If you’ve been following MLPs and energy infrastructure at all in July, you already know what happened: it was another hard month after an already disappointing year. This, despite the fact that interstate liquids pipelines raised their tariffs by 4.58% on July 1st, via a federal regulation so commonplace and accepted that MLPs don’t issue press releases about it, although nearly all petroleum transportation MLPs benefit from it. Despite a pickup in M&A activity and continued project announcements.
Not all of the news was positive, as upstream MLPs Linn Energy (LINE/LNCO) and New Source Energy Partners (NSLP) suspended their distributions. However, a lot of the news was good: of the 50 constituents in the Alerian MLP Index (AMZ), two cut their distributions this quarter (LINE and frac sand miner Hi-Crush Partners (HCLP)), two haven’t yet announced, 14 kept their distributions flat, and 32 increased their distributions. Tallgrass Energy Partners (TEP) raised its distribution 11.5% quarter over quarter.
WTI prices fell nearly 20% during July, driving the difficulties of the above-mentioned upstream names and their service providers, and interest rate fears are keeping people up at night. So, at this point, many investors are wondering, is it better to get out now because the worst is yet to come, or is this really the bottom and now is the time to add to positions because the fundamentals are still intact?
For the space to continue to fall, one or more of the following needs to be true:
1. The spread between the AMZ yield and that of the 10-year Treasury remains above 300 bps while the Treasury yield moves to 4%. The historical median is around 330 bps, but the current spread is north of 450 bps.
2. Crude falls below $40 and stays there for at least 12-18 months. A dramatic and sustained price move would be necessary to induce the supply response that reduces the need for energy infrastructure in North America, because while breakeven prices are difficult to pin down due to the wide dispersion of sunk costs even among operators in the same basin, increased availability of labor and equipment is driving down variable costs on a daily basis.
3. The demand landscape for hydrocarbon energy changes for the worse despite electricity generation moving toward natural-gas-powered plants as coal plants shutter as well as new markets created by the LNG export facilities in the final stages of construction.
Conversely, what would need to be true for investor confidence to resume?
1. Production numbers and projections stabilize. Regardless of where crude trades, the market is currently waiting for the other shoe to drop. For most investors to truly feel comfortable, production must first drop, stabilize, and then move upwards.
2. M&A activity continues indicating that management teams believe valuations have reached appropriate levels. Unitholders of QEP Midstream Partners (former ticker: QEPM) approved the company’s merger with affiliate Tesoro Logistics (TLLP), but the biggest transaction news of the month was MPLX (MPLX) announcing its proposed acquisition of MarkWest Energy Partners (MWE), which was not received favorably by the market.
3. Growth projects continue to be announced. As MLPs do not put a shovel in the ground until long-term contracts are signed guaranteeing them the necessary minimum IRR for a project, this growth is not anticipatory as in Field of Dreams. Rather, season tickets must be sold before anything is built. As an example, EQT Midstream Partners (EQM) announced a $250 million project to support the development efforts of Range Resources (RRC) in the Marcellus and Utica. The project is backed by a long-term firm capacity agreement and expected to be in service during 2017.
Recent performance indicates that below $50 oil, these announcements aren’t providing enough handholding. However, with the AMZ yielding nearly 7%, earnings reports largely continuing to meet expectations, and the majority of MLPs still raising their distributions, consistency and stability should eventually soothe investor fears. The poster child for this argument, of course, is bellwether Enterprise Products Partners (EPD), which announced its 44th consecutive quarterly distribution increase during the month.