Candid View Of MLPs And Oil Risk

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Includes: AMLP, AMLX
by: Oil Hedged MLP Index

Summary

Energy MLPs have tremendous downside risk from oil correlation.

Energy MLP investors aren't compensated for taking oil risk.

There is a new MLP ETF that lowers crude oil risk in MLPs.

Here's our investment thesis for using a commodity hedged MLP ETF.

ETP Ventures, the creator of the Oil Hedged MLP index has licensed the index to Amplify ETFs to create the Amplify Yieldshares Oil Hedged MLP Income ETF. The company, ETP Ventures, may generate licensing revenue derived from the assets under management of the aforementioned exchange traded fund.

Big Growth and Big Problems

Master limited partnership (MLP) ETFs and other investment products have become very popular in the last several years, gathering significant assets from investors who are attracted to their high dividend potential, entity-level and investor-level tax benefits, solid fundamentals, and good growth prospects. Many domestic factors accelerated their growth, including a historic near-zero interest rate environment and a massive expansion in domestic energy production. Today, that growth amounts to 75 different MLP products across ETFs, closed end funds and mutual funds, totaling $65B in assets. These products are concentrated across just 110 energy MLPs.

The market environment for MLP investors has been tough in recent years, much of which can be attributed to fluctuations in commodity prices. While MLP companies don't necessarily have revenue streams directly derived from the price of oil, declines in commodity prices can hurt MLPs on a day-to-day basis.

In order to address this commodity price sensitivity, ETP Ventures, the author of this article, has created the Oil Hedged MLP Index. For full disclosure purposes, we should note that we have licensed this index to Amplify ETFs, which is the issuer of the Amplify YieldShares Oil Hedged MLP ETF (AMLX). We are receiving index licensing fees from and are financially interested in the success of the ETF.

There is strong correlation between MLPs and crude oil prices, which have both experienced declines of 30-50% in recent years. When volatility strikes, correlations rise and MLP investors suffer. MLP investors have tolerated oil price volatility because of the high dividends paid by the MLPs, but in many cases investors have found themselves underwater and looking to recover from losses suffered when oil prices collapsed. MLPs have almost always declined when crude oil prices fall. In the last decade, in 80% of the days when the Solactive Crude Oil Index was down 2% or more, the Alerian MLP Index also fell on average 1.78%. The trend isn't limited to daily price movements either; in the 20 largest monthly declines in oil, the Alerian MLP Index was down in 18 of those months. That's a rate of 90%!

Of course, MLP values will also follow oil prices on the upside too. This is why it is important to discuss correlation when comparing different asset classes, especially for investors who are looking at strategies for managing risk. The correlation between MLPs and oil prices can be extremely high, rising to 0.95 in periods of declining oil prices and averaging 0.48 over the last 10 years. So, it would seem that your MLP investment tracks oil almost perfectly when oil is declining, but not so much when it is rising. MLP investors have learned that buying MLPs also means buying crude oil. This is a harsh lesson to learn for investors who are seeking high-yield distributions in investments that are marketed to retirees as lower risk and more conservative than other high income investments.

Still a Great Outlook for MLPs (Sometimes)

On the bright side, expectations of an ease in building permits and support for old generation job growth in fossil fuels from the current administration keep hope alive for good fundamentals in MLPs. But this doesn't necessarily support higher oil prices. Ideally, it would be a home run to keep exposure to MLP securities while reducing the risk that declining oil can have on the asset class. An ideal strategy couldn't be a "silver bullet" to remove all risk, but it could seek to help investors get more good out of their MLP exposure, while limiting the bad. Of course, the MLP space is cyclical, and MLP investors have been very happy over certain periods.

Let's examine the environment during those happy days for MLP investors. Over the last 10 years, the cumulative return for MLPs is positive in periods where oil correlations were low. Over the same time period, cumulative returns for MLPs were negative when oil price correlation was high. Low correlation environments are typically periods of market complacency, whereas declining markets create high correlations across asset classes. Yes, MLP investors have only made money in periods where correlations to crude oil have been below the 0.48 long run average.

It's true that MLP investors have consistently generated dividends through all periods, but what good is a dividend to an investor if their principal is declining? What MLP investors haven't liked are the periods where oil price correlations were above the 0.48 long run average. MLPs yielded a cumulative price return of -8.49% during these periods. Interestingly, the cumulative return for crude oil in these periods of high correlation is -121%, while crude oil was about flat in periods of below average correlation. These returns illustrate that when correlations between oil prices and MLP products rise, the commodity and equity markets are typically falling. Simply put, MLP investors should be avoiding oil price correlation like the plague if they are interested in protecting their principal.

Did You Buy MLPs to Track Oil or for the Income?

We believe that investors are largely buying MLPs for the high income, not for the price volatility. Correlations of MLP ETFs (over the last three years ending May 31, 2017, and examining those with daily volume of 10,000 shares or more) have considerable high correlation with oil on a daily basis, ranging from 0.63 to 0.95. One could argue these instruments have proven to be crude oil tracking devices, closely following the price of the commodity on a day-to-day basis. This is why we created the Oil Hedged MLP Index, which tracks a portfolio of midstream MLPs and a variable short position in crude oil futures. Our goal was to deliver the same MLP income that investors have come to love, while reducing the commodity correlation.

Use a Commodity-Hedged MLP Product

What's the bottom line? To put it candidly, if you're invested in MLPs, you are taking a directional bet on rising crude oil prices. If you've been invested in an MLP ETF, your experience only dates back to 2010 and you've carried significant crude oil risk and correlation over the life of your investment. If you don't believe oil prices are in a perpetual upward trend for the next several years, you should consider adding an MLP solution to your portfolio that can lower or neutralize your exposure to crude oil. This way, your MLP investment can focus on its likely intended purpose, generation of dividends and long term growth.

The Oil Hedged MLP Index holds 20 MLPs, while aiming to reduce crude oil risk via a continuous 40%-100% short position in near-term crude oil futures contracts, providing protection against potential declines crude oil prices. Regarding the level of the short crude oil position, in periods of high correlation between MLPs and crude oil the hedge goes to 100%, while in periods of low correlation it remains at 40%. Remember, periods of high correlation are the periods when MLP investors have historically lost money.

Impact of Hedging

MLPs were originally sold to investors as a non-correlated asset with high yield, but we've found that the asset class is highly correlated to commodities. The risks that come with this correlation can be mitigated. In addition to lowering correlation, investors could also significantly reduce potential principal losses in periods of sharply declining commodity prices, which are bound to take place again in the future. One of the major advantages of our index is that incorporating the oil hedge won't necessarily hamper the original goal for the investor: strong income generation, while securing exposure to the good fundamentals and growth prospects of the underlying MLP securities.

There are two sides to every story, and we should discuss the potential downsides to hedging for crude oil risk in MLPs. With a continuous short exposure of 40%, it is possible that the hedge position could become a drag on the MLP index in the event that oil prices rise. Generally, when oil is increasing in value, MLPs follow suit. This means that the hedge will likely cancel out any appreciation in MLPs on a price basis, but this would come before any potential dividend payout. Conversely, when oil prices are falling, a traditional un-hedged ETF -- e.g, the Alerian MLP ETF (AMLP) -- is likely to fall in a manner that could erode principal and wipe out any gains from dividend income.

Is Hedging Really Necessary?

We believe that the Oil Hedged MLP Index could have a significant advantage over traditional MLP indices when considering correlation to crude oil prices. Other MLP ETFs carry extremely high correlation, 0.48 over the last three years ended June 30, 2017. If this correlation doesn't seem high to you, consider the following scenario. If you hold an investment with 0.48 correlation to crude oil, and the commodity falls 50%, your investment would theoretically decline by approximately 24%. Would you be concerned about the impact on your investment? Your answer is probably "yes."

Conclusion

Regardless of what the price of oil is on a given day, or where you believe the trend is headed going forward, MLP prices are indeed sensitive to crude oil prices. Why not reduce your commodity price sensitivity without compromising your dividend income?

Disclosure: I am/we are long AMLX.

Business relationship disclosure: ETP Ventures, the creator of the Oil Hedged MLP index has licensed the index to Amplify ETFs to create the Amplify Yieldshares Oil Hedged MLP Income ETF. The company, ETP Ventures, may generate licensing revenue derived from the assets under management of the aforementioned exchange traded fund.