Quarterly Review Q2 2016: Keep On Keeping On

by: Richard Steinberg

Summary

The second quarter of 2016 produced primarily expected results for midstream MLPs while unit prices continue to be impacted by the actual or perceived price of the underlying commodities.

The MLP business model is not dead or broken; it just needs to be managed more conservatively than in the go-go growth times of a few years ago.

We continue to believe that midstream MLPs offer a compelling combination of attributes that are hard to find in a market trading closer to peak valuations.

The second quarter of 2016 produced primarily expected results for midstream MLPs while unit prices continue to be impacted by the actual or perceived price of the underlying commodities. We are now two years into the commodity price crash and the best positioned midstream companies continue to defy the most draconian views of vanishing cash flow. There is no doubt that headwinds from low commodity prices have negatively impacted the group, but by and large, business fundamentals are proving more resilient for companies that have managed their balance sheet well and have well placed assets in the most desirable geographies.

Overall, companies in our portfolio reported second-quarter EBITDA that was in line with our expectations or even better than anticipated. Forward guidance was as expected, with more companies raising the outlook rather than reducing it.

This may sound somewhat boring, but that is exactly the point. The group is proving that mostly fee based cash flows driven by "toll road" like assets can be resilient in the face of withering commodity prices. Strong earnings results were important to help validate the trading bounce the group experienced from the lows of early February. Although the price improvement has been driven by the recovery in crude oil, it is critical that the business results support this move. Importantly, for the first time in a few quarters, company management teams were, dare I say, somewhat upbeat about having lived through the teeth of the commodity price crash and turning the sights toward the eventual recovery phase.

Companies that needed to formulate "self-help" plans to improve balance sheets and distribution coverage (while positioning themselves to benefit when the environment improved) did just that with numerous announcements about asset sales, joint ventures, project deferments and in a few cases, cuts to the cash distributions. While many of these decisions were painful, they were typically rewarded by the market for enhancing the resilience of the business model.

The MLP business model is not dead or broken; it just needs to be managed more conservatively than in the go-go growth times of a few years ago. The early 2016 narrative of whether this group could survive has faded. We have noticed a bias toward the riskier (higher yielding) companies in this recent market bounce as the narrative around the direction of commodity prices changed. My team and I continue to feel that no one has a great ability to call the direction in commodity prices and we prefer to maintain exposure to those names with above average balance sheets (lower leverage), above average distribution coverage (solidly above 1x) and below average exposure to underlying commodity prices. This discipline has served us well over the past 15 years and should continue to be rewarded long term.

There is no doubt that midstream MLP business metrics have held up better than most parts of the energy complex, even though the group has underperformed other segments of energy. This is what I like to call the Rodney Dangerfield group of the energy complex - they get no respect! When commodity prices fell the group got hit with everything else on the incorrect assumption that MLP results would be hurt just like all other energy related companies, but when the commodity price began to recover the best quality names have lagged on the view they won't benefit as much. You can't have it both ways and the bottom line is that the true "toll road" assets do not see their fortunes swing as wildly as the commodity price.

Sure, the last two years admittedly have not been much fun for MLP investors but no one seems to remember the prior five years being terrific. Once again, I'm reminded about what caused us to be so interested in this group over 15 years ago. The stable nature of the cash flows, the need for critical infrastructure, the opportunity for growth and most importantly, the meaningful and consistent cash distributions they produce.

This thesis has been dramatically stress-tested over the past 20 months but the proof is in the pudding. Certainly, there have been bell-weather companies that have had to resort to cutting distributions, but that still remains more the exception than the rule. Of course, those types of companies typically got too far out in front of their skis regarding leverage or chasing growth, as happens in all industries. However, companies that have remained disciplined about pursuing realistic growth have been able to survive and position themselves to thrive as things improve.

With historically attractive valuations, a business model that has remained resilient and potential for growth over the next decade, we continue to believe that midstream MLPs offer a compelling combination of attributes that are hard to find in a market trading closer to peak valuations.

Disclosure: I/we 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.