As we approach the end of what is likely to go down as the worst year ever for master limited partnerships, it is worthwhile to place the current market in the context of historical MLP performance. We can get a glimpse of the bigger picture by looking at the Alerian MLP Index (AMZ), which consists primarily of large and mid-cap energy MLPs.

The AMZ is a composite of the 50 most prominent energy MLPs, capturing about 75% of the sector’s market capitalization. The index includes MLPs involved in gathering and processing, natural gas transportation, petroleum transportation, exploration and production, coal, compression services, propane, refining and shipping.  

The AMZ was launched in June 2006, but Alerian has back-tested the index by rigorously applying the index methodology to each historical rebalancing date to select and weight constituents. This shows the total returns the index would have garnered going back to 1995. The index tracking the total returns of AMZ components, including distributions, is known as AMZX.

We are currently experiencing only the second major correction in 20 years. The first took place in 2007 and 2008, and dropped the index 41%. The current correction began in the third quarter of 2014 and to date has cost the AMZX 39%.

The average yield of the index going back to 1995 is 7.45%. We might infer from the following chart that when the composite AMZ yield drops below 6%, prices have possibly overheated and are at risk. Yields had dropped below 6% prior to both major corrections:

We might also infer that when the composite yield of the index is above 10%, units may be undervalued. When the yield exceeded 10% in December 1999, the next 12 months saw the AMZX rally 46%. When the yield rose above 10% in December 2008, the AMZX rose 76% over the next year. Here is a combination of the previous two graphics, showing the relationship between yield and price:

Note that the AMZ currently yields 8.5%, up from 6% six months ago. We are approaching yields that have historically preceded a period of outperformance. Should year-end tax selling put further downward pressure on MLP units and thus bump yields up even more, history would suggest it’s about time to buy into the sector.

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

Portfolio Update

Chicago Blues for Kinder Morgan        

The holiday shopping season is here, but midstream giant and growth portfolio recommendation Kinder Morgan (NYSE: KMI) simply can’t borrow much more if it wishes to remain an investment-grade credit.

Moody’s decision to place that rating on watch for a possible downgrade merely underscored this well known fact, but was unpleasant enough of a reminder to send the seriously slumping stock down a further 5% Tuesday and an additional 8% by midday Wednesday, for a 53% markdown from a record set only in April.

Moody’s hand was forced by Kinder Morgan’s decision to increase to 50% its stake in the ailing Natural Gas Pipeline Company. That affiliate owns the Kinder-operated NGPL pipeline shipping gas from fields near the Gulf Coast to metropolitan Chicago. Demand on this route has been hurt by competition from the cheap gas produced in the bountiful Marcellus Shale in the northeast. And while NGPL’s woes were already factored into Kinder’s recently reduced dividend growth guidance for 2016, the larger stake will likely force it to borrow more in order to keep the heavily leveraged Chicago pipeline affiliate afloat, Moody’s cautioned.

That’s not going to help in bringing down debt already nearly six times as large as Kinder’s annual EBITDA. Nor will the latest stock decline help the company raise affordable equity capital for next year’s investments slate, which was only partially funded by the recent convertibles offering.

On the other hand, NGPL’s issues are not new and not sufficient to boot Kinder from the investment-grade club just yet given its near-term resilience to the commodity slump, which Moody’s also acknowledged.

Kinder could really use a rally in crude prices, and even more so a big bounce in its share price that might allow it to sell more equity without jeopardizing the dividend. Unfortunately, equity investors remain even more skittish than Moody’s at the moment.

And while that  might be an encouraging contrarian indicator for the long term, it leaves a big question mark hanging over the next year’s spending plans. Buy KMI below $35. 

— Igor Greenwald