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MLP Insights: Q1 2016

Feb 3, 2016

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Following a nearly 33% downturn in 2015, MLPs have started off the new year down another 12%1. Many funds that invest in MLPs have experienced dramatic increases in volatility, as they no longer have the benefit of a buffer from accrued taxes. In addition, midstream MLPs, which typically operate toll road business models to insulate themselves from modest changes in commodity prices, have now become highly correlated to oil. While many investors are understandably concerned about their MLP holdings, we believe the underlying real assets that comprise a midstream MLP can ultimately withstand the cyclicality of energy markets, and even continue to generate strong cash flow despite a distressed environment for oil and natural gas.

  • Asset heavy industries such as pipelines tend to perform poorly when business conditions are unfavorable
  • The longevity of these real assets help them retain long term value across business cycles
  • Investors who wait out the current volatility could be rewarded with high yields and normalization of value for these assets

In this volatile energy environment, it is common for investors and analysts to obsess over daily energy prices and extrapolate their impact on future MLP cash flows. As many have pointed out, low oil and natural gas prices can close wells and put energy producers out of business, resulting in lower supply and therefore less business for infrastructure MLPs. At distressed levels, such as we are seeing now, each tick in oil prices can heavily influence the supply stream, as producers teeter between covering their variable costs and falling short. But it’s important to remember what midstream MLPs fundamentally are: real assets, often pipelines and storage facilities, with long-term operational lifespans, and often local monopolies.

Entities comprised almost entirely of tangible assets such as factories, infrastructure, or real estate, often struggle to adapt in a slowing business cycle. While a software company can quickly pivot or scale its business, a pipeline cannot change course without huge amounts of capital expenditures. This means that investments with high tangible assets are often hit harder in adverse economic conditions than more malleable firms. Stocks with very low price-to-book ratios, which tend to have higher tangible assets as a percent of their overall market cap, fell by 89% during the financial crisis, while high price-to-book stocks (those with less tangible assets) fell 44%2. MLP investors have now witnessed this first hand as we reach the lowest energy prices in nearly a decade, and there is little MLPs can do about it.

While the rigidity of tangible assets can be a weakness in downturns, it can also be one of their greatest strengths. Often, their long operational lifespans allow them to ultimately endure the ups and downs of business cycles. Unlike a software company, which can quickly become obsolete or watch its value leave with a top programmer, a pipeline requires only some baseline maintenance to remain operational and ready to reap the rewards in a turnaround. Since the low point of the recession, stocks with very high tangible assets returned 1176%, while companies with very low assets returned 149%3.

Therefore, for investors with longer time horizons, we believe holding on to high quality durable assets and outlasting the current turmoil is a more desirable approach than taking losses and leaving the asset class in the midst of a downturn. More specifically, we believe focusing on the large cap midstream MLP space will position investors in the highest quality infrastructure assets with lower leverage and more diversified businesses, making them in our opinion, the best positioned to withstand a prolonged energy glut.

Moreover, even at these distressed energy levels, midstream MLPs have largely been able to maintain high yields and strong operating performance despite adverse market conditions. Midstream MLPs have an indicated yield of 9.49%, representing over a 750 bps spread over 10-year treasury bonds4. This high yield can provide a source of income when most yields still remain low, as well as ease the pain of waiting for a recovery in energy prices. In addition, the spread looks attractive from a valuation perspective, when compared to its five-year average of 421 bps5. From an operating perspective, midstream MLPs continue to outperform expectations. In Q3 2015, market-capitalization weighted earnings before interest, taxes, depreciation and amortization (EBITDA) averaged 2.6% higher than consensus expectations, and 7.8% higher than the Q2 2015 figures6. While some midstream entities have cut distributions to shore up their balance sheets, the average distribution increased by 2% in Q3 2015 versus Q2 20157. While EBITDA and distribution growth could come under pressure with a prolonged cycle of cheap energy prices, we believe the real assets underlying a midstream MLP will ultimately recover their value, and the historically high yields delivered from the MLP business model are an attractive form of compensation while waiting.

Category: Articles

Topics: MLPs

Definitions:
P/B or Price to Book is the share price of a security divided by the book value per share of the security.

Disclosures:

Past performance is no guarantee of future returns.

Investing involves risk, including the possible loss of principal. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Investments in securities of MLPs involve risk that differ from investments in common stock including risks related to limited control and limited rights to vote on matters affecting the MLP. MLP common units and other equity securities can be affected by macro-economic and other factors affecting the stock market in general, expectations of interest rates, investor sentiment towards MLPs or the energy sector, changes in a particular issuer’s financial condition, or unfavorable or unanticipated poor performance of a particular issuer (in the case of MLPs, generally measured in terms of distributable cash flow). MLP funds may invest in the energy industry, which entails significant risk and volatility. In addition, the funds may be non-diversified, which represents a heightened risk to investors. Furthermore, the funds may invest in small and mid-capitalization companies, which pose greater risks than large companies.

MLP funds may be taxed as a regular corporation for federal income tax purposes. The amount of taxes currently paid by the fund will vary depending on the amount of income and gains derived from MLP interests and such taxes will reduce an investor’s return from an investment in the fund. The potential tax benefits from the fund’s investment in MLPs depends largely on the MLPs being treated as partnerships for federal income tax purposes. As a partnership, an MLP has no federal income tax liability at the entity level. Therefore, treatment of one or more MLPs as a corporation for federal income tax purposes could affect the fund’s ability to meet its investment objective and would reduce the amount of cash available to pay or distribute to you. There is no guarantee distributions will be made and dividends may be reduced or eliminated at any time. Furthermore, certain distributions are expected to be treated as a return of capital for tax purposes rather than from net profits and shareholders should not assume that the source of distributions is from the net profits of the fund.

All expressions of opinion reflect judgement as of the date set forth above and are subject to change. Sources utilized for this information are believed to be accurate but no warranties are made to their accuracy or timeliness of reporting. Global X Management accepts no responsibility for the conclusions and decisions clients make utilizing this information.

Carefully consider investment objectives, risks, and charges and expenses. This and other information can be found in the fund’s summary and full prospectuses. This and additional information can be found in the Funds’ summary and full prospectuses, which may be obtained by calling 1-888-GX-FUND-1 (1.888.493.8631), or by visiting www.globalxetfs.com. Please read the prospectus carefully before investing.

Global X Management Company LLC serves as an advisor to the Global X Funds. MLPX and MLPA are distributed by SEI Investments Distribution Co., which is not affiliated with Global X Management Company or any of its affiliates. Solactive Indexes have been licensed by Solactive AG for use by Global X Management Company LLC. Global X Funds are not sponsored, endorsed, issued, sold, or promoted by Solactive AG nor does this company make any representations regarding the advisability of investing in the Global X Funds.