The UK private bank argues that a way of investing in the energy infrastructure sector can continue to deliver valuable income in a low-yield world.
With the oil price – and other energy prices – sliding this year, one segment of the investment market has taken a beating but remains a dependable source of income when so many assets deliver weak yields, according to Coutts, the private bank.
What are called Master Limited Partnerships, which own US energy infrastructure, had been gaining popularity in recent years with domestic US investors – and have also been promoted to non-US investors. The advent of new technologies to extract oil and gas from shale – aka “fracking” – and other trends, had driven demand. MLPs are a form of limited partnership that is publicly traded; there are limited partners receiving periodic income after providing the capital, and general partners that actually manage the MLPs and are paid depending on performance. For non-US investors, such as those in Europe, MLPs need to be bought via a swap to avoid being hit by heavy US taxes (total return swaps).
With oil prices under $50 a barrel, the MLP market will struggle, but previous difficult episodes have seen these vehicles recover and they remain a useful income-generator, argues Ian Higgins, UK chief investment officer at Coutts.
The oil price decline – with the odd pause or uptick – has been dramatic. Over the past 12 months, Brent crude oil futures have fallen from $92.11 per barrel to $52.15 pb (as of Tuesday early afternoon in London). At one point, the price in late August was as low as $42 bp.
“There is no delicate way of expressing it. Master Limited Partnerships, which generate income through their ownership of US energy infrastructure, have had a terrible year. The broad MLP index has lost roughly a third of its value so far in 2015, inexplicably underperforming oil producers that are directly linked to commodity prices,” Higgins said in a note.
“MLPs have been a popular source of income with many real (inflation-adjusted) bond yields being negative. But they’ve come up against the perfect storm: a halving of oil prices, sell-off in the broader energy sector and concern about rising interest rates. Although revenues from infrastructure are not directly correlated with commodity prices, and their fee-based contracts remain intact, the market has overreacted to uncertainty about future production levels,” he continued.
“MLPs last suffered a decline of this magnitude during the global financial crisis, when the index halved in line with the broad equity markets. Oil prices fell from $150 to $40 a barrel over a six-month period in 2008, and production declined by a third, though both prices and production recovered swiftly. At the height of the crisis, MLPs couldn’t raise capital through the equity and bond markets. Distributions fell by 2 per cent in 2009, but were not wiped out and returned to growth the following year. In effect, concerns about MLP sector destruction in 2008 and 2009 turned out to be overdone,” he said.
Higgins said that while the recent oil price drop has occurred for different reasons than the events of 2008-09, “we believe MLP price declines are out of proportion with the economic fundamentals”.
“Annualised yields are currently over 8.5 per cent and distributions that will be announced during the coming earnings season look likely to be about 11 per cent higher than a year earlier. But this may be drowned out by negative sentiment,” Higgins said.
“Oil prices below $50 a barrel are definitely a challenge for MLPs, but our analysis suggests that distributions are largely sustainable even if oil prices remain at this low into the middle of next year. If they do, distribution growth will slow, but MLPs appears to be already pricing that in. Though raising capital in the equity markets is difficult at the moment, bond markets remain open, even for sub-investment grade (poorer credit quality) MLPs,” he said.
“We still think there’s a good long-term case for MLPs. Energy
independence is a high priority in the US, and shale technology
and production are unlikely to be abandoned. MLP infrastructure
is needed for all this shale oil to get to market. Lastly, a
return to crude oil exports is an option in the medium term,”