Months before commodity prices shed their aura of invincibility and broke our hearts last fall, Bobby Tudor, chairman and CEO of energy investment and merchant bank Tudor, Pickering, Holt & Co. LLC, addressed the precarious nature of MLP investing.
“You need to remember that these securities still are held by a majority of retail investors as opposed to institutions,” he said during an infrastructure panel discussion at IHS CERAWeek in March 2014. “Very often, it’s a doctor or dentist in Omaha and, frankly, they don’t really understand what a gas processing plant is, but what they do understand is whether they receive their dividend check in the mail
every month.”
Investing involves risk, which comes with the territory for money pros like Tudor, but may not be tolerable for less sophisticated investors. Boardwalk Pipeline Partners LP’s decision last year to lower its distribution, which turned out to be a savvy strategic move, resulted in its unit price being drilled without benefit of Novocain—a loss of 46% on one cold, harsh February Monday.

“There are a lot of challenges in the MLP market,” Tudor said at the time.“We’ve been through a remarkable period in which they’ve worked really, really well, and it just strikes us as it’s likely to be harder going forward than easier.”

A year later, Morgan Stanley’s analysts reiterated that warning to any investors still unwilling to concede that a barrel of crude priced at $120 is not waiting for them in the next quarterly earnings summary.

“We think the MLP industry faces a changing landscape—or at least a period of recalibration—as a result of fundamental changes in the domestic upstream business,” they wrote in their recent “Midstream Energy Playbook.” Sure, oil prices are up around 25% from their low points, but Morgan Stanley dismisses that surge as a side effect of the expectation of declining volume.

“Regardless of what growth trajectory one may expect, the risk-adjusted growth has gone down,” it said.
That’s because hydrocarbons have to be extracted before they can be moved or processed, and producers are struggling. Morgan Stanley’s report hints at concerns that may be deeper than have been acknowledged and the magnitude of necessary recalibration in the upstream sector has not been fully accepted.

Noting that Rystad Energy AS cut its 2014 to 2017 production forecast for major U.S. shale basins from a 16.5% compound annual growth rate to 8.4%, the analysts projected that E&Ps will need to accelerate their capital expenditures later in this decade to offset declines on newly drilled wells. “However, efforts to reaccelerate growth could be challenged,” it wrote. “Capex levels will need to approach levels only modestly below those forecast before the OPEC meeting last November while production is expected to lag initial 2020 expectations by more than 7%.”

For the midstream, Morgan Stanley’s advice equates to tough love: get real.

“We believe midstream companies will need to reassess the viability of their backlogs (at least in the short term),” the analysts state. Ouch. Illusions be gone.

“Year-to-date we have only seen a handful of midstream projects suspended or be removed from a company’s backlog (most projects remain place-holders),” the analysts wrote. “Within that, we have seen only marginal processing plants or commodity-exposed investments (CO2, splitters) move out of the backlog, creating the risk that more meaningful, large-scale projects may need to be reconsidered (i.e., timing, scale) and/or projects are further delayed in order to better adapt to slower production growth expectations.”

This is not a negative view, just a realistic one. The midstream business model that succeeded spectacularly during an upturn is stumbling a bit during a downturn, part of the maturing process as the sector transitions from early innings to middle innings. It means that not all of the players are sure bets anymore.
“We believe investors need to stay involved,” Morgan Stanley concluded, “but stay selective and monitor the risks.”
That’s how money pros handle investments, but the approach might entail too much work and too much risk for doctors and dentists in Omaha. To invest during this downturn, even a cardiologist with disposable income needs a strong heart.

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