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The Risks as We See Them

By Peter Staas on Sep. 3, 2015

As we’ve explained in recent Alerts and issues of Energy & Income Advisor, energy-focused master limited partnerships (MLP) find themselves in the midst of a rerating process to discount slowing growth and volumetric risk.

Although buy-and-hold investors historically have gravitated toward MLPs for their above-average yields, the huge growth opportunity created by the shale oil and gas revolution shifted the focus from accumulating growing payouts to yield compression—or price appreciation that outstrips distribution increases.

But the easy-to-understand growth story that attracted so many investors has morphed into a confusing morass of oversupply, counterparty risk and uncertainty regarding future production growth.

The severe downdraft in the prices of natural gas liquids (NGL) and crude oil—and the likelihood that these prices will remain lower for longer—suggests that growth in US liquids production will slow and start to roll over, reducing demand for incremental midstream capacity and creating volumetric risk in some areas.

Against this backdrop, the faster money that entered the space in search of outsized price appreciation has started to decamp for areas that offer more lucrative returns.

A proliferation of fund products (more than 80 the last time we counted) offering outsized exposure to energy-focused MLPs has exacerbated the indiscriminate selling.

Have midstream MLPs stabilized and found a bottom?

The Alerian MLP Infrastructure Index, a capitalization-weighted basket of 25 prominent midstream partnerships, trades at 6.95 times operating earnings—less than its 10-year average of 7.15 times. This multiple is in line with the index’s valuations from early 2006, which seems reasonable given the market’s expectations for slower growth.

(Click graph to enlarge.)https://www.energyandincomeadvisor.com/wp-content/uploads/2015/09/AMZI-Price-to-EBITDA-Elliott-Gue.jpg

Headline risk related to oil prices and the potential for additional negative news flow if business conditions deteriorate further could lead to more across-the-board selling. And the prospect of further downside will raise MLPs’ cost of equity capital, challenging project returns and ratcheting up the pressure on distressed names.

Examining the factors at play in the recent correction can help us to identify the pockets of risk and the best-positioned names for when the market returns to its senses and focuses on individual stories.

 

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