- MLP stocks have traded down recently, but fundamentals are strong. The long-term trend in U.S. energy production growth has been powerful and enduring.
- At ClearBridge, we believe cash flows are poised to inflect higher as capital expenditures recede and new projects come online.
- MLPs have been successfully pursuing alternative sources of capital and becoming more self-financing.
- MLP valuations are the most attractive they have been in decades. The combination of robust fundamentals and attractive valuations highlights MLP 2018 potential.
It has been an up-and-down year for MLP stocks, or rather a short-lived up, then down, year. Despite initial gains, through November 30, 2017, the Alerian MLP Index is down over 10%. With the equity market at all-time highs and oil prices firming, this year’s performance has been frustrating. There are, however, several developments in the MLP area not reflected in this performance, and we see a potential turning point for MLPs in 2018.
U.S. Energy Production Has Been Growing
First and foremost: MLP fundamentals are in place. The fundamental driver for MLPs is the volume of oil and gas produced. MLPs suffered in 2015 and 2016 when oil production modestly declined, but the long-term trend in U.S. production growth has been powerful and enduring (Exhibit 1). Production has rebounded in 2017 and we expect further growth in 2018.
Exhibit 1: Shale Has Driven Significant Growth in U.S. Oil and Gas Production
Distribution Cuts Have Silver Lining
Recently, portfolio holding Genesis Energy announced a distribution cut, joining Enbridge, Williams and Plains All American in the list of midstream MLPs that have cut since the rout in energy prices. It's hard not to see some negative near-term optics with this move, but we also see the longer-term benefits. With a healthy distribution coverage ratio of 1.2x before the cut, there was no question that Genesis had the cash flows to pay the distribution. While Genesis could afford to pay the distribution, it does not make economic sense to pay an 11% distribution rate to bearish equity investors when a slight cut in the distribution growth rate could fund new projects and, more importantly, drive such a balance sheet improvement that Genesis would not need to access equity capital markets in the future.
Similarly, portfolio holding Enterprise recently reduced its distribution growth rate by $0.0025 per unit. This is a de minimus change that on the surface reinforces equity investor skepticism, yet Enterprise finds that even this moderation would enable it to be self-funding by as early as 2019. Both Genesis and Enterprise linked the measures to the possibility of common unit buybacks in the future (Source: company press releases, Oct. 12, 2017.)
At ClearBridge, we believe a continuation of the long-term positive trend in U.S. production growth can provide a supportive backdrop for MLPs as increased volumes drive increased cash flows. Cash flows should get a further boost as the industry exits a period of above-average capital expenditures. At the same time, the projects the capital expenditures funded are beginning to come online and generate cash flows (Exhibit 2).
Exhibit 2: Potential Inflection Point in 2018 as Capex Declines and Cash Flows Increase
MLPs Self-Financing Via Alternative Equity
As cash flows from new projects ramp up and capex ramps downs, MLPs have been reaching an important inflection. MLPs should be able to improve distribution coverage ratios, delever their balance sheets and become increasingly self-financing. In fact, this shift toward self-financing has already begun.
In addition to targeting benefits from reduced capex and higher retained earnings, MLPs have been tapping the preferred equity market to raise low-cost capital. This is an important development for MLP unit holders, as it eliminates dilution and improves the returns on MLP growth projects. Since August, MLPs have raised nearly $5 billion in alternative equity instruments at very favorable costs (Exhibit 3).
Exhibit 3: MLPs Issuing Attractively Priced Hybrids to Fund Growth Investments1
|MLP||Amount Raised ($MM)||Type of Financing||Coupon||Common Share Distribution Rate at Pricing Date|
|Genesis Energy (GEL)
||Convertible preferred share||8.75%||9.6%|
|DCP Midstream (DCP)||$500||Fixed-to-floating preferred share||7.375%||9.3%|
|Energy Transfer Partners (ETP)
||$1,500||Fixed-to-floating preferred share||6.39%2||13.6%|
|Summit Midstream Partners (SMLP)||$300||Fixed-to-floating preferred share||9.50%||11.9%|
|EnLink Midstream Partners (ENLK)||$400||Preferred share||6.00%||9.5%|
|Enterprise Products Partners (EPD)||$700||Preferred share||4.875%||6.3%|
|Plains All American (PAA)||$800||Preferred share||6.125%||5.7%|
Credit Markets Could Lead the Way
The new financing instruments also reveal a disconnect between how equity and fixed income investors value the prospects of MLPs. While equity investors are demanding high distribution rates from MLPs, the preferred share and credit markets have been willing to lend money to MLPs on very favorable terms. In the case of convertible preferreds, for example, institutional investors have been willing to buy instruments with lower coupons and higher conversion prices than they could get by purchasing MLP common equity units.
The traditional credit markets are also very bullish on MLP credits. Interest rates for MLPs are as low as they have ever been, while MLP equity yields are relatively high. Indeed, the yield spread between MLP equities and MLP bonds is now 370 basis points (bps; one one-hundredth of one percent), compared to the three-year average of 179 bps (Exhibit 4).
Exhibit 4: MLP Bonds Have Recovered but MLP Stocks Remain Cheap
The spread between the distributions on MLP common units and these alternative equity sources stands in stark contrast to the equivalent spread in other traditional income sectors, such as REITs. The average REIT preferred share coupon is 5.50%, 140 bps higher than the 4.10% average yield on common shares.3 The average MLP preferred share coupon year to date has been 7.13%, 222 bps lower than the 9.35% average yield on common shares at the time the preferred shares were issued.4 At the same time, MLP distributions are more than 1.5% higher than their average in the past seven years (Exhibit 5).
Exhibit 5: Current MLP Distributions Well Above Historical Average
Credit markets often lead equity markets as bond investors grow comfortable with a company’s earnings and cash flow prospects. In the case of MLPs, the two buyer profiles might also explain the gap between credit and equity distributions. The buyers of MLP equities are predominantly retail investors, whereas it is institutional investors buying MLP bonds, preferreds and hybrids. We believe it is this bifurcation, more than anything else, that explains the contrast in valuations. Institutional ownership of MLPs has been steadily increasing, from 23% in 2009 to 40% in 2016, but the shares are still predominantly held by retail investors.5
Valuations Attractive by Several Measures
Except for the depths of the financial crisis and the worst of the energy sell-off in early 2016, MLP valuations are the most attractive they have ever been. Whether we look at distribution rates, EV/EBITDA or spreads to other asset classes, MLPs appear cheap. These discount valuations seem aberrant to us given the strong fundamentals and our MLP outlook: growing energy volumes, growing cash flows and improving financials. In a world where nearly every sector is trading at historically high valuations, MLPs are trading at historic lows (Exhibits 6 and 7).
Exhibit 6: MLP EV/EBITDA Multiples Two Points Lower than Average
Exhibit 7: MLP Distributions and Spreads Are High
In May 2017, we noted MLP stocks were at attractive levels on both absolute and relative bases. Since then, strong fundamentals and an inflection point in free cash flows have been two signals we believe confirm our view. MLP equities, while attractive along several measures, still have not reflected these signals yet, but we believe that the credit markets will once again lead the equity markets and that there is a buying opportunity in MLP equities. With the Alerian MLP Index down for the year and investors looking to harvest losses for tax purposes, MLPs could see continued selling pressure through year-end. But January 1 is right around the corner and we think MLPs are well positioned heading into 2018: energy production volumes are strong, cash flows appear poised to step up, MLPs are becoming self-financing and we believe the selling pressure will dissipate.