarter the AMZI fell 32.9%, bottoming on February 11, and then rebounded 37.1% through quarter-end marking the greatest intra-quarter performance spread in the index’s history.

Fourth quarter reporting season for the midstream group concluded in March. Operating performance was, on average, modestly less than expectations with EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, coming in 0.5% below consensus estimates, but 5.4% higher than the prior quarter’s results. We believe these results continue to highlight the disconnect between the physical world (midstream throughput) and the financial world (commodity and equity prices) and further demonstrate the attractive risk to reward balance of long-term midstream investing.

Over the period, 38 partnerships announced distribution increases, 36 held distributions unchanged from the third quarter, and 11 reduced their distribution. We continue to believe that distribution payout adjustment will remain the exception rather than the rule, and that most of those who choose this option are likely to return to their previous policies as soon as practical. For perspective, excluding the 11 distribution cuts, the remaining sector participants increased distributions by an average of 2.4% over the third quarter of 2015 and 9.2% over the fourth quarter of 2014.

As the energy markets continue to struggle under a historically sharp and prolonged correction in the prices of both crude oil and natural gas, the debt and equity capital markets for energy companies have experienced severe disruption. Within the midstream landscape, capital raising to support growth spending has come from less traditional sources. Approximately $5.8 billion of new MLP equity supply entered the market through secondary offerings over the quarter. However, much of the marketed equity capital came via preferred equity issuance rather than common equity, as yields for common equity remained prohibitive to many partnerships. Further, 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. Additionally, several sponsors have shown significant support through other avenues such as taking equity for drop-down transactions, “pay-me-later” drop-downs, and issuing equity with incentive distribution rights (“IDR”) waivers.

We estimate MLP-focused investment vehicles, including closed-end funds, open-end funds and index-linked products, experienced approximately $2 billion of inflows over the quarter. Therefore, over the period visible equity supply into the market continued to materially outpace visible MLP product driven equity demand.

MLP capital investment over the quarter included approximately $5 billion of announced asset acquisitions and we estimate $4 to $5 billion of organic capital spending. MLP capital spending plans continue to benefit from a robust slate of growth projects needed to accommodate localized capacity constraints, demand-pull from new industrial projects, and export opportunities. While growth rates have moderated, we expect infrastructure investment to continue as energy infrastructure demand remains significant.

West Texas Intermediate (WTI) crude oil priced at the Cushing hub ended the quarter at $38.30 per barrel, up 3% from the end of the fourth quarter and 20% lower than the year-ago period. Domestically, most regional and quality crude pricing differentials were little changed, though the differential between crude oil priced in Midland, TX and Cushing OK did revert to its more historic level after trading at a modest premium for three consecutive quarters as new pipelines came into service. The spread between Brent crude, a proxy for international crude prices, and WTI widened modestly to approximately $1 per barrel as compared to the $3 to $8 per barrel average of the last 24 months.

Henry Hub natural gas spot prices declined 24% from the end of December to end the first quarter at $1.77 per million British thermal units (mmbtu). Natural gas priced in certain areas of Appalachia continued to strengthen relative to benchmark pricing over the period, benefitting from new pipelines that have alleviated some regional infrastructure constraints. For example, natural gas pricing near Leidy, PA exited the quarter at approximately $1.31 per mmbtu, a 26% discount compared to Henry Hub, as compared to the 47% and 67% discounts present at the end of fourth and third quarters, respectively. Alternatively, natural gas priced in the Rockies region (Opal/Kern River) ended the quarter at a $0.15 per mmbtu discount to Henry Hub, after exiting the year at a $0.21 per mmbtu premium.

Natural gas liquids (NGL) priced at Mont Belvieu ended the quarter at $17.61 per barrel, up 5% from the end of the fourth quarter of 2015 and down 23% from March 2015. Frac spreads, a measure of natural gas processing economics, improved over the quarter to settle at $0.25 per gallon, up 27.6% from the end of the fourth quarter but 20.0% lower than the year-ago period. Generally, the greater the frac spread, the greater the incentive for producers to seek natural gas processing capacity.

The futures curves for domestic and international crude oil and domestic natural gas flattened over the quarter but remained in a contango structure (in which futures prices are higher than near-term prices), as nearer-dated contracts were mostly unchanged while pricing for longer-dated contracts declined. Generally, for any commodity, a contango futures market is supportive of storage providers as traders are able to enter into futures contracts to sell volumes in the future at the higher price while hedging this commitment with volumes held in 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 44 basis points to end at 1.83%. The MLP yield spread at quarter-end, as measured by the implied yield of the AMZ index relative to the 10-year Treasury bond, widened by 82 basis points to 7.08%. The long-term average (2000-4Q2015, ex-financial crisis) spread is 3.25%, 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 8.91%.
Over the fourth quarter of 2015, REITs and utilities posted total returns of 6.2% and 16.7%, respectively, versus the AMZ’s 4.2% loss. Price strength for these yield-oriented sectors likely reflects the supportive movements in interest rates over the period. While MLPs are often associated with interest rates, given the yield-oriented return component, energy market duress continued to drive sector sentiment over the period.

Sector valuation statistics, such as the price-to-forward-distributable-cash-flow (DCF) ratio, ended the period little-changed, remaining significantly below both the ten-year average and normalized valuations before the organic growth opportunities created by the energy renaissance. While near-term growth has moderated as the global supply-demand imbalance correction continues, we believe long-term infrastructure needs remain significant. Further, as long-lead time sources of supply, such as deepwater offshore projects, artic exploration, and Canadian oilsands projects, continue to be delayed or cancelled outright, the production from the United States, with its shorter time to production cycle, is likely becoming more critical to meeting medium-term demand.
While it is unclear when the energy markets, or the MLP space in particular, will begin to normalize, we believe we have strategically positioned our portfolios to take advantage of the fundamentals. We feel encouraged that sector valuations rest near historic lows providing an opportunity for significant gains over time. We also remain steadfast in our belief that a recovery in energy and sector sentiment is only a matter of time.

Front Street MLP & Infrastructure Income Class

Contributors

Transmontaigne Partners (NYSE: TLP)

  • TLP units outperformed over the quarter as heightened energy market anxiety generally benefited those with lower risk assets. The partnership maintains low leverage and an asset base of fee-based, take-or-pay terminaling, storage, and transportation assets related to refined products and crude oil. Fourth-quarter operating results reported during the period reflected healthy 1.5x distribution coverage.
  • Further, the partnership’s general partner was sold to a private equity firm during the period which potentially expands the partnership’s growth options.

Energy Transfer Partner, LP (ETP)

  • ETP units underperformed over the quarter as energy market anxiety generally resulted in severe price corrections for those with higher perceived risk. During the period, ETP reported fourth-quarter results that reflected the negative impact from lower commodity prices on certain segments. Further, ETP’s growth plans create substantial funding needs over the coming year.
  • However, ETP’s backlog of growth projects provides line of sight to significant cash flow growth beginning in 2017 and the partnership’s general partner, Energy Transfer Equity (NYSE: ETE), has committed to aiding ETP near-term should assistance been necessary. ETP also raised $2.2 billion over the period to aid its growth plans through an asset sale to Sunoco LP (NYSE: SUN).

Buckeye Partners (BPL)

  • BPL units outperformed over the quarter as heightened energy market anxiety generally benefited those with lower risk assets. BPL’s refined products pipeline system has experienced improved demand trends due to low fuel pricing and stable domestic economic growth and liquids storage fundamentals are healthy.
  • The partnership is expected to benefit from its newly constructed, and fully contracted, South Texas liquids segment.
Detractors

EnLink Midstream Partners, LP (NYSE: ENLK)

  • ENLK units underperformed over the quarter as energy market anxiety generally resulted in severe price corrections for those with higher perceived risk. Though ENLK primarily operates gathering and processing assets, the entity carries little direct operating exposure to commodity prices.
  • Further, during the period the partnership acquired additional Permian and Oklahoma assets that largely generate fee-based cash flows. ENLK raised $750 million of capital via a preferred offering and another $50 million in common units sold to its general partner, Devon Crop. (NYSE: DVN), to help fund its capital investments.

Enbridge Energy Partners, LP (NYSE: EEP)

  • EEP units underperformed over quarter on market uncertainty surrounding the trajectory of oil production levels in Canada and North Dakota. EEP’s natural gas business has also been challenged by low natural gas and NGL prices and declining volumes.
  • Despite these headwinds, 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. Further, EEP’s sponsor, Enbridge Inc. (ENB), remains a supportive sponsor and continues to reaffirm its intent to provide financial assistance and strategic backing.

Energy Transfer Equity, LP (ETE)

  • ETE units underperformed over the quarter as energy market anxiety generally resulted in severe price corrections for those with higher perceived risk. Investor concern over the planned merger of ETE and The Williams Companies (NYSE: WMB) persists. Concern appears to focus on the pro forma leverage of ETE and heightened exposure to certain distressed upstream producers post-merger.
  • We continue to believe in the value of the underlying MLPs and expect ETE’s unit price to improve with the transaction’s close or a resolution to the merger agreement.
  • As a general partner, ETE units are not included in the AMZ or AMZI.
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