The energy master limited partnership (MLP) space has been quite tumultuous for the past few months as several negative and positive dynamics coalesced. On the one hand, speculation on the timing of the Federal Reserve’s “tapering” of its quantitative easing program has stoked concerns about rising interest rates, which has had a detrimental impact on all yield sensitive securities including MLPs, utilities and real estate investment trusts.

On the other hand, natural gas liquid (NGL) prices—under pressure for most of the year—rallied in the summertime, which helped to offset the macro concerns about interest rates and enabled MLPs to outperform relative to the other yield securities. However, MLPs have not fared as well as other subsectors of the energy market, which have benefited from the more steady gains in crude oil prices.

Macroeconomic headwinds

The 10-year U.S. Treasury note has already increased by more than 100 basis points this year in anticipation of the Federal Reserve’s decision to pare monetary stimulus, and this uptick has pressured all yield-related assets relative to the S&P 500. Despite the surprise decision by the Federal Reserve not to taper bond purchases at the latest policy meeting in September, the consensus is that the market is on the cusp of exiting an unprecedentedly long period of low interest rates—though the exact timing of a reversal is unknown.

The low-interest rate environment provided an accommodative backdrop for MLP expansion in several ways. First, cheap borrowing costs ensured that MLPs had easy access to the debt and equity markets, which is vital since they must often tap the public markets to finance growth since most of their own free cash flow is distributed to unitholders. Second, MLPs’ equity valuations have been supported given the backdrop of low interest rates as income-oriented investors flocked to this asset class for the distribution payments given the dearth of competitive-yield alternatives.

Therefore, valid concerns exist that as bond markets re-price in response to changing central bank policies, MLPs could face a pronounced correction due to a less attractive relative-yield spread valuation and higher cost of capital.

Interest rates have been declining for more than two decades, which is essentially the entire time span that MLPs have been in existence. As such, there are no historical comparisons for MLP performance in a sustained rising rate environment— but the effects may not prove as deleterious as feared if rates increase at a gradual, measured pace.

According to Wells Fargo research, on a month-to-month basis, MLPs are actually more strongly correlated to movements in the broader equity market (0.47 correlation to the S&P 500) and commodity prices (0.40 correlation to crude oil) than they are to the U.S. 10-year Treasury. That being said, for months in which the 10-year Treasury yield increased by more than 50 basis points, MLPs underperformed the S&P 500 by approximately 2%. In other words, MLPs are not significantly impacted by gradual movements in interest rates, but sharp changes in interest rates can materially affect MLP performance.

Sector-specific concerns

The dynamics of the NGL market have been shifting with the strength of developments from the Marcellus and emerging Utica plays. The Northeast is expected to become not only a key producing region, but also a potentially large exporter of dry natural gas and NGLs.

From a midstream perspective, the competition to provide a full suite of services to this region has been fierce: companies are committing capital—billions of dollars worth—earlier in the plays’ life cycle and more partnerships are getting involved. However, investors have been wondering about increased NGL pricing volatility within the Northeast relative to the Gulf Coast.

Raymond James estimates a total of 425,000 to 625,000 barrels per day of total NGL production for the Marcellus and Utica (assuming full ethane extraction), which would be enough to push Northeastern prices from a premium to a discount relative to prices at the Mount Belvieu, Texas, hub. And, as liquefied petroleum gas (LPG) export expansions mitigates the NGL oversupply situation in the Gulf Coast, northeastern producers might be incented to move northeastern NGLs to Mont Belvieu in order to achieve higher netbacks.

If this is the case, there may not be a need for multiple pipelines and storage options within the Northeast region and some of the recently announced projects may fall through as MLPs potentially run the risk of overbuilding.

Recent macro headwinds and sector uncertainties aside, the fundamental investment thesis regarding energy MLPs remains bullish—burgeoning U.S. crude oil, gas and NGLs production supports greater need for processing, transportation and storage infrastructure. However in the shorter term, with MLPs trading at premium valuations relative to historical trends, the market might continue to be skittish.

MLPs, particularly those that are lower yielding, will likely fall prey to profit-taking amid knee-jerk reactions by some investors to get ahead of any sustainable movement by the central bank and given the fluidity of the constantly evolving NGL market.

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