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Risk Check

By Elliott H. Gue on Mar. 23, 2015

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).

(Click graph to enlarge.)Energy prices

Although the US energy complex has dealt with depressed natural-gas prices in the not-so-distant past, the almost 50 percent drop in NGL prices will weigh heavily on producers that slowed drilling in dry-gas plays such as the Haynesville Shale to ramp up activity in liquids-rich basins. (See Breaking Down the US Onshore Rig Count.)

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.

(Click graph to enlarge.)Energy Index Perfformance

The Bloomberg North American Independent E&P Index, an equal-weighted basket of 76 exploration and production companies, has given up 58 percent of its value since June 30, 2014—easily the worst performance in our graph.

Oil-field services companies have also started to feel the squeeze from reduced drilling activity and cash-strapped customers pushing for price breaks; the Philadelphia Oil Service Sector Index has given up 40 percent of its value over the same period.

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. Here are some of the key fundamental and technical risks to consider.

Risk No. 1: Direct Exposure to Commodity Prices  

At this juncture, the market has punished the MLPs that have the most direct exposure to commodity prices, though further downside in oil and NGL prices will continue to pressure these stocks.

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 on oil and gas eventually expire.

Borrowing base redeterminations in spring and fall, coupled with a high cost of equity capital, will also ratchet up the pressure on these names, which rely primarily on acquisitions to drive production and distribution growth.

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