Don’t Jump Into MLPs With Tepper Just Yet

Range-bound markets over the past year have made it difficult to earn good returns. Most investors haven’t made any money at all. And this reality has forced them to pile into high-yield products to make up the difference.

One popular area to reach for yield has been the energy space. The general belief is that crude has hit a bottom and that energy companies are now a safe bet. Especially with the dividends some of them are offering.

Billionaire hedge fund manager David Tepper is all over this theme. His interests lie specifically in Energy Transfer Partners (ETP) and Williams Partners (WPZ). Both these companies are master limited partnerships (MLPs) and both operate in midstream energy assets such as storage and pipelines.

For those unfamiliar with the energy space, the industry can be broken up into 3 segments:

  • Upstream: These are the exploration and production (E&P) companies that include drillers. They find and extract energy products.
  • Midstream: These are transportation companies that move raw product through their pipelines. It’s in this segment that we find our MLPs.
  • Downstream: The transportation companies move raw product to downstream companies that act as the processors and distributors of the final product. Refineries are in this segment.

If you take a look at Tepper’s latest 13F filing, his top buys are ETP and WPZ. Both these companies are also part of his most concentrated holdings. Tepper is betting big on the MLP theme.

Energy Transfer Partners (ETP) is an MLP that started with natural gas pipelines, but later expanded into natural gas liquids (NGLs), refined products, and also crude oil. It currently has a dividend yield of 11.49% — exactly the type of yield investors would love to earn.

Williams Partners (WPZ) is another MLP that’s focused on dry gas pipeline transport. It’s dividend yield is 10.82%, also pretty juicy.

With dividend yields like that, this play may seem like a no brainer, but there are actually significant risks. Both these MLP’s have credit ratings one level above junk status. The reason is because both are leveraged and have debt servicing costs to take care of. They’re exposed to energy prices. If prices drop too low, these companies will have a difficult time servicing their debt.

And being so close to junk status, another downgrade would have significant effects on their current cost of borrowing. A further increase in debt servicing costs would put pressure on their dividend, which would likely be first on the chopping block to pay off debt costs.

Tepper knows this. But the reason he’s still interested is that WPZ and ETP are currently in the middle of a merger. This merger would increase the odds that the combined company could maintain their dividend regardless of volatile energy prices.

The probability of the merger going through has recently increased. This is seen in the graph below depicting the spread between the share price of WPZ’s parent company and the value of the deal. A higher reading indicates that investors are less confident in a successful merger, while a lower reading suggests that the market is more confident in the merger’s success.

Wall Street Journal May 2016

This is all well and good, and a merger may make sense, but now is still not the right time to enter this trade.

A big part of this MLP thesis rests on the idea that energy prices have bottomed. But we don’t believe this is true. The bullish US dollar trend is still in tact. And because commodities are priced in dollars, a stronger dollar means lower commodity prices.

Just looking at the relationship between oil and the dollar, dollar strength has historically accounted for 30-50% of oil’s price movement. Take a look at the graph below. It isolates an estimate of the price of oil based only on demand. It then compares it to the real price of oil in the market. The gap you see between actual prices and demand exist because of the impact of USD strength.

WTI Crude Estimate Demand and Effect

As the dollar strengthens, commodities in general (including energy) will take another trip back to prior lows. The pain in the energy space is not over. The “blood in the streets” moment has yet to occur. There were not enough defaults and there are still too many companies hanging on by a thread. There needs to be another washout once energy prices drop again.

Some may argue that these MLPs should be protected because most of their exposure is in natural gas instead of oil and their position as midstream operators is not directly affected by energy prices. These points may be valid, but they don’t matter. This reasoning didn’t save MLPs in the recent energy downturn, and it won’t save them in the next one either.

Regardless of these MLP’s position, they tend to fall victim to the classic case of the baby being thrown out with the bathwater. When energy prices drop again, investors will bail on anything energy related. All the selling creates liquidity issues that force funds invested in these MLPs to exit their holdings. Their margin level restrictions trigger and they have to sell. MLPs end up getting dumped along with every other energy play.

MLPs may make a great investment down the line, but not right now. The dollar trend has to play itself out and there needs to be a bigger washout of energy companies. At that point we’ll be interested in jumping into MLPs for the long-term.

 

 

Don't buy MLPs

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Brandon Beylo

Value Investor

Brandon has been a professional investor focusing on value for over 13 years, spending his time in small to micro-cap companies, spin-offs, SPACs, and deep value liquidation situations. Over time, he’s developed a deeper understanding for what deep-value investing actually means, and refined his philosophy to include any business trading at a wild discount to what he thinks its worth in 3-5 years.

Brandon has a tenacious passion for investing, broad-based learning, and business. He previously worked for several leading investment firms before joining the team at Macro Ops. He lives by the famous Munger mantra of trying to get a little smarter each day.

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Founder and head macro trader at Macro Ops. Alex joined the US Marine Corps on his 18th birthday just one month after the 9/11 terrorist attacks. He subsequently spent a decade in the military. Serving in various capacities from scout sniper to interrogator and counterintelligence specialist. Following his military service, he worked as a contract intelligence professional for a number of US agencies (from the DIA to FBI) with a focus on counterintelligence and terrorist financing. He also spent time consulting for a tech company that specialized in building analytic software for finance and intelligence analysis.

After leaving the field of intelligence he went to work at a global macro hedge fund. He’s been professionally involved in markets since 2005, has consulted with a number of the leading names in the hedge fund space, and now manages his own family office while running Macro Ops. He’s published over 300 white papers on complex financial and macroeconomic topics, writes regularly about investment/market trends, and frequently speaks at conferences on trading and investing.

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