Answering Client Questions About Energy Income Assets

Interest rates and dividend yields low, but oil prices are soaring, lifting the energy sector to the top spot this year among the 11 sectors tracked by the S&P 500.

In other words, 2021 is a perfect storm for master limited partnerships (MLPs). Like real estate investment trusts (REITs), MLPs enjoy certain tax benefits and as a result energy infrastructure or midstream assets – equivalent terms for MLP – sport hefty yields. The Alerian MLP Infrastructure Index, a widely followed benchmark of MLPs, has a dividend yield of 7.58% as of Oct. 4. That's nearly six times what investors earn on 10-year Treasuries and the the S&P 500.

So it's no wonder some income-starved investors are fond of MLPs. Advisors familiar with MLPs know something about the asset class beyond the high-yield reputation. Allegedly, midstream energy assets are not as tightly correlated to oil and natural gas prices as are integrated oil companies or exploration and production enterprises.

In theory, that stands to reason because midstream energy companies are primarily engaged in the processing, storage and transportation of oil and natural gas. Those commodities need to be processed or move along to end markets regardless of price. Sounds like a good deal for everyone involved, including clients that want income without the volatility that's often associated with the old guard energy sector.

However, there are instances of MLPs following the traditional energy sector lower when oil bear markets arrive. For example, the Alerian MLP Infrastructure Index tumbled 32.2% last year when the coronavirus pandemic plagued oil markets. That's barely better than 32.5% shed by the S&P 500 Energy Index and hardly the definition of “low correlation.”

Correlation Conundrum? Maybe Not.

Advisors should be seeking avenues to reduce correlations in client portfolios, but it's a delicate balancing act when adding income to the mix. Good news: The correlation for midstream energy isn't dead, it's merely a matter of perspective.

Historical data indicate that on a weekly basis, a midstream benchmark such as the Alerian MLP Infrastructure Index has a correlation of 0.5 to oil prices, but that figure rises to 0.6 to 0.7 on a monthly basis.

“Relative to other energy sectors, midstream would be expected to have a lower long-term oil correlation given its fee-based business model and the direct commodity price exposure inherent in exploration and production (E&P) or oilfield services (OS) companies. In other words, the long-term correlation data tends to align with expectations,” notes Alerian analyst Stacey Morris.

The Alerian MLP Infrastructure Index has a 10-year monthly correlation of 0.69 to West Texas Intermediate crude prices. That's not low per se, but its lower than the average correlation of 0.8 for broader energy, exploration and production and oil services indexes.

This is why advisors are important in the MLP equation. It's likely that many clients know about the income proposition and some might be aware of the lower correlations, but advisors can help mitigate disappointment by imparting upon clients that when it comes to correlations, there's a massive difference between “low” and “no.”

Tempering Frustration

For midstream investors frustrated by perceived oil correlations, actual correlations and performance may not be as bad as it 'feels' when viewed within the context of other energy indexes,” adds Alerian's Morris. “Midstream/MLPs have outperformed broad energy (IXE Index) in oil’s recovery despite a lower correlation with oil prices. Of course, total return for midstream and MLPs has been even more competitive given generous dividends. Any standalone comparison between oil prices and midstream/MLPs will leave investors feeling short-changed, but in the context of energy performance more broadly, midstream/MLP investors can take some comfort in relative price performance since the pandemic.”

At the end of the day, the best way of framing MLPs for clients is that this is an income-generating asset with sensitivity to oil prices, but the upside and downside participation with crude gyrations isn't 100%. Advisors would do well to head of correlation disappointment with MLP-inquistive clients and focus on the income and improving balance sheets in the industry.

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