Master limited partnerships (MLPs), as measured by the Alerian MLP Index (AMZ), ended May up 3.5% on a price basis, and up 5.0% once distributions are considered. The AMZ results outperformed the S&P 500 Index’s 2.4% total return for the month. The best-performing MLP subsector for May was the Gathering and Processing group, while the Natural Gas Pipeline subsector generated the weakest returns, on average.

For the year through May, the AMZ is down 2.9% on a price basis, resulting in a 0.9% total return gain. This compares to the S&P 500 Index’s 1.2% and 2.0% price and total return losses, respectively. The Upstream group has produced the best average total return year-to-date, while the Natural Gas Pipeline subsector has lagged.

MLP yield spreads, as measured by the AMZ yield relative to the 10-Year U.S. Treasury bond, narrowed by 21 basis points (bps) over the month, exiting the period at 512 bps. This compares to the trailing five-year average spread of 472 bps and the average spread since 2000 of approximately 365 bps. The AMZ-indicated distribution that the yield at month-end was 8.0%.

Midstream MLPs and affiliates raised $0.2 billion of marketed new equity (common and preferred, excluding at-the-market programs) and $0.8 billion of marketed debt during the month. MLPs and affiliates announced approximately $1.7 billion of asset acquisitions during May.

Spot West Texas Intermediate (WTI) crude oil exited the month at $67.04 per barrel, down 2.2% over the period and 38.7% higher year-over-year. Spot natural gas prices ended May at $2.89 per million British thermal units (MMBtu), up 5.0% over the prior month and 3.8% lower than May 2017. Natural gas liquids (NGL) pricing at Mont Belvieu exited the month at $34.51 per barrel, 3.3% higher than the end of April and 45.3% higher than one year ago.

News

Simplifications Abound. The Williams and Enbridge families of entities each announced simplification transactions during May. Williams (NYSE: WMB) announced an agreement to acquire all of the outstanding public common units of Williams Partners (NYSE: WPZ) in an all stock-for-unit transaction valued at $10.5 billion. Separately, Enbridge (NYSE: ENB) announced proposals to buy-in all of its sponsored vehicles, Spectra Energy Partners (NYSE: SEP), Enbridge Energy Partners (NYSE: EEP), Enbridge Energy Management (NYSE: EEQ), and Enbridge Income Fund Holdings Inc. (TSX: ENF). The proposed exchange ratios reflect a value for all of the publicly held equity securities of the sponsored vehicles of C$11.4 billion.

Organic Growth Project Announcements Continue. Numerous organic growth projects were announced in May. Magellan Midstream Partners (NYSE: MMP) announced plans for a new refined products pipeline, DCP Midstream (NYSE: DCP) announced plans to further expand natural gas processing capacity in the DJ Basin, Blueknight Energy Partners (NYSE: BKEP), alongside partners Kingfisher Midstream (private) and Ergon (private), reported agreements to construct a new crude oil pipeline to service the Sooner Trend, Anadarko Basin, Canadian and Kingfisher Counties (STACK) play in Oklahoma, and EPIC Midstream Holdings (private) partnered with Apache (NYSE: APA), Noble Energy (NYSE: NBL), and Noble Midstream Partners (NYSE: NBLX) to move forward with a pipeline that will transport crude oil from the Permian basin to Corpus Christi, TX.

First-Quarter Earnings Season Concludes. First-quarter reporting season was mostly complete by the end of May. Through month-end, 71 midstream entities had announced distributions for the quarter, including 37 distribution increases, four reductions, and 30 distributions that were unchanged from the previous quarter. Through the end of May, 69 sector participants had reported first-quarter financial results. Operating performance has been, on average, better than expected with EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization, coming in 1.9% higher than consensus estimates and 3.8% higher than the preceding quarter.

Thought of the Month: No One Needs Crude Oil in the Middle of West Texas

Crude oil priced at Midland, Texas, is currently trading at about $55 per barrel, approximately $20 per barrel below the $75 per barrel global price of crude, as represented by the Brent crude oil benchmark. Crude oil priced at Cushing, Oklahoma, the most visible U.S. pricing point, is now close to $10 per barrel below Brent prices. These “basis blowouts” reinforce a simple truth that is sometimes forgotten; no one needs crude oil in the middle of West Texas. Instead, people need gasoline or diesel at the filing station down the street or jet fuel at the airport, and it takes a large, complex network of energy infrastructure to make that happen.

What Happened?

As a result of much-improved drilling techniques and cost-control measures, some producers are achieving well economics today that rival results prior to the 2014 price collapse. With these improved economics, drilling activity has rebounded. In particular, producers have significantly increased activity in the Permian basin because of the scale and quality of the resource. In fact, the pace of the Permian’s volume ramp has exceeded even the most aggressive of previous industry predictions and appears set to overwhelm the energy infrastructure capacity for bringing that crude out of the basin.

While there are multiple new-build pipelines and expansions in progress, the long construction times required for these projects mean that meaningful relief is unlikely to come until mid-2019, at the earliest. These basis blowouts essentially reflect the cost of available transportation options to reach better pricing points, such as the Gulf Coast. In other words, since low-cost pipeline capacity with access to Gulf Coast pricing is already spoken for, crude oil priced in Midland must reflect the costs of transporting that crude oil by truck or train the 500 miles to the coast.

Natural gas is often produced coincident with crude oil production (this is often referred to as “associated natural gas”). Natural gas pipeline capacity out of the Permian basin is also tight, and temporary truck and rail options are not viable for natural gas. Permian natural gas prices, represented by gas priced at the Waha Hub in West Texas, are trading close to $2 per million British thermal units (MMBtu) compared to NYMEX gas prices at the Henry Hub of about $3 per MMBtu. Similar to the crude situation, the meaningful natural gas capacity expansions that are already underway are unlikely to provide relief until mid-2019.

While concern over Permian takeaway capacity has been a growing topic of conversation for some time, the basis blowouts discussed above only emerged over the past four to six weeks as volumes finally began approaching capacity limits. In the coming months, this pricing incentive may result in some optimization of the current infrastructure system and there may be an improvement in the availability of truck and rail assets to help limit local pricing discounts. However, until mid-2019 when significant new capacity is put into service, a significant discount is likely.

Who Is Impacted?

During this period, Permian producers without sufficient takeaway capacity will experience significantly worse pricing than peers with access to pipeline capacity. Some disadvantaged producers may slow their production growth until in-basin pricing recovers. As a result, oil-field service providers that cater to these producers could experience a period of stalled growth as well. Notably, most of these operators have already experienced sharp equity price corrections in response to these fears. However, this pricing predicament will be a relatively short-lived issue and it is open to debate whether current equity pricing is already overly discounting this dynamic.

On the flip-side, in-basin refiners or refiners with the ability to access in-basin crude will benefit from the ability to acquire crude at discounted pricing, while selling refined products at prices set by the broader market. Therefore, over this period, these refiners are likely to generate very healthy margins. Again, however, this pricing power will be relatively short-lived and many refiners have already experienced a significant equity price bounce.

What About MLPs?

Importantly, we believe certain midstream operators should enjoy both short-term and long-term benefits. Obviously, midstream operators are benefitting from, and will continue to enjoy, the full utilization of their assets servicing the basin. Some operators may also capture wide short-term marketing margins. Over the long-term, midstream operators may benefit from an increased desire by producers to commit to existing or new capacity that can earn a transportation fee for an extended period. For example, we believe Energy Transfer Partners (NYSE: ETP), Enterprise Products Partners (NYSE: EPD), Targa Resources (NYSE: TRGP), and Plains All America (NYSE: PAA/PAGP) are well positioned.

Perhaps amid the energy market tumult of the last few years, some producers began simply to take access to energy infrastructure for granted. Or perhaps some producers forgot that no one really needs crude oil in the middle of West Texas.

Investing in MLPs involves additional risks as compared to the risks of investing in common stock, including risks related to cash flow, dilution and voting rights. Each Fund’s investments are concentrated in the energy infrastructure industry with an emphasis on securities issued by MLPs, which may increase volatility. Energy infrastructure companies are subject to risks specific to the industry such as fluctuations in commodity prices, reduced volumes of natural gas or other energy commodities, environmental hazards, changes in the macroeconomic or the regulatory environment or extreme weather. MLPs may trade less frequently than larger companies due to their smaller capitalizations which may result in erratic price movement or difficulty in buying or selling. Additional management fees and other expenses are associated with investing in MLP funds. Additionally, investing in MLPs involves material income tax risks and certain other risks. Actual results, performance or events may be affected by, without limitation (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) changes in laws and regulations, and (5) changes in the policies of governments and/or regulatory authorities. Investing in MLPs may generate unrelated business taxable income (UBTI) for tax-exempt investors both during the holding period and at time of sale. Diversification does not guarantee profit or protect against loss.