MLPs staged a substantial recovery from lows reached on February 11, 2016. The recovery in MLPs coincided with the bounce in the broader equity market and the price of crude oil. Nevertheless, MLPs have underperformed the broader US stock market this quarter. The markets are concerned about counterparty risk with exploration and production customers, as well as balance-sheet and cash-flow weakness of some partnerships.
Performance (based on Alerian Total Return Index values as of 03/18/2015):
- Year-to-date partnerships performance: -2.94%
- Quarter-to-date performance: -2.94%
- Yield on Alerian Index: 8.68%
This quarter we also saw a dramatic bifurcation between smaller, less-advantaged partnerships that have distribution yields in double digits but that are having difficulty accessing the capital markets, and partnerships with lower yields or that are helped by strong sponsors and/or general partners.
We have also noticed a bias favoring partnerships which have assets that service end-user customers versus those closest to the well-head, which serve producers. We have favored the end-user-oriented (“demand-pull”) partnerships in our investments rather than producer-focused (“supply-push”) LPs. At this time, even with the recent recovery in oil prices, we believe these demand-pull partnerships offer the most attractive returns from a risk-reward perspective.
An example of the stresses experienced by producer-focused partnerships can be seen in the recent bankruptcy ruling for Sabine Oil & Gas. A federal bankruptcy judge in NY has ruled that the company can reject midstream service contracts if they find them a financial burden in bankruptcy. While each case in bankruptcy is unique, the ruling highlights counterparty risk in the gas gathering and processing business in the midstream space.
We will remain cautious near term on MLPs until we see a better balance between supply and demand in energy markets. However, we do see a good possibility that these markets will come into balance sometime in the second half of this year, and we anticipate a number of longer-term positive developments. The current yield spread and financial metrics of MLPs compared to many other yield products remain attractive. However, we would advise investors to cautiously scale into the space if the asset class meets their parameters. The catalyst to better performance will be for the crude oil and natural gas markets to achieve a longer-term bottom in pricing, and for producing assets to be acquired by stronger operators through restructuring, bankruptcy, or mergers. It appears we are midway through that process.
by Rick Daskin