Oil and gas master limited partnerships (MLPs) have not been spared the broader pressures on the energy sector this year. The S&P 500 Energy Index has underperformed the S&P 500 by 25% so far this year, and the Alerian MLP Index has dropped 6% over the same period (and is currently yielding 8.0%).
For investors looking to buy and sell MLP stocks, daily swings in crude oil prices appear to be driving trades. This marks a big change from the past. Once considered boring yield instruments, MLPs (U.S.-based publicly traded partnerships that typically manage oil and gas pipelines) historically demonstrated higher correlations to utility stocks than to crude oil prices. This made sense, given that MLPs earn tolling fees based on volumes transported and are thus not affected significantly by the underlying price of the commodity. But today, the MLP sector’s correlation to utilities has actually turned negative, dropping to the lowest levels of the past 15 years (see Figure 1).
So what happened, and when can we expect this trend to reverse?
Looking back: An equity funding gap begets dividend cuts
From 2003 to 2007, the Alerian MLP Index and S&P 500 Utilities Index closely tracked each other, with near-identical total returns of about 165%. As the outlook for energy infrastructure spending grew increasingly positive over the following six years (ending 2013), MLPs consistently outperformed utilities, generating roughly 113% excess returns. MLPs had essentially become “utilities with better growth prospects.”
This began to change starting in 2014, when the dramatic oil price correction hurt sentiment toward companies exposed to the energy sector. With stock prices coming under pressure, MLPs found it difficult to raise the capital they needed periodically in order to execute on their growth projects. As it became difficult to raise equity capital from MLPs’ predominantly retail investor base, the outlook for distribution growth became less certain, causing stock prices to contract. This process gave rise to an adverse feedback loop: As share prices fell, equity needs grew, thereby further penalizing the dividend outlook.