Reexamining MLP/Midstream Oil Correlations

05/28/20 | Bryce Bingham

Summary //

  • Due to the fee-based nature of its cash flows, midstream has historically had a lower correlation to oil prices among its oil and gas peers.
  • Midstream’s correlation to WTI crude tends to increase during periods of declining prices.
  • Correlations have weakened in recent weeks for energy broadly, with midstream companies benefitting from constructive guidance updates even as oil prices deteriorated further.

After historic one-day declines of 24.6% for West Texas Intermediate (WTI) crude and 27.7% for the Alerian MLP Infrastructure Index (AMZI) on March 9 following the beginning of a price war between Saudi Arabia and Russia, the correlation between oil prices and energy infrastructure has come back into focus for many investors. While the nature of midstream’s business model helps insulate cash flows from commodity price volatility, midstream stock prices are not immune from the implications of the decline in oil prices. Today’s note discusses the factors that drive the correlation between MLPs/midstream and oil prices in different commodity price environments as well as the disconnect between recent midstream price performance and financial fundamentals.

Midstream is less correlated to oil prices than its oil and gas peers.
As we have discussed before (read more), the fee-based nature of midstream’s contracts helps protect  cash flows from swings in energy commodity prices. However, oil prices still tend to impact the space from a sentiment standpoint. Investors do not always make the distinction between midstream and other sectors of energy with direct commodity price exposure when oil is collapsing, resulting in energy infrastructure equities tracking oil prices to a degree even if their bottom line is not materially impacted. The table below compares five and ten-year correlations to WTI crude for MLPs and midstream, as represented by the AMZI and Alerian Midstream Energy Select Index (AMEI), respectively, to other sectors of energy. The historical correlation between midstream MLPs and WTI crude has been the lowest among the energy subsectors shown and broader energy represented by the Energy Select Sector Index (IXE). However, a ten-year correlation of 0.55 between AMZI and oil based on monthly data is still somewhat elevated compared to expectations given the relative stability of the midstream business model, demonstrating the effect that changes in broader energy sentiment have on the space.

Correlations tend to strengthen when oil falls.
While midstream typically performs defensively relative to its peers in an environment of declining oil prices, correlations with oil still tend to strengthen. As we have seen in recent months, dramatically lower oil prices have brought about issues that could impact midstream fundamentals (read more). The cash flows of midstream’s exploration and production (E&P) customers are directly threatened by lower commodity prices, which creates counterparty risk. This also can result in lower throughput volumes as producers pull back on drilling and completion activity or potentially curtail production, impacting midstream as volume-driven businesses and reducing future growth opportunities (read more). This macro uncertainty also has historically resulted in distribution cuts. While cash flows are not necessarily distressed thanks to the combination of fee-based revenue streams and contract protections (read more), many smaller midstream companies will prioritize financial flexibility and balance sheet strength over their distribution, especially if yields soar to lofty levels. This reallocation of capital may be the best course of action for ensuring the long-term stability of many operators but could be frustrating to income-focused investors. Additionally, declining oil prices only compound the impact of negative energy sentiment on the space. The combination of these factors adds pressure to midstream equities and heightens their correlation to declining oil prices. As seen in the chart below, the correlation between the AMZI and WTI crude based on weekly data jumped to 0.62 during the 2014 – 2016 downturn, and AMEI’s correlation to oil rose to 0.65 during that period. For context, E&Ps, as represented by the S&P Oil & Gas Exploration & Production Select Industry Index (SPSIOP), and oilfield service names, as represented by the PHLX Oil Service Sector Index (OSX), had weekly correlations of 0.69 and 0.71 to WTI crude over the same time period.

Examining recent oil correlations for midstream.
Given the dramatic movements in both midstream equities and oil prices this year, the relationship between the two has been somewhat out of the ordinary but has continued to follow the patterns seen in previous downturns. In the first quarter, the AMZI and AMEI indexes had weekly correlations of 0.81 and 0.88, respectively, to WTI crude prices, which fell 66.5%. As a comparison, the IXE index had a 0.84 weekly correlation to oil prices in 1Q20. In addition to the counterparty risk, threat of lower throughput volumes and changing growth prospects, and potential for distribution cuts all augmented by negative sentiment discussed above, MLPs faced additional pressure from dedicated closed-end fund deleveraging that occurred in March, magnifying the sell-off in the space and further strengthening its correlation to declining oil prices. However, midstream has recovered and correlations have weakened significantly in April and May despite the continued volatility in oil prices. As seen in the chart below, midstream and MLPs reached a relative bottom in March and began their recovery well before oil prices bottomed in April. AMZI and AMEI’s year-to-date correlations to oil through May 26 have fallen to 0.48 and 0.46 based on weekly data as the indexes have increased 96.6% and 82.3%, respectively, since reaching all-time lows on March 18. Given that MLPs sold-off more dramatically than broader midstream initially, the AMZI still trails the AMEI by 539 basis points year-to-date, with AMZI down 35.9% and AMEI down 30.5% through May 26. IXE’s year-to-date crude correlations have also weakened but are slightly higher than that of MLPs and midstream at 0.49 based on weekly data.

More moderate oil correlations have come as energy infrastructure companies continue to provide constructive updates on their operations and financial guidance, potentially leading investors to look past the noise created by oil prices. As the dust began to settle, midstream may also have benefitted from a sector rotation into the space given its more defensive qualities relative to other energy sectors (read more). Full-year 2020 midstream EBITDA forecasts have been resilient when compared to the rest of energy and further emphasize both the stability of midstream’s fee-based businesses and the disconnect between fundamentals and equity prices (read more).This stability has also been mirrored by midstream dividend announcements. While several names did cut their dividends in 1Q20 due to the challenged macro energy environment, the majority of both AMZI and AMEI constituents by weighting grew or maintained their dividends sequentially (read more). Overall, these updates point to more stability than what is implied by the 43.7% year-to-date decline in WTI crude prices and midstream performance through May 26.

Bottom Line
Heightened crude correlations for midstream in 1Q20 were undoubtedly a source of frustration for investors. However, the more recent disconnect between midstream and oil has been encouraging as WTI fell further in April while midstream recovered. The unprecedented sell-off in oil prices weighed on energy equities across the board, but the fee-based nature of midstream cash flows and contract protections help to insulate the sector from adverse oil price movements and provide defensive energy exposure compared to other energy sectors.