Where To Invest When The Cycle Turns

|
Includes: AMJ, AMLP, AMU
by: Alerian

By Maria Halmo

Click to enlarge

Correlation is a slippery beast. It varies drastically depending on the time period and time intervals you analyze. Daily correlations will be significantly different from monthly correlations. Industry standard is to use monthly data over a period of three years. However, one of the most common questions I still get (complaints, really) is about how MLPs and crude prices now move together, or, how MLPs are down on a particular day when crude was up. Given that oil has only been falling for around 18 months, not three years, there is no perfect way to answer "how correlated are MLPs with crude recently."

The short, unsatisfactory answer is that MLPs are not really any more correlated with crude now than they've been in the past few years. Actually, compared to this time last year, MLP correlation to crude has fallen. That isn't to discredit the gut feeling we all have that MLPs are now (at least in the minds of investors) inextricably tied to crude oil. It's true-in the chart below, you can see correlation spike upwards around the end of 2014 and beginning of 2015, when everyone was panicking in earnest that this commodity price drop may be measured in years, not weeks or months. You can also see how E&P companies (represented by the SIG Oil Exploration & Production Index (EPX)) shows a consistently higher correlation to WTI.

Click to enlarge
Since correlation is best measured monthly over three years, we also examined daily interactions with MLPs and WTI, but only over the past five years, and even split that into Before the Commodity Crisis (BCC) and After Commodity Crisis (ACC). Ignoring magnitude and looking only at direction, the AMZ has tended to move with WTI more generally since the Commodity Crisis. As a reference, over the past five years, the AMZ moved in the same direction as WTI 65.1% of the time. As a further reference, if I flipped a coin every day and heads was positive and tails was negative, this chart would show that coin flipping (aka randomness) would move with WTI 50% of the time.

Click to enlarge

In examining historic correlations, it's fascinating to watch correlations climb during the energy renaissance. New drilling technologies combined with stable prices around $100 led to a massive need for more energy infrastructure in North America. As a possible theory for the rising correlation: when oil prices rose, investors traded MLPs up as well, anticipating the need for more pipelines, storage tanks, and processing plants. It wasn't the crude price per se that drove MLP prices, but that price implied volume which implied infrastructure.

This may be the same reason correlation spiked initially as crude fell: if WTI is below a breakeven price, then volumes will fall and the expected infrastructure will no longer be needed. However, correlations are now returning to what may be considered a more normalized level. Normal is, of course, in the eye of the beholder. Over the past ten years, the overall monthly correlation between AMZ and WTI, the average three-year rolling correlation, and the median three-year rolling correlation are all 0.5.

So, investors may be disappointed if they are waiting for a crude oil recovery due to assumptions that their MLP portfolio will also rise in lockstep. In fact, if an investor is expecting a crude oil recovery, the best way to invest in that will be to buy crude oil futures themselves. The next best way would be to buy the E&P companies who have direct commodity price exposure, as their correlations typically range from 0.6-0.8 to crude prices. MLP investors, as always, are those people who want to invest in the build-out of energy infrastructure over the next several decades.

Disclosure: © Alerian 2015. All rights reserved. This material is reproduced with the prior consent of Alerian. It is provided as general information only and should not be taken as investment advice. Employees of Alerian are prohibited from owning individual MLPs. For more information on Alerian and to see our full disclaimer, visit http://www.alerian.com/disclaimers.

Maria Halmo is the Director of Research at Alerian, which equips investors to make informed decisions about Master Limited Partnerships (MLPs) and energy infrastructure. Ms. Halmo leads the firm's research efforts, which include examining MLP regulatory filings, monitoring legislative activity, and investigating industry developments. She also oversees Alerian's public communications strategy through investor and media outreach. Ms. Halmo is a former Associate at SteelPath Capital Management LLC, a Dallas-based MLP investment manager, where she conducted valuation analyses of petroleum transportation partnerships and researched macro-level energy issues. Ms. Halmo graduated with a Bachelor of Arts in Astrophysics from Barnard College at Columbia University. She is also a contributing author to Midstream Business, a monthly publication addressing the need for business market intelligence on North American energy infrastructure.