High interest rates are tempting. But they aren’t nearly as appealing when the securities that generate them are plummeting in value.
But that’s what happened to energy master limited partnerships when energy prices began to fall in 2014.
These partnerships aren’t required to pay taxes themselves. Instead, they pass on most of their earnings to investors, who eventually pay taxes on the payouts, which typically come from investments in the transportation, processing and storage of oil, natural gas and natural gas liquids like propane and butane.
When energy prices plunged, the prices of units (the name for shares) in these partnerships fell, too. Between September 2014 and the downturn’s 2016 trough, for example, the Alps Alerian MLP ETF, based on the Alerian M.L.P. index benchmark, lost more than half its value. On Tuesday, it was about 40 percent below that 2014 peak.
Now, though, the outlook may be brightening for energy partnerships and the mutual funds and E.T.F.s that own them. Fund prices have stabilized and the average energy partnership mutual fund tracked by Morningstar returned 3.57 percent in the third quarter.
“The financial outlook for these companies is dramatically improved from the depths of the downturn,” said Bobby Edemeka, portfolio manager of the PGIM Jennison MLP mutual fund (PRPAX).
Rising production of oil and natural gas in the United States should translate into higher volumes of business, improved cash flow and better cash payouts for investors in the partnerships, said Kyri Loupis, portfolio manager of the Goldman Sachs MLP Energy Infrastructure fund (GLPAX). Rapidly expanding production is “the real story here,” he said.
United States oil production is expected to rise to 11.5 million barrels a day in 2019 from 9.4 million barrels a day in 2017, the U.S. Energy Information Administration forecasts. Natural gas production should rise by just over 14 percent during the same two-year period, the agency said.
Much of that production is coming from the Permian Basin of West Texas and Southeastern New Mexico. Long a major domestic oil mainstay, the Permian’s output was in decline until hydraulic fracturing — or fracking — unearthed new supplies. In 2010, the Permian yielded less than one million barrels of oil a day. This year, it should yield over three million and should rise by 2023 to 5.4 million barrels, according to IHS Markit. Aside from Saudi Arabia, that is more than the total production of any nation in the Organization of the Petroleum Exporting Countries, IHS Markit said.
Plains All American Pipeline (PAA) and other partnerships have projects to expand their pipeline capacity to handle all that Permian oil. NuStar Energy (NS) and others are beefing up their energy export infrastructure at ports like Corpus Christi, Tex.
Because the energy partnership business is usually volume-driven and based on long-term contracts, moderate price declines need not be crippling. But major declines are another matter.
The drop in oil prices that started in late 2014, from more than $100 a barrel to less than half that price, was sharp enough to hurt.
“People began to worry: ‘What if half of the customers go bankrupt?’” said Brian Watson, lead portfolio manager of the Oppenheimer Steel Path MLP Alpha Plus mutual fund (MLPLX). But most energy partnerships survived and are benefiting from the oil price rebound. Recent oil prices in the $70 to $80 range should be sustainable, Mr. Loupis said.
The financial positions of the partnerships have also stabilized after a period of severe strain, several analysts said.
Unlike real estate investment trusts, which are required to pay out at least 90 percent of their free cash flow — cash that remains after operating and capital expenses — energy partnerships “have some leeway” on distributions, according to Stephen Ellis, a Morningstar analyst.
In 2014, many partnerships distributed 90 percent or more of their cash flow and dipped into capital needed for substantial projects, Mr. Edemeka of the PGIM Jennison fund said. Darin Turner, manager of the Invesco MLP fund (ILPAX), said that soured many investors, who simply said, “I’m not going to buy your stock.”
By now, though, many partnerships have changed course, slashing payouts and building up cash reserves.
“Instead of paying out 100 percent, some partnerships are paying out 60 percent or less,” said Colton Bean, analyst with the energy investment banker Tudor, Pickering, Holt & Co.
Mr. Watson of Oppenheimer said such dividend cuts have left energy partnerships with a stronger financial base, producing a 30 percent increase in available cash, on average. “That extra 30 percent can be applied to capital expenses,” Mr. Watson said.
Despite these improvements, there is, of course, no guarantee that the stocks — or the funds that own them — will rise much. Mr. Ellis of Morningstar describes energy partnership stocks as only “slightly undervalued.”
But Mr. Loupis suggests the undervaluation could be substantial. Energy partnership cash flow has typically grown at roughly 6.5 percent a year in the past, but he predicts annual growth of 8.6 percent from 2018 to 2020.
Partnership stocks are also at the lower end of their long-term price-to-earnings ratios. They usually trade at 13.1 to 24.7 times expected earnings, he said, but they have been selling at a 14 multiple, leaving room for price gains to supplement increasingly safe yields.
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