The Outlook for 2014
The AMZ spent most of the year ahead of the S&P 500 Index — which gained 30 percent in 2013 — but in the second half the S&P 500 pulled ahead. Of course AMZ components also yielded about 6 percent in 2013, versus 1.9 percent for the S&P 500.
2013 Performance of Alerian MLP Index versus the S&P 500 IndexWhile the average MLP investor was probably happy with 2013’s performance, there was of course a wide variation of performance in the MLP world. Among the conventional midstream and upstream MLPs, performance ranged from American Midstream Partners (NYSE:AMID) — the best performing midstream MLP with a gain of 98.5 percent in 2013 — down to the upstream MLP EV Energy Partners (Nasdaq: EVEP), which lost 40 percent for the year.
2013 Performance of American Midstream Partners versus EV Energy PartnersAmong the unconventional MLPs the disparity between the top and bottom performers was even greater, with several financial services/holding companies near the top of the heap, and nitrogen fertilizer MLPs clogging the drain.
But 2013 is in the rear view mirror, and what you really want to know is where to position yourself for 2014. First, let’s review some terminology.“Upstream” refers to the extraction of oil and gas. An upstream company can be predominantly an oil producer or a natural gas producer, but generally will produce both. Over the past few years it has generally been much more lucrative in the upstream business to be an oil producer. Among the natural gas producers, those that produce a lot of natural gas liquids (NGLs), which are condensed out of wet gas, have fared better than those that produce predominantly dry natural gas.
“Midstream” refers to the transportation of oil and gas. MLPs based on midstream assets comprise the largest category of MLPs, and are less volatile than upstream MLPs. A midstream MLP acts as a toll collector, charging for the use of its storage tanks, pipelines, and oil and gas gathering infrastructure.“Downstream” typically refers to the business of refining oil, but can also sometimes refer to the purification of natural gas. Because downstream businesses are sensitive to the price of both the crude oil and the finished products they have historically been more cyclical and less predictable than the upstream or midstream businesses.
As a result, most of the downstream MLPs (including their “cousins” the fertilizer MLPs) have chosen to make variable distributions. This is in contrast to the policy of most midstream MLPs, which tend to have stable and growing distributions over time. Most upstream MLPs also strive for consistent distribution growth, but during prolonged periods of weak oil and gas prices they may have difficulty maintaining the payouts despite extensive hedging.Beyond the upstream, midstream, and downstream MLPs, there are a variety of MLPs in related businesses like natural gas compression, shipping, oilfield services, coal and wholesale fuel distribution. Then there are nonconventional MLPs in industries like financial services and even operators of cemeteries and amusement parks.
But most of our focus is on the more conventional MLPs. Here is how we see them faring in light of our expectations for oil and gas prices in 2014. We expect globally traded Brent crude to hold up fairly well over the next year, with odds favoring a yearly average somewhat below current levels of about $107 per barrel (bbl). Ever-growing demand in emerging markets should consume virtually all of the expected 1.2 million bbl/d non-OPEC global supply increase for 2014 (most of which is expected to come from the US).US oil is expected to become increasingly plentiful next year, as shale plays in the Eagle Ford and the Bakken ramp up production alongside older basins such as the Permian in Texas. But the International Energy Agency projects that a recovering US economy stimulate fuel demand in 2014.
Nevertheless, it seems likely that the expansion of domestic crude oil production will put downward pressure on US oil price benchmarks like West Texas Intermediate (WTI), which has already weakened in recent weeks. Many in the oil industry have suggested changing the law to allow US oil producers to export the light, sweet crude they are producing, since so many US refineries are now designed for heavier, sour crudes. Don’t expect legislation allowing this in 2014.A collapse in the price of US crude oil is unlikely, as marginal production would begin to shut in if prices fell below $85/bbl for long. Thus the upstream MLPs will likely do OK in 2014. I would be an aggressive buyer of select upstream MLPs if the price of WTI touches $80 this year, because I don’t believe that level to be sustainable. With possible weakness in the WTI price, I expect most upstream MLPs will be happy to maintain their distribution levels.
Upstream MLPs that are more gas-focused are perhaps a compelling long-term investment. Natural gas prices have recovered strongly over the past year, and while I don’t expect a major move outside of seasonal norms in 2014, over the next three to five years there are a lot of factors that argue for higher gas prices. Thus, an out-of-favor natural gas producer could prove to be a profitable addition to your MLP portfolio in 2014.Midstream will continue to be the safest play in the MLP sector. Even if oil prices surprise us and move sharply to the downside, the midstream MLPs will be the least affected. The nature of most of their contracts protects them from commodity exposure, and with US oil production expected to expand once more in 2014, the midstream MLPs should benefit from transporting that crude oil.
The refining MLPs are a special case. These are more suitable for traders as opposed to long-term investors. You want to accumulate these when refining margins have dropped, which can be approximated by the size of the Brent-WTI price differential (because finished products are more influenced by Brent prices). If this differential is falling — particularly if it spends a quarter below $10/bbl as it did in Q3 2013 — this can present a buying opportunity for bargain hunters and short-term traders
When the posted yields for these MLPs are in the 15-to-20+ percent range, I would exercise extreme caution, because huge quarters that boost the variable distribution are often followed by quarters that require a deep distribution cut. This is why we warned investors in Q3 of last year that results would be poor and that refining MLPs would likely correct when earnings were released, but that prices would bounce back in Q4 (true on both counts).
There are a few US coal MLPs, many of which have seen their market caps decimated in the past 2 ½ years. Most MLP investors should avoid this sector, as more restrictive EPA regulations and competition from natural gas and renewables will continue to put pressure on coal producers. For bargain hunters who are prepared for the possibility of further downside, there are one or two that have strong balance sheets. But don’t go bargain hunting just on the basis of price. Remember that the worst-performing of all MLPs in 2013 was coal producer Oxford Resource Partners (NYSE: OXF) — down 73 percent for the year and illustrative of the coal industry’s struggles.
Bargain hunters and contrarian investors might want to watch the fertilizer MLP space. The sector was in the cellar in 2013 — accounting for three of the five worst performances among all MLPs. Unit prices are depressed, but the fertilizer business, like the refining business, is cyclical. Fertilizer MLPs will at some point run back up, just as they dropped in 2013.
Risk factors for the sector are sharply higher natural gas prices that cut into margins, and lower demand — particularly in light of the EPA’s indication that it will lower ethanol mandates (which would lower corn demand, and hence fertilizer demand). But once it becomes clear that conditions are improving, units could easily gain 30 to 50 percent relatively quickly.