“In capital markets, price is set by the most panicked seller at the end of a trading day. Value, which is determined by cash flows and assets, is not. In this environment, the chaos is so extreme, the panic selling so urgent, that there is almost no possibility that sellers are acting on superior information. Indeed, in situation after situation, it seems clear that fundamentals do not factor into their decision making at all.”

– Seth Klarman

The great investor is describing a market mood that should sound very familiar to MLP investors by now. I was reminded of this quote recently while reading an interview with an MLP fund manager in which he impugned the market’s rationality no fewer than 10 times, based on its treatment of his investments.

It’s only natural to write off drastic price movements at odds with our own thinking as devoid of reason, and I’m not immune from that temptation. We know markets aren’t always rational, especially at times when big moves breed outsized emotional responses, be they fear or greed.

We also know – so well that it’s become almost a cliché – that markets can remain irrational longer than any of us can remain solvent.

Just as dangerously for an investor on the wrong end of a market trend, it may not be irrational at all but rather based on logic that’s eluded us or an a low-probability scenario that’s not entirely implausible. I can’t stress enough how important it is to remain open to those possibilities, giving the arguments with which we disagree a thorough and fair examination.

I do that constantly with regard to MLPs, and my last such public exercise back in August foreshadowed the crash they have since endured even as it failed to predict it. This time, I’d like to shift the focus from the structural changes in the MLP investor base to the fundamental challenges confronting the midstream industry.

They’re obviously immense with crude trading below $30 a barrel, because while midstream processors are shielded to varying degrees from a direct hit based on the price of crude they’re very much vulnerable to the resulting slowdown in domestic drilling and production.

As noted elsewhere in this issue, the slowdown and the resulting production drop-off have been gentle so far and are expected to remain so this year since the strongest producers continue to raise cash, both debt and equity, on affordable terms.

But this is also why many industry skeptics expect energy prices to stay depressed for longer. And in that scenario the declines in domestic production figure to accelerate, even as the midstream sector continues to plow tens of billions of dollars from its own debt and equity fundraisings into infrastructure expansion projects greenlighted in better times.

In the short term, such projects will serve to prop up cash flows thanks to favorable depreciation rules for pipelines (and assuming the increasingly hard-pressed drillers among the customers continue to pay their bills.) But as the buildout inevitably slows in the years ahead the depreciation and amortization tax shield should shrink, possibly leaving less for distributions. And that’s before considering the effect of volume declines and potential contract renegotiations as more producers go bankrupt.

Keep in mind that cash flow impairments affect not only the distribution coverage but also debt leverage calculations. A 20% EBITDA drop can turn a manageable 4.5x debt/EBITDA ratio into a much more worrisome 5.6x. And the midstream sector’s debt is very likely to rise faster than its cash flow at least for the next year, increasing borrowing costs.

I have a “but” for every one of these bearish assumptions. The biggest one is that at some point in the next couple of years energy prices will revert to levels that let producers dream about making money again. And if they fail to do so relatively quickly, it will very likely be because North American output is holding up, which should in turn protect the revenue of midstream pipeline operators.

Producer bankruptcies won’t stop the flow of oil and gas from wells already drilled, and the creditors who end up owning those wells will often not have the flexibility to switch their processors and shippers.

As global demand for oil and gas continues to grow the current supply glut should dissipate. The state-sponsored producers in the Middle East, Russia and Africa that failed to increase output at much higher prices will struggle to do so while coping with mounting budget deficits and political unrest. North American drilling will be needed once more to make up for the declines of mature fields.

Above all, North America’s energy demand continues to grow and can’t be met without all the processing plants, pipelines and storage tanks. So the sector’s long-term future looks secure even if that’s not the message the markets are currently dishing out.

But that future is not written in stone, and in the meantime the evaporating equity is placing a lot of short-term stress on the business model.

I’m not worried about the charlatans claiming that MLPs are done. I’m worried about some knowledgeable market pros predicting the MLPs are not done going down because of the downward momentum they’ve built up, the short-term fundamental pressures they face and a dearth of obvious buyers in this environment.

These concerns are not irrational in the least, and to dismiss market moves based on them as such is a mistake. If an MLP’s price has dropped 60% peak-to-trough there’s no reason the decline can’t eventually reach 75%, which would imply 37% of additional downside.

So the bottom line is that, despite the punishment absorbed to date, MLPs retain much more risk in this environment than in more normal times, and it is not irrational at all to think that prices haven’t bottomed.

And while the worst-case scenarios animating the sellers are unlikely to come true, that’s not the same as claiming that they can’t. In fact, a rational observer should acknowledge that the probability of further dislocations has increased.

Accepting that the bears are not, in fact, irrational and that their concerns have grown increasingly plausible should moderate every MLP investor’s appetite for bargain shopping. There will be plenty of time to lock in healthy yields with much less tail risk after the tide turns.