By Brian Watson, CFA

September brought energy market volatility that carried over to midstream equity prices. During the month, midstream sector participants continued placing growth projects into place, while also finding creative ways to reduce capital expenditure requirements. Bond investors have taken notice, but equity valuations continued to lag likely due to lackluster fund flows.

MLP market overview

Midstream MLPs, as measured by the Alerian MLP Index (AMZ), ended September down 13.6% on a price basis and once distributions are considered. The AMZ results underperformed the S&P 500 Index’s 3.8% total return loss for the month. The best performing midstream subsector for September was the Propane group, while the Gathering and Processing subsector underperformed, on average.

For the year through September, the AMZ is down 50.5% on a price basis, resulting in a 46.2% total return loss. This compares to the S&P 500 Index’s 4.1% and 5.6% price and total returns, respectively. The Propane group has produced the best average total return year-to-date, while the Gathering and Processing subsector has lagged.

MLP yield spreads, as measured by the AMZ yield relative to the 10-year U.S. Treasury bond, widened by 219 basis points (bps) over the month, exiting the period at 1,410 bps. This compares to the trailing five-year average spread of 665 bps and the average spread since 2000 of approximately 412 bps. The AMZ indicated distribution yield at month-end was 14.8%.

Midstream MLPs and affiliates raised no new marketed equity (common or preferred, excluding at-the-market programs) and $3.0 billion of debt during the month. No new asset acquisitions were announced in September.

Spot West Texas Intermediate (WTI) crude oil exited the month at $40.22 per barrel, down 5.6% over the period and 25.6% lower year over year. Spot natural gas prices ended September at $1.63 per million British thermal

The MLP sector has been one of maximum pain for investors. Such long and brutal bear markets often tend to produce conditions for maximum returns for sectors. Often, not always though. We have stated our bias here previously, and the MLPs investors will be best served by sticking to quality and avoiding common shares. Preferred shares and baby bonds where feasible offer the best possible risk-adjusted returns, in our view.

But what if we are wrong? What if the sector has bottomed and the market has discounted the tremors ahead? In that case, which is the best way to play the sector? We recently highlighted two funds in this space (see here and here), and neither of them come close to the one we are about to talk about today.

The First Trust MLP & Energy Income Fund (FEI) is one of the best-performing MLP funds and is shockingly ignored. This “not-so-well-known” closed-end fund invests in the MLP sector using one of our favorite strategies. It uses covered calls to reduce volatility and enhance returns. We have always deployed options in our own trades, and they are the single best “free” source of alpha there is. They act to reduce volatility and also help investors buy low and sell high (not a marijuana reference).

The Fund

FEI has managed to do something rather extraordinary from the point of view of the common investor. It has taken leverage, within a sector that has gotten decimated, and managed to outperform non-leveraged passive ETFs like ALPS Alerian MLP ETF (AMLP).

ChartData by YCharts

That is a truly outstanding achievement from the point of view of the common investor, but one we predicted as the fund was busy selling covered calls in a thoughtful manner. FEI delivered -47.79% over the last five years

MLPs followed up last week’s modest bounce with a huge week in a risk-on surge for equity markets, commodity markets and everything else this week. MLPs led the way for a second straight week, beating the AMNA by nearly 300 basis points. Oil prices, natural gas prices, and the stock market were all strong this week, which helped.

Monday’s big positive move was helped by an MLP roll-up announcement and TRGP’s positive update. Wednesday’s big positive move seemed to be short covering after the vice presidential debate where Kamala Harris was emphatic about Biden not banning fracking. PAA was particularly strong after being pressured as the posterchild for a fracking ban on federal land.

This year, including this week, the AMZ has rallied 8% or more in a week five times, reflective of the heightened volatility of 2020. For context, 2019 had just one such week (the first week of 2019), and 2017 and 2018 had no 8% weeks.

AMZ has bounced 11% off the low point of September, and AMNA has bounced 6%. The positive move after the horrible September has been a nice respite, but it does feel like the rest of 2020 will continue to exhibit high levels of volatility in both directions as hedge funds whip things around and investors trade through the election and tax loss season.

Universe Update: Right Now

It’s been a few months since I updated the below chart. A few notes on the changes in the last few months:

  • CNXM and EQM have exited the MLP structure (although ETRN is still out there)

  • I also moved TCP’s market cap into TRP-CA’s in the chart below and removed it from the MLP count.

  • There are only 28 midstream MLPs left with $250mm or more in market cap.

    • There are 7 midstream MLPs