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Is It Time for an MLP Mulligan?

One year ago my colleague Richard Stavros wrote an article for Personal Finance titled “Bear-Proofing” that laid out the case for removing ing income-producing oil stocks from your portfolio given the heightening level of risk in the energy sector due to declining oil prices. Since then his call has proven to be remarkable prescient, as virtually the entire energy sector has taken a huge hit.

One of the hardest things to do as an investor is buy into a sector that has just been devastated, but it may be time to consider getting back into certain income-producing energy companies, especially mid-stream MLPs that have been punished the same as their upstream counterparts (for the uninitiated, “midstream” primarily refers to the transportation & storage of oil, while “upstream” refers to its exploration & production).

There is no telling exactly when the Saudi oil ministers will discontinue flooding the market with oil to drive prices down, but recent events suggests they may be nearing an end. Just last month the price of oil dropped below $40/barrel for a few days, with many analysts predicting it would go all the way to $30 before leveling off. That didn’t happen, and recently oil has been trading above $45.

If Saudi Arabia’s intent was to inflict permanent damage on U.S. shale oil production, then it can only claim partial success as domestic oil production has continued at close to normal rates despite decreasing profitability. And if they wanted to punish Russia and China at the same time for entering into a long term natural gas deal, then it can also feel vindicated by the weakening economies of both countries.

So what else does Saudi Arabia and OPEC have to gain by keeping prices so low? Not much, in my estimation. At this point the opportunity cost to them appears to be greater than the actual cost to everyone else, since most countries’ GDPs benefit from lower oil prices. If the true “magic number” for the price of oil for Saudi Arabia to balance its budget is north of $100/barrel – as even they have admitted – then continuing to produce it at a rate of 10 million bpd (barrels per day) at a price less than half of that doesn’t make much sense.

My guess is OPEC will continue to talk down the price of oil to discourage U.S. production, but will gradually let its price drift upward into next year. If so, then midstream MLPs should be among the first to benefit since they are not locked into fixed-price contracts, but instead are paid a fee based on demand for their services that is not directly tied to the current price of oil.

For income investors who kick themselves for missing out on the first boom in MLPs that occurred during the 2009 – 2014 stock market recovery, this may be a rare chance for a “mulligan” by buying some MLPs at valuations similar to pre-2009 levels.  Of course, nothing ever happens exactly the same way twice and I doubt there will be as much appreciation potential in MLP unit prices as last time, but distributions (the MLP equivalent of dividends) could increase by a similar amount.

The trick is in knowing which MLPs to buy, and which to avoid. One big difference between now and then is the expected direction of interest rates, which the Fed pushed lower in the aftermath of the “Great Recession” during its implementation of quantitative easing. Given the apparent success of that program, the Fed is on the verge of raising rates gradually to allow the economy to revert to a less artificial state.

That means how an MLP manages debt will be critical to long term success since all of them use a large amount of leverage to acquire assets. However, higher interest rates do not necessarily spell doom for the entire MLP universe as some investors fear. But it will require an effective hedging strategy combined with a dynamic pricing policy that can respond to the increasing cost of capital.

Just as Richard Stavros bravely declared that the MLP party was over a year ago, I am sticking my neck out and stating that it is time to start getting back into the pool. Not all at once, but systematically over the next several months as the market adapts to the reality of higher interest rates. If you’re not sure where to start, the PF Maximum Income for Retirees portfolio includes a sleeve of recommended MLPs. And for in-depth analysis of the entire MLP space, consider a trial subscription to our sister publication MLP Profits.


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