“By now, most of the world knows about the tragic tale of the [Master Limited Partnerships] MLP sector’s fall from grace,” writes Mizuho’s MLPs and Natural Gas Analyst Gabriel Moreen in his recent 2019 outlook. The reasons for the sector’s tumble are varied, from excessive leverage and exposure to the commodity backdrop, to MLPs’ overly convoluted corporate structure.
MLPs are partnerships that are traded on national exchanges, in which investors buy units of the partnership rather than shares of stock. The benefits of such a setup vary, but MLPs came into favor in slow-growing, capital-intensive industries because they take advantage of lower taxes, which in turn help to reduce costs of capital and allow for attractive investor yields.
Despite these advantages, investor enthusiasm for the midstream and MLP sector has been lackluster for the past several years, and the trauma continued in 2018, starting with the Federal Energy Regulatory Commission’s (FERC) tax ruling in March which stated that oil and natural gas pipelines organized as MLPs would no longer benefit from a favorable tax allowance. The sector then saw drawbacks from another downturn in commodity prices during Q4, and capped off the year with a December sell-off.
The good news, says Moreen, is that the multi-year process of repair associated with transforming this area into a more stable and long-term investable sector is well underway. Perhaps, as the year starts afresh, we should reassess MLPs.
Never Gonna Keep Them Down
According to Moreen, the MLP/midstream sector of 2019 is much more investible than in recent years. Healthier balance sheets, simpler structures, and more cash on hand to fund operations are all signs of better times to come. While some companies have maintained the complex, traditional MLP structure, the list is dwindling and will continue to shrink.
Furthermore, the industry trend toward joint ventures should benefit the sector overall. Companies that are able to share capital costs (thereby reducing costs on an individual basis) will be able to keep sector leverage and equity market reliance in check. And if joint ventures can operate in comparative advantage terms, by playing to the strengths of the partners involved, they can increase project returns and make everyone a winner.
Importantly, Moreen believes most of the ‘surprises’ – from the sudden collapse of supply and demand fundamentals to reversals of regulatory precedents – have already occurred. With a clearer path ahead, investor confidence in the sector should grow.
They (Could) Get Knocked Down Again
An improved outlook doesn’t mean, however, that it’s smooth sailing ahead. Not all players are alike, and the industry needs to keep an eye on certain fundamentals to maintain investor confidence. According to Moreen, investors will be looking at two groups: management teams that show restraint even if the commodity macro turns bullish, and ones that are flexible and able to reduce capital programs as needed in the event of a downturn. Companies that have self-funded the majority equity portion of capital plans while still maintaining acceptable levels of leverage are particularly appealing.
We must also keep in mind that US shale development and the midstream sector go hand-in-hand. While the majority of companies in the space have minimized their direct exposure to commodity prices, they still rely on production volumes. Those that do not have contracts in high-growth oil fields – i.e., the Permian Basin – would be most exposed to a broader production slowdown.
The midstream sector is no stranger to volatility, but Moreen is confident in the sector’s prospects in 2019. Lessons have been learned, and while surprises, by definition, cannot be predicted, things are looking up.
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