The Coronavirus OPEC+ Double Black Swan

Summary

• The S&P has rebounded to fair value.
• The MLP sector crashed due to excessive leverage creating significant opportunities.
• Kayne Anderson, Energy Transfer and Antero Midstream are probable doubles.

In response to the COVID-19 epidemic and the March 9^th OPEC+ oil collapse - two Black Swans - the S&P 500 declined 35% between February 20^th and March 23^rd. With effective behavioral and medical mitigation COVID-19 case rates began to slow, weakening the first Black Swan and decelerating the stock market plunge. The second Black Swan began to mend when the United States helped to resolve the OPEC+ dispute - principally between Saudi Arabia and Russia - over global oil market share. The resolution of this oil collapse has put the global energy sector on the road to recovery and helping the 32% recovery in the S&P 500.

The Deep Employment Wound

Since March 23^rd, unemployment claims have risen with unprecedented speed - to nearly ten times the worst weekly numbers ever reported. Weekly claims spiked from the 200,000 per week range to 3,307,000 the week of March 23 and 6,867,000 the following week forewarning of the terrible economic consequences resulting from the 30.3 million people who have filed unemployment claims. Most restaurants, hotels and airlines have substantially ceased operations to stop the virus spread.

The shuttering of business operations can occur rapidly; unfortunately, the business re-openings and reemployment of those displaced will occur more slowly. It will take nearly two years to restore air travel to the levels experienced in January and February. The chart below shows the incredible spike in unemployment claims during the last seven weeks.

The S&P Earnings Collapse

Earnings estimates for the S&P 500 have plunged along with the market. The Fed Model Risk Premium chart set below shows the red S&P 500 earnings estimate line, in the second chart, drops off like a cliff. The earnings decline is as deep as the 2008 Financial Crisis.

The Fed Model Risk Premium Data set below shows a fully valued market in February with a forward price earnings (PE) ratio of 15.5 dropping to 12.5. The S&P 500 price decline led the earnings decline. The Risk Premium buy signal in late March correctly anticipated the March-April rebound in the S&P 500 from 2304 to 2836. We are now cautious on the broad market.

Government To The Rescue

Massive Federal Government programs like the Coronavirus Aid, Relief, and Economic Security Act or “CARES Act” and the Paycheck Protection Program or “PPP” are funneling trillions of dollars to US citizens and corporations to blunt the job loss crisis. Additionally, the Federal Reserve has been providing trillions in financial accommodations to avoid liquidity crises in the capital markets. These extraordinary steps have provided critical capital and reduced financial risks, aiding an economic recovery.

These government actions have boosted optimism by demonstrating that central banks will do "whatever it takes" to prevent this crisis from crashing the global economy. These actions have bolstered the stock market and consumer confidence. News of COVID-19 cases and fears of overwhelmed hospital facilities have shifted to the reopening of the United States. States are reopening with the hope that a disciplined approach will not prompt a reacceleration in the spread of the coronavirus.

How To Invest Now

While travel and offline businesses have seen a collapse, the shares of online businesses such as those represented by the FAANG stocks have recouped most of their losses. The chart below shows the stock performance of Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NFLX) and Alphabet (Google) (GOOG) (GOOGL) year to date. Netflix and Amazon are up 28% and 23%. We see little near-term opportunity in these largely immune businesses.

Other sectors of the economy such as retailers, hotels, airlines and autos will need to rebuild. Their earnings will struggle and recover with the economy. Many cyclicals may be good investments, but cyclicals are dependent on an economic recovery and have execution risks.

One area Income Growth Advisors, LLC believes still has significant potential with nominal risk is in Master Limited Partnerships MLPs. MLPs are compelling investments due to the extreme sector selloff in spite of their defensive cash flows. The case for MLPs lies in two extraordinary factors surrounding their decline:

• Both the COVID-19 market plunge and the OPEC+ oil collapse black swans drove historic declines in the MLP sector.
• The decline in MLPs was a financial accident, an event-driven primarily by automated factors not fundamental factors. The decline in MLPs was due to forced selling - margin calls and/or 1940 Act leverage limits on MLP closed-end funds. Forced liquidations created waves of institutional selling that led to oversold conditions and valuations of nearly 20 standard deviations below normal according to some professionals. These extreme undervaluations have created the extraordinary opportunity that persists today.

For this reason, we continue to believe MLPs make a sensible investment in the current market environment. The chart below shows the Alerian Index declining 67.5%.

The MLP Financial Accident

This Alerian 67% decline was nearly twice that of the S&P 500 despite MLPs’ high yields and defensive cash flows. Even during the Financial Crisis and Great Recession, MLPs were always cash flow positive due to their defensive natural monopoly and fee-based business models. Goldman Sachs wrote “The aggregate earnings before interest and taxes (EBITDA) for the Alerian MLP Index has shown positive growth in each calendar year historically, including during the financial crisis.”

The Alerian Index declined 51.7% in March and 58.2% in the first quarter of 2020. The chart below shows the daily declines of 27%, 17%, 16% and 15% significantly exceeding the indexes’ worst down days. These sharp declines were examples of the forced selling feedback loop which occurred in the MLP sector.

What happened? Numerous closed-end MLP funds which employed seemingly reasonable 30% levels of leverage were forced to sell MLP units which drove MLP prices ever lower. Those declining prices forced more selling at closed-end MLP funds and margin accounts which had employed a “carry trade strategy” to enhance their returns. The “carry trade” used low interest rates to buy higher-yielding MLPs. The feedback loop of selling creating more selling continued until most leveraged players were liquidated.

Kayne Anderson MLP/Midstream Investment Company (NYSE:KYN) is a MLP closed-end fund we have owned experienced this mechanical and panicked selling. At the sector’s nadir KYN’s shares were trading at a 37% discount to its liquidation value. KYN’s portfolio consists of stable midstream energy assets whose cash flows are largely uncorrelated to the price of oil and the stock market. At its March 18^th low of $2/share, KYN’s posted distribution yield of $0.12 per month implied a yield of 72%.

Since we have owned KYN historically, we had a firm grasp of their portfolio. Further, IGA has been investing in MLPs for nearly 18 years. Rarely does a publicly traded mutual fund of high-quality assets trade at such extraordinary discounts to liquidation value or with such an exceptionally high yield supported by steady midstream energy franchises.

The chart below shows the abnormally high discount to Net Asset Value (liquidation value) for KYN.

The Continued Case for MLPs

We continue to like KYN and other MLPs due to their yield spread differential to Treasuries which shows an exceptionally high spread of 12.52% as of May 1. The spread is the Alerian MLP index yield of 13.16% less the 10-year US Treasury note yield of 0.64% = 12.52%. If the MLP index yield reverts to 6%, then the MLP index should double in price. That MLP prospect is highly probable.

In addition to KYN, as a leveraged way to invest in MLPs, which are probable double over the next 12 months, as COVID-19 and the oil shock fade from our memories, we like several individual MLPs.

Specifically, we are keen on Energy Transfer, LP (ET), the leveraged $85 billion enterprise value MLP yielding 14.52%. ET has 1.8x distribution coverage and has announced its $0.305 quarterly distribution payable May 19 to shareholders of record May 7^th. This past week, Blackstone reported a 7% position in ET, a powerful endorsement.

We also like Antero Resources Corporation (AR) and Antero Midstream Corporation (AM). Both AR and AM are major natural gas midstream energy companies benefiting from the strong demand prospects for its clean natural gas and shrinking gas supply from rig closures. On Thursday, Antero Resources reported that they bought their own stock and bonds during the first quarter. In an environment where many are predicting bankruptcies in the energy sector, for Antero to be buying their own stock and bonds is impressive. Natural gas prices are improving implying strong cash flows in the future. AM announced its $0.3075 quarterly dividend equating to a 25.8% yield.

Below are the year to date charts of Kayne Anderson MLP/Midstream Investment Company, Energy Transfer, LP and Antero Midstream Corporation.

Conclusion

There remains an unusual opportunity in the MLP sector which can be captured. Due to the vicious feedback loop of forced liquidations, valuations in the midstream energy space are still three standard deviations below normal. Based on MLPs’ historic and predictable reversion to the mean, the current opportunity in MLPs and MLP closed-end funds offers compelling upside. Our confidence lies in the unwavering interest in high and predictable income streams from investors all over the world.

While we are positive about the future, the economic and equity markets’ prospects are not without risks. Given the rebound in the S&P 500, the general equity market is unappealing, particularly as the US economy must reemploy nearly 30 million workers, while grappling with high unemployment, COVID-19 and Wuhan’s Pandora’s Box.

Analyst’s Disclosure: I am/we are long KYN, AM, ET. 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.

Comments

[jarhead68]

I just wonder....

I have been hearing about the impending resurgence of MLPs for YEARS. It never happens.

There is no evidence of a resurgence to mean. I don't know why, but this asset is out of favor and fights its way lower at any opportunity.

In theory, the MLP trade/investment briefs well, but ultimately doesn't perform on a short term horizon. (5-10 years)

[iel76]

I wrote the following comment after KYN's most recent update:

"First of all I applaud the fund manager for the incredible amount of disclosure since the crash in late February early March. I wish all fund managers were so forthcoming.

That said, I just took a look at the KYN Annual Report from November 2018. Pretty much the same number of shares outstanding now as there were then. Investments held are down to $1.161 million from $3.467 million in late 2018. Net assets are down to $803 million from $2.066 million in November 2018. I guess it's fair to say there were better investments than KYN over this time frame.

Clearly the dividend will be cut, the question is how much? If you bought some of this at the recent lows,cutting the dividend in half still provides a double digit yield (as I write this a $.06 dividend yields 14%). No guarantee however that they won't cut more than 50%.

For those of us that bought this in 2019 or before, hard to see how you get your investment back..."

Anyone buying now (and I did average down significantly) absolutely has to anticipate a significant dividend cut or deferral. There is no way in the near/intermediate term KYN get close to prior levels. De-levering cost them an opportunity to invest at these levels.

[River18]

Great update. Long KYN

[35nakedshorts]

MLPs haven't been good investment in bull market, now they're supposed to rebound while the economy is disintegrating?

[Dudley13]

@ Tyson Halsey, What do you think of Tortoise NTG. They have really been beaten down, and just went through a 10 for 1 reverse split. Thanks

[LIBERTARIAN FOR FREEDOM & ENDING THE FED]

Run do not walk from the turtles, horrible management and terribly run funds. Do not chase yield, chase quality please. Your future self will thank you

[River18]

Plus now Tortoise dropped the quarterly dividend till the end of the year.
I think only TPZ is still getting a monthly dividend, but for how long???