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Following the strong recent performance in precious metals, I have been searching for new areas to invest that fit into my general “long inflation” investment theme. One key area of growing interest is the energy sector as a whole, most notably the downtrodden industries such as uranium, oil, and natural gas.
After the attack on Saudi Aramco’s oil pipelines, I wrote an article called “XOP: Long-Term Bottom May Be In” that details my overall bullish view on oil and how I think the long-term bottom for the energy sector may be in.
The problem with most energy stocks and the underlying commodities is that they do not generate any income for investors. Many of these companies barely breakeven today and have been struggling with insolvency for quite some time. One area where very high-income distributions can be found is in the MLP space.
I’d like to focus this article on the popular Alerian MLP ETF (AMLP). The fund invests primarily (75% of assets) in pipeline transportation MLPs and the other quarter in natural gas processing and gathering.
The risk factors facing such MLPs are more complicated than those facing traditional energy producers. Low energy commodity prices do not directly harm MLPs, but indirectly do so because lower prices usually cause lower production (MLPs earn a fee for transporting/processing). Even more, the companies managing MLPs often don’t act in MLP unitholder’s best interest and conflicts of interest occasionally arise.
Risks considered, I believe the bottom for MLPs may be in or at least coming soon. Many investors fear that a 2008 style recession is on the horizon and that demand for energy is likely to decline. Thus, already depressed MLPs have become even more depressed. In my opinion, the next recession will look very different from the last, and demand for energy may actually climb despite a slowdown due to rising wages and strong employment fundamentals. (Recessions don’t always mean a huge increase in unemployment)
Let’s dig in to AMLP to see if it is a good way to invest in the MLP space, or if investors should look to other assets.
Introduction to the Alerian MLP Fund
To put it nicely, AMLP has made for a generally poor investment over the past decade. Take a look at the chart of the total returns of AMLP (which include dividends) vs. the price of crude oil since the fund started in 2010:
Data by YCharts
As you can see, the two are generally pretty well correlated but not entirely as MLP tends to move a lot more slowly and with the general equity market than crude oil.
On a positive note, the fund does currently pay a very high dividend yield of 8.15% which is near its all-time high. On a less positive note, the fund has a higher expense ratio than many at 85 basis points. Still, for investors who are not interested in exposing themselves to individual names, this could be a good option. Despite its poor performance, the fund is highly liquid with around $8.5B in AUM.
Take a look at the fund’s price vs. its dividend yield and AUM over the past decade:
Data by YCharts
AUM has been surprisingly stable which is probably because investors like the fund’s high yield. Considering the fact that the sovereign debt of most developed countries today delivers a negative yield (and an extremely negative return after inflation), AMLP is pretty attractive with 8%+ dividends despite its risks.
Even more, if inflation rises, the book value of the MLPs will rise and investors are effectively hedged against inflation. Let’s take a closer look at the exposure of the fund.
Inflationary Exposure is a Plus
For relatively complicated investments like MLPs, I often find that cross-asset exposure is an invaluable way to assess the true risks of the investment. To be honest, many investors seem to misunderstand the true exposure of MLPs.
It is often said that MLPs have high-interest rate exposure which is certainly the case for other yielding investments like utilities, REITs, and consumer staples. This actually is not exactly the case for MLPs as the rapidly falling interest rates over summer actually coincided with a fall in AMLP and its constituents.
Why? Because interest rates are directly tied to inflation expectations and MLPs benefit enormously from higher inflation. While higher interest rates cause most yielding assets to fall, if those interest rate increases are due to inflation, then the book value of the MLP is increased as its underlying assets rise with inflation and its debt is effectively devalued. Even more, higher inflation usually coincides with higher commodity demand which is also a plus for MLPs.
To put it simply, low inflation has been the primary boon on MLPs over the past decade. If inflation finally rises (which I believe is just beginning to happen), MLPs will take off.
Using the method of least squares we can find the statistical exposure of AMLP. This effectively gives us how much a 1% change in a given asset is likely to impact AMLP. This is akin to “Beta” but for an array of assets. Here is the exposure for AMLP vs. major asset classes:
(Data Source – Google Finance)
As you can see, the fund actually has pretty low direct exposure to equities and is correlated heavily with a mix of high yield bonds (most MLP debt is very high yielding) and, of course, crude oil. Interestingly, the fund’s primary driver is short term treasury bonds. A 1% increase in the short-term treasury ETF (SHY) typically coincides with a 1% fall in AMLP. Why? Because short-term rates are primarily driven by inflation expectations.
To get a better insight into how these macroeconomic variables and the fund are connected, let’s take a look at the fundamentals of the ETF’s holdings.
High Dividends Come With Risks
I like the MLP space and expect strong performance in it over the coming years. That said, it is one of the riskiest asset groups/industries today because many of the LPs are very beaten down following the past decade of weak commodity demand and low inflation. If these trends do not change soon, many of the MLPs in the fund could go bankrupt.
Take a look at our select fundamental statistics for the LPs in the fund:
Note, “Typical” denotes harmonic mean for valuation statistics and median for others.
(Data Source – Unclestock)
As you can see, valuations are pretty low for these companies and they trade at a 20% discount from a price to revenue perspective. Many are also trading below book value and saw substantial revenue growth last year.
Some of these LPs have significant debt levels that pose a substantial risk to investors. While MLPs gain from pass-through taxes, the effect is reversed in the case of debt cancellation due to archaic U.S. tax laws that treat debt reductions as a capital gain. In other words, if an MLP needs to restructure its debt, its investors are subject to an extra capital gains tax bill. TC PipeLines (TCP) and DCP Midstream (DCP) look slightly worrisome in this regard.
Revenue growth for oil and gas MLPs are closely tied to the U.S. total rig count because that is the primary upstream driver of energy supply. Take a look at the revenues for the largest LPs in the fund, Enterprise LP (EPD) and Energy Transfer (ET), vs. the U.S. rig count:
Data by YCharts
As you can see, the two generally follow the same pattern and show how the LPs have gained tremendously from the energy boom in the 2000s. Remember, rig counts trail energy prices. When energy prices fall, suppliers cut production (rigs) and the LP’s infrastructure sees less demand. Of course, supply cuts like this cause energy prices to rise and for the cycle to repeat.
Right now, that cycle is in favor of MLPs as the rig count is likely to reverse to the upside following the Saudi pipeline attack (and heightened risk of future supply constraining attacks).
The Long Run and Our Bottom Line
Tension in the Middle East is a solid short-term upward catalyst for AMLP as well as other energy related companies and ETFs. Of course, if a war or larger conflict occurs, then that catalyst will become very supportive over the long-run.
That said, to make for a good investment, we need to know if the energy market is secure even without Middle Eastern conflict. In my opinion, U.S. energy demand is likely going to rise substantially over the coming years. As detailed in this article, I believe that inflation is likely to rise over the next decades due to a reversal of the major economic trends that had pushed inflation down.
Shown below, we can see that wage inflation continues to march above inflation expectations:
(Source – Federal Reserve Economic Database)
Most likely, this will increase aggregate consumption which will, in turn, eventually boost inflation and demand for energy and other commodities.
We can already see that the amount of personal consumption expenditures on food and energy is beginning to rise faster than PCE in general:
(Source – Federal Reserve Economic Database)
If this trend continues, then the primary winners will be the MLPs that are servicing the rising demand for energy. Of course, many will argue that renewable energy will halt the long-term prospects for the non-renewables that MLPs work with, but I view that as a very low probability outcome. Renewable energy production and consumption have been growing much slower than would be needed to harm MLPs.
Overall, for income investors who are not afraid of risk, AMLP looks like a solid investment opportunity. It is a hedge against inflation, higher energy demand, and has many very cheap holdings. Of course, better investment results are likely by looking at the individual LPs, but the benefits of no K-1’s and ease of investment make AMLP an attractive ETF.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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