In Search Of: Why MLPs Have Underperformed In 2017

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Includes: AMLP
by: Non-Correlating Stock Ideas

Summary

Investigate 5 potential explanations for the group's underperformance.

Energy prices, energy sector relative performance, interest rates, MLP financing costs, tax reform.

Can any one, or a mix, explain the MLP's declines since August?

I've been seeing an increasing number of articles recently concerning the relative poor performance of Master Limited Partnership stocks (MLPs). Most are making the connection to the early 2016 period for the group, but I haven't seen anything that tries to explain why they're getting beaten up. I'm seeing a lot of comments with people's theories, but those are mostly lacking empirical evidence to back up their beliefs. In this review, I'm going to take a look at what I consider to be the leading suspects in this mystery and if the evidence supports or debunks the theories.

For better or worse, let's use the Alerian MLP ETF (AMLP) as our proxy for the group. Whether we look at a traditional chart, or a technical chart like its Point & Figure, it's pretty ugly.

Source: AMLP 1 Year Price chart from YCharts

Source: AMLP point & figure chart

Question #1: Are Energy Prices the Culprit?

Back in 2016, clearly, the decline in Oil prices preceded the MLP's struggles, and the entire Energy sector followed suit. As I'm sure most readers know, this is not the case this time, which is probably the primary source of consternation currently for investors in this group. The disconnect between AMLP and the price of Oil started in the summer. Since the start of August, there is a clear separation: the price of Oil (USO) has risen about 12%, while the MLP group has declined materially. It doesn't look like Energy prices are driving this decline.

Source: AMLP, USO (Blue Line) from 8/1/17 on Fidelity Trader Pro

Question #2: Is The Culprit Due To The Energy Sector Being Out Of Favor?

To represent the Energy stock sector, I like to use the Guggenheim S&P 500 Equal Weighted Energy ETF (NYSE:RYE). Since the beginning of August, what we've seen is that the RYE has essentially gone sideways to slightly up. While that isn't as strong as the price of Oil during this period, it does outperform the MLP group by a significant factor. Normally, Energy and MLPs tend to correlate pretty strongly. Over the last two years, there have only been a couple of periods of separation, this current time frame being one of them. However, the last time during the beginning of the year, the separation occurred as the RYE outperformed the MLPs versus the current situation of deteriorating value for the latter.

Source: AMLP, RYE (Purple Line) 2 Year Chart on Fidelity Trader Pro

Hence, we can see a clear separation between MLPs and the Energy sector as a whole, but what about just a general investor distaste of the Energy sector relative to the market?

Source: RYE vs RSP on Point & Figure:dorseywright.com

Certainly, from a longer term perspective, the Energy sector has been a relative market loser. Since August of this year, however, the Energy sector has been actually holding its own relative to the market. In fact, if we look since the bottom of the Energy group on August 18th, the Energy sector has actually outperformed the equal weighted version of the S&P 500 since then.

(As an aside, for those interested in investing in the Energy sector versus the market, I would wait until there is a second confirmation Buy signal generated on the Point & Figure chart above before doing so. Note the two false single Buy signals generated in 2015 versus the 2016 move after the second confirmation signal.)

Source: RYE vs. RSP (Blue Line) since 8/18/17 on Fidelity Trader Pro

Bottom line, again, it does not look like the markets' general appetite for Energy stocks explains the AMLP underperformance during this period.

Question #3: Is The Culprit Due To Expectations For Higher Interest Rates?

Source: 10 Year US Treasury Rate (TNX), 5 Year Treasury Rate (FVX in Blue), since 8/1/17 on Fidelity Trader Pro

MLPs are definitely members of the alternative equity income stocks basket. In fact, I like to analyze different MLPs by looking at their historical spreads to the US 10 Year Treasury Rate. Other members of this group include Utilities and Real Estate Investment Trusts (REITs). The 10 Year US Treasury rate has moved up since the start of August, and the 5 Year rate has seen a significant increase during this period. Could this be the explanation for MLP's struggles?

If the issue is investors' expectations for rising interest rates pushing the required yield higher for MLPs, then logically, we should see commensurate difficulties for the other equity alternative income members. Unfortunately, that's not the case, and somewhat surprisingly, we see no real weakness from those groups at all.

Source: AMLP, RYU (Yellow Line), VNQ (Blue Line), from 8/1/17 on Fidelity Trader Pro

As you can see from the chart above, not only have the other two traditional equity income alternative groups not declined during this period but the Utilities, as depicted by the Guggenheim S&P 500 Equal Weighted Utilities ETF (NYSE:RYU), is actually up over this time frame. The REITs, as represented by the Vanguard REIT ETF (NYSEARCA:VNQ), has gone sideways as well. This certainly also suggests that interest rate expectations are not the source of the MLP's woes.

Question #4: Is the MLP's Cost of Financing the Culprit?

This question gets to the heart of the reason for the very existence of the MLP structure. If the tax advantaged structure doesn't provide the General Partner with a vehicle to obtain a cheaper source of financing than they could acquire on their own, then there's no incentive for them to create the elaborate corporate structure in the first place.

I wanted to post a nice picture here of an up-to-date index, depicting the current price levels, but unfortunately, I couldn't locate anything better than for the end of the third quarter. At that point, credit for the Midstream MLPs was actually up on the year, and nothing I've found suggests that in the aggregate, that has changed much since then. For example, pricing on the largest component of the AMLP's long dated debt: Magellan Midstream Partners LP Note 4.2% 10/30/2047 Call Make Whole, hasn't changed measurably at all over the last three months. In fact, according to Fidelity, the last trade price in this security today was still over par at $101.908. Thus, if there's something fundamental driving the decline in MLPs, it doesn't appear serious enough to have concerned the debt markets. At least, we can say that the stronger individual companies in this group are not seeing a change in their financing costs to a significant degree relative to the market.

Question #5: Is the Potential Change in Tax Law the Culprit?

So far, we haven't had much success in pinpointing why this group has been so weak the last four months. However, MLPs are a clear beneficiary of the current tax law. With Congress in motion to significantly alter the current tax law for the first time in decades, could this be the issue we've been looking for?

Source

Looking at a chart of Google Trends for the terms "tax cut" in the United States does show that it bottomed in August. The degree of the rise doesn't perfectly correlate with the separation in performance, but it's not out of the realm of possibility either. However, in general, REITs share similar tax benefits as MLPs, and thereby similar risk to a change in the tax code. Yet, as we've already seen before, the REITs haven't shown any concerns recently. Thus, if it's a tax issue driving this disparity, then it must somehow separate between the two groups. Here is where we do have something that could be an issue for MLPs.

As this article details, the Senate's proposal for a tax cut plan does have a provision that would hurt the effective tax rate for MLPs more than for the REIT industry alone. So is this it? It would be nice to believe this is the issue. It certainly would matter if the Senate's version does indeed become the law of the land. That's by no means certain, as the House's bill does not contain the same provisions, but the other issue for this to be the source of the explanation is that no one knew about this until a few weeks ago. In other words, this doesn't explain the group's deterioration dating all the way back to August.

Conclusion:

Unfortunately, like the classic show In Search Of..., there doesn't appear to be an obvious answer to this market mystery: just more theory and conjecture. The usual suspects of Energy Prices, Sector Rotation, and Interest Rates, all appear to fail in their explanatory power in this case. The fact that similar groups of stocks that should be affected by these influences have not, in this case, suggests something very unusual and specific is pushing these prices lower. One last theory that hasn't been addressed is the need to file K-1s for MLPs versus REITs and their 1099s. You could argue that the expectation for tax reform might be swaying current investors to abandon the MLP structure. I find that difficult to accept as an explanation for the entirety of the decline, considering that current investors were already comfortable with the K-1s beforehand. Hence, not sure why tax reform would suddenly sway them away from this group at this point.

Clearly, the MLP group is now at risk of further pressure from potential tax loss selling at the end of this year. The question then becomes, will the new year mark the end of the separation between the MLPs and other income and energy stocks, or are we missing something that suggests this is just the beginning of a fundamental change in the nature of how this group trades? It shouldn't take more than a few months to find out the answer.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.