Downside Risks for MLPs

The Shale Revolution is a powerful recent example of why America’s system of capitalism is so enduring. We’re not just leaders in shale oil and gas, the U.S. is pretty much the only game in town (see America Is Great!). One day it will probably be the basis for college courses across the country to illustrate the power of the free market. A year ago OPEC abandoned its efforts to bankrupt the U.S. shale industry through ruinously low crude oil prices (see OPEC Blinks). Although it wasn’t well recognized in many other parts of the world, our domestic energy industry was able to harness a long list of advantages:

1) The right geology

2) Existing network of energy infrastructure

3) A highly skilled labor force

4) An entrepreneurial culture

5) Water supplies in the right places

6) Technological excellence

7) Constant drive for productivity improvements

8) Privately owned mineral rights

9) Highly developed capital markets

It’s not the first time the U.S. has used its economic advantages to win a battle. As a result, we are on a path to greater energy security, improved geopolitical flexibility and American Energy Independence.

It’s a great story and recounting it to clients is never boring. But where can it go wrong?

Clients often ask, and it’s a fair question, not least because few investors have forgotten the 58.2% drop in the Alerian Index from August 2014-February 2016. The recent distribution cut at Plains All American (PAA) (see MLP Investors Learn About Logistics) remind that the occasional negative surprise remains possible across a landscape of generally rising cashflows and declining leverage.

The most obvious threat is a recession. Energy infrastructure is about moving, processing and storing volumes of hydrocarbons. If economic activity slows, energy consumption of all kinds slows too. Although many pipeline contracts are underwritten by volume commitments from shippers, overall cashflows for the sector would still suffer from less throughput. During the 2008 Financial Crisis MLPs fell along with everything.

Lower crude prices are an ever-present threat, very real after 2015. Oil affects investor sentiment far more than cashflows, as we often note. However, the industry is also much more invested in the growth of domestic hydrocarbon output than it was ten years ago. The sensitivity of domestic production to pricing broadly affects the utilization of existing and newly built capacity. Energy infrastructure is mostly about volumes, but those volumes are increasingly sensitive to prices. As the U.S. increases its role in export markets, domestic output will be impacted by global prices.

Slower growth and weaker hydrocarbon prices are the obvious threats. Geopolitical risks rarely receive consideration until they’re presenting an imminent threat, but we think about those too.

The Middle East remains an unstable place. The nuclear agreement with Iran is at some risk of being abrogated by the U.S., with unpredictable regional consequences. Substantial crude oil passes through the narrow Straits of Hormuz, between Iran and the United Arab Emirates. The recent vote by Iraqi Kurds for independence risks creating a backlash not just from Iraq’s central government but also from Turkey with its sizeable Kurdish population. Recently, Turkey suspended deliveries of oil from Iraqi Kurdistan passing through a pipeline on its territory.

A disruption of crude oil from the Middle East would drive up prices, and might even stimulate increased U.S. production if sustained. In any event, domestic output would be unlikely to fall.

North Korea represent another potential hotspot, with the very real possibility of the U.S. being involved in armed conflict. While we won’t make any investment forecasts based on a scenario of war on the Korean peninsula, we do note that the physical assets of energy infrastructure businesses are virtually 100% located in North America dispersed across the country. There’s minimal non-U.S. exposure, although swings in commodity prices could still impact significantly.

When considering what can go wrong outside America, investments in Energy Independence would seem to offer more protection than other sectors.

The tax reform proposals lack sufficient clarity to assess their impact. However, a lower U.S. corporate tax rate should boost after-tax profits at most corporations, In addition, allowing investors in pass-through vehicles (which should include MLPs) to pay tax on their passive earnings at the lower, corporate rate rather than at ordinary income tax rates should further boost their attractiveness (see MLPs and Tax Reform).

Former Defense Secretary Donald Rumsfeld’s famous “unknown unknowns” are what planners in many fields worry about. What we’ve highlighted above includes certain known “tail-risk” events (i.e. unlikely but impactful). We consider these regularly, and new ones as they appear on the horizon. Part of defense includes owning solid businesses and avoiding leverage, which is how we invest.

Print Friendly, PDF & Email

Important Disclosures

The information provided is for informational purposes only and investors should determine for themselves whether a particular service, security or product is suitable for their investment needs. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the disclosure, prospectus, and offering. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy,  completeness or timeliness of this information. Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments.  Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios managed by SL Advisors as they have different underlying investments and may use different strategies or have different objectives than portfolios managed by SL Advisors (e.g. The Alerian index is a group MLP securities in the oil and gas industries. Portfolios may not include the same investments that are included in the Alerian Index. The S & P Index does not directly relate to investment strategies managed by SL Advisers.)

This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involves a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of SL Advisors LLC or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made. r

Certain hyperlinks or referenced websites on the Site, if any, are for your convenience and forward you to third parties’ websites, which generally are recognized by their top level domain name. Any descriptions of, references to, or links to other products, publications or services does not constitute an endorsement, authorization, sponsorship by or affiliation with SL Advisors LLC with respect to any linked site or its sponsor, unless expressly stated by SL Advisors LLC. Any such information, products or sites have not necessarily been reviewed by SL Advisors LLC and are provided or maintained by third parties over whom SL Advisors LLC exercise no control. SL Advisors LLC expressly disclaim any responsibility for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on these third-party sites.

All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.

Past performance of the American Energy Independence Index is not indicative of future returns.

Print Friendly, PDF & Email
1 reply
  1. Elliot Miller
    Elliot Miller says:

    It is regrettable that sentiment follows crude pricing and irrationally impacts natural gas oriented midstream companies. Why the price of DCP units should rise or fall based on crude pricing is incomprehensible. It is true that associated gas will increase in volume as more oil wells are drilled but that fact doesn’t justify the correlation of midstream gas oriented company unit prices with that of crude.


Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.