Midstream and MLPs looked to be coasting to a third straight week of solid gains, but a sharp selloff across energy stocks Friday erased the gains for the week.  There was little volatility in the market generally this week.  In the summary dashboard below, only natural gas prices moved more than 1% vs. last week.  In the absence of material catalysts, the market is in a holding pattern ahead of the election.

Earnings season for midstream kicks off this week with KMI on Wednesday.  Expect earnings to bring some catalysts for individual stocks, including opportunities for management teams to discuss fundamental outlooks, free cash flow plans, cost cutting initiatives, and capital allocation.  Even with that opportunity, midstream and the energy market overall has the election and tax loss selling looming in the next few months, so it will be interesting to see how much impact earnings will have.

Fund Flows: Structurally Challenged

There seems to be a pause in the ongoing fund outflows from midstream fund products.  That reprieve in selling pressure, combined with the lack of volatility and news this week afford me a chance to call back to old posts to help explain fund flow dynamics at play in midstream.

Based on Wells Fargo data, in just the last 21 months through 9/30/20, there have been $6.2bn of total net outflows from midstream ETFs and open-end mutual funds, $8.5bn from February 2018.  This is in addition to more than $3bn of institutional outflows from reported mandate terminations.  The overall amount of institutional “money-in-motion” out of midstream is much larger when considering those that do not report publicly.  This money is moving into listed infrastructure, listed real assets, broader equity mandates, and into private equity.

The reasons for the outflows are many, and they’ve been discussed at length here at MLPguy for years now.  To summarize:

• Small Universe: Shrinking number of companies has reduced the need for a dedicated sector asset manager to choose among the few remaining companies.
  • Combined market capitalization of just $200bn of market capitalization ($335 if you include Canadian midstream), and more than 60% of the market capitalization from 5 stocks
  • With more MLPs becoming corporations, there is less justification for this group of stocks to be its own allocation vs. regular equity allocations
  • Discussed last week, but also in a few earlier posts, including one from March (Elephants Come Home to Roost), and two from 2018 (MLPs and the Elephants in the Room)

• Poor Performance: lower returns and higher volatility than was expected.
  • Discussed at the close of most months and years lately

• Income Reduction: 125+ distribution and dividend cuts in 6 years has reduced confidence in the income component of the return that likely a big selling point of the original allocation.
  • Discussed extensively in 2017 when the first rounds of distribution cuts were being whitewashed by other managers and by Alerian (Distribution Checks)

• ESG Considerations: de-carbonization focus has impacted all energy stocks, but MLPs have an added layer of weak governance and high incidence of “controversy” due to news coverage of efforts to build pipelines.
  • Weak returns also make it easy to move away from midstream and cite ESG reasons.

• Inefficient Structures: many fund vehicles were structured as corporations specifically to own MLPs
  • If MLPs make up less than 50% of the fund, those funds makes little sense and should be arbitraged away.
  • Also, structural issues of the big ETF discussed in this guest post we published earlier this year

This multi-year unwind is ongoing.  But there are times when the pressure abates, often coinciding with renewed optimism in January or the ramp into third quarter distribution payments in October.  There will eventually be a time when fund outflows run their course, and the unwind is complete.  There will be large opportunities in the surviving midstream players. 

Midstream companies have been challenged by the above dynamic and weak commodity prices, which makes their efforts to change their excessive spending and leverage situations.  The path thus far has been to reduce dividends, reduce costs and reduce capital outlays.  While top line growth will remain challenged, free cash flow visibility is growing.