Commentary

MLPs Q2 2016

07/01/2016

Market Overview

OFI Steelpath

For the second quarter of 2016, master limited partnerships (MLPs), as measured by the Alerian MLP Index (AMZ), were up 17.4% on a price basis and 19.7% 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 increased 18.2% on a price basis and 20.6% on a total return basis. For context, the broader market, as measured by the S&P 500, gained 1.9% on a price basis or 2.5% from a total return perspective.

While the depths of this energy cycle appear to be behind us, a recovery is far from complete. The supply-demand picture for both crude oil and natural gas have improved and suggest a resumption of growth lies ahead. Importantly for midstream investors, the call on U.S.-sourced volumes over the medium-term appears to have shifted higher which over time should aid midstream asset utilization. This fundamentally positive commodity outlook, combined with midstream valuations that remain below long-term averages, we believe, makes a compelling case for midstream investment. As a rough guide, midstream MLP unit prices would have to rise by approximately 20% in order for yields to return to their historic average. Further, the asset class currently offers a 7.2% level of annual yield which should also help to garner investor attention as investor anxiety wanes.

First quarter operating performance was, on average, modestly better than expectations with EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, coming in 2.1% above consensus estimates and 2.9% higher than the prior quarter’s results. Further, 81 midstream entities announced distributions for the quarter, including 32 distribution increases, 44 distributions that were unchanged from the fourth quarter, and five distribution reductions. Interestingly, the average one-week price performance of those who announced a first quarter 2016 distribution reduction was a 15% increase (with a range of -29% to +47%). Historically, distribution cuts have resulted in severe price corrections. We believe these post-cut gains in part reflect the extreme oversold condition to which many of these names had fallen.
Approximately $1.9 billion of new MLP equity supply entered the market through secondary offerings over the quarter. Of note, roughly half of this total was issued through traditional secondary offerings of common units signaling capital markets access for midstream entities has begun to improve. 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.

We estimate MLP-focused investment vehicles, including closed-end funds, open-end funds and index-linked products, experienced approximately $1.6 billion of inflows over the quarter. Therefore, over the period visible equity supply into the market continued to 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 $48.33 per barrel, up 26% from the end of the first quarter but still 19% lower than the year-ago period. Domestically, most regional and quality crude pricing differentials were little changed. However, the differential between crude oil priced in Clearbrook, MN (a proxy for Bakken barrels) and WTI, traded at a premium during the quarter as compared to a historic discounted price, benefitting from outages caused by the wildfires in Canada. The spread between Brent crude, a proxy for international crude prices, and WTI ended the quarter relatively unchanged near $1 per barrel as compared to the $3 to $8 per barrel average of the last two years.

Henry Hub natural gas spot prices rose 50% from the end of March to end the second quarter at $2.90 per million British thermal units (mmbtu). Natural gas priced in certain areas of Appalachia weakened relative to benchmark pricing over the period as incremental capacity from new pipelines has yet to sufficiently debottleneck the region. For example, natural gas pricing near Leidy, PA exited the quarter at approximately $1.60 per mmbtu, a 45% discount compared to Henry Hub.

Natural gas liquids (NGL) priced at Mont Belvieu ended the quarter at $21.15 per barrel, up 20% from the end of the first quarter of 2016 and 4% higher than June 2015. Frac spreads, a measure of natural gas processing economics, improved over the quarter to settle at $0.25 per gallon, effectively unchanged from the end of the first quarter and approximately 3% higher 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 pricing on nearer-dated contracts increased more than pricing for longer-dated contracts. 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 30 basis points to end at 1.47%. 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 120 basis points to 5.76%. The long-term average (2000-2Q2016, ex-financial crisis) spread is 3.30%, 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 7.23%.

Over the second quarter of 2016, REITs and utilities posted total returns of 7.0% and 8.0%, respectively, versus the AMZ’s 19.7% gain. Price strength for these yield-oriented sectors likely reflects the supportive movements in interest rates over the period. Although MLPs are often associated with interest rates, given the yield-oriented return component, the unfinished energy market recovery drove improved sector sentiment over the period that was further augmented by the interest rate tailwind.

If historical cycle patterns hold, a period of recovery for midstream equities may lie ahead. We believe such a scenario is possible driven by what we expect to be a slow, uneven, but prolonged improvement in the commodity price environment and production trends which we believe will allow expectations for midstream asset utilization and business growth to reemerge. Importantly, we believe the peak in required midstream asset investment has likely passed which should result in a moderation of capital markets needs. As a result, we believe the midstream asset class offers attractive total return potential comprised of the potential for price appreciation as well as a stable or growing distribution stream..

Sector Commentary

For the first time in several quarters the flight to safety trade reversed as crude prices bounced off of February’s lows. While the Alerian MLP Index tracked crude prices higher (both up ~17% during the quarter), several partnerships and midstream companies experienced substantial appreciation after balance sheet strain was relieved through new funding announcements or future spending obligations were ameliorated. Sub-sector performance similarly reversed course, with several higher beta groups leading the way while defensive sectors lagged.

Outperformers

Coal partnerships exhibited the strongest outperformance during the quarter on the back of higher commodity prices. These partnerships bore the brunt of the commodity downturn due to lower coal prices and reduced demand, and may benefit from higher natural gas prices which could encourage gas-to-coal switching for power generation.

Diversified partnerships reversed the prior quarter’s underperformance, helped primarily by the dissolution of the Energy Transfer and Williams merger along with Semgroup’s announced acquisition of Rose Rock, its limited partnership.

Gathering & Processing partnerships similarly reversed course and moved higher during the quarter, driven by higher oil, gas, and NGL prices combined with the market’s swing to a risk-on mentality.

Underperformers

Natural Gas Pipelines partnerships underperformed during the quarter, albeit with positive absolute performance. The sector benefited from the flight-to-safety trade during the pullback in commodity prices over the past several quarters, but lagged higher-beta peers during the subsequent move higher in commodities.

Propane partnerships experienced a similar reversal of prior period outperformance as investors flocked to higher beta sectors, however the sector still produced positive absolute performance.

Variable Distribution partnerships, composed primarily of refiners, continued to decline during the quarter as crack spreads, a generic measure of refining profitability, experienced further reductions driven by elevated global product inventories.

Front Street MLP & Infrastructure Income Class

Contributors

NGL Energy Partners (NGL)

  • NGL units outperformed following the partnership’s announcement of a strategic preferred equity investment and an agreement to temporarily reduce its distribution payments as it constructs a large scale crude oil pipeline that is expected to begin generating cash flow during the second half of 2016.
  • Management has stated an intent to recommend the resumption of the previous distribution level after four quarters at the reduced rate.

EnLink Midstream Partners, LP (NYSE: ENLK)

  • ENLK units outperformed over the period as improved market sentiment supported partnerships with higher risk assets or those that benefit from higher commodity prices.
  • ENLK is expected to benefit from growing volumes in the Permian Basin in Texas and New Mexico and the SCOOP and STACK play in Oklahoma, as producers in both areas have recently announced plans to add rigs during the second half of 2016 or early 2017.

BTarga Resources Corp (TRGP)

  • TRGP shares outperformed over the quarter, as improved market sentiment supported partnerships with higher risk assets or those that benefit from higher commodity prices.
  • TRGP reported strong first quarter financial and operating results including distribution coverage of 1.2x, despite low commodity prices. TRGP’s assets are expected to benefit from improved ethane recoveries to support petrochemical facilities expected to begin operations over the next several years.
Detractors

Buckeye Partners (BPL)

  • Buckeye was a relative underperformer over the period as improved market sentiment supported partnerships with higher risk assets.
  • Buckeye benefits from a highly contracted network of petroleum logistics assets that offer stable cash flow. However Buckeye has less direct exposure to higher commodity prices than other sector participants.

CrossAmerica Partners, LP (CAPL)

  • CAPL underperformed over the period as improved market sentiment supported partnerships with higher risk assets or those that benefit from higher commodity prices. In addition, the partnership’s sponsor, CST Brands (CST), announced plans to consider strategic alternatives to improve returns to shareholders and that such plans include a potential sale of CST. The uncertainty created has likely served to temper investor interest in CAPL.
  • However, during the quarter CAPL maintained its 2016 distribution growth target of 5-7%.

Holly Energy Partners, LP (NYSE: HEP)

  • HEP underperformed over the quarter as the improved energy market sentiment generally benefited those with higher risk assets.
  • HEP operates a suite of stable petroleum products and crude oil pipelines and tankage that primarily serve the refining assets of its sponsor, HollyFrontier Corp. (NYSE: HFC), and which are backed by long-term, fee-based contracts. The company is on pace to achieve its recently increased distribution growth target of 8%.
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