The carnage in the energy markets has continued during this first full week of 2015, with the price of West Texas Intermediate dipping below $50 per barrel. But most MLPs have thus far withstood the onslaught that began last summer. As I reported in last week’s issue (see The Top MLPs of 2014) a number of MLPs produced returns of more than 50% for the year. In fact, not only were most MLPs spared the type of punishment that was doled out to the C-Corp drillers, the Alerian MLP Index (AMZ) outperformed the S&P 500 for almost the entire year, before taking a dive near the end:

2014 performance of the S&P 500 versus the Alerian MLP Index

Because of the year-end dip, for the third consecutive year the S&P 500 beat the Alerian MLP Index in 2014, but going back to 2009, the Alerian retains the lead:

2009-2014 performance of the S&P 500 versus the Alerian MLP Index

The AMZ does include a number of the upstream partnerships that were hit so hard in the second half of 2014, but if you stuck to the more conventional midstream MLPs odds are your performance was better than the index. Incidentally, the implied annual yield on the AMZ is currently 6.1%, just about where it was a year ago.

But now that 2014 is behind us, we turn our attention to 2015. For the last five years I have been making predictions about the upcoming year, and I think there is more uncertainty around 2015 than any other year I have had to forecast. Nevertheless, here is what I think.

We should be near a bottom in oil prices. I have seen some forecasts for crude to drop down into the $30s or even $20s/bbl, but those are not sustainable prices. The world may not have reached peak oil yet, but we have certainly passed peak $30/bbl oil. At that price, there isn’t enough supply to meet demand, which has grown for the past four years despite $100/bbl oil.

A more sustainable floor for oil is probably around $70/bbl. The reason is that shale oil accounts for most of the new production added around the world over the past five years, and a lot of that resource requires prices above $70/bbl to turn a profit. There are some producers and some plays that are economic below that price, but the longer we see sub-$70 oil, the more marginal production is at risk of being idled — which then risks overshooting prices to the upside.

I think oil will find its footing in the first half of the year, and we will see prices back in the $60-$70/bbl range in the second half of 2015.

I am not as optimistic about natural gas prices. I correctly predicted higher natural gas prices for two years in a row, but the 2015 average will almost certainly reverse this trend. We are already starting out the year over $1/MMBtu lower than the average closing price for all of 2014. Why? A mild summer in the U.S. allowed seriously depleted natural gas inventories to be mostly replenished by the time the high demand winter season rolled around. Unless we have a repeat of last winter, demand for natural gas won’t reach last year’s levels, and we risk a 2012-style price collapse. Natural gas futures have already dipped under $3/MMBtu, and barring a new round of polar vortices like we experienced last winter, we could see the sub-$2/MMBtu prices of the spring of 2012.

This implies continued risk to upstream MLPs, most of which already have some expectations of distribution cuts priced in. In fact, BreitBurn Energy Partners (NASDAQ: BBEP) and Linn Energy (NASDAQ: LINE) have both already announced distribution cuts. LINE initially rallied by over 12% on the news, while BBEP units fell more than 10%. But with the softness in oil and gas prices expected to continue, more distribution cuts are expected in the upstream segment.

The midstream sector has held up fairly well during this downturn, given its lower exposure to commodity prices. Because so much of this sector’s income tends to be fixed, midstream should continue to hold up. However, the number of new projects will slow if oil and gas prices remain low, which implies slower distribution growth ahead for the sector. The only scenarios where midstream could tank substantially is if there are a number of bankruptcies among upstream producers that deprive them of their fixed fee income, or if oil and gas prices remain depressed for long enough that the midstream providers begin renewing contracts on significantly worse terms. In any case, with the possibility of slower growth ahead, I would be wary about investing in midstream MLPs with particularly low yields (which have often had unit prices bid up on the expectation of strong distribution growth).  

Downstream, consisting primarily of refiners and fuel distributors, should fare well as long as oil prices remain depressed. Refiners usually make their best margins during periods of falling oil prices. However, be wary of this segment if you are a short-term investor and oil prices start to regain strength.

Overall, after the beatdown over the past six months, I expect the energy sector to break back into positive territory this year, but it may still be three to six months before we start to see the sector begin to recover. For most conservative-minded MLP investors, midstream is where you will find the most opportunities.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Update

Filling Up on CVR Refining  

I can’t find a refining stock that’s done worse than CVR Refining (NYSE: CVRR) over the last six months. Which is crazy, because CVRR remains one of the lowest cost, highest value added refiners.

Its two refineries are among the most sophisticated in the industry, and are advantageously located near the major Cushing, Oklahoma crude storage and distribution hub.

What’s crazier still is what’s happened to the unit price in recent weeks. It’s down 27% since Thanksgiving, which this year coincided with the crash stage of the oil plunge.

Ordinarily, lower crude prices are good for refining crack spreads, but given big stockpiles of gasoline and other refined products, so far the crack spreads are merely holding up. Still, merely holding up ought to be plenty good enough for CVRR, which now trades at a trailing yield of 17% based on its variable distributions over the last year. This is higher than the yield of many of the drilling MLPs, including a couple that have recently slashed their distributions.

Which is crazier still, because drillers bear much more of a long-term commodity pricing risk than refiners in a period of low crude prices. Cheap crude tends to lift fuel demand and benefit crack spreads. Cheap natural gas is another tailwind, since it’s one of the biggest input costs for refiners.

Refiners can take a hit on the crude inventories they hold in a period of rapidly plunging prices, as HollyFrontier (NYSE: HFC) warned it would last week. But while the one-time cost can be large, over the long-term such inventory adjustments should even out, and they say little about the profitability of underlying operations, so investors tend to look past them.

It’s also possible that CVRR simply got swept up in a wave of year-end MLP tax loss selling, though it should be noted that it has underperformed the other variable-distribution refining MLP, Alon USA Partners (NYSE: ALDW) over the last three weeks.

Whatever the explanation for CVRR’s lag, it doesn’t seem likely to be related to its operations, now undervalued to an extent that can’t please Carl Icahn, the majority owner of CVRR’s parent (and majority owner) CVR Energy (NYSE: CVI).

His impatience might be tempered by the prospect of another year of distributions yielding well into the double digits. Alternately, CVI and CVRR certainly have the financial flexibility for an opportunistic unit buyback.

In any case, the big discount on CVRR relative to other refiners is unlikely to last. CVRR is a strong Buy here and a sensible one all the way up to $26.

— Igor Greenwald