Coronavirus and OPEC Black Swans Create Rare 1987-like Opportunity in MLPs

Market decline of 33% on par with 1987.
•    MLP Treasury spreads at historic levels.
•    MLPs have stable cash flows.
•    KYN looks especially attractive with 41% yield and 21% discount to NAV.

The continued worsening news due to COVID-19 and Oil prices have led to generational declines in the stock and oil markets. Like 1987, and other major declines, rare opportunities to buy distressed mispriced securities are at hand. This week saw positive news regarding COVID-19 and Oil Prices, which paused the rapid declines in both the S&P 500 and oil; the feedback loop of bad news and computerized selling halted and created an inflection point in this global market meltdown. This inflection point in the market’s rate of decline suggests the beginnings of a market bottom and an opportunity for those steely nerved investors.

Kayne Anderson Midstream MLP Company—KYN with a discount to NAV of 21% and 41% yield and Kayne Anderson Midstream Energy Fund—KMF with a discount to NAV of 30.5% and 43% yield offer compelling risk-return potential.

The S&P 500 dropped 33% in one month.

Source: Interactive Brokers TraderWorkstation

This is the fastest decline of any in history. Faster than 1929, 1987, 2008…

Source: ClearBridge Investments

Hopeful News: COVID-19 and OPEC

The global response to COVID-19 is providing multiple avenues of a possible cure for the virus. Hydroxyquinoline news is one of several promising antidotes or solutions which is helping to create the hope that this virus will be conquered. With the total number of deaths from COVID-19 across the world having surpassed 10,000 and the total number of confirmed COVID-19 cases across the globe standing at 244,000, the simple fact that progress is being made fighting this virus improves the probabilities for a resolution to this health crisis, turning panic to calm.COVID-19 has run its course in Wuhan, China. This fact provides hope, medical data and statistics to stop its spread and to lessen its impact. Likewise, South Korea took rapid intrusive measures and they have worked.

Safe distancing protocols are slowing the spread of COVID-19.

Last week witnessed the engagement of the United States in the OPEC oil crisis with the Texas Railroad Commission to meet with Saudi Arabian and Russian counterparts to stabilize oil’s price. US oil production has been a significant economic engine, and the current OPEC spat threatens to bankrupt many oil companies adding to the economic slowdown caused by COVID-19.

The Oil rally was spurred on after Donald Trump said he will intervene in the global price at an “appropriate time” – Russia also said on Thursday that it won’t back down to Saudi “blackmail”.  The Texas Railroad Commissioner came out yesterday – “The Texas Railroad Commission, which regulates oil and gas production in the state, has the authority to set pro-rationing schedules, thereby limiting production for Texas producers. That power has not been used since 1973. In theory, Texas could cut production by 10%, and if Saudi Arabia is willing to cut production by 10% from its pre-pandemic levels and Russia is willing to do the same, it would return the market to pre-crisis levels (and only somewhat oversupplied)”  SPX and Oil moving almost in lockstep

Both COVID-19 and the decline in oil are problems that will be resolved in time. Consequently, timing the market’s bottom is the key market issue. When the US bends the curve on COVID-19 and or OPEC rebalances market shares, global markets will begin to normalize. This week’s news changed the trajectory of the stock and oil market declines, which slowed the negative feedback loop of bad news and market panic.

Both COVID-19 and the decline in oil are problems that will be resolved in time. Consequently, timing the market’s bottom is the key market issue. When the US bends the curve on COVID-19 and or OPEC rebalances market shares, global markets will begin to normalize. This week’s news changed the trajectory of the stock and oil market declines, which slowed the negative feedback loop of bad news and market panic.

The MLP Analysis:

Income Growth Advisors, LLC “IGA” advocated buying dips in the MLP market in 2008 and 2016. We are recommending buying these aberrantly high yield securities again. The underlying cash flows of MLPs have nominal correlation to oil prices and their distributions or dividends are relatively safe.

MLPs (midstream fee-based operators) offer exceptionally high yields which are aggressively sought by yield chasing investors. These two closed-end MLP funds–KYN and KMF–are fundamentally cheap and should improve significantly.
Kayne Anderson Midstream MLP Company–KYN–closed at $3.49 with a $4.47 Net Asset Value (NAV)

  • 21% discount to NAV
  • Yield $0.12/month times 12= $1.44
  • $1.44/3.49 yield 41%

KMF Kayne Anderson Midstream Energy Fund—KMF—closed at $2.50 with a 3.60 NAV

  • 30.5% discount to NAV
  • Yield $0.09/month or $1.08/yr
  • $1.08/ 2.50 43% yield
Both KYN and KMF saw a 95% price drop in the last 30 days, before doubling of their bottoms March 18th, 2020. Should they return to yields of 9%, these funds could nearly triple, before you count the 40% yields.

Source Yahoo Finance.

In market crises, MLPs are often subject to deleveraging, quantitative, ETF, index and indiscriminate selling. Kayne Anderson reported MLP sales, risk mitigation and distribution coverage actions to reduce leverage in KYN and KMF and maintain their high yields. Goldman Sachs also unwound some leveraged MLP strategies.

It this institutional de-risking that has caused the extreme pressure on the MLP sector, this opportunity and valuation level. These factors led to the extraordinarily low prices in these predictable high yield investments. The MLP sector should improve from these extreme oversold levels.

The charts below illustrate that MLPs have had severe sell-offs in the past, often occurring in conjunction with stock and oil market plunges. Since the buyers of KMF and KYN will be yield seekers, these investors are not forecasting the same earning and economic risks that challenge common stock investments. It is the unique combination of earnings quality and high yield that will drive the sharp returns in MLPs following this decline.

Off the 2008 low, the MLP index rose 385% or 44.9% for over three years. Off the 2016 low, MLPs returned 77%. The returns below are very attractive and correlate with yield normalizations.
Because the demand for energy is relatively constant, the cash flows from fees from midstream assets are stable. Since the 2016 oil bear market, MLPs have reduced their leverage. Further, while some drillers will close due to this oil collapse, sector-wide we anticipate only a single-digit decline in cash flows from this shock. High MLP yields will be bought aggressively by those understanding the risk implied by their current prices is inaccurate. Even with an economic recession, domestic energy consumption is unlikely to fall by double digits.

Goldman Sach’s March 12, 2020 estimate of a modest single-digit decline in EBITDA is reasonably accurate. “If the oil dispute is resolved in 2020, we would expect a modest mid-single-digit reduction in EBITDA, whereas a prolonged market share battle could see incremental profits fall 20% cumulatively, as they did over the course of 2015 and 2016.” Combined with the high average distribution coverage in the MLP sector of 1.58, distribution or dividend cuts are generally unlikely for the midstream MLP sector.

Another valuable MLP market indicator is the yield spread between MLPs and 10-year US Treasuries. It has been very effective in identifying MLPs’ market bottoms and yield opportunities. The chart below shows the extreme and historic oversold conditions today.

The databox below shows the risk premium in 2008, 2000, 2012 and today of 7.15%, 6.61%, 6.61% and 5.38%, respectively. The risk premium is the difference between the earnings yield of the S&P 500 and the 10 year US Treasury yield. The earnings yield measures how much earnings is generated by a dollar’s worth of the S&P 500. Today the S&P 500 earnings yield is 6.33%. In 2008, 2009 and 2012, the databox below shows it was 10.32%, 9.44%, 8.18%.

These MLP market factors suggest that the MLP market is at lows and all the forced liquidation is complete.

Historic market panics like this offer a rare opportunity for those investors who can distinguish between the price of an investment and the value of that investment. We see an unusual opportunity in MLPs and are buying diversified MLP funds KYN and KMF for our clients. Their distribution coverage, cash flow stability, and risk mitigation through a diversified portfolio provides an unprecedented risk to reward proposition of 100-300% to informed investors.

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The information expressed on our website is based upon the interpretation of available data. The data being presented was obtained or derived from sources believed to be accurate, but Tyson Halsey and Income Growth Advisors, LLC

(IGA) cannot and does not guarantee the accuracy of these sources which may be incomplete and/or condensed. The data and information presented is provided for informational purposes only, and is not offered as a basis for trading in securities nor is it offered for that purpose.

Nothing contained herein should be construed as a recommendation to buy or sell any securities.

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