Last week, we attended the MLP and Energy Infrastructure Conference hosted by the Master Limited Partnership Association in Orlando. The event was well attended, surpassing last year’s record. While the FERC news, Permian discounts and oil prices were all relevant topics, the main focus was around the frustrating disconnect between fundamentals and equity values in the midstream space. With the recent restructuring announcements from several MLPs, corporate structure was a major topic, as well as what it will take for investors to become more constructive on this asset class.
Fundamentals intact but noise distracts.
Fundamentals continue to look strong with WTI crude just under $70 per barrel, and US oil and gas production growing rapidly. Multiple MLPs reported strong first quarter 2018 results, and management teams were broadly optimistic on the fundamental outlook for their businesses. As we’ve written about several times, the underlying fundamentals for US oil and natural gas production are robust, with growing exports representing a significant opportunity for the energy infrastructure space.
While improved fundamentals are widely understood, the frustration has been equity performance relative to the fundamental backdrop. Most investors are aware of energy’s low relative weighting in the S&P 500 (just over 6% currently relative to 10+% prior to 2013), which reflects a broader underinvestment in the energy sector. Specific to the MLP and energy infrastructure space, noise from headlines (restructurings, FERC news, distribution cuts) has likely kept some investors on the sidelines, particularly new investors, past retail investors and institutional investors not required to allocate money to the space. Others have already bought dips in the past and are comfortable with their existing exposure.
What does it take for money to move back into the space?
Generalists and non-dedicated MLP investors have been perhaps sidelined due to corporate governance concerns ((lack of board independence, inability of LP holders to elect board members)), questions around capital discipline (investors don’t want growth for growth’s sake), and the noise from headline risk mentioned above. While K-1s are also cited as a hindrance, it’s difficult to gauge the extent to which institutional investors are really sidelined by this. Some institutional and retail investors may not return to the space after being frustrated with past performance. Others are waiting to see a stabilization of distributions, continued oil stability or perhaps a few quarters without negative headlines. Checking those boxes will take time.
What’s the right business model?
With the conference following on the heels of several restructuring announcements, there was plenty of commentary around business structure. Restructuring from an MLP to a corporation is obviously a one-time decision with long-term implications. The new tax reform policy is only months old. Broadly, a corporate structure may make more sense for some MLPs, but it’s also not a cure-all. It’s valid that a corporate structure may attract a broader base of investors and may open the door for inclusion to broader market indices for certain companies, but it doesn’t change the company’s asset base, growth project backlog or management team. In other words, restructurings are ultimately a tool for financial engineering that can be useful, but it doesn’t change the underlying business fundamentals – which have been largely set aside to focus on questions around structure.
Undoubtedly, restructurings can be an effective way to address issues around the cost of capital and eliminate IDRs for some MLPs, but restructuring isn’t the only option. For example, several MLPs have addressed their IDRs by buying out their GP interest. A reorganization or conversion to a corporation isn’t required to address investor concerns around corporate governance and capital discipline. The general sense from the conference was that different structures will fit different companies’ unique situations, but corporate structure should not be the primary focus or determinant of performance.
What’s the silver lining?
Fundamentals for energy infrastructure remain strong, and billions of dollars of infrastructure investment will be required for the US to fully assume its expected role as the world’s major energy exporter. As volume-driven businesses, production growth creates more opportunities for MLPs and energy infrastructure companies. While the space is in a period of transition (moving toward self-funding, more focused on capital discipline, restructurings, moderating distribution growth), the hope expounded at the conference for energy infrastructure investors is that a healthier, more sustainable and more widely held sector emerges from today’s frustrating transitional phase.