The impact of rising rates on energy investments is clearly relevant given the macro concerns blamed for last week’s abysmal market showings. As we assess Master Limited Partnerships (MLPS) we evaluate the impact of rising rates from both a direct and indirect basis.
From a direct standpoint, there is an impact to the extent that a company has floating rate leverage. The key mitigating factor is that midstream MLPs are approximately 80% fixed rate debt, so this impact is very minimal on cash flow. From an indirect standpoint, we look to assess the impact on the weighted average cost of capital and returns over and above that cost of capital.
While you could see some increases in the cost of debt and equity, there are several mitigating factors in our view that help lessen the impact of the higher rates and ultimately allow companies to continue growing their distributions.
A few of those mitigating factors are:
1) Excess coverage,
2) Internal versus external growth; and
3) The ability to pass through inflation via either higher rates or volumes
The next point simply looks at what history has shown us. Historically, when rates have increased by 50 basis points or more, the return of MLPs has actually been quite positive and similar to what you see in the S&P 500. In fact, MLPs have averaged a 6.8% return based on the 15 different time periods that we have noted since 2000. This compares favorably to the S&P 500 average return of 5.1% for the same time periods.
Finally, one of the key factors to assess is WHY are rates moving higher?
In this case, it seems fair to say that indications point to a strong economy, driving lower unemployment, leading to rising wage pressure.
Assuming all of that is correct, we would fully expect it leads to higher consumption of energy, not lower. Higher consumption of energy means more molecules flowing through the pipelines and more revenue for pipeline companies.
In summary, while you may see some near term impact on MLPs from rate moves, we feel the data points to a more positive story and history has shown that to be the case as well.
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