The 75% recovery in crude oil prices since their February lows has caused a significant uplift in energy sector debt and equity valuations. But with West Texas Intermediate (WTI) crude prices stuck in the $45-$50 per barrel range in recent weeks, many investors are asking whether there is any value left. While we agree that most energy sectors look fair or even rich vis-à-vis current crude oil prices, we see an attractive investment opportunity in midstream (or processing, infrastructure and distribution focused) master limited partnerships (MLPs) in North America.
The MLP model isn’t broken
When some large midstream energy companies were forced to cut their dividends at the end of 2015 amid collapsing oil prices, MLP equities as a whole sold off. This raised concerns about the sustainability of the MLP model amid persistently lower oil prices. However, in our view, the largest dividend cuts were due to company specific issues, rather than any structural flaw in the MLP model.
In fact, MLPs have relatively low exposure to commodity prices due to their high percentage of fee-based contracts (projected to contribute more than 85% of EBITDA (earnings before interest, tax, depreciation and amortization) in fiscal 2016). They benefit from a roughly $60 billion backlog of announced growth capital projects for fiscal years 2016-2019, about 90% of which benefits from guaranteed long-term “take or pay” contracts. Moreover, a number of MLPs have exposure to natural gas transportation, which is benefiting from tailwinds from exports to Mexico, along with liquefied natural gas (LNG) exports and construction of new petrochemical plants on the U.S. Gulf Coast.
Technical headwinds have faded
Meanwhile, technical factors that played a key role in the sector’s underperformance late last year and in the first quarter of 2016 have faded in recent months: The heavy selling pressure from retail investors in the second half of 2015 has abated, and the sector is seeing meaningful inflows into equity products. The wave of energy sector downgrades by credit rating agencies has also calmed considerably. What’s more, because MLPs are not part of broad energy benchmarks, they remain an under-owned sector among investors.
Valuations look appealing
Finally, valuations look appealing: The average midstream MLP is pricing in a 10% cut in cash distributions in fiscal 2016 and no growth in distributions through 2020. Their current yield and price to discounted cash flow (DCF) are at a discount to five- and 10-year averages. And on a relative basis, yields are higher than many other income-oriented sectors (see chart), although it should be noted that the risk profiles across these sectors differ.
In a world where investors are starved for income-generating assets and around 35% of global sovereign yields are negative, U.S. midstream energy MLPs may offer a potentially compelling risk/reward opportunity – especially considering that the majority of MLP cash flows are backed by guaranteed fee-based contracts that minimize commodity price risk.
John M. Devir is a PIMCO portfolio manager focusing on long/short equity strategies.