The balance between supply and demand of MLP paper has always been delicate. In the past it was a balance between perpetually growing inflows and equity issuance. There were times when equity offerings temporarily overwhelmed investor appetite for MLPs. But as liquidity has diminished in recent years, the structural risks to this group to a stampede to the exits grew larger.
Thin and Getting Thinner, With a Long Tail
A few years ago, we raised concerns over how concentrated MLPs had become at the top, in a paper and blog post that referenced the “Elephants in the Room”. The basic idea being that because of consolidation, corporatization and rationalization, there was too much concentration for the group to be considered a sector on its own.
We also called into question the ability of active managers dedicated to this group to produce alpha in an environment when they had to hold as much of the biggest names they could, regardless of their individual outlook.
Fast forward to today, and it has only gotten worse. The chart below breaks down how much of the daily trading liquidity the top 5 largest MLPs and midstream corporations represent of the U.S. universe. For MLPs, the top 5 represent more than 70% and for the broader universe, the top 5 represent 60%. In other words, it’s very top heavy.
The chart below includes all midstream MLPs and U.S. corporations with more than $250mm market capitalization. There are 8 with more than $50mm in daily trading value.
Doing some simple math. Say you manage $5bn in this sector and you have 5% of your portfolio ($250mm) in a name that trades $50mm in a day. If you represent 20% of volume in that stock, it would take you 25 trading days to get out of a position without too much friction. But you are forced to own each of those 8 stocks and probably bigger positions than you should in the lower liquidity names.
When several managers and funds do that, and there is an event like we experienced the last few weeks, there just is not enough liquidity to keep up with the selling.
The number of midstream companies with more than $2bn in market cap is down from 62 in 2014 to just 21 after last week’s carnage.
So, when considering the potential recovery of this group of stocks, think about where the next influx of capital comes from. Consider the likelihood of institutional investors making midstream-specific allocations. What allocator is going to look at the size of this group, the recent (and not so recent) volatility, and choose to make or increase an allocation?
It doesn’t seem likely. The recovery of midstream will need to come from the ground up. Retail investors need to return. Given the next round of distribution and dividend cuts coming this year, it feels unlikely they get too excited in the near-term.
When the forced selling abates and perhaps after there is a rally in oil prices and energy stocks, MLPs and Midstream should see a substantial bounce from very oversold levels. Perhaps value investors enter and help put a floor into the sector, maybe it’s a private equity bid that draws some interest back. However, as opportunities to develop new assets dwindles, it is more likely that we see the stronger midstream companies survive as others continue to fall by the wayside in a lengthy weeding out process. In the end, there will be a small number of very strong midstream companies.
With so few companies from which to choose, there will no longer be a need for midstream and MLP-dedicated fund products and asset managers to invest in them. Their rationalization was hastened by last week’s pain.
Other areas of real assets have exhibited lower volatility and higher returns over the long-term, including REITs and Infrastructure. We wrote earlier this year about global listed infrastructure as the solution to those seeking refuge from midstream exposure, in a post titled “Infrastructure Delivers“. Infrastructure has exhibited higher than normal volatility in the last few weeks, which we believe offers a compelling opportunity for investors who have hesitated due to performance and valuation concerns.
While stock prices have changed for infrastructure stocks along with the rest of the equity market, the reasons for owning infrastructure have not changed. Those include: