When energy prices are volatile, master limited partnership returns may follow commodity trends in the short run. Over long periods, however, MLP returns have generally exhibited a relatively low correlation with energy prices. In fact, today's volatile energy environment may be a key time to stay the course or, for appropriate investor profiles, even add to MLP allocations. Here are some key dynamics underlying the MLP market.
1. Short-term correlations can spike, but long-term correlations have generally been low.
In the near term, MLP returns can demonstrate high correlations with energy prices. When we look at the performance of energy versus MLPs over short periods, the relationship looks tight. For example, oil (measured by WTI crude futures) has endured a few short-term trends since the beginning of 2015 and in those short periods, MLPs have moved in the same direction, to varying degrees. For many clients, this relationship may feel too connected for comfort.
(More: Investors facing the dark side of MLP investing)
Over longer periods, however, the correlations historically have become much weaker. In some recent calendar years, for instance, the returns of oil and MLPs haven't even gone in the same direction — MLPs have gone up while oil has gone down, or vice versa. Generally speaking, since 2002, the longer the window of time, the less correlation we see between oil and MLP returns.
2. Fundamentals can improve when energy prices fall.
Most midstream MLPs are pipeline businesses that move oil and natural gas from point A to point B. Typically, they are not owners of commodities; their businesses rely instead on the volume of oil or natural gas being consumed and transported. Just as economic theory predicts, when energy prices fall, consumption often goes up. Higher consumption means higher volumes, which is generally a good thing for the “tollkeepers” that transport or store energy.
3. Rise in yields could indicate an attractive entry point for MLPs.
When MLP prices take a hit but their distributions stay steady or continue to increase, we often see a spike in yields. The yield on an MLP (distributions divided by price) has an inverse relationship to its price, so when prices go down, yields tend to rise. As of the end of August, the spread between MLP yields and the 10-year U.S. Treasury was particularly attractive, at more than 500 basis points.
During other periods when this spread has jumped, it often wound up being an attractive entry point. In the 2008 downturn, for example, MLP prices fell significantly and yields rose accordingly. In 2009, MLP returns soared. The current environment could also wind up being an opportune time to add or increase exposure to MLPs.
(More: MLPs yield headaches for advisers who bought them for income)
In the volatile commodity market, it can take a long time to reach equilibrium in the face of disruption. Clients are right to be concerned about the implications for their portfolios, but it is important to separate the effects of commodity volatility from the performance of investments like MLPs and evaluate long-term correlations within the context of an overall portfolio. With a lower long-term correlation to energy prices, attractive prospects for MLP companies with higher volumes and the buying opportunity that often comes with a spike in yields, there is a strong case to stay the course with MLPs.
Brian Hahn is a managing director and wealth adviser at Neuberger Berman.
