Underlying cash flows in the midstream sector have slumped around 15% since oil and gas prices began their epic tumble in late 2014, but equity values have plunged by more than 50%.
For serious investors, that’s a cue to jump back in.
“MLPs today represent a cheaply priced option on future North American growth,” said Brad Olsen, portfolio manager of BP Capital’s TwinLine MLP Fund, who attributed the disproportionate market troubles to an unfortunate collision of perception and reality.
“We believe that the market became enthralled with what we call the ‘irrefutable truths of MLP investing,’ he said during a recent webcast, listing these ‘truths’ as:
- MLPs are stable “toll roads”;
- MLP cash flows are fixed-fee;
- MLPs have long-term contracts;
- MLPs are commodity price agnostic; and
- MLP sell-offs are technically driven.
“The reality is that many MLPs enjoy highly durable cash flows that are derived from near-monopolies in the markets they serve,” Olsen said. “That said, a significant portion of MLP cash flow is also derived from businesses with commodity and volumetric exposure even within the confines of traditional midstream infrastructure assets. The misperception that MLPs are nearly risk-free has created a dislocation in the MLP market the likes of which we’ve historically seen about once per decade.”
The last one was during the financial crisis of 2008. During the MLP recovery in 2009, the top and bottom quartiles were widely dispersed. Olsen and the BP Capital team expect that the upcoming recovery could feature an even harsher differentiation between haves and have-nots, given that a robust recovery in the price of oil is considered to be unlikely.
While cash-flow declines in midstream pale before the catastrophic losses suffered by many E&Ps and oilfield service providers, BP Capital sees an industry facing a three-point challenge to:
- Reduce leverage;
- complete significant projects through 2017; and
- maintain meaningful payouts to investors.
To achieve that, BP Capital anticipates that the sector will need to significantly reduce dividends and issue highly diluted equity that will separate the top quartile from weaker performers.
As to why the sector is primed for a significant market rebound, Olsen pointed to yield spreads, which have a historical high correlation with forward 12-month returns.
“While correlation does not imply causation, yields did in fact go wider than they are today for a period of time back in 2008 during the financial crisis,” he said. “Historically, we are sitting several standard deviations above our historical spread to Treasuries.”
Equity valuations for many in the midstream are touching levels not seen since the financial crisis or even the NASDAQ bubble when oil prices hovered at around $10 per barrel in 1998, Olsen said.
“Today, we believe that we have a chance to own energy infrastructure assets at valuations comparable to what the market was offering in the late ’90s, when large-cap pipeline bankruptcies were a real risk and U.S. oil and gas production was on a multi-decade downward trend,” he said. “Today, midstream MLPs represent a cheap option on the potential resumption of U.S. shale growth as well as a cheap entry point before U.S. energy demand grows dramatically in the next five years.”
Joseph Markman can be reached at jmarkman@hartenergy.com and @JHMarkman
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