Ever since OPEC’s announcement of oil production quotas in late 2016, core OPEC countries have, to the surprise of many, largely complied with the agreement. However, higher-than-expected output from Libya, Nigeria and especially U.S. shale oil has caused oil prices to decline by more than 20% from their recent highs in early 2017.
Alongside weakness in oil, we are seeing indiscriminate selling in energy-related sectors, including MLPs. (Master limited partnerships are U.S.-based publicly traded partnerships, listed and traded on a public exchange. They are most common in the energy industry, providing and managing resources such as oil and gas pipelines.) The recent selling pressure, especially from retail investors, is similar in magnitude to what we witnessed in the second half of 2015: This June marks the first month of negative retail flows since January 2016, even though initial conditions today are much better. Crude oil inventory balances are actually improving (just more slowly than anticipated), and our fundamental medium-term outlook forecasts oil prices in the range of $45–$55 per barrel. Nonetheless, compared with the S&P 500 U.S. stock index, the MLP sector as measured by the Alerian MLP Index currently trades at ratios as low as early 2016 (see chart), and with a record-high advantage in yields compared with the high yield bond sector (as measured by the BofA Merrill Lynch Developed Markets High Yield Constrained Index).
Low MLP prices create an attractive opportunity
The real news is the resilience of the U.S. shale industry and its ability to increase output at benign oil price levels. Yes, the oil price decline led to MLP weakness, but ultimately, we believe a competitive U.S. shale industry is the best driver of MLP success in the future. MLP revenues are largely fee-based and therefore more dependent on volume growth than on commodity price increases. The more oil is pumped in the U.S., the better for energy infrastructure companies like MLPs.
Looking at valuations alone, MLPs in the Alerian Index have yielded more than 8%. Couple this with our forecast (based on our proprietary research) of distribution growth in the high single digits per year for MLPs, and we see potential for combined total return in the MLP space in the low to mid-teens over the next year. Of course, MLP investments come with certain risks, including susceptibility to sharp increases in interest rates, a global recession or an abrupt end to OPEC’s production agreement.
We largely attribute the recent pullback in MLPs to technical factors rather than any meaningful deterioration in underlying fundamentals. While no one can predict when the retail selling pressure will abate, our analysis suggests we are at over-sold levels similar to what the sector experienced in early 2016. Combining attractive pricing with strong distribution yields, we believe this is an excellent time for investors to consider a capital allocation to MLPs.
For more on PIMCO’s approach to investing in MLPs, please read our recent “MLP & Energy Outlook.”
John Devir is a portfolio manager for long/short equity strategies and a contributor to the PIMCO Blog.