Invesco: The Case For Midstream Energy In An Alternative Portfolio

(Brian Watson, Invesco) Historically, midstream equities have outperformed other yielding equity sectors during periods of rising interest rates.

With inflation running high, investor anxiety over the potential impact of rising interest rates has begun to intensify. For midstream companies in particular, investors often wonder if the sector’s relatively high distribution or dividend yields tend to help or hurt performance during periods of rising rates. In summary, while there have been short-term periods of weakness in response to dramatic rate moves, we find that over long-term periods, midstream equities, specifically MLPs, have not demonstrated meaningful correlation to interest-rate changes.

Over the past fifteen years, there have now been six periods over which interest rates have increased by at least 100 basis points (bps):

In the wake of the 2008 financial crisis, the yield on the 10-year U.S Treasury increased by 190 bps. Over this period, MLP equities, as measured by the AMZ index, appreciated 29% while utilities and real estate investment trusts (REITs) declined 5% and 3%, respectively. Utilities and REITs are often cited as yielding equity-sector comparisons.

• From late 2010 to February 2011, the 10-year yield increased by 134 bps. Over this period, the AMZ appreciated 8% while utilities and REITs increased 3% and 8%, respectively.
• From June 2012 until September 2013, the 10-year yield increased by 154 bps. Over this period, the AMZ appreciated 10% while utilities and REITs each fell 2%.
• From July 2016 through the end of January 2017, the 10-yearyield increased by 123 bps. Over this period, the AMZ declined 3% while utilities and REITs declined by 8% and 9%, respectively.
• From September 2017 through October 2018 the 10-year yield increased by 118 bps. Over this period, the AMZ declined 1% while utilities and REITs declined 1% and 5%, respectively.
• And finally, from August 2020 to March 2021 the 10-year yield increased 122 basis points while the AMZ was up 27% while utilities rose 6% and REITs increased 15%.

Exhibit 1

Source: Bloomberg, United States Treasury and Invesco SteelPath as of 12/31/2021.

While the proclivity to compare interest rates and MLPs is natural given the yield component of each, we believe history reveals that MLP price performance over these periods is not necessarily dictated by the rate change. In fact, as demonstrated in the examples above, midstream equities have often performed well suggesting that the interplay between rate changes and the midstream sector is fairly weak or fleeting. In fact, MLP equities actually provided positive returns over four of the six periods examined. Interestingly, though utilities and REITs are often assumed to exhibit particular interest rate sensitivity, both sectors also exhibited price appreciation over some, though fewer, of the periods examined and delivered a modest 1.4% loss and 0.7% gain on average over these periods respectively. Though, we do caution that within some of these periods, there were short-lived stretches of broad market, as well as high-yield, equity price weakness. Overall, however, we believe this historical performance suggest yielding equities in general, and midstream equities in particular, may carry less interest rate sensitivity than often assumed.

Market trading trends aside, it is also worth noting that many midstream contracts include annual rate adjustments linked to inflation indexes such as the Producer Price Index (“PPI”) or the Consumer Price Index (“CPI”) which provide a direct and timely cash flow adjustment to changes in inflationary environments. Using the FERC Oil Pipeline Index as a proxy, which is linked to the Producer Price Index for Finished Goods, according to the analysts at Wolfe Research the preliminary data suggests FERC liquids pipelines are on track to affect a 9.7% rate increase in July 2022. Further the carryover impact of the elevated inflation of 2021 is pointing toward another 4.5% rate increase in July 2023 if the index holds steady from here, and more should inflation persist.

Historically, then, we believe there is little evidence to suggest rising interest rates pose a particular headwind to long-term midstream equity price performance. Further, we believe the greatest drivers of midstream sector performance in recent years have been energy market macro factors and individual company growth or balance sheet concerns. Importantly, we believe both of these influencing factors may be more stable than in years past.

Outlook

The commodity price backdrop today is very supportive of producer drilling activity while the current era of producer financial discipline is resulting in a relatively muted uptick in drilling activity. While producer discipline means US production growth is likely to be modest relative to today’s prices, we believe producer drilling and production plans will also remain fairly stable even if pricing were to move lower. We believe this energy macro backdrop is healthy for midstream companies.

Further, over the past several years, many energy midstream companies have been able to grow cash flows, reduce leverage, and are beginning to resume distribution growth. According to Wells Fargo, midstream free cash flow yields are set to reach 9.2% in 2022, compared to -1.5% back in 2018, and exceed 12% by 2026. Distribution coverage for 2022 is expected to average approximately 1.9x compared to 1.5x in 2018, while Debt-to-Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) multiples are expected to have fallen to 4.0x in 2022 from 4.4x in 2018.

Despite these macro and company fundamental improvements, midstream equities still trade at valuations substantially below the five- and ten-year averages. Therefore, we continue to believe the sector may provide investors an attractive yield and total return experience over the coming years despite the potential for a more volatile or rising rate environment.

Invesco is one of few global money management complexes with the scale to track MLPs and other segments of the alternative investment universe. You can review the full list of models HERE.