24 Sep Market Insights – September 2015 Urban Legends and Master Limited Partnerships
One of the great advantages of being a Registered Investment Advisor (“RIA”) is independence of thought. This independence allows us to direct time and energy to research efforts that may be overlooked. As the title of this article suggests, we believe there are a number of urban legends swirling around about the midstream Master Limited Partnership (MLP) sector of the energy markets that need attention. For reference, midstream MLPs are companies providing transportation of energy commodities (usually via pipeline) from the well-head to a downstream company like a refiner or marketer.
Urban Legend Defined
Before we jump in, let’s first define an urban legend. According to the Merriam-Webster dictionary, an urban legend is defined as an “anecdote that is based on hearsay and widely circulated as true”. In the case of MLPs, there are a few urban legends that need to be addressed.
First, in reading countless publications and listening to many asset managers speak about midstream MLPs in recent weeks, what becomes apparent is this idea that their business model is “low risk” due to the fact that most MLPs in this space have fixed-fee contracts with minimum volume commitments. This contract structure, as the thinking goes, insulates these midstream MLPs from commodity price risk. As we’ve contended for some time, this commodity price insulation is merely an illusion which we’ll expand upon later in the article. However, if one were to look at the actual data, you’d find a strong correlation between midstream MLPs and energy prices, as you can see in the chart below which shows the price movements of both MLPs (Alerian MLP Index in green) and energy prices (WTI Crude oil in blue).
When you examine the chart, the following points become apparent:
- Correlation between the two series appears to be (and in fact actually is) high. Downloading and running the correlation coefficient between these two series generates a reading of 0.84 (where a correlation of +1 would indicate the two data series movements are perfectly positively correlated and a -1 would indicate the two data series movements have perfect negative correlation). Statistically, a 0.84 reading is significant and high.
- The compound annual growth rate (CAGR) for each asset grew at similar rates over the last 20 years (MLPs at 6.3% and 5.05% for WTI Crude). The differential can be (in part) explained by the presence of leverage in MLPs. Thus, it appears one is receiving levered energy exposure.
However, looking more closely at the contract argument described above and applying a careful thought process is where the urban legend begins to break down. I’ve listed a few thoughts on this idea below.
- A contract is only as good as the counter-party. Over the last few years energy exploration and production companies (the pipelines’ counterparties) have been some of the largest issuers of junk-rated debt, i.e. in order to find buyers for the debt issuance the interest rate has to be much higher than a market interest rate, indicating buyers see greater than market risk in their investment. This increased riskiness of the counterparty means contracted cash flows are more at risk. In fact, with the recent Chapter 11 filing of Samson Energy (a potential signal that other bankruptcies may occur), other fixed-fee, minimum volume commitment contracts may also be at risk.
- Contracts can be broken. Further, to stave off bankruptcy and receive (potentially) zero cash flows, many pipeline companies have already started renegotiating their contracts with producers so that the contract won’t put the producer out of business due to the changing commodity environment. (For example, see Williams Companies renegotiating their Utica gathering system contract with Chesapeake Energy). This contract renegotiation also occurred in the banking sector in 2009/2010 where banks renegotiated lending terms with borrowers during the great recession. Specific to the commodity sector, a large-scale renegotiation of contracts occurred in the marine shipping sector in late 2007/2008. There is precedent.
- Growth in MLP distributions (dividends) is entirely dependent on new project development by MLPs. While some of the larger MLPs have excellent relationships with high quality producers, some of the smaller MLPs find their capital project backlog at risk of curtailment given the persistently weak commodity environment. Since MLPs have come to be primarily valued on the basis of yield, a slow-down in distribution growth rate puts share prices at risk.
Pulling it all together, we view MLPs with extra caution in the current environment. This anxiety would speak to the elimination of our MLP index in Q4 of 2014, on the idea that the MLP sector has never before experienced such a significant decline in energy prices outside of a credit crisis. Further, with such high correlation to energy prices AND more flexible cash flows than many market participants think, we felt that further downside in MLP prices was a high probability. This type of thought process is what Howard Marks of Oaktree Capital refers to as “second-level thinking”; where conventional wisdom is eschewed for deeper insight. Urban legends exist in the first-level of thought, which expose investors to unforeseen/unimaginable risks. Our efforts at Gratus Capital attempt to focus on the second and third-level of thinking as we attempt to sidestep hidden risks and capitalize on difficult-to-see opportunities.
Thank you for the continued confidence you place in our firm.
Todd Jones, CAIA Director of Investments