Crude oil prices have plummeted from above $100 a barrel to below $50, much to the delight of U.S. consumers and the chagrin of global energy investors. Even master limited partnerships (MLPs), which are supposed to be relatively insensitive to oil prices, have taken it on the chin, with the Alerian MLP Index suffering a 20% correction from its August highs to its January lows.
But Michael Clarfeld and Chris Eades, both Managing Directors for Legg Mason’s ClearBridge Investment Company, have written a whitepaper explaining why the oil market in general and MLPs in particular should bounce back. In a work titled Can MLPs Weather the Storm?, the authors answer their own question by making the economic case for higher oil prices and the fundamental case that MLPs are undervalued at current yields.
MLPs became hot investments during the early stages of the U.S. shale boom, up through August 2014 when oil prices began to crater. MLPs are “flow-through” entities, like real estate investment trusts (REITs), that are required to derive the bulk of their revenue from natural resource-related activities. In practice, most MLPs are involved in the transport of oil and natural gas via pipelines, for which they receive toll payments.
These payments are based on volume, irrespective of the price of oil, so many investors have been surprised by the extent to which MLPs have suffered along with oil prices since the summer. But since yields move inversely with prices, MLPs are now generating significantly higher yields:
As you can see from the image above, the yield of the Alerian MLP Index has jumped from 5.2% at the index’s price peak on August 29, 2014 to 6.4% as of January 29, 2015. Meanwhile, the yields of REITs, utilities, 10-Year Treasurys, and investment-grade bonds have all declined; and although the yields of the S&P 500and high-yield bonds have gone up, they haven’t gone up as much as MLP yields.
Economics of Oil Production
Mr. Clarfeld and Mr. Eades do an excellent job of concisely explaining the economics of the global oil market. Prices can fluctuate between around $150, where “demand destruction” kicks in; on down to around $30 a barrel, where even the easiest-to-produce oil becomes uneconomical. Supply and demand factors – including the supply of and demand for U.S. dollars – can move prices between these two extremes, but ultimately, only about 30 million barrels of oil can sustainably be produced at current prices around $50 a barrel, while global demand is 92 million a day, and growing.
The image above explains the global oil market, broken down by production source: The vertical axis represents the breakeven production cost of a barrel of oil, and the horizontal axis represents daily production in millions of barrels per day. Eagle Ford and Bakken are North American shale deposits in Texas and North Dakota, respectively.
Don’t Forget About Nat Gas
The massive correction in oil prices has reasonably garnered all the headlines, but natural gas actually accounts for 55% of U.S. energy production, according to Clarfeld and Eades. Indeed, crude oil only accounts for 37%, while the remainder consists of natural gas liquids (NGLs) that are produced alongside oil and gas.
Natural gas is a cleaner alternative than coal. Both can be used as fuel for electricity generation, but nat gas has steadily been taking market share from coal, as demonstrated by the image below:
Mr. Clarfeld and Mr. Eades believe the recent correction in energy MLPs has been in reaction to the steep decline in oil prices, but these declines may have created opportunities for long-term investors who can stomach near-term volatility. In spite of the oil declines, Clarfeld and Eades say they expect oil and gas production volumes in the U.S. to be up in 2015, which will continue to drive growth for “toll road” energy pipeline MLPs. These investments will continue to be volatile, though, so long as oil prices remain depressed – but in the meantime, patient investors can collect a 6.4% yield while they wait for the sector to recover.
For more information, download a pdf copy of the whitepaper.