Energy Markets Update: Energy Valuations
About This Video
September 2018. This video is the second in a 3 part series on timely issues related to North American energy focusing on Midstream Pipelines & MLPs, Energy Stock Valuations, and Natural Gas Demand Growth.
Energy Markets Update: Energy Valuations

I'm Michael Roomberg, a portfolio manager with Miller/Howard Investments. This video is the second in a three-part series on timely issues related to North American energy focusing on Midstream Pipelines and MLPs, Energy Stock Valuations, and Natural Gas Demand Growth.

There are three indices that thematically capture the primary North American–focused energy subsectors in which we invest. These are the Revere Natural Gas Index, which represents the upstream, the Alerian MLP Index, which represents the midstream, and the S&P Oil & Gas Equipment & Services Select Industry Index, which represents the enabling companies of the shale revolution. Given our North American focus, we generally access "energy beta" via stocks that are mainly found in these three indices—which do not include the global oil major companies that predominate the more widely followed S&P 500 Energy Index.

From the beginning of 2017 through the end of the third quarter of 2018, North American energy stocks have significantly lagged these large global counterparts. Each domestic-oriented index (that I just referenced) has lagged the globally oriented S&P 500 Energy Index by as much as 29% over this period.

So one natural question is whether this lag is justified by inferior underlying performance at the North American energy companies in which we invest, relative to their global peers. We don't think that's the case, because most of the lag is explained not by an absence of earnings growth at the companies but to earnings multiple compression—investors are simply paying less today for North American energy earnings compared to the beginning of last year. Since January 1, 2017, the EV/EBITDA multiple of S&P 500 energy index has compressed by as much as 12%, as earnings have risen faster than stock prices. This compares to a 23% decline in the earnings multiple for the Revere Natural Gas Index (the upstream index), and 18% for the S&P Oil & Gas Equipment & Services Select Industry Index over this period, according to Bloomberg data. This multiple compression explains substantially all of the lag of the upstream E&P stocks, and a significant part of the equipment & services' lag.

So, while North American energy companies have indeed fundamentally recovered, we believe that investors have simply overlooked this recovery relative to their global counterparts, as reflected in company stock prices. To the extent that this reverses, it would provide a tailwind to North American–focused energy stocks. Simply put, when it comes to relative valuation—shale is on sale!

NOTE:
EV/EBITDA: A ratio that compares a company's Enterprise Value (EV) to its Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA). The EV/EBITDA ratio is commonly used as a valuation metric to compare the relative value of different businesses.

MLP: Master Limited Partnership is a type of business venture that exists in the form of a publicly traded limited partnership. It combines the tax benefits of a partnership—profits are taxed only when investors actually receive distributions—with the liquidity of a public company.

Revere Natural Gas Index: The ISE-REVERE Natural Gas Index consists of securities that derive a substantial portion of their revenues from the exploration & production of natural gas. The index was created with a base value of 25 as of December 29, 2000.

Alerian MLP Index: A composite of energy Master Limited Partnerships calculated by Standard & Poor's using a float-adjusted market capitalization methodology. The index is disseminated by the New York Stock Exchange real-time on a price-return basis (NYSE: AMZ). The corresponding total return index is calculated and disseminated daily through ticker AMZX.

S&P Oil & Gas Equipment & Services Select Industry Index: S&P Select Industry Indices are designed to measure the performance of narrow GICS® sub-industries. The index comprises stocks in the S&P Total Market Index that are classified in the GICS oil & gas equipment & services sub-industry.

S&P 500 Energy Index: The S&P 500® Energy Index comprises those companies included in the S&P 500 that are classified as members of the GICS® energy sector.

© 2018 Miller/Howard Investments, Inc.

DISCLOSURE
Common stocks do not assure distribution payments. Distributions are paid only when declared by an issuer's board of directors and the amount of any distribution may vary over time. Distribution yield is one component of performance and should not be the only consideration for investment. The information and analyses contained herein are not intended as tax, legal or investment advice and may not be suitable for your specific circumstances; accordingly, you should consult your own tax, legal, investment or other advisors, at both the outset of any transaction and on an ongoing basis, to determine such suitability. The views expressed here represent Miller/Howard Investments' views and are subject to change at any time. Nothing stated herein, including the mention of specific company names, should be construed as a recommendation to buy, hold, or sell any security, sector, or MLPs in general. The material may also contain forward-looking statements that involve risk and uncertainty, and there is no guarantee they will come to pass.

Past performance does not guarantee future results.

Risk Factors to Consider When Investing in Master Limited Partnerships (MLPs)
  • Cash distributions are not guaranteed and may fluctuate with the MLP's operating or business performance.
  • MLPs typically have a General Partner that maintains an aggregate 2% General Partner interest. Unit holders will have limited voting rights and do not own an interest in, vote with, or control the General Partner. The General Partner often cannot be removed without its own consent, and the General Partner has conflicts of interest and limited fiduciary responsibilities, which may permit it to favor its own interests to the detriment of unit holders.
  • The MLP may issue additional common units, diluting existing unit holders' interests.
  • Unit holders may be required to pay taxes on income from the MLP even if they do not receive cash distributions.
  • The IRS could reclassify the MLP as a taxable entity, which could reduce the cash available for distribution to unit holders.
  • If at any time the GP owns 85% or more of the issued and outstanding limited partner interests, the GP will have the right to purchase all of the limited partnership interests not held by the GP at a price that may be undesirable.

Tax Considerations of MLPs
The tax treatment for investors in MLPs is different than that of an investment in stock, including (a) the investor's share of the MLP's income, deductions and expenses are reported on Schedule K-1, not Form 1099, (b) because of the possibility of unrelated business taxable income, charitable remainder trusts should not invest in this strategy, and other non-taxable investors (such as ERISA and IRA accounts) should carefully consider whether to invest in this strategy, (c) investors may have to file income tax returns in states in which the MLP's do business and (d) MLP tax information is sent directly from the partnership, which generally has until April 15th to provide this information. You should discuss these and any other tax implications with your tax advisor.

DISCLOSURE
Common stocks do not assure distribution payments. Distributions are paid only when declared by an issuer's board of directors and the amount of any distribution may vary over time. Distribution yield is one component of performance and should not be the only consideration for investment. The information and analyses contained herein are not intended as tax, legal or investment advice and may not be suitable for your specific circumstances; accordingly, you should consult your own tax, legal, investment or other advisors, at both the outset of any transaction and on an ongoing basis, to determine such suitability. The views expressed here represent Miller/Howard Investments' views and are subject to change at any time. Nothing stated herein, including the mention of specific company names, should be construed as a recommendation to buy, hold, or sell any security, sector, or MLPs in general. The material may also contain forward-looking statements that involve risk and uncertainty, and there is no guarantee they will come to pass. It is not possible to invest directly in an index.

Past performance does not guarantee future results.

Risk Factors to Consider When Investing in Master Limited Partnerships (MLPs)
  • Cash distributions are not guaranteed and may fluctuate with the MLP's operating or business performance.
  • MLPs typically have a General Partner that maintains an aggregate 2% General Partner interest. Unit holders will have limited voting rights and do not own an interest in, vote with, or control the General Partner. The General Partner often cannot be removed without its own consent, and the General Partner has conflicts of interest and limited fiduciary responsibilities, which may permit it to favor its own interests to the detriment of unit holders.
  • The MLP may issue additional common units, diluting existing unit holders' interests.
  • Unit holders may be required to pay taxes on income from the MLP even if they do not receive cash distributions.
  • The IRS could reclassify the MLP as a taxable entity, which could reduce the cash available for distribution to unit holders.
  • If at any time the GP owns 85% or more of the issued and outstanding limited partner interests, the GP will have the right to purchase all of the limited partnership interests not held by the GP at a price that may be undesirable.

Tax Considerations of MLPs
The tax treatment for investors in MLPs is different than that of an investment in stock, including (a) the investor's share of the MLP's income, deductions and expenses are reported on Schedule K-1, not Form 1099, (b) because of the possibility of unrelated business taxable income, charitable remainder trusts should not invest in this strategy, and other non-taxable investors (such as ERISA and IRA accounts) should carefully consider whether to invest in this strategy, (c) investors may have to file income tax returns in states in which the MLP's do business and (d) MLP tax information is sent directly from the partnership, which generally has until April 15th to provide this information. You should discuss these and any other tax implications with your tax advisor.