Master limited partnerships (MLP) have held up better than most energy-related equities, with the exception of US independent refiners.
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 to defer taxes—until unitholders exit their positions. This setup makes for a relatively stable investor base.
However, the Alerian MLP Index, a basket of 50 prominent publicly traded partnerships, has succumbed to gravity in the new year, giving up 7.6 percent of its value.
This pullback likely reflects many partnerships dialing back their guidance for the coming year and warning that cash flow and distribution growth could slow.
Counterparty risk also continues to rise. American Midstream Partners LP’s (NYSE: AMID) general partner, for example, recently had to scale back its planned expansion to a gathering system in the Eagle Ford Shale after its customer, the former Forest Oil Corp, decided to scale back its drilling activity.
Within the MLP space, Linn Energy LLC (NSDQ: LINE) and other upstream operators—partnerships that produce oil and gas—have absorbed the hardest hit, with the Yorkville MLP E&P Index giving up 50 percent of its value over the past 12 months.
Although many of these names hedge their exposure to commodity prices, a lack of liquidity in the NGL futures market means that these producers have no protection against the severe downdraft in the price of these commodities. And hedges eventually expire.
Borrowing base redeterminations in spring and fall will ratchet up the pressure on these names.
But Energy & Income Advisor readers who followed our lead have booked impressive gains on Linn Energy LLC’s senior secured debt. These securities actually benefited from the MLP’s recent distribution cut. (See Afraid of Dividend Cuts? Buy Bonds.)
Partnerships that focus on gathering and processing have also taken their lumps, with the Yorkville MLP Gathering & Processing Index giving up about 10 percent of its value.
Small-diameter gathering systems deliver production from the wellhead to larger pipelines and processing plants further downstream.
Accordingly, throughput volumes and growth opportunities in the gathering space depend on producers’ drilling activity; those serving marginal producers or marginal basins entail the most risk.
Gas-processing plants separate NGLs–a heaver group of hydrocarbons that includes propane, butane and ethane–from the gas stream.
Fee-based agreements guarantee that the processor receives a volume-based payment; in these deals, any upside comes from an uptick in drilling activity and production.
Percent-of-proceeds contracts, on the other hand, grant the processor a portion of the natural gas and/or NGLs–an attractive proposition when commodity prices are on the rise, less so when prices plummet.
In a keep-whole deal, the processor receives all the NGLs removed from the stream and collects a volume-based fee for the natural gas. These arrangements generate the best returns when gas prices are low and NGL prices are elevated.
Gathering and processing MLPs with contracts that entail significant exposure to NGL prices have suffered the hardest hits.
The Yorkville MLP Downstream Index, which owns primarily propane distribution and refining MLPs, has outperformed because these names involve little exposure to commodity prices or benefit from lower oil prices.
In this environment, investors should take advantage of market volatility to add to or establish positions in high-quality MLPs with low costs of capital that stand to benefit from a visible pipeline of drop-down transactions.
Blue-chip MLPs like Enterprise Products Partners LP (NYSE: EPD) will weather the storm, thanks to their integrated assets, exposure to multiple basins and diversified customer bases. However, slower production gains and outright declines in some basins will put a speed limit on future growth.
Midstream operators that lack scale and/or serve marginal producers and basins will find themselves under the most pressure.
We’ll highlight some of our favorite MLPs to buy on pullbacks and hold for the long term in next week’s issue of Energy & Income Advisor.
Elliott and Roger on Oct. 29, 2018
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