MLPs: Providing Growth and Income Potential Despite Low Oil Prices

by Joe Rodriguez, Darin Turner, Walt Stabell III of Invesco Blog, 5/8/15

With oil prices down around approximately 50% since June 2014, investors are increasingly wary of the entire energy sector. Even given this environment, master limited partnerships (MLPs) represent an energy investment that we believe may weather short-term volatility in energy prices, benefit from the US’s long-term infrastructure needs, and provide attractive income potential for investors.

To understand why, let’s take a quick tour of the US oil patch.

US production growth is slowing

Simply put, oil prices crashed because supply currently exceeds demand. With OPEC refusing to cut production to bring supply and demand more into balance (as it has done in the past), US exploration and production (E&P) companies are abandoning higher-cost projects and consolidating their activity around lower-cost wells. Rig counts have dropped 50% year-over-year,1 and capital expenditures for E&P companies are down 40% this year versus 2014.2

What’s the expected result on US oil and natural gas production? Due to the momentum of backlogged projects in 2014, production is still expected to grow overall, but the rate of growth is slowing. The Energy Information Administration projects US crude oil production to increase from an average of 8.7 million barrels a day in 2014 to 9.2 million in 2015, and to stay virtually level at 9.3 million in 2016.3 It expects natural gas production to grow by 5% in 2015 and 1.9% in 2016.3

Fee-based contracts have largely shielded MLPs from the impact

While a small number of MLPs operate in the E&P (or “upstream”) space, the majority of MLPs are in the “midstream” market, which includes pipelines, rail and truck transportation, and other assets that lie between the producing fields and the end users. MLP security prices have not been immune to the crash in oil prices, but the impact has been much less severe in midstream than in upstream. In contrast to E&P companies, so far this earnings season MLPs have only reduced their earnings guidance by an average of 3%, distribution growth by an average of 0.74% and growth capital by an average of 8%.4

For the 20 largest MLPs, distribution per unit (DPU) estimates for 2015 have come down 1% since September 2014, and 2016 DPU growth estimates have declined 0.14% — but are still a healthy 12.1%.5

Why are MLPs faring this well, given the steep cuts in E&P activity?

  • MLP cash flow largely comes from fee-based contracts with minimum volume commitments and take-or-pay stipulations. Because of this business structure, their commodity- price exposure is more modest than that of E&P companies.
  • 2015 growth in the MLP space is predicated on projects that are already secured or completed.

Drilling deeper into MLP performance

While MLPs may be attractive as a sector, it is critical for investors to understand that there are important differences between — and even within — MLP sub-sectors. These differences illustrate the value that active management can provide to MLP investors. For example:

  • Liquid Transportation & Services MLPs expect their DPU to grow an average of about 15% in 2015. This expectation has remained consistent both before and after fourth- quarter 2014 earnings reports.6
  • Upstream MLPs, on the other hand, have a deteriorating outlook. Before the fourth-quarter earnings announcements, Upstream MLPs expected their DPU to fall an average of 44% in 2015. Since then, they’ve revised that expectation to 48%.6
  • Company-specific differences can be dramatic. Within the Gathering & Processing space, DCP Midstream Partners LP cut its expected DPU growth rate from 6.6% to 3.8%, while Western Gas Partners LP issued a much smaller revision, from 16.2% to 15.1%.6 (0.00% and 2.79% of Invesco MLP Fund, respectively, as of March 31, 2015.)

Questions for 2016

As we gain further clarity on 2015 expectations, questions do remain for 2016. Trends that could greatly impact MLP growth next year and beyond:

  • On the downside, if commodity prices do not show some form of recovery and volume projections come down further, that will create headwinds for midstream company growth in 2016.
  • Conversely, there are still a significant number of midstream assets that are owned by publicly traded E&P companies as well as private equity firms. These assets could be acquired by existing MLPs or spun off into new MLPs if E&P companies continue to need additional capital, representing potential future growth for the industry.

Conclusion

The long-term outlook for MLPs should transcend short-term oil price fluctuations, and the proper selection of MLPs can still be a means of generating income with the potential for attractive total returns over the long term.

Currently, MLPs are yielding 6.1% versus 3.4% for real estate investment trusts, 3.5% for utility stocks, 2.7% for consumer staples stocks and 1.9% for 10-year Treasuries.7 This compares to the past five years where MLPs on average have yielded 3.4% above 10-year Treasuries.7

For income-seeking investors, these numbers could prove to be an attractive entry point. Talk to your financial advisor to discuss how MLPs may fit into your portfolio.

Ready to learn more about MLPs?

1 Source: US Capital Advisors, March 13, 2015

2 Source: Wells Fargo, March 6, 2015

3 Source: Energy Information Administration, April 7, 2015

4 Source: Wells Fargo, March 9, 2015

5 Source: US Capital Advisors

6 Source: UBS, March 6, 2015

7 Source: Bloomberg L.P. as of March 31, 2015. MLPs represented by the Alerian MLP Index. REITs by the FTSE NAREIT All Equity REITs Index. Utility stocks by the MSCI US Utilities Index and consumer staple stocks by the MSCI US Consumer Staples Index.

Important information

Generally MLPs’ partnership agreements require a quarterly cash distribution to unit holders. Distribution per unit (DPU) equals the total cash distributions paid divided by an MLP’s number of outstanding units.

As a “C” corporation, the fund is subject to US federal income tax on its taxable income at the graduated rates applicable to corporations, as well as state and local income taxes. The fund will not benefit from the current favorable federal income tax rates on long-term capital gains and Fund income, losses and expenses will not be passed through to the shareholders.

Energy infrastructure MLPs are subject to a variety of industry specific risk factors that may adversely affect their business or operations, including those due to commodity production, volumes, commodity prices, weather conditions, terrorist attacks, etc. They are also subject to significant federal, state and local government regulation.

Although the characteristics of MLPs closely resemble a traditional limited partnership, a major difference is that MLPs may trade on a public exchange or in the over-the-counter market. Although this provides a certain amount of liquidity, MLP interests may be less liquid and subject to more abrupt or erratic price movements than conventional publicly traded securities. The risks of investing in an MLP are similar to those of investing in a partnership and include more flexible governance structures, which could result in less protection for investors than investments in a corporation. MLPs are generally considered interest-rate sensitive investments. During periods of interest rate volatility, these investments may not provide attractive returns.

A change in current tax law, or a change in the underlying business mix of a given MLP, could result in an MLP being treated as a corporation for U.S. federal income tax purposes. This would result in such MLP being required to pay U.S. federal income tax on its taxable income and could result in a reduction of the value of the MLP.

The fund is considered non-diversified and may experience greater volatility than a more diversified investment.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.All data provided by Invesco unless otherwise noted.

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