MLP outlook for 2015

Natural gas price weakness appears primarily driven by warmer-than-normal weather patterns in December 2014 as well as continued robust production growth. The pullback in natural gas prices is likely to have only a marginal impact on the broader energy sector as producers' focus on natural gas-based reservoirs has been limited since the commodity experienced its own price collapse in 2012. Only the most economic natural gas basins have received any significant drilling activity in recent years.

However, the impact across the energy sector from the cyclical break in crude prices is likely to be significant should prices remain at current levels. For example, a number of oil and gas producers have provided updated 2015 guidance that reflects 25% or greater reductions in capital spending but with the majority still expecting to generate production growth from current levels. Notably, capital spending cuts primarily reflect a focus on core acreage and the level of production growth for some is now quite modest versus robust previous expectations.

We note that given the breadth of change that has occurred, and will likely continue to occur, across such basic variables as commodity prices, drilling and completion costs, labor costs, materials costs, completion design, and pricing differentials that company guidance as well as Wall Street estimates today are highly suspect and investors should expect little precision from such estimates. Generally, we believe that should pricing sustain at current levels or slide further, oilfield services providers will likely be forced to offer much greater than anticipated price concessions as they seek to protect equipment utilization rates, and producer focus on efficiency will likely result in a more resilient production volume trend than broadly anticipated.

Further, the decline in crude-directed activity also carries important implications for natural gas. As many oil wells also produce significant volumes of natural gas, should oil production growth slow, associated natural gas production growth may also moderate at about the same time that the US begins exporting larger quantities of natural gas via liquefied natural gas (LNG). Further, the rate of return for natural gas drilling opportunities may rise in relative attractiveness to oil targets within the E&P opportunity set.

Midstream commentary

At Oppenheimer SteelPath we maintain an investment philosophy that near to medium-term crude oil and natural gas prices, like that of most commodities, are fundamentally unknowable. Therefore, we seek to invest in businesses that can perform across a wide range of price assumptions. In fact, our belief in the wisdom of this investment philosophy is at the heart of the creation of Oppenheimer SteelPath and our suite of midstream-focused funds.

Most midstream energy businesses typically receive a fixed fee or a fee-like margin to move a particular commodity through a discrete component of infrastructure. Therefore, midstream businesses typically carry little short-term exposure to commodity price changes but instead may be exposed to longer-term reactionary shifts in volumes produced or consumed. As such, midstream investors have to pay attention to the impact pricing trends may have on the production and/or consumption trends surrounding individual assets. Further, the contract structure supporting a particular asset must be considered.

For example, some midstream assets, particularly those that have been constructed in recent years, benefit from volume commitments helping to further protect the economics of those assets. Similarly, a number of midstream providers should benefit from upcoming project completions that are independent of total volume growth within related basins. Moreover, pipeline volumes typically represent the most efficient route for production and therefore can benefit from producer concentration on "core" properties.

Some midstream MLPs do generate revenue that is tied to commodity prices, such as certain natural gas gathering and processing operators. However, we believe that most of these operators have been managing with prudent levels of excess cash flow coverage, reasonable leverage metrics, and/or have employed hedging techniques such that the impact of recent commodity price weakness should be manageable. However, we caution some within this subsector are more exposed to commodity price weakness than others.

Some late 2014 industry updates showcase the reduced commodity price sensitivity prevalent in the real world. For example, with the pullback in crude oil prices several larger gathering and processing focused MLPs highlighted that they expect only a very modest impact to revenues. Further, a number of other partnerships have also reaffirmed distribution growth guidance in light of the current commodity price environment. Such guidance demonstrates the shift to greater fee-based revenues many in the subsector have achieved in recent years.

Notably, in order to assess those assets that have revenues tied to commodity prices and to consider long-term volume expectations we do maintain a view on long-term commodity prices. In particular, we maintain our view that long-term crude oil prices are likely to average in a range of $75-to-$85 per barrel but caution that crude oil prices could trade in a materially higher or lower range for an extended period of time. Historically, we have assumed cyclical breaks should be expected to last for up to two years.

2015 Outlook

During 2014, MLPs, as measured by the Alerian MLP Index (AMZ), were up approximately 0.2%, and up [6.1% once distributions are considered. Midstream MLPs, as measured by the Alerian MLP Infrastructure Index (AMZI) were up approximately 2.0%, and 7.6% once distributions are considered. However, price performance over the year was more dramatic with a peak to trough price correction of 25.0% (August 29th to December 16th) as investor sentiment reacted to the uncertainty surrounding the broader energy sector.

Similarly, basic valuation metrics exhibited considerable variation over the period. The peak price-to-median distributable cash flow (p/dcf) metric hit 13.2x and the AMZ's implied yield narrowed to 5.2% on August 29th but exited the year at 11.2x and 6.0%, respectively.

We believe the price correction in crude oil, should it continue, will serve to moderate crude oil production growth rates in aggregate but that the impact for the majority of midstream focused MLPs will be modest. Further, after the sector's recent trading weakness we believe basic valuation metrics exited 2014 well within historical averages and provide an opportunity to earn a reasonable return on investment for those businesses positioned appropriately. Importantly, we believe that despite near-term price weakness and the likely moderation in growth trends for certain basins, the long-term production trends associated with the North American energy renaissance remain in place and are supportive of midstream assets generally.

It is also important to highlight that many businesses utilizing the MLP structure today are not related to energy infrastructure. A number of non-midstream businesses have entered the public markets utilizing the MLP structure. Clearly, an oil and gas producer, a refinery, or an oilfield services provider, whether organized as a corporation or MLP, will experience the underlying margin and business trends of those industries. Therefore, while we believe recent price weakness may represent an attractive entry point for those MLPs positioned to perform well despite recent commodity price weakness, investors should consider carefully the fundamental exposure presented by each specific MLP before committing capital.

About the author

Brian Watson, CFA, serves as a senior portfolio manager and director of MLP Research of Oppenheimer SteelPath MLP Funds. Prior to joining SteelPath in 2009, he was a portfolio manager and led the MLP research effort at Swank Capital LLC, in Dallas. He also covered the MLP and diversified energy sectors for RBC Capital Markets. Prior to this, Watson worked for Prudential Capital Group, helping to analyze, structure, and invest in debt private placements issued primarily by companies in the energy industry including those involved in oil field services, midstream services, and oil and gas exploration and production. He earned his BBA from the University of Texas at Austin and his MBA from the McCombs School of Business at the University of Texas at Austin. He is a CFA® charterholder.