Despite geopolitics and trade war uncertainty driving a choppy quarter for the broad markets, MLPs and energy infrastructure stocks largely carried forward their positive momentum from Q1. Conditions in the space improved enough that we saw the first MLP Initial Public Offering (IPO) in nearly 18 months. In our Q2 2019 MLP Insights, we discuss some of the major factors driving the midstream energy space, including:
- The Impact of Trade Wars
- Help from the Fed
- Transactions: Private Equity, Institutional Interest, and M&A Activity
Impact of Trade Wars
The broad equity markets have primarily been driven by geopolitics this year, with trade wars taking center stage. Many megacap companies have significant exposure to international markets via their supply chains, growth strategies, or both, making trade wars, and the uncertainty they cause, particularly impactful.
By contrast, MLPs and midstream energy companies largely derive their revenues from domestic sources. While 39% of the S&P 500's revenue comes from abroad, approximately just 15% of midstream revenues come from outside the United States.1 And for midstream firms with revenue exposures outside the US, they are typically limited to Canada and Mexico. On average, the industry has about 10-15% of its revenues with exposure to Canada and less than 1% to Mexico.2 This geographic exposure has helped insulate midstream firms from the trade war pressures affecting the broader equity markets. As such, the midstream segment is up 19% in 2019, outperforming the S&P 500's 10.4% return through June 3rd.3
Source: Bloomberg. Data using full year 2018 revenues. Weighted average of Solactive MLP & Energy Infrastructure Index.
In conjunction with its domestic focus, the midstream segment's significant dollar-based currency exposure has helped further insulate it from geopolitics. While the trade wars, shifting monetary policies, and volatile commodity prices have dented international currency values, the dollar has held up well. As a result, companies with significant foreign revenue have suffered from depreciating currency values - a headwind that has not afflicted the midstream space.
Source: Bloomberg. Data from 6/4/17 to 6/4/19. Data based on the Dollar Index that measures dollar strength against a basket of currencies.
Help from the Fed
The Fed's December pivot to a more dovish stance has offered additional support for the midstream space, with higher yielding investments benefiting from falling bond yields. Since the end of 2018, the US 10-year Treasury rate fell by 65 basis points (bps), dropping from slightly over 270 bps to just above 200 bps now.4 The market is now pricing in three rate cuts by the end of 2019, and four total by the end of 2020, expressing that it believes rates will be aggressively heading downward in the near term.5
This has provided positive support for income-oriented segments like MLPs & midstream companies, REITs, and Utilities. With monetary policy becoming more accommodative, yield is once again becoming challenging to find. High yielding areas like MLPs have become more attractive in this environment, with their yield spread over the 10-year treasury rising quickly to near multi-year highs.
Source: Bloomberg. Data from 6/6/17 to 6/6/19. MLPs measured by S&P MLP Index, REITs measured by FTSE NAREIT Equity REIT Index, & Utilities measured by Utilities Select Sector Index.
Transactions: Private Equity, Institutional Interest, and M&A Activity
Transactions in the midstream segment appear to have picked up in 2019, with the first MLP IPO in a year and a half, various private equity deals, and JV transactions.
On the MLP side, market participants were greeted with the IPO of Diamondback Energy's (NASDAQ:FANG) midstream assets on May 22nd. The entity, Rattler Midstream Partners (NASDAQ:RTLR) is structured as a partnership, but taxed as a corporation that offers a 1099 tax form to investors instead of a K-1. It was the first MLP IPO since BP created BP Midstream Partners (NYSE:BPMP) to house their midstream assets in November 2017. RTLR priced at the mid-point in its IPO range and has returned 7.3% since inception against a -2.9% for the broader MLP asset class, indicating there is still demand for the MLP structure and a willingness to invest in it. Yet asset quality, sponsor, and business model are being scrutinized more than ever in today's environment.6
Another deal included the simplification of Andeavor Logistics LP (NYSE:ANDX), which announced an agreement to be acquired by its sister MLP (NYSE:MPLX) at a 7.3% premium. Unfortunately, as we've seen in other family simplification transactions, this will result in a ~27% backdoor distribution cut for ANDX unitholders based on the terms of the deal.7
There has also been news of greater private equity interest in midstream, indicating demand from a new investor type. Buckeye Partners L.P. (NYSE:BPL), a publicly traded entity, announced an agreement to be acquired by an Australian private equity infrastructure company, IFM, at a 27.5% premium. The significant premium indicates that private equity firms may be seeing value in midstream assets. In the table below, we provide a snapshot of a handful of deals that recently taken place and the different parties involved.
We believe that renewed interest from buyside firms and their willingness to engage in transactions with public entities represents a vote of confidence for the space and could serve as an eventual catalyst for valuation expansion.
While midstream performance has started off strong this year, we believe that a confluence of tailwinds could further power returns. With strong domestic exposure during heightened geopolitical risk, attractive yields in a falling rate environment, and growing interest from private equity sources, we believe MLPs and midstream companies are facing an attractive macro backdrop.
These tailwinds could help to reverse years of challenges in the midstream space. Over the last few years, multiples for midstream entities have shrunk from close to 13x EBITDA in 2014 to 10.5-11x currently.8 Therefore, we believe there is room for multiple expansion, should oil prices remain range-bound and midstream entities continue to make smart operational decisions.
MLPA: The Global X MLP ETF invests in some of the largest, most liquid midstream Master Limited Partnerships (MLPs).
MLPX: The Global X MLP & Energy Infrastructure ETF is a tax-efficient vehicle for gaining access to MLPs and similar entities, such as the General Partners of MLPs and energy infrastructure corporations.
Please click the fund names above for current fund holdings. Holdings are subject to change.
1. FactSet, "Earnings Insight," May 31, 2019.
2. Based on a weighted average of the Solactive MLP & Energy Infrastructure Index. Using 2018 full year revenues. Data as of 6/3/19. Data from Bloomberg and Global X Research.
3. Midstream measured by Solactive MLP & Energy Infrastructure Index. Data from 12/31/18 to 6/3/19. Source: Bloomberg.
4. Bloomberg. Data as of 6/6/19.
5. Bloomberg. Data as of 6/7/19. Based on Fed Futures Rates and Implied Probabilities.
6. Bloomberg. Data from 5/22/19 to 6/6/19. 5/22/19 was Rattler Midstream's IPO date.
7. Andeavor Logistics LP. Backdoor distribution cut approximation based on terms of the deal.
8. Based on forward EV/EBITDA multiples.
The information presented here is for informational purposes only. It was prepared on information and sources that we believe to be reliable, but we make no representations or guarantees as to the accuracy or the completeness of the information contained herein. All expressions of opinion reflect Global X's judgement as of the date set forth above and are subject to change. This information is not intended to be individual or personalized investment or tax advice. Please consult a financial advisor or tax professional for more information regarding your tax situation. Global X Management accepts no responsibility for the conclusions and decisions clients make utilizing this information.
Investing involves risk, including the possible loss of principal. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Investments in securities of MLPs involve risk that differ from investments in common stock including risks related to limited control and limited rights to vote on matters affecting the MLP. MLP common units and other equity securities can be affected by macro-economic and other factors affecting the stock market in general, expectations of interest rates, investor sentiment towards MLPs or the energy sector, changes in a particular issuer's financial condition, or unfavorable or unanticipated poor performance of a particular issuer (in the case of MLPs, generally measured in terms of distributable cash flow). The Global X MLP funds invest in the energy industry, which entails significant risk and volatility. The funds invest in small and mid-capitalization companies, which pose greater risks than large companies. MLPA and MLPX are non-diversified.
The potential tax benefits from investing in MLPs depends on the MLPs being treated as partnerships for federal income tax purposes. If the MLP is deemed to be a corporation then its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution to the fund which could result in a reduction of the fund's value. Indices are unmanaged and do not include the effect of fees. One cannot invest directly in an index.
MLPA has a different and more complex tax structure than traditional ETFs and investors should carefully consider the significant tax implications of an investment. MLPA is taxed as a regular corporation for federal income tax purposes, which differs from most investment companies. Due to its investment in MLPs, the fund will be obligated to pay applicable federal and state corporate income taxes on its taxable income, as opposed to most other investment companies. The fund expects that a portion of the distributions it receives from MLPs may be treated as tax-deferred return of capital. The amount of taxes currently paid by the fund will vary depending on the amount of income and gains derived from MLP interests and such taxes will reduce an investor's return. The fund will accrue deferred income taxes for any future tax liability associated certain MLP interests. Upon the sale of an MLP security, the fund may be liable for previously deferred taxes which may increase expenses and lower the fund's NAV.
Carefully consider the Funds' investment objectives, risks, and charges and expenses before investing. This and additional information can be found in the Funds' summary and full prospectuses, which may be obtained by calling 1-888-GX-FUND-1 (1.888.493.8631), or by visiting www.globalxfunds.com. Please read the prospectus carefully before investing.
Global X Management Company LLC serves as an advisor to the Global X Funds. Global X Funds are distributed by SEI Investments Distribution Co., which is not affiliated with Global X Management Company or any of its affiliates. Solactive Indexes have been licensed by Solactive AG for use by Global X Management Company LLC. Global X Funds are not sponsored, endorsed, issued, sold, or promoted by Solactive AG nor does this company make any representations regarding the advisability of investing in the Global X Funds. Neither SIDCO nor Global X is affiliated with Solactive."
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.