- Energy MLP companies rebounded strongly in the first quarter, outperforming the broad U.S. equity market.
- Continued growth in U.S. energy production and associated infrastructure buildout will drive increasing cash flows for energy infrastructure companies.
- Given their higher cash flow growth and yields, we do not believe MLP stocks trading at lower multiples than the broader U.S. equity market, utilities and REITs will be sustainable in the long term.
Market Overview and Outlook
U.S. equities rallied in the first quarter, with the S&P 500 Index gaining 13.65%. Energy MLP companies also rebounded from fourth-quarter declines: the Alerian MLP Index rose 16.82% for the first quarter. Oil prices recovered as well, rising over 30% as OPEC agreed to continue output cuts and accommodative monetary policy raised the outlook for energy demand. Meanwhile, supply disruptions continued due to political unrest in Venezuela and U.S. sanctions on both Venezuela and Iran. A barrel of WTI crude fetched $60.14 at the end of the quarter.
U.S. energy production growth remains robust. As of February 2019, oil production was up 17% year over year, natural gas production up 12%, and natural gas liquids production up 13%. While U.S. energy production growth rates may slow in 2019 due to infrastructure bottlenecks (primarily in the Permian Basin of West Texas), we expect production growth to continue. Such infrastructure bottlenecks are a clear signal from the market that growth opportunities to build new pipeline, storage and processing facilities will continue for at least the next several years. This continued growth in U.S. energy production and associated infrastructure buildout will drive increasing cash flows for energy infrastructure companies. Looking ahead, we expect 11% cash flow growth from the MLP sector compared to 3% for the S&P 500, 4% for utility stocks, and 3% for REIT stocks.
As of the end of the first quarter, the MLP index yields 7.7% compared to 1.9% for the S&P 500, 3.3% for utility stocks and 3.2% for REIT stocks. Yet, despite higher cash flow growth and higher yields, MLP stocks trade at lower EV/EBITDA multiples than the broader U.S. equity market, utility stocks and REIT stocks. We remain of the opinion that this disconnect is not sustainable in the long term.
"Private equity buying public midstream assets is a clear indicator of how inexpensive these assets are."
We have also seen M&A activity and notable interest from private equity buyers: typically, private market deals are transacted at lower multiples than public market valuations. For midstream, however, the opposite has been true. Public valuations are cheaper than private market assets, which has led to private equity buying select assets in the public midstream space. This is a clear indicator as to how inexpensive public market midstream assets are.
Risks to the sector include protracted U.S.-China trade negotiations having a negative effect on global GDP and slowing U.S. corporate profit growth leading to a weakening U.S. equity market, which would likely present a headwind for midstream stock prices. Against these, the potential for multiple revaluation, increased M&A and private equity activity, and more aggressive share buybacks makes for a positive outlook for MLPs and midstream energy companies, in our view. We expect WTI oil prices to trade in an intermediate to long-term range of $50 to $70 per barrel. In this price range, oil prices are high enough to incent drilling necessary to ensure supply growth and low enough to ensure continued demand growth.
On an absolute basis, the Strategy had a positive return for the first quarter but underperformed its benchmark. In terms of absolute performance, the Strategy had gains in all six of the subsectors in which it was invested. Of these, the diversified energy infrastructure, liquids transportation & storage and gathering/processing subsectors had the strongest contributions. The shipping subsector was the main laggard.
Leading individual contributors to Strategy performance included ONEOK, Enterprise Products Partners LP, Williams Companies, Genesis Energy, LP and Energy Transfer, LP The top detractors during the quarter were Holly Energy Partners, LP, Western Midstream Partners LP, BP Midstream Partners LP, CNX Midstream Partners LP and Dominion Energy Midstream Partners LP.
During the quarter, we closed a position in KNOT Offshore Partners LP.
In addition, Antero Midstream Partners LP (AM) completed the previously announced simplification
transaction between Antero Midstream and its general partner, Antero Midstream GP LP (AMGP). The Strategy received shares of the renamed entity, Antero Midstream Corporation (AM).
Western Gas Partners, LP (WES) and Western Gas Equity Partners (WGP) completed their simplification process, changing the name of Western Gas Equity Partners to Western Midstream Partners, LP (WES); the Strategy received and retained shares of Western Midstream Partners, LP (WES).
Dominion Energy Midstream Partners, LP (DM) and Dominion Energy, Inc. (D) completed their proposed merger in which Dominion Energy acquired all the outstanding public common units of Dominion Energy Midstream Partners. Shares received of Dominion Energy (D) were subsequently sold.
Lastly, EnLink Midstream Partners, LP (ENLK) and EnLink Midstream, LLC (ENLC) completed the simplification transaction in which ENLC acquired all outstanding common units of ENLK. The Strategy received and retained shares of EnLink Midstream, LLC (ENLC).