Focus On The Music

by: Richard Steinberg

I have written in the past about how corrections can be welcome events. The pause that refreshes. The correction we experienced in MLPs from the highs of late-August to the lows of mid-October did not feel welcome or refreshing but I remain optimistic about future midstream MLP performance given that key trends remain strong. I fully recognize that the recent OPEC decision to not cut oil production (leading to a further sharp decline in oil prices) will create more volatility and selling pressure, but opportunity is born from such extreme moves.

The Alerian total return index declined approximately 16% peak to trough with the first two weeks of October seeing heightened downside momentum. The speed and viciousness of the decline caught most by surprise and a key issue we are left with is understanding why the group came under such strong selling pressure.

Although the historic correlation of midstream MLP performance to spot oil prices is rather low, it appears that the dramatic decline in oil prices became a convenient excuse. There is no doubt that the material selloff in the entire energy complex, driven by oil prices falling into a bear-market, became an issue that no corner of the energy food chain was able to avoid. Midstream MLPs performed strongly for most of the year (and most of the past five years for that matter) so profit-taking as nerves frayed over declining energy prices is understandable. Add to the stew the fact that a lot of MLP equity (IPO and Secondaries) was sold during late summer/fall and you have the makings of a material correction. However, the severe nature of the move down in the last few days of the mid-October selloff demonstrates a lack of understanding as to what drives midstream fundamentals.

A correction after a meaningful move up is not to be feared if key industry fundamentals remain supportive. Based on recent earnings releases and quarterly updates, the bulk of the midstream MLP industry continues to perform well and has attractive outlooks. There is no doubt that if oil and other energy prices decline further and remain low then there could be some future project curtailments as producers slow growth plans to preserve cash. I have not seen evidence of this shift yet, but growth of cash distribution is crucial in valuing MLPs. Anything that alters the outlook for growth in a negative way will have an impact. We could see growth estimates reduced (especially for the more commodity sensitive names) but current cash distributions are well supported.

While my team and I understand the concern, we do not understand the sheer panic-like selling that is taking place now as it did in mid-October. Panic is never an investment option! We own midstream MLPs for their strong and visible cash distributions coupled with the potential for growth of those distributions. Growth risks have increased but the cash flow associated with the physical hard assets in the ground is not in doubt. Many of the best positioned midstream operators have announced substantial increases to their organic project backlog, further increasing growth visibility. While commodity prices have declined, the need for critical infrastructure remains elevated. Opportunities to deploy capital at an attractive spread to the cost of capital are driving the growth that we MLP investors enjoy, and individual company growth has only improved in many cases. The IEA (International Energy Agency) estimates that most Bakken Shale production remains commercially viable at $42 a barrel and expects that US oil production will rise by another one million barrels a day next year fostering the need for additional infrastructure.

The sharp decline in MLP prices coupled with consistently supportive fundamentals creates a beautiful buying opportunity. Unfortunately, too many investors react to price movements and "throw out the baby with the bath water." Some levered investors may have been forced out of certain positions, further accelerating the down move, but if you can keep your head in the game while others are losing theirs, profit usually follows. Near-term performance could continue to be impacted by fear, negative headlines, and year-end tax loss selling but longer-term trends remain constructive.

When the noise of the market drowns out the true fundamentals, put your head phones on and focus on the music (or the fundamental trends in this situation), and you will like what you hear.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.