Last week a Federal Energy Regulatory Commission (FERC) ruling sent the MLP and energy infrastructure stocks into a tailspin. The news release caused an immediate 10% drop in the MLP indexes. Prices recovered to close at a 5% decline. A closer read of the facts shows the fears were overblown and this steep drop may end up in hindsight as the MLP sector’s equivalent of the March 2009 bottom of the last stock bear market.
Here is the scary headline from Bloomberg:
Pipeline Stocks Plunge After FERC Kills Key Income-Tax Allowance
The reality is that the ruling only applies to interstate (not intrastate, which is most pipeline miles) pipelines and to just one of the methods a pipeline company can use to set interstate transport rates. Here is how large cap MLP Magellan Midstream Partners, L.P. (NYSE: MMP) explains the effect of the FERC ruling on its business:
“Although Magellan is organized as an MLP, it does not have cost-of-service rates that would be directly impacted by this policy change. Rather, the rates on approximately 40% of the shipments on Magellan’s refined products pipeline system are regulated by the FERC primarily through an index methodology. As an alternative to cost-of-service or index-based rates, interstate pipeline companies may establish rates by obtaining authority to charge market-based rates in competitive markets or by negotiation with unaffiliated shippers. Approximately 60% of Magellan’s refined products pipeline system’s markets are either subject to regulations by the related state or approved for market-based rates by the FERC. In addition, most of the tariffs on Magellan’s crude oil pipelines are established by negotiated rates that generally provide for annual adjustments in line with changes in the FERC index, subject to certain modifications.”
Numerous other large cap MLPs and corporate pipeline companies have issued press releases to state that their business results will not be affected by the FERC ruling. It appears that few pipelines have rates set using the “cost of service” rules.
Related: A High-Yield Stock That’s Better at 15% Than One at 20%
In the bigger picture, MLP values have been falling since late January. Over the same period companies in the sector reported 2017 fourth quarter results that were very positive. MLP fundamentals have been improving for several quarters, and the trend will continue as North American oil and gas production continues to grow.
15 MLPs in the Alerian MLP Infrastructure Index raised distributions and the other 10 kept them level. There were no reductions. This combination of falling market values against strong fundamentals reminds me very much of the bottom of the last bear market which occurred in March 2009. At that time, it seemed that nothing would stop the market decline. In hindsight that point in time was when stocks reached what I politely call “stupidly cheap” prices. Currently quality MLPs look “stupidly cheap.”
Here are the bear market charts of the SPDR S&P 500 ETF (NYSE: SPY) for the 2007 to 2009 bear market compared to the Alerian MLP ETF (NYSE: AMLP) bear market which started in February 2017. If MLPs form a bottom here, the pattern points to significant gains over the next few years.
If you own quality MLPs that have fallen in value, it is a good time to add more to your positions. In my Dividend Hunter newsletter, my primary MLP recommendation is the InfraCap MLP ETF (NYSE: AMZA). This ETF pays monthly dividends which benefit from option selling by the fund managers. After the big FERC fueled drop, AMZA yields over 17%.
At the top of the list of steel stocks to avoid is U.S. Steel (NYSE: X), which saddens me because my grandfather used to work for the company.
The second stock on the no-touch list is AK Steel Holding (NYSE: AKS). Like U.S. Steel, it faces planned maintenance outages in some facilities, affecting production. The company recorded outage costs of $85 million in 2017 and in 2018, it expects expenses associated with planned outages to be about $50 million.
Finally, a broad way to play the chronic overcapacity in the global steel industry is through an exchange traded fund – the VanEck Vectors Steel ETF (NYSE: SLX).
That’s bad news for big, multinational U.S. automakers like Ford Motor Co. (NYSE: F).
An ETF owns shares of stock to match the components of a specific stock index. For example, the SPDR S&P 500 ETF (NYSE: SPY) owns the 500 stocks in the same proportion as tracked by the Standard & Poor’s 500 stock index. The financial products industry has gone nuts with the development of new indexes to carve up the market into sectors and ETFs to track them. Currently there are over 2,000 ETFs listed in the U.S. The majority —78% of assets—of ETFs are based on stock market indexes. Those assets total over $2.4 trillion. ETF trading has become a very big part of what goes on in the stock markets.
There are two ways ETF action can affect the share values of individual stocks. The most obvious and easy to discern is when the weighting of a stock in an index is changed. One high yield example is Energy Transfer Partners LP (NYSE: ETP), a large cap master limited partnership, commonly abbreviated as MLP. In April 2017 ETP completed a merger with Sunoco Logistics Partners LP, another MLP that was a large component of MLP indexes. Because of the merger, ETFs and index funds tracking MLP indexes were forced to sell significant portions of their ETP holdings to bring the size of the positions down to match the index weightings. This merger was the start of a year long decline in the ETP unit value. Later in 2017, Alerian, the provider of the most popular MLP tracking indexes, changed its methodology to cap Alerian MLP Index constituents to a 10% weight. At that time, ETP’s weight was much higher than 10% in the index, so index tracking funds were again forced to sell ETP units, regardless of investment merit. These forced sales of ETP are the source of much of the 25% value decline over the past year. The company’s fundamentals have been steadily improving, but you could not tell by the market price. ETP currently yields 12.5%.
A subtler effect of the ETF boom is that trading of these funds leads to lack of discrimination between the financial results and business prospects. Stocks get lumped together into the ETFs that track specific market sectors. It is tough to figure out whether stock share prices and ETF trading are a chicken and egg dilemma, but it is becoming clearer that increases in ETF trading are tightening correlations, or the tendency for individual stocks and sectors to move up or down in lock step, regardless of a company’s fundamentals. While ETFs account for about 8% of the U.S. stock market value, ETFs are the source of more than 25% of the trading volume. Market observation clearly shows that share prices are greatly affected by short term sector switching by traders. The iShares Mortgage Real Estate ETF (NYSE: REM) provides a couple of examples. Most of the 30 or so stocks in this ETF own leveraged portfolios of residential mortgage backed securities, MBS in industry parlance. This business model is a dangerous game of lending long and borrowing short. This is a group of companies whose finances can be destroyed by a quick change in the yield curve. I recommend against owning any residential MBS focused REITs.
In contrast, the third and fourth heavily weighted stocks in REM are solid companies with business operations that are sustainable through market cycles. In contrast to the rest of the REM portfolio stocks, these two will do even better when short term rates rise. Starwood Property Trust, Inc. (NYSE: STWD) and New Residential Investment Corp (NYSE: NRZ) are very attractive stocks with share prices that have trouble escaping from the trading in REM. STWD currently yields 9% and NRZ is over 11%.
