Favorable Valuations for the MLP Sector
Investors buy MLPs to lock in tax-advantaged income streams; one of the best valuation metrics for the group is the spread between the yield on the Alerian MLP Index and the yield on the 10-year Treasury bond. When the yield on the Alerian MLP Index is elevated compared to the yield on 10-year Treasuries, investors can earn an above-average yield for accepting the risk of owning MLPs.
The yield spread between the Alerian MLP Index and the 10-year Treasury bond spiked to record levels in late 2008 and early 2009. At the height of the credit crunch, investors shunned risky assets and fled to the safety of Treasuries. At times in late 2008, the short-term Treasury notes offered negative yields; investors were effectively paying interest for the right to lend money to the U.S. government — a sign of extreme risk aversion.
The underlying fundamentals for MLPs also deteriorated somewhat in late 2008. Most MLPs have little or no exposure to oil and natural gas prices, though some firms involved in oil and gas production, gathering and processing suffered a decline in cash flow when commodity prices plummeted. Producers curtailed drilling, limiting the number of new wells hooked up to gathering systems and reducing throughput on processing systems. You can find out more about the basics of MLP investing in my free report: Master Limited Partnerships Revealed.
But the credit crunch was an even bigger challenge for MLPs. Banks ceased lending money and the implosion in the stock and bond markets prevented many well-capitalized MLPs from issuing new units or selling bonds.
It’s a testament to MLPs’ stability and defensive qualities that only a handful cut their distributions during the worst financial crisis since the Great Depression. Nonetheless, investors still punished the group; the yield on the Alerien MLP Index skyrocketed to as much as 1,000 basis points (10 percent) over the yield on the 10-year Treasury bond.
In late September 2011, the yield on one-month Treasuries slumped into negative territory once again, as investors sold stocks en masse and piled money into safe havens.
The yield spread between the Alerian MLP Index jumped to more than 5% at the end of September. Although MLPs have rallied substantially since mid-2009, these stocks are dirt cheap by any historical measure. The recent upswing in the stock market has lowered this yield spread somewhat, but the Alerian MLP Index still offers an attractive yield margin for income-oriented investors relative to government bonds.
Of course, valuation alone is never ample justification to buy a stock or industry group. Some stocks are cheap for a good reason. But business conditions remain sanguine for strong MLPs.
In my Oct. 5, 2011, Seeking Alpha article, Credit Conditions Should Remain Stable For MLPs And Oil & Gas Producers, I examined conditions in global credit markets and concluded that most MLPs still have cheap access to credit despite the turmoil in the EU. Demand for energy commodities is also much healthier than it was before.
This graph tracks the prices of West Texas Intermediate (WTI) crude oil, Brent crude oil and a mixed barrel of natural gas liquids (NGLs) that includes ethane, propane, butane and iso-butane.
The last time the yield spread between the Alerian MLP Index and 10-year Treasury bonds was this elevated, oil prices had collapsed from a high of almost $150 per barrel to less than $40 per barrel. This year, oil prices have pulled back from their springtime high but remain elevated.
The pullback in the price of WTI crude oil has been more pronounced because of the oversupply of oil the delivery point in Cushing, Okla. Nevertheless, WTI crude oil barely dipped under $80 per barrel in September and is still up on a year-over-year basis.
The price of Brent crude oil has receded only modestly this year, an indication that global supply and demand conditions remain tight. Despite the sensationalist headlines about plummeting energy prices, Brent crude oil currently trades for well over $110 per barrel and never dipped under $100 per barrel during the September sell-off. The price of Brent crude oil has increased by almost one-third on a year-over-year basis.
Earlier this year, the growth scare prompted concerns that an oversupply of ethane and propane would weigh on NGL prices. However, NGL prices have held up even better than crude oil in recent months.
Although U.S. natural gas prices remain depressed, strong NGL and oil prices continue to incentivize aggressive drilling activity in liquids-rich fields. Check out this graph of the U.S. active rig count.
In late 2008 and early 2009, producers slashed their drilling budgets in response to tumbling energy prices, pushing the rig count well under 1,000 by mid-2009.
Today, the U.S. rig count has swelled since the first quarter of 2011 and has continued to rise even after oil prices pulled back in the third quarter. More than 2,000 rigs are actively drilling for oil and gas in the U.S., compared to 887 rigs at one point in mid-2009. All this drilling activity is a boon for MLPs involved in gas gathering and processing
There is a major disconnect between MLPs’ stock valuations and business conditions. Investors’ panic and risk-aversion offers investors an attractive opportunity to buy our favorite names at a discount.