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Issues

MLP Madness

During our August Live Chat with subscribers, readers inundated us with questions about master limited partnerships (MLP), specifically which ones were at risk of cutting their distributions and which names were worth buying after the most recent pullback.

To address these concerns, we’ve dedicated this issue to the MLPs, highlighting the risk factors that have driven the group’s painful re-rating and identifying a number of popular MLPs that could cut their distributions or could be at risk for significant downside.

However, the universe of publicly traded partnerships still contains a number of appealing total-return stories–and the potential for further downside in crude-oil prices this fall and in early 2016 could create an excellent buying opportunity for savvy investors.

To help readers take advantage of this opportunity, we’ve created a list of dream buy prices for our MLP Portfolio holdings. The next issue of Energy & Income Advisor will include dream buy prices for names that we would consider adding to our model Portfolios if the stocks get cheap enough.

Ripping Off the Band-Aid

Throughout the energy sector’s recovery rally earlier this year (a false spring), we warned of a second leg down for crude-oil prices, with the selling pressure intensifying in fall and winter, when refineries usually shutter some of their capacity for maintenance and upgrades.

Valero Energy Corp (NYSE: VLO) and other refiners have warned that this year’s turnaround season could involve more outages than usual because the industry ran flat out in the spring and summer to take advantage of robust demand for gasoline and favorable crack spreads.

And even after record refinery runs and gasoline demand this summer, resilient production and overseas imports have ensured that US crude-oil inventories remain about 26 percent above their five-year average for this time of year.

This overhang, coupled with the prospect of reduced demand, suggests that oil prices could suffer significant downside this fall. Albeit painful, such a correction could accelerate the process of squeezing production from marginal acreage and ratchet up the pressure on those with stretched balance sheets.

The potential for crude-oil prices to slip into the $30s per barrel (and perhaps even lower), coupled with slowing production growth in some basins and outright shrinkage in others, suggests that the energy sector could be in for more pain this fall and into early 2016.

Exploration and production companies likely face the most downside in this scenario, and we would continue to steer clear of onshore and offshore contract drillers and other equipment providers. Even midstream master limited partnerships face near-term uncertainties related to counterparty and volumetric risk.

However, we remain bullish on US oil and gas production over the next three to four years, as we expect reductions in non-OPEC drilling activity and reduced capital expenditures in international markets to create an opportunity for short-cycle shale plays to fill the gap and win market share.

Rest assured, there’s more pain coming for the energy sector in the near term, creating a real buying opportunity for investors with a longer time horizon. Keep your powder dry and your head level.

Pain and Gain

Oil prices will stay lower for longer: We reiterated this outlook in the July 18 issue of Energy & Income Advisor and have maintained this forecast since fall 2014, despite many commentators calling for a V-shaped recovery in prices.

Earlier this year, far too many investors eager to load up on what they regarded as emerging values. And the short-lived relief rally in oil prices and energy-related equities earlier this year gave them confidence that the market had bottomed and emboldened them to plow money into ostensibly bargain-priced stocks.

Although many energy stocks look inexpensive relative to their recent price history, industry fundamentals have changed dramatically; a cheap stock can always get cheaper.

Investors should expect an uptick in bankruptcies among highly leveraged exploration and production companies with marginal assets. For example, investors betting that a takeover offer will rescue their underwater positions in SandRidge Energy (NYSE: SD) likely will be disappointed.

And even shares of best-in-class energy companies will suffer further downside if West Texas Intermediate (WTI) crude oil drops to less than $40 per barrel during the upcoming refinery turnaround season. This downside likely would extend to high-quality midstream names and the major integrated oil companies.

But real opportunities lurk amid all this pain.

Oil Prices: Still Lower for Longer

In the Dec. 25, 2013, issue of Energy & Income AdvisorCommodity Price Outlook for 2014, we made the following prognostication:

With North American production of light sweet crude oil on the rise, investors should gird themselves for bouts of volatility that could entail a short-lived drop in WTI [West Texas Intermediate]—potentially to less than $80 per barrel.

At the time, we didn’t foresee a selloff as severe as the one that rocked the industry last fall; rather, we thought oil prices would come under more pressure than usual during periods of seasonal refinery outages.

We also worried that surging US production eventually could overwhelm domestic refiners’ capacity to process volumes of light, sweet crude oil.

But we still took steps to reduce the Portfolio’s risk, cashing out of SeaDrill (NYSE: SDRL) in fall 2013 and selling fracking sand specialist Hi-Crush Partners LP (NYSE: HCLP) in spring 2014 for a roughly 60 percent gain.

We also reiterated our Sell call on SeaDrill, a stock we first highlighted in 2007, on several occasions in 2014 and added American Airlines (NSDQ: AAL) to the Model Portfolio as a hedge against lower oil prices in January 2014. (See Why SeaDrill Still Rates a SellFive Myths about SeaDrill That Could Cost You Real Money and Buy the Friendly Skies.)

Last fall, we warned that the price of West Texas Intermediate (WTI) crude oil could slip to as low as $40 per barrel in early in 2015 and that further loosening in the supply-demand balance could depress prices to as low as $30 per barrel.

Although WTI hasn’t pulled back to this nadir, our forecast—reiterated in numerous issues of Energy & Income Advisor—for crude-oil prices to remain lower for longer has more important implications for investors.

Our outlook calls for WTI price to range between $40 and $60 per barrel for most of 2016—a forecast that we’ve reiterated numerous times during our monthly Live Chats.

Crude-oil prices enjoyed a brief relief rally from mid-March to early May, fueled by profit-taking and higher refinery utilization rates in anticipation of the summer driving season, a period of peak demand.

But elevated inventory levels in the US and the prospect of refinery outages for regular maintenance and upgrades has sent WTI lower in recent weeks.

LNG Market Update: Near-Term Volatility, Long-Term Opportunity

When natural gas is cooled to minus 260 degrees Fahrenheit at a liquefaction facility, the fuel condenses to roughly 1/600th of its original volume, facilitating overseas transport in specially designed ships.

Regasification terminals heat the liquefied natural gas (LNG) to restore the delivered volumes to a gaseous state before pipelines transmit the product to end users.

This network of LNG carriers and import and export terminals effectively releases natural gas from the geographical constraints of the pipeline network, enabling producers to deliver their output to overseas end markets.

In recent years, investors have become obsessed with the wide price differential between US and Asian natural-gas prices and the potential for meaningful LNG exports to provide a much-needed release valve for the oversupplied North American market.

However, the start-up of Exxon Mobil Corp (NYSE: XOM) and Oil Search’s (ASX: OSH, OTC: OISHY) LNG export project in Papua New Guinea, coupled with lower-than-expected Chinese demand growth and a mild winter in Northeast Asia, has led to a regional oversupply in the spot market.

Over the next two years, the start-up of other massive LNG export facilities in Australia and on the US Gulf Coast will exacerbate this emergent oversupply, intensifying competition among suppliers and redirect flexible volumes from Qatar and other producers back to Europe, the market of last resort.

At the same time, most long-term LNG supply contracts with Asian buyers allow for regular price resets based on movements in the Japanese crude cocktail, or the monthly average price of a basket of imported crude oils.

Second-quarter results for LNG buyers and sellers that operate primarily in the Asia-Pacific region should reflect the full effect of the severe downdraft in crude-oil prices; the price reset mechanism included in these oil-indexed supply agreements usually occurs on a three- to six-month lag.

With the global LNG market shifting into an oversupply after a period of tightness, we’ve updated our macro outlook for this niche business and revisited opportunities on the supply side to identify the best bets for investors seeking exposure to this theme.

The Lay of the Land in the MLP Space

The National Association of Publicly Traded Partnerships’ (NAPTP) investor conference featured roughly the same number of attendees as the prior year, but the uncertainty facing the energy sector made this edition one of the most important in recent history.

With the exception of Enterprise Products Partners LP’s (NYSE: EPD) in-depth macro outlook, the majority of midstream master limited partnerships (MLP) that presented at the conference avoided discussing energy prices, focusing instead on their growth projects and outlook for distribution increases.

Management teams also leaned heavily on their favorite buzzwords, emphasizing their companies’ long-term, fee-based contracts and assets located in the core of various unconventional basins.

Nevertheless, uncertainty created by the severe downdraft in energy prices and planned reductions in upstream capital expenditures has started to show up in the form of tighter distribution coverage for many midstream outfits, project delays and cancellations, and a diminished outlook for future growth.

In this issue, we update our MLP investment strategy, highlighting the pockets of opportunity and areas of higher risk. We also explain the rationale behind the latest additions to our MLP Portfolios and update our take on our current holdings in light of their first-quarter results and our conversations with their management teams.

Paddling Upstream, Part 2

The first issue in our two-part series on US independent oil and gas producers examined the opportunity set for these names in an environment where oil prices remain lower for longer, likely settling at a level that incentivizes rational development but not growth for growth’s sake. We also looked at some of the larger, diversified exploration and production companies.

This time, we shift our focus to the leading lights of the shale oil and gas revolution, the names that have captured investors’ capital and their imaginations. The best of these companies boast savvy management teams, high-quality resource bases, strong balance sheets and a number of levers they can pull to unlock value.

Over time, these names should be able to grow their production and win market share from higher-cost producers. Unfortunately, the best of the best still trade at elevated valuations that don’t reflect the challenges on the ground. Simply put, a good value is hard to find in the upstream space, if you focus on quality. Investors should maintain their discipline and patience.

Paddling Upstream

During our February and March Live Chats, we fielded a number of questions about specific US exploration and production companies, including Continental Resources (NYSE: CLR), a top producer in North Dakota’s Bakken Shale and leading proponent of the emerging South-Central Oklahoma Oil Province (SCOOP).

Readers’ interest in Continental Resources didn’t come as a surprise; as one of the preeminent players in the Bakken Shale, the name features prominently in many energy-focused investment portfolios.

Outspoken CEO Harold Hamm also appears regularly on financial television to tout Continental Resources’ story, argue for repealing the US ban on crude-oil exports and share his bullish outlook for a snapback in energy prices.

However, questions about SandRidge Energy (NYSE: SD) and Magnum Hunter Resources Corp (NYSE: MHR)—marginal producers with high leverage and dubious business models that struggled even with oil at $100 per barrel—took us aback.

This shift in sentiment in part reflects value-seeking tourists looking for bargains in a late-stage bull market. After all, the Bloomberg North American Independent E&P Index gave up almost 50 percent of its value in the back half of 2014—fertile hunting grounds for non-specialists who remember the snapback that occurred after energy prices collapsed in late 2008 and early 2009.

We prefer to stand aside on most upstream names, as valuations look full, especially when you consider that crude-oil prices will remain lower for longer now that service costs have started to go down, drilling efficiency continues to improve and Saudi Arabia remains committed to building market share by ramping up exports.

Investors interested in wading into the upstream space should consider easing into their positions and focusing on names with strong balance sheets, low production costs, a history of solid execution and franchise assets that can deliver production growth in a challenging environment. Names that can expand their output and win market share should outperform, as cash-strapped peers or those with inferior assets struggle.

With oil prices expected to be lower for longer, better buying opportunities will emerge in the future.

The Renewable-Energy Investment Bible

In the US, renewable-energy developers continue to reap the rewards of favorable policies at the state and federal level. However, concerns about rising electricity costs and general opposition to government subsidies raise questions about whether this support will continue.

Although SolarCity Corp (NSDQ: SCTY) and other outfits with unsustainable business models pose the most risk to investors’ wealth, long-term contracts and the participation of utilities in the space should ensure that renewable energy won’t reprise its disappearing act from the 1980s.

Don’t be surprised if SolarCity tumbles to less than $10 per share when the going gets tough.

At the same time, because many investors view renewable energy as an opportunity for developers to usurp utilities, a good chunk of this industry trades at reasonable valuations relative to their long-run growth prospects.

This issue highlights the best opportunities and names to avoid in the following areas: yieldcos, generation, energy storage, transmission, energy retailing, regulated utilities and components manufacturers.

Risks and Opportunities

Most energy-related equities have taken some serious lumps since the second half of last year, hit by the precipitous decline in the prices of crude oil, natural gas and natural gas liquids (NGL).

With the exception of US independent refiners, most groups in the energy sector have pulled back since the end of last year’s second quarter.

The Alerian MLP Index, which tracks 50 prominent publicly traded partnerships, has pulled back by 17 percent. This resilience reflects the group’s focus on pipelines and other midstream infrastructure that often operates under longer-term, fee-based contracts.

MLPs’ above-average yields also make them popular among buy-and-hold retail investors, while their unique structure helps unitholders to defer taxes—until they exit their positions. This setup makes for a relatively stable investor base.

Although we expect MLPs to continue to outperform relative to other energy groups, investors shouldn’t overlook the headwinds facing these stocks and the potential for further downside.

Rather than viewing the space holistically, investors need to evaluate each MLP’s individual strengths, weaknesses and growth prospects.

In this issue, we review some of the risks in the MLP space, set dream prices for our favorite blue-chip MLPs and highlight a handful of names that offer exposure to growth stories that are independent of commodity prices or driven by drop-down transactions from supportive general partners.

  • Live Chat with

    Elliott and Roger on Aug. 25, 2015

  • Portfolios & Ratings

    • Model Portfolios

      Balanced portfolios of energy stocks for aggressive and conservative investors.

    • Coverage Universe

      Our take on more than 50 energy-related equities, from upstream to downstream and everything in between.

    • MLP Ratings

      Our assessment of every energy-related master limited partnership.

    • International Coverage Universe

      Roger Conrad’s coverage of more than 70 dividend-paying energy names.

    Experts

    • Roger S. Conrad

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

    • Elliott H. Gue

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

    • Peter Staas

      Managing Editor: Capitalist Times and Energy & Income Advisor