SCOTTSDALE, Ariz. -- Since the stock-market lows reached in February 2016, stock prices for master limited partnerships (MLPs) have had a good run.
MLPs increased 77% as represented by the Alerian MLP ETF (exchange-traded fund), compared to a 17% increase for the Standard & Poor’s Index. In the three-year comparison chart included here, note the sharp drop in MLP prices as they fell with oil prices during that period. The decline in oil dragged down all MLPs, even midstream and downstream MLPs, which are normally less sensitive to crude prices.
Oil prices recovering to the $50-per-barrel range has certainly helped many exploration and production companies. This is despite several bankruptcies and the fact that $50 oil will only inspire so much new drilling. Crude prices are a good economic indicator because they often reflect demand from emerging countries that are typically the true drivers of growth, unlike mature countries with their aging populations. And sub-$50 oil is very important to the Saudis, who once again may look to gain “swing supplier” status, whether they want that position or not.
The refining and transportation sectors of the MLP index remain a mixed bag. First, the 1 million barrel-per-day (bpd) cut in domestic production reduces important pipeline, storage and rail volume, which in turn reduces efficiencies. Also, the ability to export oil since the beginning of the year has narrowed the West Texas Intermediate-Brent spread “subsidies,” which so greatly improved domestic landlocked refiner profits during the prior two years. Recently, oil exports have increased to 700,000 bpd.
Although well below the levels of a couple of years ago, most retail and wholesale-oriented MLPs have recovered nicely, while generally holding their attractive distribution yields. Unlike real estate investment trusts (REITs), MLPs have considerable flexibility to determine the size of their distributions. The fact that they have held up well implies they must feel good about their business prospects, especially considering some are near their credit limits for reasonable leverage ratios on their debt.
Retail margins in 2016 are expected to be a few cents lower than they were in 2014 and 2015, or perhaps even worse as crude oil and refining margins improve. Yet, strong store sales are helping maintain excellent industry profitability, despite several uncontrollable regulatory cost increases.
Wholesale profits are similarly pinched. Many dealers and franchisees face competitive pressures from strong foodservice-oriented retailers and from the huge competitive advantages offered to unbranded marketers using Renewable Identification Numbers (RINs), yet another market distortion created by government regulation. The net result is that retail and wholesale company profitability is strong overall, but will vary considerably by region and local competitive position.
There are other positive changes that the MLP stock prices do not reflect. One is the conclusion of the merger battle between Energy Transfer Equity LP and Williams Cos. The substantial rise in both companies’ stock prices from their lows this year—304% and 173%, respectively—shows that two very viable entities remain. It also will be interesting to watch the future direction of Alimentation Couche-Tard after its recent purchase of CST Brands Inc. and associated ownership in CrossAmerica Partners LP, where there are many alternatives.
If stable earnings are in store for the downstream side of the business, how long will Wall Street ignore the whopping spread between many of the MLPs’ distributions, averaging from 5% to 10% compared to 10-year Treasuries averaging 1.7%, the very high end of historical spreads? MLP prices and the high-yield, lower-quality bond market often move in tandem, partially due to MLPs often using maximum leverage to maximize distributions. The good news is that the high-yield market has also performed well this year as institutions push for yield.
Finally, and important in the long run for real-estate investing, REITs have outperformed the S&P Index for many years and are now separated from the S&P Financial Index. REITs recently provided average yields of 4.3%, compared to 2.3% for the overall financial sector, 2.2% for the S&P and 1.7% for 10-year Treasuries. Further, in 2015, almost 80% of all REITs raised their dividends.
MLPs overall have been much more volatile than REITs. But between yield strength and the potential for greater capital appreciation, they should keep looking more attractive to Wall Street. If prices and equity multiples do improve, MLPs may become more willing to issue shares and purchase stores and chains that will be accretive to earnings. Some might choose to offer shares as part of their purchase price, which can bring sizable tax and estate-planning advantages for sellers. One always reliable gauge of market strength is whether some potential MLP IPOs are finally able to go public.
MLPs’ volatility has likely caused them to lose their “widows and orphans” investor reputation, perhaps forever. Because they are very complex, with different business units and overlapping interrelated types of securities, the industry is likely to be more institutionally driven by Wall Street. If economic growth and interest rates can remain relatively stable while growing, my bet is that the MLP market should continue to outperform the rest of the market.
With MLPs’ upside—large financial incentives to grow and improve distributions—there should be renewed industry merger and acquisition activity. But given slow growth and leverage limitations, it is very unlikely we will see the record multiples paid late last year again.