This week, the Alerian MLP Index hit a new all-time high. That’s the latest milestone for the index of the 50 largest US energy master limited partnerships (MLP), which began its ascent nearly four years ago. Since then, the index has gained nearly 250 percent, including distributions.
MLPs are understandably popular these days. Investors are hungry for high, safe yields at a time of record-low interest rates. Dividend taxes look set to go up in 2013, with MLPs a notable exception. In particular, pipeline stocks have earned a well-deserved reputation for safety. And rising prices in turn have encouraged buying momentum, sending prices higher still.
Judging from the reader feedback I’ve received, however, MLPs’ enviable run is reviving speculation that they’re in some sort of bubble that’s about to pop. That’s caused concern that the hard-won gains since their bottom in late 2008 could soon be wiped out. Potential catalysts cited include a future upward spike in interest rates, rumored government bans on hydraulic fracturing (fracking) in the US, and a potential change in the tax code that revokes MLPs’ current advantages.
Ironically, the threat that doesn’t get mentioned much is the one that’s potentially the most dangerous. That’s the inevitable overbuilding that accompanies every bull market, particularly those involving volatile commodities like energy.
To date, MLPs have invested almost exclusively in projects where revenues were assured after the assets were bought or built. For energy midstream companies, that’s meant securing contracts for pipelines, processing facilities and other assets even before raising financing. For energy producers, that’s meant locking in prices for output in advance.
Sooner or later, however, market history shows that businesses in booming industries always start investing more aggressively. That’s in large part because the low-hanging fruit is gone and it’s necessary to take risks to maintain high returns on investment. But it’s also because investors coming late to the party start demanding faster growth.
Some day, we will begin to see energy midstream companies build and buy assets before they have customers for them. Oil and gas producers, meanwhile, will leave larger and larger portions of their output without locked-in prices, essentially becoming commodity market speculators.
When this does happen, it will be the telltale sign of a top for MLP midstream asset owners and energy producers. And when the market does turn down, the more leveraged partnerships will be exposed to distribution cuts and steep drops in unit prices.
In other words, it will be the sell signal for this bull market in MLPs. The good news is we’re still nowhere close to that point now. In fact, fear of another 2008 has induced MLP managements to use low interest rates to strengthen balance sheets, rather than lever up. So long as that’s the governing ethos, sector blow-ups will be minimal.
Moreover, as Pipeline & Gas Journal notes, a recent study by ICF International shows projected growth in North American gas production alone will require $130 billion to $210 billion in spending on new midstream assets over the next 20 years. Getting oil to market from abundant shale and tar sands is likely to require at least as much investment.
That’s an enormous long-term opportunity for US energy MLPs, though the pace of spending will wax and wane with economic conditions. But as long as it lasts, it means higher distributions and, therefore, rising unit prices well into the future.
An upward spike in interest rates and/or Congressional action on taxes and fracking could definitely have an impact on the pace of MLPs’ invest-to-grow strategies–and therefore distribution growth and unit price performance. Fortunately, none of these are likely at this time.
Over the past four years, the Federal Reserve has proved it can push down interest rates without igniting inflation, while even keeping the US dollar relatively stable. That’s because of the massive deflationary hangover from the 2008 crash. And until we see a lot less slack in the economy–i.e., much lower unemployment and a return to wage growth–inflation will likely remain subdued. That, in turn, will keep interest rates low.
But at some point, rates will inevitably start to rise. That will push up borrowing costs for MLPs. Still, it’s highly unlikely we’ll see higher rates without more economic activity, which will bring more opportunities for investment. And many MLPs are effectively hedged against higher inflation: Energy midstream companies have rate escalators, and energy producers benefit from the fact that oil and gas prices usually lead inflation.
Fracking has become intensely controversial in many areas of the US, with the state of Vermont actually banning the practice back in May. Other state governments, such as California and New York, are under intense pressure to dramatically regulate, if not ban fracking altogether. And localities in states that have been largely pro-fracking–such as Pennsylvania–are pushing for their own bans.
Under Democratic control, the previous US House of Representatives held hearings on hydraulic fracturing, but in the end did little more than authorize the Environmental Protection Agency (EPA) to study the matter. The current Republican-controlled House has been considerably more hostile toward tighter regulation.
As for the EPA, its only aggressive move to date has been an investigation of a drilling site in Wyoming that’s run by Canadian giant Encana (TSX: ECA, NYSE: ECA). Its conclusion from testing is that the Encana wells did contaminate local water supplies, but that they are vastly dissimilar to wells dug elsewhere in the US—and therefore that the conclusions in Wyoming do not apply in, for example, Pennsylvania.
There’s a rumor circulating that the EPA is preparing a post-election ban on fracking throughout the US. To me, that sounds suspiciously like something being circulated by opponents of the current president–and it’s right in line with other assertions that there are hidden plans to ratchet up taxes, subvert the Second Amendment and so on.
It’s not my place to tell anyone how to vote. But when it comes to investment dollars, it’s absolutely critical to be skeptical of all things political.
Letting your politics dictate how you invest your hard-earned dollars is a formula for disaster. Just ask those who’ve been out of the stock market since 2009, for fear of what the Obama administration would do. They’ve missed one of the most explosive bull markets in history and simultaneously locked in losses from 2008, the worst bear market wipeout since 1929.
In my view, should President Obama win a second term, it’s unlikely he would try to do anything he didn’t already pursue during 2009-10, when his party controlled both houses of Congress, including a filibuster-proof majority in the Senate. And with odds heavily in favor of a Republican majority at least in the House, there’s going to be plenty of opposition to block anything that’s not negotiated.
But just to play devil’s advocate, suppose the EPA actually does have a hidden agenda and tries to ban fracking nationwide. A wave of lawsuits would block any immediate action. Energy midstream company revenue growth would likely stall from fewer new projects, as producers reassessed their activities. But revenue from existing ones would still be protected by contracts.
Producers would face new restrictions on drilling. But a ban on fracking would also trigger a spike in energy prices in North America, with natural gas prices per million British Thermal Units surging to double digits. MLPs would almost certainly suffer a selloff on the initial news. But the bottom line is companies would still find a way to make revenues and pay dividends, so eventually their unit prices would recover.
Rescission of MLPs’ ability to pass on cash flow to unitholders without paying corporate tax would similarly cause an immediate selloff. But as former Canadian income trusts have shown–when a government announces new taxation, as the Canadian government did in the so-called “Halloween Massacre” back in 2006–well-run companies will build wealth no matter how they’re taxed. In fact, the only dividend-paying stock group to outperform MLPs since October 2006 has been former Canadian income trusts, most of which are now corporations whose stocks pay high dividends.
Here too, however, such action is extremely unlikely. The 2009-10 Congress did see bills introduced to tax non-energy MLPs, but ultimately failed to muster the votes, with little support or leadership from the White House. Such efforts have made even less headway in the current Republican-controlled House.
One of the proposals for cutting the deficit did include changes to MLP taxation. But again, taxes in the US can’t be passed without support of Congress. Given both parties’ stated aim of encouraging US energy production–and the support MLPs have enjoyed from both sides of the aisle over the years–forces would seem to be arrayed to block any changes to their tax-advantaged status.
And keep in mind that the combined market capitalization of the Alerian MLP Index is still just $201 billion, or less than half that of ExxonMobil (NYSE: XOM). Taxing MLPs as corporations isn’t going to raise more than a few billion dollars at best.
If there is a risk to MLPs right now, it has to do with the lofty expectations built into unit prices. Higher prices mean more room for disappointment, and that can trigger selling. And with many MLPs bid up on buying momentum in recent months, it won’t take much to reverse that momentum and cause a sharp drop.
Several MLPs have already taken hits for simply not raising distributions as they have in the past. And the lone MLP to cut its distribution this year–Inergy LP (NSDQ: NRGY)–was basically mauled.
Some MLPs, however, have definitely been left out of the bull market for one reason or another. As a result, they continue to trade at prices that offer solid yields and growth potential. It’s hard to argue these MLPs are in anything resembling a bubble, or that they’re not superb buys for those who don’t already own them.
It really boils down to one thing: In a market where so many are blindly following momentum, those who hunt value are kings. Investors who focus on the best and cheapest individual MLPs will still have many happy returns ahead, even as those chasing the most popular ones are doomed to mediocre results.
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