Fourth Quarter 2017 Energy MLP Strategy Key Takeaways Michael Clarfeld, CFA Managing Director, Portfolio Manager Global crude oil demand growth is outstripping global supply growth driving inventory reductions and firming oil prices. In our view, the disconnect between growing MLP cash flow fundamentals and lower MLP stock valuations is not sustainable in the intermediate to long term. Tax reform enacted in late December is more or less a neutral for MLP investors, in our opinion. Distributions will remain tax-deferred until the security is sold. Chris Eades Managing Director, Portfolio Manager Market Overview and Outlook Energy commodities continued to rebound during the fourth quarter of 2017, as crude oil prices rose 17% from $51.67 per barrel at the end of September to $60.42 at the end of the year, helped by cuts in non-u.s. production and concern over unrest in Iran. Oil prices benefited from better-than-expected global demand, constrained OPEC supply, and flat to declining non- OPEC production outside the U.S. Natural gas prices in the U.S. were down slightly for the quarter, but only slightly, as growing demand for industrial users, power generation plants and liquefied natural gas (LNG) exporters are met with U.S. production growth. The Alerian MLP Index declined -0.95% during the fourth quarter, leaving the index down -6.52% for the year. U.S. stocks also continued their positive performance in the fourth quarter, supported by solid economic data, including healthy projected holiday sales, and, importantly, the tax reform bill that passed in December. The S&P 500 Index returned 6.64% for the quarter and ended the year up 21.83%. During the quarter the consumer discretionary, information technology (IT), and financials sectors led the market, while utilities, health care and real estate lagged. For the year, the market experienced positive returns in all but two sectors and was led by a 38.83% gain in the IT sector. Telecommunications services and energy were the trailing sectors, declining 1.25% and 1.01%, respectively. The most significant economic development in the quarter was the passage and signing of the tax reform bill in December. Its passage helped sustain investor optimism, which was supported as well by steady economic growth and historically low interest rates. Final third-quarter U.S. GDP growth was revised to an 620 Eighth Avenue, New York, NY 10018 800 691 6960 ClearBridge.com
CLEARBRIDGE ENERGY MLP STRATEGY annualized 3.2%, largely in line with the second quarter s 3.1%. U.S. manufacturing remained strong in the quarter, with the IHS Markit U.S. Manufacturing PMI at 55.1 in December, above November s 53.9 and the highest since March 2015. Panelists in December s survey cited favorable domestic demand conditions, while business confidence rose again, reaching a two-year high. Meanwhile, consumer sentiment as reported by the University of Michigan survey remained elevated, with respondents split on the economic impact of December s tax reform bill. New home sales rose over 17% to a seasonally adjusted 733,000 in November, the highest since July 2007, while the economy added jobs at a healthy rate. As expected, in December the Federal Reserve raised the Federal Funds rate by 0.25%; equity markets reacted calmly. Core PCE, the Federal Reserve s preferred measure of inflation, rose slightly in November to 1.48% from October s 1.45%, marking three consecutive months of increases. Both the 10-year U.S. Treasury yield and the U.S. dollar remained largely flat during the quarter, with the 10-Year Treasury closing at 2.41%, and the dollar stabilizing after declining in the first three quarters of 2017. Portfolio Highlights On an absolute basis, the Strategy had a negative return for the fourth quarter. Of the five energy MLP subsectors in which the Strategy was invested during the quarter, liquids transportation & storage, gathering/processing and diversified energy infrastructure detracted the most from absolute returns. Leading individual contributors to Strategy performance included BP Midstream Partners, Enterprise Products Partners, DCP Midstream, Shell Midstream Partners and Brookfield Infrastructure Partners. The top detractors during the quarter were Genesis Energy, NuStar Energy, Buckeye Partners, Enbridge Energy Partners and Spectra Energy Partners. During the quarter the Strategy added a position in BP Midstream Partners and closed a position in Rice Midstream Partners. MLP Market Outlook Energy macro and MLP fundamentals continue to improve looking ahead into 2018. The crude oil story is straightforward. Global demand growth is outstripping global supply growth driving inventory reductions and firming oil prices. In 2017, total demand is expected to have increased by 1.6 million barrels per day. OPEC production is down by 1.2 million barrels per day from its 2016 peak. Non-OPEC production (outside the U.S.) is flat to down. Thus, without an increase in U.S. oil production, the market
MLP balance sheets on average are in good shape, with Debt/EBITDA multiples at 4.0x. would be almost 3 million barrels per day tighter than in 2016. Even with an average increase in U.S. oil production of 0.6 million barrels per day in 2017, demand exceeds available supply, inventories are decreasing and pricing has firmed. In 2018, the story likely remains much the same. Rising demand, constrained OPEC production, flat to down non-opec production outside the U.S., and another 0.6 million barrels per day increase in U.S. oil production should result in continued declines in inventories and firm prices. In 2018, the U.S. natural gas market should continue to be a demand-driven market. Natural gas will likely continue to gain market share at the expense of coal and nuclear to generate electricity. Exports of natural gas (via LNG) began in 2016 and will continue to ramp higher over the next two to three years. Greenfield construction of 11 petrochemical plants should drive industrial demand growth for natural gas through 2020. A likely steady increase in demand for U.S. natural gas will likely require a steady increase in production of U.S. natural gas in the coming years driving throughput for many MLP companies. In terms of distribution growth, investor focus was directed at Genesis Energy cutting its distribution in October. The instinctual fear was that many others would follow suit. Yet, as the remainder of the MLP companies announced distributions for the September quarter, distributions largely came in as expected. On average (even with the Genesis surprise cut), the roughly 70 companies we consider our investable universe announced 5.1% distribution growth year over year for the September quarter and 1.8% sequential growth over the June quarter. There will likely always be company-specific situations that spur distribution cuts. Even when the MLP market made its all-time highs in 2014, Boardwalk Partners (considered a blue chip MLP at the time) cut its distribution. Investors should focus on whether a distribution cut is a company-specific issue or a macrodriven issue. In our view, cuts announced to date have been company specific and not indicative of a coming tidal wave of distribution cuts. MLP balance sheets on average are in good shape, with Debt/EBITDA multiples at 4.0x in line with historical averages. MLP companies continue to enjoy ready access to capital markets. In 2017, MLP companies issued $32 billion in equity, $7 billion in preferred stock, and $29 billion in debt. The last two years also saw elevated capital spending for MLP companies as they moved to build new energy infrastructure to facilitate transportation, processing and storage of rising oil and natural gas production. This has obviously resulted in elevated levels of MLP companies accessing the capital markets to fund these growth projects. However, this should shift in 2018 and 2019. Growth projects will come into service, driving cash flow growth. Capital market needs
CLEARBRIDGE ENERGY MLP STRATEGY Institutional equity investors and bond market investors seem to be more properly valuing MLP securities. will decline as capital spending declines. A recent Barclays analysis suggests that MLP equity capital market needs will decline by 60% in 2018 versus 2017 lessening what was an overhang in the equity market during parts of 2017. Less equity issuance coupled with growing cash flow should be supportive of MLP stock prices in 2018. We think this is a critical component to why MLP stocks are well positioned for a rebound in 2018 lower capex requiring less equity issuance and projects coming into service driving cash flow growth. Looking at cash flow multiples, MLP stocks have only traded at lower multiples during the Financial Crisis in 2008 2009. Despite a vastly improved macro environment for MLP stocks today, cash flow multiples are lower now than they were during the oil price collapse during 2015 and early 2016. In our view, the disconnect between MLP cash flow fundamentals and MLP stock valuations is not sustainable in the intermediate to long term. Institutional equity investors and bond market investors seem to be more properly valuing MLP securities. MLP preferred stock offerings which are typically sold to institutional investors in 2017 priced at an average yield 222 basis points (bps) lower than the average distribution rate on MLP common stock. This is unusual, as preferred stock typically trades at a higher yield than common stock. In the REIT sector (another heavy issuing sector for preferred stock offerings), the average yield on preferred stock offerings was 140 bps higher than common stock yields. Looking at the MLP bond market, there has been a continual healing of this market since the oil price collapse in 2015 and early 2016. Average yields on MLP bonds have declined by over 200 bps since early 2016. Typically, MLP stock yields are roughly 180 bps above MLP bond yields. Today, the spread is 370 bps. For MLP stocks to trade at their historical spread to MLP bond yields, MLP stocks would need to increase by roughly 25%. Tax reform enacted in late December is more or less a neutral for MLP investors, in our opinion. The MLP structure itself remains intact and unchanged. Distributions from MLP companies will remain tax-deferred until the security is sold. Upon sale, taxation of distributions will remain advantaged compared to C-Corp dividends (~30% for MLP distributions and ~37% for C-Corp dividends). A limit on deducting interest expense is a modest negative. When you boil it all down, you are left with a sector with macro tailwinds (rising U.S. oil and natural gas production driving throughput and cash flow growth), declining capex in 2018 and 2019 requiring less equity issuance, and new projects coming into service and driving cash flow growth in 2018 and again in 2019. These positives, with MLP stock valuations at levels not seen since
the Financial Crisis, set the stage for a rebound in MLP stock prices in 2018. Past performance is no guarantee of future results. Copyright 2017 ClearBridge Investments. All opinions and data included in this commentary are as of December 31, 2017, and are subject to change. The opinions and views expressed herein are of the portfolio management team named above and may differ from other investment professionals, or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge nor its information providers are responsible for any damages or losses arising from any use of this information. Performance source: Internal. Benchmark source: Alerian MLP ETF. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information. The accuracy and/or completeness of any Alerian index, any data included therein, or any data from which it is based is not guaranteed by Alerian, and it shall have no liability for any errors, omissions, or interruptions therein. Alerian makes no warranties, express or implied, as to results to be obtained from use of information provided by Alerian and used in this service, and Alerian expressly disclaims all warranties of suitability with respect thereto.