A Rare Opportunity for Income and Growth

Equity investors are most compelled by income and, to a lesser degree, momentum, earnings surprises, earnings and cash flow. The big income anomaly is the driving force of this rare and historic opportunity in Master Limited Partnerships (MLPs) and the reason for this series of four notes in two months.

From year-end through March 18^th, when oil prices collapsed, the Alerian Index had declined by 67.5%. Now MLP indexes are yielding in the mid-teens, Kayne Anderson MLP funds yield in the 20% to 30% range and individual MLPs like Energy Transfer LP (ET) and Antero Midstream Corporation (AM) yield 21.4% and 44.8%, respectively.

Extraordinarily high yields like these are often a sign of financial distress; however, in this case–with MLPs–it is not. Midstream MLP energy assets are high-quality defensible franchise assets that despite the stock market decline, oil price crash and impending severe recession should only experience a high single-digit average decline in their fee-based EBITDA. Further with distribution coverage of 1.58 for the Alerian index, distribution cuts on average will be modest. The opportunity here is in the exceptionally high yield supported by high-quality cash flows. To capitalize on this opportunity, one must understand the factors which have driven this decline in MLPs: MLPs have been hit by two Black Swans and a financial accident.

The chart below shows the MLP yield spread to 10-year Treasuries spiking to 18.55% on April 3^rd. As of April 17th, the spread between MLP yields and 10-year US Treasury notes was 15.9%. Relative to other MLP crashes, this spread is substantially higher than all others including the peak spread hit during the 2008 Financial Crisis. The chart below shows the MLP Treasury yield spread exceeding three standard deviations above normal.

MLP yields are extremely attractive compared to REITs, Utilities, S&P 500 as well as US Treasuries. As normalcy returns to the markets, money will flow to MLPs due to their exceptionally high yield. The chart below shows the yields for MLPs compared to other income alternatives.

Two unpredictable and severe events drove the record market decline and crash in MLP. First was the deadly Coronavirus, whose rapid spread has shut down cities, states and countries causing a record 35% decline in the S&P 500 in 32 days and a simultaneous rapid global recession. The second Black Swan started on March 9^th with a dispute between Saudi Arabia, Russia and the OPEC+ alliance leading to a 33% one-day oil price collapse resulting in oil prices that are near 18-year lows.

The charts below of the two Black Swans illustrate the severe declines in both crude oil and the S&P 500.

A financial “accident” is an event where computer programs or investment strategies temporarily overwhelm their normal market price discovery function in which humans decide prices by reacting to the news and trends of the day. A financial accident occurred during the crash of 1987 when “portfolio insurance” overwhelmed the stock market causing a historic 22% one day decline in the S&P 500. Another financial accident occurred in 1998 when Long Term Capital Management, a $126 billion dollar hedge fund which levered up its strategies nearly 100 times, imploded and risked the solvency in the global capital markets for several weeks. We believe a similar set of sophisticated strategies led to the extraordinary decline in MLP assets and current opportunities.Neither the stock market nor oil prices should materially impact MLPs’ cash flows or distribution profiles. However, in today’s information age, with computerized capital markets interlinked through indexes, ETFs, derivatives, and leverage, when the selling starts, a feedback loop of news, panic and selling can prompt more selling. These factors drove the 35% 32-day decline in the S&P 500 and five-week decline in oil.

There are three types of selling: regular selling, panicked selling and forced selling. Forced selling is typically margin call-related and is the most intense form of selling. Forced selling also creates the greatest bargains for those able to act. MLPs were subjected to unprecedented forced selling in March. This occurred because MLPs are stable high yield investments where a “carry trade” strategy was broadly used by institutions and individuals, carry tradetrading. MLPs offer high yields and interest rates are at historic low levels. This strategy is brilliant until a pair of Black Swans create a three standard deviation move that risk managers assumed would never happen. Since carried MLP strategies entail leverage or margin, the three standard deviation move in MLPs created forced selling, which fed on itself in a negative feedback loop. This forced selling is exactly what happened to Kayne Anderson and countless other professional institutions including Goldman Sachs where leveraged MLP strategies suffered massive forced selling and disastrous declines—even though the underlying securities should only see a modest decline in cash flows. This forced selling and liquidations have created exceptional value in fee-based midstream energy assets.

Herein lies the opportunity. Knowing the value of a security and not just the price is what creates investment opportunity.

MLPs are durable franchises because they provide a non-discretionary service. About 80% of MLP income is fee-based revenues based on volumes tied to the consumption of natural gas and oil which have relatively noncyclical volume consumption patterns. While there will be some decline in travel due to this recession, we do not expect to see high levels of distribution cuts as the distribution coverage ratio of the Alerian Index was 1.58 times in mid-March. Most industry EBITDA estimates are down less than 10%.Below is a list of top ten Alerian MLP Index constituent yields and market capitalizations. Their average yield is 13.85% with a $7.129 billion market capitalization.

The recent history for MLPs has been challenging. Since September 2014, the Alerian Index has declined by 86.8%. US fracking has made the United States a leading energy provider competitive with Saudi Arabia and Russia. This market share shift has led to two oil crashes.With excessive financing leverage used in the build-out of the US energy infrastructure, MLP returns have struggled with balance sheet deleveraging. Lastly, the rise in “ESG” Environment, Social and Corporate Governance investing has created selling in the US fossil fuel sector exemplified by “ESG divestitures.” These forces have added to the selling pressure which has culminated in the 67.5% decline in the MLP index and a 71.3% decline in oil this year.

Below is a six-year chart of the Alerian MLP Index reflecting 86.8% peak to trough decline.

Historically, market cycles and crashes have been characterized by spikes in volatility which are measured through option premiums. Option premiums are the amount investors will pay for portfolio protection. Option premiums can be tracked through the Chicago Board Option Exchange’s Volatility Index (^VIX). The recent spike in the VIX index shown in the chart below occurred simultaneously with the 35% decline in the S&P 500 which ended on March 23rd.

The VIX chart below shows that the recent spike in volatility rose to levels comparable with the 2008 Financial Crisis. Historically, spikes in the VIX and the MLP Treasury spread are concurrent and both revert to normalized historic levels in about one year.

Why Now?

Lastly, the two Black Swans which triggered this disaster are now in retreat. The corona virus has peaked and begun to decline in China and South Korea. Additionally, less restrictive Italy, New York and New Jersey have also seen a peak in the number of corona virus infections.

The article below suggests this leading pandemic model was off by a factor of 25x and the 2.2 million deaths estimated for the United States should be 88,000. This model was used by the CDC and FDA in their forecasting. Today, the US is estimating fewer than 60,000 deaths and the United States is reopening on a staggered basis.

The oil Black Swan is concluding, too. Russia, Saudi Arabia, OPEC+ and the United States have agreed to production cuts and now it is a matter of time until the supply glut is absorbed.

The S&P 500 bottomed on March 23rd. On April 3rd, the Fed Model recorded a near-record 5.58% risk premium showing that the stock market had not been that cheap since the 2008 Financial Crisis. Stocks were very cheap with the S&P 500 earnings yield 6.17% and 10-year US Treasury yielded 0.58%.Asset allocators have been selling bonds and buying stocks since the bottom and the S&P 500 is up 31.1%. Today, the S&P 500 earnings yield is 4.91%, 10-year US Treasuries yield 0.65% and the risk premium is 4.26%. S&P earnings are turning down. We are cautious on equities as terrible corporate earnings, guidance and mind-numbing unemployment rolls must be digested over the coming quarters.

The Fed Model which compares the earnings yield of the S&P 500 to the 10-year Treasury note yield. The chart below shows an MLP valuation model, like the Fed Model, of the yield differential between MLPs and the 10-year US Treasury note. As of April 17th, the MLP to 10-year US Treasury note yield spread is 15.9%. This MLP spread still exceeds the peak spread hit during the 2008 Financial Crisis. The chart below shows the spread widened by well over three standard deviations above normal which were the result of the industry carry trade forced liquidations.

Based on our experience through previous declines, MLP yields should return to their historic normal yield levels below 5%. The price implication for this sector is double or triple. Not only is the price appreciation extraordinary, but the yield profile is also one of the most compelling we have seen during our career for a group of stable business franchises.

Kayne Anderson MLP / Midstream Investment Company (KYN) share price $4.58 as of 4/17/2020.
NAV $5.37 14.7% discount. Yield 30.5% $1.44/4.58.Kayne Anderson Midstream / Energy Fund (KMF) share price $4.08 as of 4/17/2020.
NAV $4.83 15.5% discount. Yield 22.0% $0.90/4.08.

Both of these funds have had to reduce their leverage during this market rout. After they report their distributions on April 31, 2020, we will be reviewing their balance sheets to see if they are reinstituting the carry trade which is so compelling at current spreads. As closed-end funds, these securities can be held in retirement accounts which could be a tremendous opportunity in this low-interest rate environment.

The holdings of both funds are listed below.

There are many attractive MLPs at distressed prices. Two, in particular, we have been buying for clients.

Antero Midstream Corporation (AM), a natural gas operator focused on the Utica and Marcellus shales. AM just reported their quarterly $0.3075 distribution ($1.23 on an annualized basis). Based on Friday’s $3.52/share this is a 34.9% yield. Antero is benefitting from improving natural gas prices and could have tremendous upside given the growing demand for natural gas and fewer wells producing natural gas.

Energy Transfer Partners (ET) is one of the largest integrated MLPs with a $68.5 billion enterprise value and run by industry veteran Kelcy Warren. Energy Transfer is highly leveraged and on March 31 announced its $0.305 distribution ($1.22 on an annualized basis).
Based on Friday’s $6.16/share close, ET has a 19.8% yield.

Below are charts of KYN, KMF, AM and ET:

We have invested through the 1987 crash, 2000-2003, 2008-9, the 2016 Oil and MLP crash and studied each decline and recovery. Market crashes and financial accidents create extraordinary valuation opportunities.The sharpest MLP declines, before this current one, occurred in 2008 and 2016. Those MLP declines occurred concurrently with equity and oil market declines like the current crash. Those previous MLP bear markets rebounded with remarkable strength due to the yield spread compression typical of market normalization. We think these four investments each could double or triple. We have capitalized on this MLP scenario before and MLPs are an industry we have been investing in for nearly twenty years. This idea has compelling merit.