Don’t Let The Energy Sector’s Volatility Turn You Away From MLPs
The Arabs have a proverb an American shale producer could appreciate: “All sunshine makes a desert.” It means too much of a good thing can actually bring negative results.
North America’s embarrassment of oil riches comes to mind. Fracking has become more efficient and cheaper, lowering the breakeven threshold for producers and making it profitable to continue pumping black gold. But the net effect has left global markets sloshing with an excess of cheap crude, which in turn weighs on oil prices and the bottom lines of already indebted energy companies.
This issue, I show you how to cope with volatility in the energy patch — and profit from it.
I particularly focus on an asset class that’s a favorite of income investors: energy infrastructure master limited partnerships (MLPs). These midstream MLPs earn a majority of their cash flow from the transportation, storage and processing of energy commodities.
Below, I highlight my favorite high-yielding MLP investment, but first let’s look at the topsy-turvy energy patch and what this turmoil portends for investors.
Twilight in the desert…
OPEC leader Saudi Arabia is girding itself yet again to deal with the paradoxes of the energy markets.
Reports surfaced this week that the desert kingdom is preparing to drag members Libya and Nigeria kicking and screaming into the cartel’s oil production cut. It’s yet another reminder that the once mighty House of Saud has lost control of global oil markets.
Through their ill-conceived price war, the Saudis have made a desert of their dominance.
As part of its production reduction agreement now in force, OPEC initially exempted Libya and Nigeria because of the severe economic and infrastructure woes in those two countries. However, it has been revealed in recent days that the Saudis now want to compel the two countries to limit their production to match the cartel’s collective reductions.
Rising Libyan and Nigerian production in June has put downward pressure on oil prices. With production continuing to increase in the U.S., total petroleum inventories among OPEC members remained 9% above the previous five-year average at the end of June, despite OPEC’s production cut agreement.
The United States has ridden the shale revolution to overtake the Saudis as the globe’s top producer of petroleum and natural gas. As they observe Saudi Arabia’s plight, American energy producers aren’t shedding any tears, but they’re still getting buffeted by supply and demand imbalances.
Increased drilling activity in the U.S., uncertainty over OPEC’s production cut agreement, and stubbornly high inventories have thrown the energy markets into turmoil. Key OPEC ministers are scheduled to meet with non-OPEC producer Russia on July 24 in St. Petersburg, Russia, to discuss ways to stabilize the sector.
American energy firms continue to boost production, which is a sharp stick in the eye of OPEC and a bane for many energy equities as the persistent glut dampens oil prices. According to the latest Baker Hughes rig count released on July 7, U.S. energy firms added 12 oil drilling rigs last week, bringing the count to 952. The rig count has been on an upward trajectory since June 2016 (see chart).
Source: Baker Hughes
Small wonder, the energy sector got clobbered during the first half of 2017, as the price of West Texas Intermediate (WTI) and Brent North Sea crude both fell 14%. Crude prices now hover at $45 per barrel for WTI and $48/bbl for Brent. Those levels are below the $50/bbl threshold that energy companies generally need to break even, but they far exceed the nadir of the mid-$20s reached in February 2016.
Robert Rapier, chief investment strategist of The Energy Strategist, puts it this way: “The worst first-half performance for crude oil since 1998 is in the books.”
The energy sector within the S&P’s Goldman Sachs Commodity Index (GSCI) declined by 11% during the first half of 2017. The midstream sector was punished, but it performed better than the upstream or the overall sector. The Alerian MLP Index (AMZ), which captures about 75% of the midstream sector’s market, generated a first-half total return of -6.3%.
Robert Rapier comments: “We are deep into emotional territory at this point. Investors are making little differentiation between good companies and bad…
Some companies deserve to be sold off. A company with a lot of debt and an average breakeven cost of $55/bbl isn’t going to survive long in this market.”
Quality companies that are essentially debt-free with breakeven costs of $40/bbl are suffering, too. And yet, Robert and other Investing Daily strategists remain guardedly optimistic over the energy sector’s prospects. The trick is knowing where to look.
Ari Charney, chief investment strategist of Utility Forecaster, plays a dual role as income expert on the staff of our flagship publication, Personal Finance. Ari is bullish on select MLPs:
“The energy sector’s downturn forced shale producers to cut every bit of fat from their operations and find additional savings through various innovations, so they can remain profitable even if oil does stay lower for longer. As one senior executive at an MLP giant recently quipped, $55 per barrel is the new $85 per barrel.
That’s good news for MLPs, whose businesses are ultimately dependent on financially healthy producers being able to pay for their services.
Breakeven costs for production in the most prolific shale basins are in the low $40s per barrel. Furthermore, many producers used oil’s end-of-year rally as an opportunity to hedge most of their output at prices above $50 per barrel for the rest of the decade.
So even if crude does hover between $50 per barrel and $60 per barrel for the next few years, there should still be plenty of hydrocarbons pulled from the ground and pushed through pipelines.”
Saudi Arabia launched a price war in 2014 by opening its spigots, with the goal of driving U.S. shale producers out of business. The unintended consequences remind me of another proverb, this one of English origin: “He who laughs last, laughs longest.”
Pumping out safe and steady income…
When you put money into an MLP, that’s exactly what you become: a partner, although a passive one. Every penny of the MLP’s income (as well as depreciation, new debt, etc.) is annually attributed to the partners, and that includes you.
This flow-through means that the income doled out to you is offset by heavy depreciation charges, because most MLPs invest in energy plant and equipment. The upshot: you shelter most if not all of your MLP income from taxes.
It’s a sweet investment deal and traders poured into the MLP space when oil prices were at their zenith of $80 to $100 a barrel in 2014. Then energy prices collapsed and many MLPs, especially those that had recklessly expanded by taking on huge debt, turned sour. Bankruptcies proliferated.
During the latter part of 2016, energy prices hit bottom and began recovering. Now they’re sputtering again. Regardless, if you choose wisely, MLPs should be an intrinsic part of your core income portfolio. When the price of oil eventually takes off again as we expect, MLPs will richly reward investor patience.
For risk-averse income investors, the easiest and safest bets are exchange traded funds (ETFs) that invest in MLPs. The best-of-breed and industry benchmark is the ALPS Alerian MLP ETF (AMLP), a member of the Personal Finance Fund Portfolio.
With net assets of $10.1 billion, AMLP seeks investment results that correspond to the price and yield performance of its underlying index, the Alerian MLP Infrastructure Index. The fund’s one-year total return is 3.4% and the yield is a robust 7.3%. The expense ratio is a reasonable 0.85%.
Comments or questions? Drop me a line: firstname.lastname@example.org — John Persinos
Turning sand into dollars…
As I’ve just explained, MLPs are volatile but still appealing.
In addition to oil, there’s another widely available commodity poised to make big gains for investors who act now. As with oil, this natural substance is found around the globe and conveys a variety of practical uses.
This commodity is sand.
Consider America’s beaches. Oceanfront properties are fighting a ceaseless fight against coastline erosion, an environmental dilemma that only gets worse with each passing year. That means the best-positioned providers of sand are on track to make outsized gains.
Want to know more about these profitable sand-based trades? Watch our brief presentation.