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Inside MLPs: Our Mid-Year Review Part II

Not so long ago, a tanker on fire in the Persian Gulf would have spiked the price of crude oil. But despite the potentially destabilizing standoff between the US and Iran, West Texas Intermediate crude oil still sells for about $10 a barrel less than a month ago.

That’s in large part due to concerns about global economic growth. But generally flat oil prices are also the most compelling evidence yet of the immense changes in global energy politics wrought by the rise of US shale oil and gas. And don’t forget this is happening as Venezuelan output is imploding, Iran is embargoed and unrest is again threatening Libya.

Inside MLPs: Our Mid-Year Review Part I

As we write this issue, the yield on 10-year US government bonds is just 2.12%, down from north of 3.2% as recently as November 2018.

Against that pay-nothing interest rate backdrop, you’d think MLPs with an average yield closer to 8% would be attracting attention from yield-hungry investors.

However, returns from MLPs have been mixed at best over the past year as investor fret about several issues including potential exposure to energy commodity prices, rising cost of capital, and MLP-to-corporation conversions.

In June each year, we conduct a detailed deep-dive analysis of the MLP industry timed to coincide with the conclusion of the annual MLP Association Conference. And we reveal the results of this analysis in the pages of Energy & Income Advisor.

This week, in Part I, we present our discussions surrounding 6 crucial, hot button “talking points” that are receiving the most attention from MLP investors these days and offer some of our top recommendations in the industry.

Around the middle of the month, we’ll be back with Part II of our Inside MLPs Mid-Year Review.

There’s Deep Value in Energy

For the past five years, it’s become an all too familiar refrain for energy investors: Oil and gas prices drop, but sector stocks fall harder. Then when prices rebound, the shares lag the recovery.

The pattern has also largely held this year, despite the fact that the S&P Energy Index has consistently shown up among the top performing S&P 500 sectors. No matter how positive underlying conditions have become, many investors still favor the commodities to energy stocks.

On the other hand, it’s much harder to ignore the good news that’s increasingly flowing from American energy companies. First quarter 2019 results once again showcased the recovery up and down the energy value chain. And as highlighted in the previous issue, the macro outlook strongly suggests this will continue.

Oil: It’s Not October 2018

Brent and West Texas Intermediate (WTI) oil prices have fallen around 9% from their late April highs to their early May lows amid a spate of concerns including: Trends in US oil production, OPEC’s commitment to recent supply reductions, rising US oil inventories, the health of the global economy and the pote ntial for a destabilizing US-China trade war.

All told, some of these factors appear eerily reminiscent of last October, the start of a serious sell-off in oil that saw WTI prices plummet from $76.90/bbl to the low $40s and Brent to fall from $86.74 to under $50/bbl.

Late last year, we took a look at supply and demand conditions in global oil markets and (correctly) predicted that the selling pressure was near an exhaustion point and that prices would see a sharp recovery into 2019.

With our targets for crude now achieved, and market volatility on the rise, it’s time for an updated deep dive into the oil markets.

Our conclusion: This is not the beginning of another late 2018 style market swoon nor are we seeing any evidence of excess global oil supplies. Rather we see the recent sell-off as a correction driven largely by hedge fund profit-taking following a record-setting start to 2019 for crude.

In this issue, we update our outlook for crude and explain some of the surprising factors behind last week’s larger-than-expected build in US oil inventories.

Don’t Let Energy Politics Derail Your 2019 Profits

“Badly needed energy infrastructure is being held back by special-interest groups, entrenched bureaucracies and radical activists.” That statement this week from President Trump is bound to elicit more than a few “amens” from oil and gas pipeline developers.

The president announced two sweeping executive orders aimed at jump-starting projects stalled by adverse court rulings and state permitting delays. One would rein in state governments’ power to use Section 401 of the Clean Water Act to deny construction permits. It would also direct US agencies to loosen regulation on shipping LNG by rail and truck, seek measures to limit shareholders’ ability to alter companies’ environmental policies and challenge ESG focused retirement funds on the grounds they’re neglecting fiduciary responsibility.

We’re watching closely for any sign of revived activity at delayed natural gas projects such as the Atlantic Coast Pipeline and the Mountain Valley Pipeline, as well as challenged oil pipes like Enbridge Inc’s (TSX: ENB, NYSE: ENB) upgrades of Line 3 in Minnesota and Line 5 in Michigan.

Regulatory Risks: Real and Rising but so is Opportunity

Last November, Colorado voters defeated Proposition 112, a ballot measure that would have imposed significant new limits on oil and gas drilling. This month, the state’s senate advanced legislation that would have much the same impact, if the state house and governor give their assent as expected.

By no means will the new law end energy production in Colorado. But it will for the first time allow city and county governments to use planning and land-use powers to regulate drilling, and with a mandate to prioritize public health and the environment. At a minimum, that means more hurdles for companies to jump through before they drill or build new midstream infrastructure, at least in some jurisdictions.

As our feature article highlights, the “Centennial State” isn’t the only place in the US that’s tightening regulation of energy companies. Even Oklahoma has ramped up industry oversight in recent years, following a dramatic increase in earthquakes.

The Revolution is (Almost) Over

Change in the US energy industry has been dramatic over the past decade.

Sentiment has shifted from a culture of energy scarcity to one of abundance and the US overtook Russia and Saudi Arabia as the world’s largest oil producer.

And, not long ago, you would have been laughed out of a room for predicting that the US would ever export meaningful quantities of oil. Soon however, the nation looks on track to overtake Saudi Arabia as the world’s largest exporter of crude oil on a full-year basis.

We’d argue the shale revolution has also been one of the most important positive developments for the US economy in recent years, helping to reduce dependence on energy imports from politically unstable countries, revitalizing vast swathes of the US manufacturing industry and giving us all a break in the form of lower gasoline prices.

The end of the shale revolution does NOT mean that all of these positive changes and economic trends will reverse, nor does it mean that US energy production will fall again. It does mean that the industry is maturing and that has profound implications for investors.

Gone are the days of growth for growth’s sake, access to seemingly unlimited pools of capital at ultra-low prices and boom-or-bust shale drilling cycles. The winners in the next phase of the shale boom will be disciplined producers that can generate reliable free cash flow with moderate oil and gas prices and services and equipment firms that focus on driving efficiency rather than simple providing basic, commodity services to their customers.

Can Energy Stay Hot?

Energy stocks are showing real signs 2019 will be the year they break out of a nearly five-year slump.

Both the S&P 500 Energy Index and the Alerian MLP Index posted total returns in the low teens for the first two months of 2019. That’s energy stocks’ best start to a calendar year since 2013, when those two indexes finished up 25 percent and 27.6 percent, respectively, en route to making all-time highs.

Benchmark WTI Cushing crude started 2013 in the low $90s per barrel, briefly broke down to the mid-$80s in April, then hit a high of $110 plus in late August before closing the year right around $100. Henry Hub gas, meanwhile, traded between $4 and $5 per thousand cubic foot for most of the year.

Those prices are a far cry from where we are now. But the trajectory of the commodities themselves has been generally encouraging in recent months. So is the fact that energy midstream master limited partnerships weren’t left out of this uptrend, as they were when oil rallied last year.

Where the Rubber Meets the Road

Earnings reporting and guidance call season often provoke investor confusion, angst and unfortunately all too often some very bad decisions. But they’re also where the rubber meets the road in this business.

Basically, companies have to own up to what’s going on with their operations, how strong their balance sheets really are and what challenges they face that could possibly derail their fortunes.

Earnings reporting seasons have more often than not been unhappy times for energy investors since oil prices first cut under $100 a barrel back in mid-2014. But for at least a year, we’ve noticed a decided change for the better, at least for the sector’s best in class companies. Basically, companies have gotten their acts together when they could, or else fallen of the map entirely.

The result is our Energy and Income Advisor coverage universes of producers, services companies, midstream/master limited partnerships and international companies have been winnowed down considerably. The vast majority is either decidedly back on track, or else are virtual zombies awaiting oblivion.

We’ve yet to see any real investor excitement flow back into the survivors. But there is certainly a lot to get pumped about when it comes to US companies, with surging energy exports and expanding output of oil and gas. Even in Canada there’s reason for optimism, as new transport capacity has cut the price differential between Western Canada Select and West Texas Intermediate Cushing to only around $10 a barrel.

There are multiple explanations why investors’ money hasn’t flowed back into energy stocks yet, starting with anxiety about energy prices and the global economy. But it always has when energy companies have continued to drive down costs and boost revenue on a sustained basis. And our bet is it’s only a matter of time at this point.

Focus on Dividends

Dividend investors can certainly be forgiven for distrusting energy companies’ dividends.

We launched the Energy and Income Advisor Endangered Dividends List on June 30. Of the original list of 16 names, only four have managed to avoid a dividend cut since. Of the dozen or so we’ve added to the list more recently, fewer than half have managed to hold up. And all 15 companies currently on the EDL are at high risk of making reductions sometime in the next 6 to 9 months, if not eliminating distributions entirely.

All of these cuts are, of course, on top of dozens more through the first half of 2018, dating back to when oil prices first broke under $100 a barrel back in 2014. And it doesn’t help that the latest round has come with benchmark West Texas Intermediate Crude oil prices still nearly twice their early 2016 lows.

The carnage has understandably made many skeptical that any energy company’s dividend is secure, no matter how good numbers and guidance get. Kinder Morgan Inc (NYSE: KMI), for example, earlier this month announced strong fourth quarter operating numbers, raised guidance and affirmed a 25 percent dividend increase for April. Its shares, however, managed only a small surge, which they’ve since given up.

Skepticism is even more clearly etched in prices of the three dozen or so master limited partnerships we track that currently yield 10 percent or more. Sure, some of them are headed for dividend cuts, with EDL companies at the greatest risk. But other high yield companies appear to have fallen despite all indications they’re still strong on the inside.

This issue, we highlight high yielders still likely to hold their payouts this year and recover their lost ground. Timing will depend squarely on what happens to oil and natural gas prices. The Alerian Index, for example, has closely followed oil prices, though recently outperforming the commodity.

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      Founder and Chief Analyst: Capitalist Times and Energy & Income Advisor