Key points Accessing the US Energy Revolution
- Master Limited Partnerships (MLPs) have delivered a growth in their quarterly distributions since 2014 at an average coverage ratio of 1.25 in their latest quarterly results in Mar 2016 allaying concerns of distributions cuts by MLPs. (Source: Bloomberg, Individual MLP websites)
- The sustainability of the revenue stream of MLPs when compared to oil companies amidst the backdrop of volatile oil prices, highlights that MLPs would have offered a more resilient exposure to the energy sector.
- On analysing Distribution Coverage and EV/EBITDA, we believe MLPs offer an attractive value proposition.
- MLPs recent price performance is as a result of negative sentiment transpiring from equity markets and oil price volatility, evidenced by rising correlation 0.85 and 0.63 respectively. (Source: Bloomberg, ETF Securities) [correlation of monthly returns over 5 years]
- TICKER: MLPI LN Accessing the US Energy Revolution
Valuation
- 2016 expected distribution yield is 7.14% (Source: Bloomberg, ETF Securities)
- The majority of MLPs in our index have a distribution coverage above 1 which supports the case for sufficient cash flows available to pay distributions.
- Weighted average distribution paid in Q4 2015 have risen on average by 15% over the prior quarter despite the heightened concerns on the sustainability of distributions. In comparison the funds available for distribution have increased by 25% leaving a margin of 10% as a cushion for future distributions.
- Historically we have witnessed MLPs increase debt levels during periods of favourable valuation. However in 2014, despite valuations EV/EBITDA reaching their peaks, MLPs have not raised debt as aggressively as done in the past rendering them in a stronger balance sheet position.
(Based on current basket historical data to mitigate survivorship bias)
(Based on current basket historical data to mitigate survivorship bias)
Performance
- Solactive continues to outperform its peers due to midstream focus and equal weighting methodology
- Solactive has outperformed crude oil over the past 5 years
- MLPs offer an inflation hedge due their long-term contracts which are regulated by the Federal Energy Regulatory Commission (FERC) and adjust to inflation annually (PPI), as well as distributions which adjust upwards according to changes in the CPI
Index recomposition March 2016
• Following the index recomposition, the representation of General Partner (GPs) has increased from 7% to 17%.
• Possible reasons:
o Undervaluation – GPs had the largest 6-month drawdown (June 15 – Jan 16) which has meant a higher expected future distribution yield.
o Alignment of interests – Owning GPs better align investors with management as most GPs own a stake (usually 2%) in their underlying LPs.
o Incentive distribution rights (IDRs) – GPs hold IDRs which entitle them to an increasing share of the total distribution released by the LP to its unitholders (in spite of a mere 2% ownership). As LPs increase their distribution to unitholders, the GP’s distribution increases proportionally much faster, in accordance with a pre-set IDR schedule. At the highest tier of the IDR schedule, a GP – through its IDR ownership – may be receiving up to 50% of equivalent cash distributions made to LP unitholders. This is known as IDR leverage. Thus IDRs have the power to significantly enhance the cash distribution profile of GPs. (IDRs are explained below)
• BAML Equity Research data shows that GPs have underperformed LPs on a total return basis but outperformed LPs on a cash distribution growth basis.
(as at 17 April 2016)
Takeaways
- The average distribution coverage across the index is 1.25 which is comfortably above 1 and reflects sufficient cash flow to meet cash distributions
- The expected 2016 distribution yield is 7.14% backed by healthy fundamentals and oil price-resilient revenues (i.e. good cash flow)
- MLPs offer a good inflation hedge with distributions often outpacing the Consumer Price Index (CPI) and pipeline contracts that adjust for inflation annually (Producer Price Index = PPI)
- Funds for distribution are trading at a 10% premium to distributions paid so we may expect IDRs to gain value and give momentum to GP price performance
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