Most people welcome a new dawn, and the rise in West Texas Intermediate (WTI) to over $50 per barrel in late September/early October gave reason for optimism regarding the MLP sector.
For MLP investors, how realistic are these rays of hope?
A rotation back into energy may be in the making, but as yet it’s only “a modest uptick in interest,” according to a late-September research report by Wells Fargo Securities. “It’s definitely feeling better,” the report said. “For the first time in a while, we’re getting interest from ‘new money,’ i.e. investors that as far as we can tell are not invested in the space.”
The inflow of fresh money may be improving “modestly,” said Wells Fargo, as valuation metrics screen attractively vs. historical averages.
On enterprise value-to-2018 EBITDA, the midstream MLP sector trades at an average multiple of 11.2x vs. a 5-year average of 13.4x, representing a 15.9% discount, according to Wells Fargo. In addition, the sector is priced to yield 7.8% vs. a 5-year average of 6.5%. Relative to the 10-year U.S. Treasury, the sector yields an additional 5.54% vs. 5-year and 10-year averages of 4.70% and 4.22%.
Wells Fargo said “this relative dislocation in valuation” has likely caught the attention of some yield-oriented investors, mostly income and infrastructure funds. Also, it noted that Phillips 66 Partners LP, Shell Midstream Partners LP and Buckeye Partners LP had collectively raised $575 million through PIPE (Private Investment in Public Equity) deals struck with MLP-dedicated funds, “perhaps suggesting that these funds are seeing new fund flows.”
The question here can be asked two ways: How is the MLP sector bouncing off its recent lows? Or, more pointedly, how did it drop to such depths in the first place?
Even with a rebound in crude, midstream MLPs have dramatically lagged their peers. While WTI rose 13.4% over the period from Aug. 30 to Sept. 27, the Wells Fargo MLP Index gained just 2.8%. Meanwhile, the S&P 500 Oil & Gas Exploration & Production Index and the PHLX Oil Service Index added 17.4% and 18.3%, respectively, according to Wells Fargo.
In a research note just a week earlier, Wells Fargo noted that, as with the E&P sector, the MLP market was seeing an increasing emphasis among investors on return-on-invested capital.
Wells Fargo observed that, in midstream companies’ slide decks, what typically is highlighted is a graph of growing volumes, EBITDA and distributable cash flow (DCF), but not DCF per unit. Midstream management teams “love to proclaim ‘record EBITDA,’ but it’s pretty rare to hear an MLP tout year-over-year DCF per-unit growth or return-on-invested capital metrics,” it added.
Wells Fargo cited a “perceived lack of capital discipline” by the sector as a possible reason for investor frustration and, perhaps in part, midstream sector underperformance. Given some companies’ “less than stellar” track records in value creation on a per-share basis, “investors would prefer that companies be more prudent in deploying additional capital unless the returns are highly secure and very attractive.”
In short, MLP management teams ought to be “prudent stewards of capital”—and for sound reasons.
“For an industry that is so very capital-intensive by nature, and that finances its business in a structure (i.e., MLP) that requires outside capital issuances to fund growth, it seems to us that there should be a greater emphasis on DCF per unit,” Wells Fargo said. “This means incremental investments should be generating returns above the cost of capital. Put another way, they should be creating per-unit accretion and per-unit growth.”
Wells Fargo foresees a test awaiting the sector when, later this year, it gives guidance on 2018 growth capex levels. A trend to lower capex vs. 2017 will likely augur “strong performance” for the sector, while flat-to-higher capex will likely mean the sector “could continue to underperform,” it said.
“With energy investors more focused on capital efficiency and returns on invested capital, we think companies that can demonstrate this discipline will be rewarded,” said Wells Fargo. “The game has changed. With equity market access more challenging, companies that can move to a more self-funding model will likely be rewarded.”
Chris Sheehan can be reached at firstname.lastname@example.org or 303-800-4702.
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