By Gary Stringer, Kim Escue and Chad Keller, Stringer Asset Management
Though we believe long-term fundamentals look attractive for oil and energy stocks, we expect near-term volatility to continue in the wake of geopolitical tensions. Risks from trade wars and sanctions linger and the potential upside for the broad oil and energy sectors in the near-term does not outweigh the downside risk in our opinion.
However, we do find value in energy Master Limited Partnerships (MLPs), which are traded on national exchanges like equity securities, but offer some tax benefits due to their limited partnership structure. With a recent decoupling from oil prices, depressed valuations, and stable interest rates, we think MLPs are attractive, especially for income investors seeking high dividends and diversification from traditional income products.
FERC CHANGES TO MLP SPACE
In March of this year, the Federal Energy Regulatory Commission (FERC) came out with a change that would take away an important income tax allowance used by cost of service pipeline MLPs. This rule adjustment threatened the profitability and dividends of a specific subset of MLPs, along with heightening the risk of a shrinking universe as more MLPs would find converting to a C-corp structure more appealing without the tax allowance. As is often typical, investors threw the baby out with the bathwater and the broad MLP sector was affected. While the ruling only impacted a small number of interstate pipelines and was not expected to have an impact for some years, the news was met with a large selloff within the MLP universe.
In July, FERC announced the new tax allowance rule would not impact certain MLPs that have a corporate parent company. This has eased some of the strain in the MLP market and prices have moved back up from their lows, but prices remain attractive in our opinion, especially for income investors that benefit from the high dividend yield.
RECENT DIVERGENCE FROM OIL PRICES
Over the past several months, the MLP sector has decoupled and correlations to oil prices have fallen. If this trend continues, we would expect to see less volatility in the shorter-term from geopolitical risks, as well as from stabilized interest rates and more favorable tax rulings.
THE OUTLOOK IS GOOD FOR MLPS
All together, we think this is a positive backdrop for the MLP space. The MLP sector can be interest rate sensitive, and with our current view that longer term interest rates will not move up significantly from here, this is a favorable environment for the sector. Additionally, MLPs can provide a nice income stream for those investors looking to diversify their sources of income.
However, we are concerned about the longer-term trend of MLPs switching to C-corps that began years back when Kinder Morgan converted. While the latest FERC ruling takes some of the pressure off, the tax spread between the MLP structure and the C-Corp will remain wider and advantageous for most MLPs. In general, there are other factors driving the decision to convert to a C-Corp or not, such as the access and the cost of capital, and how the MLP would value as a C-Corp. Despite recent developments with the FERC ruling, this conversion trend should be watched as dedicated MLP ETFs would become more concentrated with fewer holdings.
When coupled with a diversified asset allocation, MLPs can help increase the diversification and enhance the potential for returns and income. In the current environment, we favor MLP ETFs that focus on midstream businesses, such as pipelines. Our outlook for interest rates over the near term, attractive valuations, and potentially reduced volatility should bode well for the sector. Additionally, many MLP ETFs can provide access to this market without the tax filing headaches associated with K-1s.
This article was written by Gary Stringer, CIO, Kim Escue, Senior Portfolio Manager, and Chad Keller, COO and CCO at Stringer Asset Management, a participant in the ETF Strategist Channel.
DISCLOSURES
Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management, LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not be taken as an advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested.
Past performance and yield may not be a reliable guide to future performance. Current performance may be higher or lower than the performance quoted.
The securities identified and described may not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.
Data is provided by various sources and prepared by Stringer Asset Management, LLC and has not been verified or audited by an independent accountant.