Are MLPs A Good Investment Now?

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Includes: EEP, EPD, ETP, GEL, KMI, LNCOQ, LNGG, MMP, MWE, NGLS, OKE, PAA, SEP, TGP, USAC, WPZ
by: Ken Veit

Summary

Energy prices are in a major bear market, but the end of the era of oil is not likely.

Selling of MLPs has been overdone, as everything connected with energy is being shunned.

The news is relentlessly negative.

The time to buy is generally when everyone is sure the worst is yet to come.

Energy markets constantly confound the experts. It was only a little more than a year ago that the experts were telling us confidently that "the era of cheap oil is over."

Then came the worry that lower Chinese demand and a slowing global economy would result in over-capacity and falling prices. OPEC put the finishing touches on this by refusing to cut production last Thanksgiving, and another rout was on. The likelihood of Iran resuming full production piled on more bad news for producers.

Today, anything connected with energy is shunned like leprosy, even if a company's earnings are little affected by the price of oil or, in the case of refiners, actually improved when their input prices are low.

Energy prices (and hence the fortunes of many companies in businesses where the price of a barrel is critical) have always been cyclical, and they always will be.

We appear to be approaching the bottom of the cycle. That bottom may still be as much as a year or more away, something that is unappealing to those investors for whom the long term may only be measured in days. However, a bottom there will be.

The demand curve will inexorably move from lower left to upper right on the charts, despite occasional blips along the way.

The Saudis put on a bold front in declaring that the price of oil is immaterial to them. But this is nonsense. Oil is virtually their only source of income, and Saudi Arabia sells nearly 4 billion barrels a year. Anyone, even the Saudis, cannot help but feel the pain of a drop in income of 50%. Despite enormous foreign exchange reserves and huge borrowing capacity, they will eventually have to address the tremendous loss of revenues they are experiencing. In fact, recently they began to borrow again, as their foreign exchange reserves have been falling sharply.

Initially, it was thought that Saudi Arabia needed $90 oil to balance their budget. To keep their masses quiet they maintain an expensive program of public support, so they don't have the option of cutting public spending. Suddenly, however, it now seems they can get by on much less than $90. Similarly, the U.S. shale producers, who were originally thought to need in excess of $60 oil to be viable, suddenly found a way to shave 20% off their costs.

What this suggests is that producers are scrambling in order to stay afloat while prices are low. I can't see it continuing permanently. As I write, energy prices are testing lows for the year. Inevitably lower prices must affect production.

Another factor that could affect many of the shale drillers who are currently putting on a brave front in continuing to drill-drill-drill is that they will soon be facing their annual revaluation of "proven reserves," the basis for the collateral backing their bank loans. When the industry speaks of its "proven reserves," it means how much oil do we have that can be extracted profitably at current prices? Not all wells are created equal. Costs vary considerably. A deposit that can be exploited profitably at $60/bbl may not be so at $40. At the moment, drillers are concentrating on completed wells and focusing on the "sweet spots" where costs are lowest, rather that just drilling anywhere and everywhere.

With respect to loans, bankers can be very creative at "extend and pretend" (witness: Greece) when it is in their interest to do so. Nevertheless, drillers will have a harder time this fall in securing loans than was true a year ago. That too will eventually show up as lower production.

The financial press regularly trumpets massive reductions in energy company capex and large numbers of layoffs. As night follows day, reduced capex will eventually mean supply shortages, and all those layoffs will mean a shortage of experienced workers, which will push costs back up. The only unknown is: When?

It could be longer than the average investor is able to tolerate. Meanwhile, what should he or she do, especially if one is an income-oriented investor? Above average yields have always been a magnet for the individual investor, MLPs have a long history of providing solid distributions, even in times of price turbulence for commodities. This is especially true of the "midstream" group that own pipelines and whose revenues are largely fee-based, insulating them to a great extent from fluctuations in the price of oil and gas. Despite a drop of over 50% in the price of a barrel of oil in the last year, every one of the 14 midstream MLPs I follow (currently holding all except MMP and OKE) has increased their distributions to shareholders since December 31 (some more than once). The median increase is 4.7%, and the year is not yet complete. These increases are in line with historical averages, despite the collapse in energy prices. The median yield at the lows was nearly 8%:

Current

Monthly

Stock

Stock

Yield at

Monthly

Dividend

52 Wk.

52 Wk.

Low

Dividend

12/31/14

Increase

High

Low

Decrease

Price

EPD

0.38

0.365

4.1%

41.38

24.69

-40%

6.2%

KMI

0.49

0.44

11.4%

44.71

31.09

-30%

6.3%

ETP

1.035

0.975

6.2%

69.66

44.76

-36%

9.2%

MMP

0.74

0.6675

10.9%

90.08

61.37

-32%

4.8%

SEP

0.6138

0.57625

6.5%

60.07

44.27

-26%

5.5%

EEP

0.583

0.57

2.3%

41.68

26.64

-36%

8.8%

NGLS

0.825

0.7975

3.4%

74.51

30.23

-59%

10.9%

GEL

0.625

0.58

7.8%

56.32

34.57

-39%

7.2%

MWE

0.92

0.89

3.4%

80.79

53.19

-34%

6.9%

OKE

0.605

0.59

2.5%

71.19

33.72

-53%

7.2%

PAA

0.695

0.66

5.3%

61.09

32.53

-47%

8.5%

TGP

0.70

0.6918

1.2%

44.21

24.00

-46%

11.7%

WPZ

0.85

0.615

38.2%

62.92

38.53

-39%

8.8%

USAC

0.525

0.505

4.0%

26.44

14.45

-45%

14.5%

Nevertheless, the average retail investor to whom these shares normally appeal has been stampeded into selling because anything associated with "energy" is currently considered to be toxic. As can be seen from the table, the average share has dropped by more than 40% from its high, with several over 50%. The same thing happened in the great meltdown of 2008-9. The companies continued paying their dividends, but their stock prices were savaged by half. Over the next few years, they recovered.

There is a basic fact to consider. The modern world runs on energy. Oil is not going to be replaced by wind, solar, etc. in the lifetimes of most people reading this, no matter what the environmental movement tries to make us believe is possible. Eventually, maybe, but oil will be king for a long long time, with gas also playing a major role.

Oil (and gas) need to be transported. Pipelines are by far the cheapest and safest way to do so. There are thousands of pipelines crisscrossing the United States. Yet there are not enough to meet the demand. This is why MLPs have a tax incentive to build more. Demand is not going to dry up over time.

Now there is a small army (suspected short sellers) who are out to trash the MLP concept. They allege that the companies use phony accounting and are too highly leveraged to avoid eventual collapse. Barron's seems to run articles making these claims fairly regularly.

Short sellers scored a great coup in 2013 when they brought LINN Energy (LINE) (LNCO) to its knees and materially affected their acquisition of Berry Petroleum. Their claims were so loud that the SEC called for an investigation of LINN's accounting. After months of analysis, the SEC concluded that LINN had done nothing wrong.

Things were looking up for LINN until the oil price collapse in 2014, and now they have had to cut and then eliminate their distribution entirely, sinking the shares. Some argue that LINN's unhappy story shows what is in store for all MLPs.

However, there is an important difference.

LINN is not a pipeline company. It is a producing company that drills for oil. Unlike the pipeline MLPs, its revenues are directly impacted by the rise and fall of oil prices, although it has always hedged to a great extent. Tarring midstream MLPs with the same brush as the upstream (producing) is comparing apples to oranges.

Is there any reason to be concerned about the long-term viability of the pipeline companies?

The main argument revolves around the fact that their favored tax status requires them to distribute most of their profits to shareholders. If you look at a cash flow statement, you will see that their cash flows from operations exceed their payouts. For the most part, this difference is used for capital expenditures for maintenance of their existing systems.

In order to keep growing, however, they must invest capital in new ventures (or acquisitions). The source of this capital is primarily new debt or equity. The new ventures must produce enough profit to cover either the distributions on the new shares or the interest on the new debt. That is no different from say Boeing (NYSE:BA) financing a new class of jetliner.

What worries the bears is whether the companies have sufficient excess cash flow from operations to cover maintenance capex, since the companies only report total capex, not separating out what portion is for growth and what portion is for maintenance. If some of their new financing goes towards maintenance, then it puts pressure on their ability to continue or raise distributions. The way that the bears express it is that it appears to them that the companies are raising fresh capital in order to support distributions, the classic definition of a Ponzi scheme.

The MLPs counter with a metric known as "Distributable Cash Flow" (NYSE:DCF), which purports to indicate how much cash they have earned to cover distributions. The stronger companies have DCFs that cover more than 100% of their distributions. The bears don't like this metric because it gives the companies a certain amount of discretion in deciding what to include and what to exclude. This, of course, is no different from companies that routinely report "adjusted" earnings or maintain discretionary reserves against "future contingencies" that can be used to smooth earnings.

The reason that MLPs are not Ponzi schemes is that in a Ponzi scheme, the need for fresh capital is so large that it eventually swamps dividend requirements as more and more shareholders must be serviced, while the cash coming in is not being used for productive (i.e., profit generating) purposes.

A second reason that MLPs have sold off so sharply is that there is a widespread fear that when the Fed starts to raise interest rates, investors will dump high yielding stocks and rush into government bonds. This assumes that income oriented investors are primarily interested in safety. Why sell a high-yielding MLP in order to buy a 30-year government bond yielding half as much? The bond's return is fixed, while the MLPs' returns historically rise consistently over time. Of course, the MLPs have greater principal risk, but the reward/risk ratio clearly favors them (in my opinion).

MLPs have thrived over a long period, but one that has been marked by declining interest rates. Interest rates are surely going to rise, although most observers believe it will be a slow and gradual rise. Nevertheless, rising interest rates are not helpful for capital intensive companies. To me the greatest risk for MLPs would be a combination of rising interest rates and a stock market in which MLP prices fall irrationally to the point where equity financing becomes too expensive. It is difficult to grow if raising capital is squeezed between rising interest rates and falling stock prices.

Investors in high-yielding stocks want not only a high yield, but also increasing distributions over time. Those who do not raise their payouts quickly fall from favor. Investors in MLPs need the same attitude as long-term bond investors. If your income received is sufficient for your requirements, don't worry about the price of the security.

While it is true that MLP total returns (distributions + capital gains) have been outstanding over the last 15 years, and a rough rule of thumb has been that investors could expect a total return of approximately the distribution yield plus the growth rate of their distributions, that formula only holds when distributions are increasing.

The top MLPs have balance sheets that should be strong enough to withstand a period of low oil prices and increasing interest rates. Whether they can do so and also increase distributions is not as clear.

It is an interesting fact, contrary to general belief, that when the Fed raises interest rates, the value of the U.S. dollar goes down. (It rises before the fact, but then sells off on the news.) Since there has been a close correlation between the rise and fall of the dollar and the fall and rise of the price of a barrel of oil, perhaps the price of oil will actually rise when the Fed finally raises rates in September or December. In that event, MLP prices might also be a beneficiary.

Regardless of whether those relationships prove to be true again in the near future, if one can be satisfied with the historically high current yields available at the current low prices for the shares, then MLPs still seem like a compelling investment at this time. The stock market is in the sixth year of a bull market that is unlikely to go on forever. The MLPs listed above could decline further. But their distributions seem secure, barring some company specific disaster.

The important thing to remember is that supply and demand for energy are in a process of continually adjusting to each other. At the moment, supply is growing "at breakneck speed" (FT, 8/13/15) and so that grabs the headline. At the same time, however, demand is increasing in the face of falling prices and "has reacted more swiftly than supply to lower prices." There will be an equilibrium price, and then the cycle will reverse.

As for MLPs, now the bears are arguing that if shale production starts to fall, the MLPs will find that they have overbuilt capacity. Their throughput volumes could fall. Possibly so. But MLPs are insulated from this risk to some extent (although not completely) by long-term play-or-pay contracts.

In all the back and forth of debate, there is a school of thought that technological advances will continue to push down costs for shale drillers to the point where they will be able to pump out ever more production profitably despite permanently lower prices. While I am skeptical of this position, if it is true it would mean that the need for more and more pipelines would continue, crushing the argument that overbuilding will be the Achilles heel of the MLPs.

The bottom line in all this is that the daily news is overwhelmingly gloomy with respect to the prospects for the energy sector. The International Energy Agency (EIA) forecasts that the oil glut will persist throughout 2016. (It should be noted that their forecasting record is even worse than that of the Fed's in predicting GDP growth.) It is a rare day when there is not some bad news or pessimistic article. We are about to see the end of the peak summer driving season. Refiners are due to shut down for fall maintenance. Drillers are reducing rig counts in the face of a dim outlook for prices. The respected Gary Shilling has opined (July Insights and earlier editions) says oil could go to $10/bbl. How could anyone think of putting money to work in such a disaster area?

These are the optimal conditions for investing -- when every shred of evidence proclaims the opposite, and when your stomach rebels at such an apparent folly. The negative news and pessimistic prognostications are relentless. The highly regarded Richard Bernstein recently wrote in the August edition of Richard Bernstein Associates' Insights:

Energy and commodities are credit-related asset classes and have significantly underperformed as the credit bubble deflated. It is curious though that investors have thought that MLPs would be immune. MLPs are now in a bear market with some of the highest quality MLPs leading the decline (weren't they supposed to be the ones least effected by the fall in the commodity price?). The MLP industry has been free cash flow negative for some time, which questions the companies' abilities to continue growing, maintain distributions, or both. The recent volatility has wiped out about four years of dividend payments, yet investors generally seem complacent

I would say that complacency considerably misstates what MLP investors are experiencing. However, as Warren Buffett often opines, the time to be fearful is when other are greedy, and greedy when others are fearful. At this juncture in the market, the greedy ones seem to me to be those investing in the hot stocks with stratospheric P/Es. The fearful have exited MLPs.

It should be noted that when the consensus is positive, things are usually about to head south, and when the experts predict gloom and doom, the trend is about to turn up. The excellent market analyst, Jim Stack, regularly includes examples in his newsletter, Investech.

Today, MLPs offer compelling yields at prices not seen in years. I may be wrong (I frequently am), but unless one is a trader looking for quick in and out profits, MLPs make sense to me. One caveat would be to be careful in selecting. All are not created equal or are equally strong financially. Unfortunately (for most investors), you have to do some homework. I hold bullish positions in most of the names shown in the chart above. Am I worried? Of course. No one likes to see the market value of his portfolio decline. My risk is distribution sustainability, but it is a risk that I can live with. The rewards, I believe, will compensate for the risk for those who don't panic.

It is dangerous to try to capture the lowest price for any stock, but I would think that a good time to buy would be right after the Fed announces its first rate hike. The market will likely overreact, as it usually does.

Disclosure: I am/we are long EPD,KMI,ETP,SEP,EEP,NGLS,GEL,MWE,PAA,TGP,WPZ,USAC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.