In prior articles I looked at the sustainability of distributable cash flows with respect to a number of MLPs. In this article I focus on something quite different - the relationship between MLP returns and oil prices.
Now that the earnings season is in full swing, I will be updating my reports on the sustainability of distributable cash flows with 4Q11 data and will also apply the same analytical method to additional MLPs. However, important as it is, distributable cash flow is but one factor and a serious analysis of the risks and potential rewards investments in MLPs should be multi-faceted. It is critical to evaluate the degree to which an investment in MLPs is correlated to other portfolio assets and to understand risks inherent in holding MLPs as part of a diversified investment portfolio.
It is a common perception that energy MLPs have limited commodity exposure. Intuitively it seems to make sense because energy MLP are in the business of transporting and/or storing crude oil and gas. For the most part, they are not engaged in exploration or production and therefore their returns should not be too closely correlated with prices of the commodities they carry over their pipelines. Energy MLPs are generally classified in the lower-risk segment of the energy chain and are perceived to exhibit low correlation with other asset classes, including commodities such as natural gas, crude oil, and various equity and fixed income securities.
Looking at the relationship between MLP returns and oil prices, it appears that prior to 2008 the two were indeed largely uncorrelated:
In this chart, Bbl = the month-end Cushing, OK Crude Oil Future Contract price ($ per barrel) reported by the U.S. Energy Information Administration. AMZX is the Alerian MLP Index, a composite of the 50 most prominent energy MLPs calculated using a float-adjusted, capitalization-weighted methodology and disseminated real-time on a price-return basis (AMZ) and on a total-return basis (AMZX). I derived the chart by indexing the price per barrel as of December 31, 2008 (the actual price was $42.04) to 100 and adjusting all prior prices proportionately. Likewise, I set the AMZX to 100 as of December 31, 2008 (the actual level was 428.12) and adjusted all prior month-end prices proportionately.
While the perception of low correlation with oil prices persists, reality has markedly changed over the last few years. Recent data now point to a very significant correlation between MLP returns and oil prices:
I derived the chart by indexing the price per barrel as of December 31, 2011 (the actual price was $98.58) to 100 and adjusted all prior prices proportionately. Likewise, I set the AMZX to 100 as of December 31, 2011 (the actual level was 1168.41) and adjusted all prior month-end prices proportionately.
The second chart shows the same 2.5x increase in value from an investment in the AMZX and an investment in a barrel of oil (excluding, of course, storage and transaction costs) over the last 3 years. True, oil prices exhibit greater volatility but the close correlation between oil prices and energy MLP returns is apparent even without running regression analysis. It seems to have begun following the economic and financial crisis which, as noted by the Financial Crisis Inquiry Commission, reached seismic proportions in September 2008 with the failure of Lehman Brothers and the impending collapse of the insurance giant American International Group (NYSE:AIG).
The conventional wisdom that returns offered by energy MLPs are not closely correlated with commodity price movements does not appear to hold water, at least not with respect to oil prices in the last 3 years. Increasing NGL production may offer a partial explanation since NGL prices more closely mirror the price of crude oil than of natural gas prices. I do not have a full explanation for this phenomenon, and do not know whether it is temporary in nature.
But I do not dismiss it, and believe it should be carefully considered and taken into account in any attempt to build a balanced investment portfolio. If the recent pattern of close correlation continues, there appears to be a significant risk that a decline in oil will be accompanied by a decline in the per unit prices of energy MLPs. Investors with significant amounts invested in MLPs should evaluate their exposure to oil price fluctuations with that in mind.
Disclosure: I am long EPB, EPD, ETE, ETP, PAA, BPL.