You know market sentiment has a Rodney Dangerfield air to it when a research report raises the question: “Why is the Market Mispricing Midstream Stocks?”
After all, midstream energy stocks—both MLPs and C-corps—justifiably sank with oil prices during the early part of the current downturn in oil, when the collapse in crude prices did in fact lead to a drop in U.S. production and, hence, pipeline throughput. But, more recently, the correlation between midstream players and oil has broken down, “since the retreat in oil prices has been largely driven by concerns that U.S. crude production will rise too fast,” according to Raymond James research.
Examining the relationship between midstream stocks and the price of crude oil was a challenge that analysts at Raymond James recently undertook in the face of something that, in their view, defied logic.
“Since when was rising production bad for midstream companies?” the Raymond James report asked. “While rapid U.S. crude production (increases) could be a headwind for global crude prices, it is also a clear tailwind for U.S. midstream players,” it continued. “Rising U.S. oil production is very bullish for the midstream companies that process and transport those rising volumes of oil.”
Makes sense, right?
Unfortunately, while there are clear differences that define midstream players’ business models, the stock market continues to paint midstream stocks with an energy-risk profile similar to those that are more directly exposed to the commodity. For example, the correlation of the Alerian MLP Index (AMZ) to West Texas Intermediate (WTI) over a one-year period is put at 0.58 according to Raymond James, while its correlation to the E&P sector is as much as 0.76.
To emphasize the point, Raymond James also highlighted the particularly steep selloff in crude that occurred late in the second quarter and dragged down with it the midstream sector.
“From late May through June, the AMZ traded down in near lockstep with crude—losing about 12% vs. a roughly 17% fall in WTI,” the report noted.
One interesting observation was that a sub-group of midstream C-corp stocks had “a very strong price-return correlation” with crude oil, even though their fundamentals were by no means uniformly crude-oriented. While a couple of C-corp names were “crude oil-centric,” others made up a diverse group. As examples, “Williams Companies is focused on natural gas,” the report noted. “Kinder Morgan Inc. is diversified, hedged and has a visible composition of contracted cash flow with a diverse, high-quality customer mix.”
The above sub-group is being traded less on their fundamentals and more on the fact that the stocks themselves are of “at least moderate size” and organized as C-corps, said Raymond James. “These are both factors that improve the trading liquidity of these stocks and the ability to sell short the stocks.” In turn, the implication is that they are used in shorter-term trades focused on going long or short in tune with movements in crude prices.
But looking beyond the maze of trading patterns, the Raymond James analysts see better times ahead—and opportunities to be seized in the wake of the market’s recent mispricing of midstream stocks.
“Short-term concerns remain, but the medium- to long-term outlook is improving,” said the analysts. “Since this most recent pullback (late-May through June) was due largely to concerns over rising U.S. oil supplies, it appears to us to be a great buying opportunity created by a misguided market understanding of current midstream fundamentals, expected long-term trends, and the level of intrinsic risk reflected in current valuations.”
Current midstream valuations “don’t reflect the underlying secular fundamentals driving long-term cash flow growth,” said Raymond James. In addition to the midstream sector benefiting “tremendously” from expected Lower 48 crude production growth, capital discipline in force during the downturn has “placed the midstream space on more sound financial footing,” it observed.
In the meantime, for those wondering if the ups and downs of their stocks were “justly” or “unjustly” correlated to crude oil price moves (i.e. correctly or incorrectly priced by the market) over the last 12 months, they are:
- Those “justly” correlated: Plains All American Pipeline LP, Plains GP Holdings LP, SemGroup Corp. and Targa Resources Corp.; and
- Those “unjustly” correlated: Crestwood Equity Partners LP, EnLink Midstream LLC, EnLink Midstream Partners LP, The Williams Cos. Inc. and Teekay Corp.
Chris Sheehan can be reached at firstname.lastname@example.org or 303-800-4702.