TIM SA Interview 2015-08-27

In light of all the action happening in the MLP space of late, it seemed like a good time to delve deeper into what’s happening in the sector, where the opportunities are right now, and what investors can expect later on in the year. The stories coming out of the MLP sector have been dismal and disappointing: Chesapeake (NYSE:CHK) and Linn (NASDAQ:LINE) (NASDAQ:LNCO) eliminated their distributions, Memorial Production Partners (NASDAQ:MEMP) just slashed theirs 45% last week, earnings and cash flows have been declining, and the specters of rising interest rates and plunging oil prices have cast a pall over more debt-burdened operators. One positive is that yields have become more attractive as stock prices have fallen, but some industry observers point to shaky fundamentals as a reason to avoid MLPs right now.

I asked Seeking Alpha’s very own Tim Plaehn to weigh in on the sector. Tim is one of our resident experts on the MLP space, and he’s covered dividends & income investments as an analyst for several outlets in addition to Seeking Alpha, including Investors Alley, The Motley Fool, and USA Today. Here are his thoughts on MLPs.

Seeking Alpha: Just a few weeks ago, industry observers writing about the space were discussing an “MLP meltdown,” which seems like something that’s been progressing since oil prices took a nosedive last year. In mid-August, however, analysts at Credit Suisse upgraded the MLP sector to overweight. Credit Suisse says it now believes MLP risks are skewed to the upside. Would you agree with this? Are we out of the woods yet with MLPs?

Tim Plaehn: The MLP sector is in a full-blown bear market. The Alerian MLP index is down 30.5% compared to a year ago. The group still faces several strong headwinds. First, as the price of crude continues to fall, the market sells off the energy sector en masse, including MLPs. Also, when MLPs were hot in 2013 and the first two-thirds of 2014, investors used MLP fund products to jump into the sector. Now the fickle, “chase the hot sector” crowd is bailing out of their MLP ETFs and CEFs, putting additional selling pressure on the sector. My gut tells me that both of these trends may have several quarters yet to run.

Fundamental and historical factors point more towards an MLP recovery. For the second quarter, 86% of MLPs maintained or increased their distributions, with median year over year increases of 5.5%. The MLP distribution growth model is still functioning. The average MLP yield is now 5% or 500 basis points greater the 10-year Treasury yield. Over the last 20 years, when the MLP yield was more than 5% above than the Treasury yield, the MLP sector has averaged greater than 30% total returns for the next 12 months. (Thanks to Yorkville Capital for providing MLP market data.)

SA: According to Barron’s, analysts at InfraCap and Cohen & Steers are calling for increased M&A in the MLP sector going forward. They say the sector is vastly undervalued, and that MLPs can get even cheaper still as macroeconomic factors like declining energy prices, rising interest rates, economic concerns in China and Greece, and the nuclear treaty with Iran spur concerns about crude supply. Do you agree with these analysts, and how do you see MLPs responding to these macro trends in the next few quarters?

TP: As a basis of analysis, the energy market operates with very long-term actions and outcomes. The markets and financial sector view everything with a very short-term perspective, reacting on a day-to-day basis to news that in the longer term will have little or no effect on energy prices. For example, in spite of Greek and Chinese economic fears, last week the International Energy Agency increased its 2015 crude oil demand by 1.1 million barrels per day compared to last year. In 2014, demand growth came in at 700,000 bpd. On the supply side, low crude prices will eventually show up as a global production growth slows down. The flip from excess supply to a shortage could happen very fast and catch the markets by surprise.

On the M&A front, it appears that owners of energy assets have not been willing to lower asking prices to a point that would make them attractive to buyers. There is also a lot of private equity money chasing energy assets, making it tough for the publicly traded, cash flow focused MLPs to compete. I am frankly surprised at the limited number of deals that have been put together, since on every earnings call management teams discuss their willingness to acquire assets.

SA: Are there any other trends impacting the MLP sector that investors should be wary of?

TP: I expect distribution growth from the midstream MLPs to slow. Investors must take a look at current yields and be happy with those rates for the next couple of years. The positive side is that you can get very attractive yields, such as the close to 10% payout from a large, financially stable MLP like Oneok Partners LP (NYSE:OKS) while you wait for energy prices to recover and U.S. production to again ramp up. Outside of the core, large MLPs, asset and revenue quality varies tremendously. Some MLPs will not be able to live up to their growth forecasts, and a few will be forced to reduce distributions.

SA: Energy Transfer (NYSE:ETE), Magellan Midstream Partners (NYSE:MMP), MarkWest Energy Partners (NYSE:MWE) and Sunoco (NYSE:SUN) recently raised their payouts, while firms such as LINE and CHK have eliminated their distributions completely. Why can some MLPs afford to raise their distributions, while others are forced to stop paying or reduce payments to unit holders? Should investors completely abandon those that are eliminating or cutting their payouts?

TP: There is a tremendous difference between upstream MLP producers like Linn Energy and Chesapeake Energy and the midstream MLPs such as ETE, MMP, MWE and SUN. Upstream revenues are based on energy commodity prices. The midstream companies provide the infrastructure services that get used in any energy price environment. Also, the market is not differentiating between companies that generate revenues from the crude oil side and those that are primarily natural gas producers or midstream operators.

SA: Some industry watchers, at Fitch Ratings, for example, suggest sticking with the most liquid, capital-rich midstream MLP players, because they believe the smaller guys may have difficulty raising capital, thus, funding risk is a concern. Then again, this has the potential to fuel the M&A opportunities we mentioned earlier, which could be a boon for investors who are in the right stock at the right time, so to speak. With the caveat that most merger discussions right now would perhaps be speculative at best, where do you see opportunities in the MLP sector? Are there stocks you like in particular right now, and why?

TP: Please, please someone make a deal for Williams Companies (NYSE:WMB)! Williams trades at $54 and has turned down an all-stock offer valued at $64 per share. Just this week, Seeking Alpha noted that others are looking to acquire WMB. My forecast is a $70 target price for WMB. Just in the last few days, I have been thinking that a takeover of Western Refining (NYSE:WNR) by Tesoro Corp (NYSE:TSO) would be an awesome match. On the MLP side, Tesoro Logistics LP (NYSE:TLLP) could absorb Western Refining Logistics LP (NYSE:WNRL), which would result in a large cap midstream MLP with a very attractive 5% yield plus 15% distribution growth prospects. WNR also controls downstream MLP Northern Tier Energy LP (NYSE:NTI), which is going to generate huge piles of cash in the second half of 2015.

SA: What type of investor is this sector best suited for currently? And should those who have large stakes in MLPs consider trimming those holdings? If so, what other favorable opportunities exist for yield-hungry investors? Are there other, less risky ways to play the sector, i.e., ETFs?

TP: Direct MLP ownership remains a very attractive investment theme for high tax-bracket investors. With 80% to 100% of MLP income shielded from income taxes, the after-tax cash flow cannot be matched by any other investment sector. Investing in high growth rate MLPs is another attractive investment theme. These MLPs have sponsors with large midstream asset holdings that can be transferred to the partnerships over time. These transfer schedules give high visibility to 20%+ annual distribution growth. High distribution growth rates should produce similar unit price gains, resulting in 20% to 30% total annual returns.

For investors who don’t want to do the research (or subscribe to my new MLP-focused newsletter linked HERE), or work with K-1 tax reporting, I am recommending the InfraCap MLP ETF (NYSEARCA:AMZA). This is the first actively managed MLP ETF. The fund currently yields 12% and is increasing dividends by 1% every quarter. The RBC Yorkville MLP Distribution Growth Leaders Liquid PR Index ETN (NYSEARCA:YGRO) is another new packaged MLP product that focuses on the high distribution growth MLPs.

SA: Any other thoughts or observations you’d like to add that might be important for investors to know?

TP: First, the upstream MLPs have become very speculative investments. I think the group is very oversold, but unit prices will not recover until crude moves higher. The rest of the MLP sector is attractive, but there could be several more quarters of ugly unit price action. I do think that when the energy markets and MLP values turn upward, it will happen very quickly, catching most of the market by surprise.