Wells Fargo & Co. is warning its wealth management clients that the allure of cheap, high-yielding energy master limited partnerships could ensnare them amid a shakeout poised to pick up almost two years after oil's plunge.
MLPs, which include pipeline operators and other energy infrastructure companies, began diverging last summer into a financially stronger group positioned to muddle through the commodities slump and another that's imperiled by it, according to Wells Fargo Investment Institute, the registered investment advisory arm of the bank's wealth and investment management division.
Financial advisers and their clients should steer clear from the bottom half of what's become a bifurcated MLP market, according to John LaForge, head of real asset strategy at Wells Fargo Investment Institute. The fallout from the oil bust that began in mid-2014 has already burned and fooled many investors, and barring a sustained jump in prices, more pain may be ahead.
“This is survival time as an investor — not just company-wise,” said Mr. LaForge. “Commodities run in these long super-cycles. When they finally do crack there's bifurcation among the types of names you want to own.”
The widening divergence in the financial strength of energy MLPs is a sign that investors should be aware that their dividends may dry up, or worse, some of the pipeline operators they invest in could fail, according to Mr. LaForge. Citing Ned Davis Research, he said he's evaluated their financial strength based how much cash flow they have to spend on the maintenance of energy infrastructure such as pipelines and storage tanks as well as for investor payouts.
“The quality names tend to be larger-cap, they tend to have plenty of reserve to pay their dividend, and possibly increase their dividend,” said Mr. LaForge.
The cash flow of some MLPs may become squeezed as their customers, which include exploration and production companies, struggle to pay them what's owed under contract as their own cash flows are hurt by the industry downturn, he said. MLPs with heavy debt loads may be even more vulnerable because they may find it difficult to meet interest payments.
“They might have great assets, but if their customers are unable to pay or have to renegotiate their contract, investors will recalculate what they are willing to pay for an MLP,” said Mr. LaForge, who noted the average bear market for commodities prices is 20 years.
The Alerian MLP index, which tracks the biggest energy infrastructure partnerships, has lost almost 7% this year through April 1, compared with a 35% loss in 2015 and an almost 6% gain in 2014. The top five companies in the index include Enterprise Products Partners, Magellan Midstream Partners, Energy Transfer Partners, Buckeye Partners and Plains All American Pipeline, Alerian's website shows.
With U.S. oil prices down about 65% from June 2014, the month they reached about $107 a barrel, the commodities slump is still playing out. Some individual investors took steps just this year to file claims against their advisers with the Financial Industry Regulatory Authority Inc. because of the toll the slump has taken on their nest eggs as they were over-exposed to oil and gas.
“You might get significant bounces” in oil prices, but it could take a decade before they return to levels seen in June 2014, Mr. LaForge said. “You get stuck in this lower range as you work excess off production from the bull-market.”
In other words, don't be too quick to embrace a rally.
“You can pick over MLPs now that it looks like oil has found its major low, but just make sure that you buy quality," Mr. LaForge said.