The main story for MLPs for the fourth quarter was a three-letter word: Oil. Petroleum prices are now down almost 50% from their peak six months ago. That drop has impacted MLP valuations, which do have some correlation to energy prices. In most cases, though, the correlation has not been as strong this time around. At their peak midyear, most broad-based MLP indexes were up substantially for 2014. At this point, MLPs are up about 5% for the year, which lags both long government bonds and US equity index performance. It seems there was some tax-loss selling, and it also appears there were some investor tourists who sold MLPs fairly indiscriminately.
We would expect some impact from lower energy prices on the MLP space. However, quite a few MLPs with only marginal exposure to energy prices generally – be they oil, natural gas, or natural gas liquids MLPs – sold off quite a bit. The hardest-hit sector was E&P-producing MLPs, which makes sense, though the selloff seems overdone since these companies hedge a fair amount of their production for the following 12–24 months. Cumberland had a very small exposure in such MLPs by design, and we eventually swapped this exposure for another hard-hit MLP that we expect to outperform E&P producers over the short-to-intermediate term.
The other area that has been impacted by low petroleum prices in a fairly significant way is MLPs that gather and process natural gas and natural gas liquids. This impact also makes some sense, as prices reflected expectations of a growth trajectory based on increasing demand for NGLs as a replacement for oil in some applications. We would expect demand for this type of replacement infrastructure to slow down several years out if low prices continue. However, the sort of correction we have seen represents a future slowdown in growth, not a reduction in distributions, in our estimation. Needless to say, the selloff has changed valuations and also created some good entry points into partnerships such as gathering and processing MLPs that have been punished too hard by the selloff, in our view.
The outlook for E&P MLPs at this time is cloudy. There are probably some opportunities in this space, but it may be too early to invest, as oil prices may be volatile for the next year. MLPs that are involved in the bread-and-butter midstream businesses such as long-distance pipelines, gathering and processing of products, and distribution of products (such as propane) are now at very attractive levels. Once oil demonstrates a more stable market-clearing price, I expect the sector to resume its upward performance trajectory. There is plenty of opportunity in these sectors generally, so I would recommend emphasizing these midstream businesses in our strategy for the present. My opinion on the long-term return potential of the sector has not changed, but the mix of businesses and types of products will change with shifts in the energy markets.
Written by Rick Daskin, the research and valuation sub advisor for the MLP strategy at Cumberland Advisors.