Duff & Phelps Still Bullish on MLPs
Energy master limited partnerships (MLPs) experienced an unprecedented sell-off last week with the Alerian MLP Index (AMZ) falling from 532 at the start of the month to 457 on Tuesday, a 14% drop in 10 days which included a nearly 11% drop close to close from October 8 to October 14 (see table below). The index has bounced back nicely, closing last night at 503, a 10% move from the bottom.
The biggest driver of the sell-off was falling oil prices. Brent crude is down 25% a barrel from its mid-June high, and $10 since the start of October. Oil futures have declined on fears about global supply growth and stagnant demand. Concerns remain focused on OPEC’s unwillingness to cut output to drive prices up.
Outside of upstream MLPs, which are involved in oil and gas drilling and production, most MLPs do not have direct commodity exposure. Nevertheless, the concern is that if oil prices get low enough, producers will curtail production, lowering pipeline volumes. A number of midstream MLPs, which focus on oil transportation and storage, would still be protected with fee-based contracts. Oil would need to settle in the low to mid $70s before we would expect U.S. producers to curtail production. At this point, the decline in oil should not affect near-term MLP revenues or earnings.
MLP performance has also been impacted by constrained liquidity in the sector despite significant growth. Compounding the problem has been a combination of hedge fund derisking, retail investor panic, and forced institutional selling to cover redemptions and leverage. Last week, there were a number of instances where the prices of MLP stocks dropped sharply as investors seemed to be selling indiscriminately.
Despite the tumult in the market last week, we remain bullish on the MLP space and believe it will bounce back for several reasons:
- As shown in the table below, this is the fifth correction (greater than 10% drop) in the MLP market over the last four-plus years. Each of the other times proved to be a buying opportunity with the AMZ rebounding to its previous level, on average, 41 trading days later.
- While MLPs have been falling, interest rates have been going the other way. A month ago, the biggest fear around MLPs was the prospect of rising interest rates. After 10-year U.S. Treasury yields plummeted last week, touching a low of 1.88% last Wednesday, they recovered somewhat to settle at 2.19% yesterday.
- The current yield on the AMZ is 5.5% — down from its peak of 5.1% on August 29 — a 330 basis point spread which is right back in line with the long-term average after falling as low as a 260 basis point spread.
- Oil is a concern, but our view is that it will stabilize. The oil futures curve has inverted during the MLP sell-off, meaning oil is projected to be higher longer term. Additionally, despite all the speculation and fear-mongering about the Saudis, we do not believe they want to crash the oil market and think the long-term backdrop for oil remains constructive.
We believe the long-term fundamentals for MLPs remain excellent. A ton of required investment is still needed to support the U.S. Energy Renaissance that we believe is only just beginning.
To learn more about Duff & Phelps’ views on MLPs, read this October 15, 2014 interview with the investment team of the Duff & Phelps Select Energy MLP Fund (DSE).