A Lesson for MLP Investors from Past Selloffs
Utility stocks have outperformed thus far in 2016, eking out a 0.3 percent gain in a turbulent market where every other S&P 500 sector has given up ground—a testament to the group’s defensive nature, reliable dividends and visible growth opportunities.
But few stocks remain unscathed in a bear market. When the S&P 500 imploded in 2008, the utility sector outperformed, but still gave up almost 29 percent of its value.
The damage was even worse in 2001 and 2002, when the Dow Jones Utilities Average plummeted by almost 60 percent. In addition to the selling pressure associated with the bear market, utilities found themselves undone by excessive debt and following Enron into riskier business lines to drive growth.
Over this trying period, about 20 percent of the power companies in my coverage universe slashed or eliminated their dividends. And by early 2003, roughly two-dozen utilities were on the brink of collapse or had filed for bankruptcy.
Even best-in-class stocks got caught up in the selloff. Over a six-week period that started in late August 2002, Dominion Resources (NYSE: D) gave up almost half its value after issuing $1.07 billion in equity to avoid a credit downgrade.
The rating agencies had no beef with Dominion Resources’ underlying business; rather, analysts worried that the sharp decline in the company’s stock price would force the utility to fund planned capital expenditures by issuing debt.
The MLP Selloff
A similar story has played out among energy-focused master limited partnerships (MLP), former market darlings that profited from surging US oil and gas production.
But volumetric and counterparty risk in an environment where crude-oil prices remain lower for longer present formidable obstacles to future growth and could threaten the cash flow generated by existing assets, especially those serving marginal acreage.
As investors have soured on MLPs’ growth prospects, the Alerian MLP Infrastructure Index has given up about 55 percent of its value since its peak in early September 2014.
Thus far, distribution cuts have been concentrated among upstream MLPs that produce oil and gas and cyclical names that operate nontraditional business lines.
For example, SeaDrill Partners LP (NYSE: SDLP), which slashed its payout by 55 percent, owns offshore drilling rigs. Fellow cutters Emerge Energy Services LP (NYSE: EMES) and Hi-Crush Partners LP (NYSE: HCLP), both of which eliminated their payouts completely, produce crush-resistant silica sand used in hydraulic fracturing.
Southcross Energy Partners LP (NYSE: SXE), which owns gas-processing plants in the Eagle Ford Shale, recently suspended its quarterly distribution after its general partner threw in the towel on offsetting the MLP’s cash flow shortfall.
Midstream giant Kinder Morgan (NYSE: KMI) also caused investors a lot of pain when the company slashed its dividend by 75 percent, a response to the stock’s elevated yield and the threat of a rating downgrade from Moody’s Investor Service.
On the plus side, this move shores up Kinder Morgan’s balance sheet, enables the company to maintain its coveted investment-grade rating and improves the economics on future projects by funding them out of retained cash flow. After the move, Kinder Morgan’s lenders increased the company’s revolving credit line to $5 billion from $4 billion.
Risks in the midstream industry remain elevated; a sustainable recovery in crude-oil prices implies a decline in US onshore oil production, with the biggest volumetric hits occurring in marginal basins such as the Mississippi Lime.
However, the indiscriminate selling of MLPs creates lucrative opportunities for discriminating investors who can spot and pluck the proverbial babies from the muddy bathwater.
Investors who kept their wits about them when utility stocks imploded in 2002 and 2003 reaped ample rewards once the market returned to its senses. By mid-2005, the Dow Jones Utilities Average had recovered the losses suffered during the bear market. Even investors who bought this basket of 15 utility stocks at the top in late 2000 were up almost 40 percent at the market’s next peak in early 2008.
Shares of Dominion Resources, my top pick in November 2002, have generated an almost 500 percent return since those darkest of days.
Toward MLP Redemption
At this point, few investors expect a similarly happy ending for MLPs.
The near-term outlook for this group looks challenging, with the Alerian MLP Index yielding more than 10 percent and uncertainty about future throughput volumes weighing heavily on investor sentiment.
And the indiscriminate buying of MLPs in recent years—more than 80 fund products offer exposure to this universe of about 125 names—begets indiscriminate selling when headwinds emerge.
However, investors should keep a few encouraging thoughts in mind to help them through these challenging times.
Mantra No. 1: Yes, We Shale
Although the near-term outlook for midstream MLPs includes a number of risks that could lead to further downside for the group, we remain bullish on the longer-term growth prospects for US oil and gas production, especially in the lowest-cost basins.
The next one to two years could be challenging for throughput volumes on midstream infrastructure, as exploration and production companies jockey for market share and competitive forces squeeze out the excesses of recent years.
But over the long term, reductions in non-OPEC drilling activity and reduced capital expenditures in international markets create an opportunity for short-cycle shale plays to fill the gap and win market share.
In the meantime, focus on the safety-first names and the fundamental growth stories that will play out regardless of what happens with oil prices.
Investors should also keep an eye out for distribution cuts at names that own well-positioned assets, but also find themselves hamstrung by leverage issues and high costs of equity capital.
Repairing the capital structure and funding commercially secured growth projects internally will unlock long-term value for shareholders, making a distribution cut a buying opportunity. However, names with significant exposure to marginal producers and basins should be avoided at all costs.
During the previous decade, utilities’ stock prices bounced back because they reduced exposure to operations vulnerable to collapsing electricity prices while cutting operating costs and debt. That’s a winning formula for midstream MLPs that have some warts, but also own assets that will continue to generate solid cash flow in an environment where energy prices remain lower for longer.
Mantra No. 2: Closer to a Bottom
Over the past 20 years, the Alerian MLP Infrastructure Index’s yield has approached 10 percent on three occasions: today, the bottom in late 2008 and when oil prices scraped $10 per barrel in 1999. The index’s enterprise value to estimated cash flow also stands at 8.5 times—a level last seen during the previous selloffs.
Of course, cheap stocks can always get cheaper. And the current selloff occurs in a much different environment than its two antecedents. But valuations this low price in a multitude of potential ills, from distribution cuts to bankruptcies.
Remember that the market eventually will have a better feel for the volumetric risk in the US onshore market and the pockets of strength that exist. Given the massive inflows to MLP-focused funds, you can rest assured that the selloff will overshoot to the downside, just as it did on the upside. Fundamentals will win out eventually.
For now, investor sentiment remains extraordinarily negative, with views questioning the MLP structure itself gaining visibility in the mainstream financial media. Fears that the worst is yet to come also mean that investors receive any bit of positive news with skepticism.
Utilities found themselves in a similar situation in the aftermath of the Enron implosion. The Wall Street Journal captured the zeitgeist with the February 2003 headline “Power Glut Expected to 2006.” A few months later, I attended a conference hosted by Standard & Poor’s where the lead utility analyst warned that the sector had entered “a dark tunnel” from which it would emerge only after a decade or more of pain.
At that point, utilities’ turnaround efforts had been underway for more than a year. But Standard & Poor’s and Moody’s Investors Service remained negative on the utility sector for many years thereafter. Nevertheless, by mid-2003, all but the weakest utilities could raise debt and equity capital on reasonable enough terms to facilitate their recovery.
Mantra No. 3: Be Selective
Not every utility stock recovered from the 2001-02 meltdown. And you can rest assured that not every MLP will survive this challenging environment—one of the reasons our MLP Ratings table has more Sells (49) than Buys (26).
Moreover, most midstream MLPs’ cash flow and growth prospects depend on production volumes; these stocks probably won’t bottom until we have greater clarity on the extent to which lower prices will affect US onshore output.
Here’s a true confession: When the Dow Jones Utilities Average hovered between 230 and 240 in mid-2002, I pounded the table for utility stocks somewhat prematurely— fourth months later, the index bottomed four at 167 and change. But by spring 2003, this bullishness had translated into real profits, despite some faith-shaking moments along the way.
In these unsettled times, investors must exercise patience and add to their positions incrementally instead of just backing up the truck. As always, the key is focusing on names with solid underlying businesses that can weather the storm and build wealth over the long term.
Best-in-class MLPs have plenty of upside drivers once rationality returns to the market. Instead of losing your head, now is the time to use it and add to our favorite names incrementally.
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