An analyst that previews MLP's wrote about KYN. Here are excerpts + I added comments.
There are three types of selling: regular selling, panicked selling, and forced selling. Forced selling is typically margin call-related and is the most intense form of selling. Forced selling also creates the greatest bargains for those able to act. MLPs were subjected to unprecedented forced selling in March. This occurred because MLPs are stable high-yield investments where a "carry trade" strategy was broadly used by institutions and individuals. A carry trade is a trading strategy that uses borrowing at a low-interest rate and investing in an asset that provides a higher yield. MLPs offer high yields and interest rates are at historic low levels. This strategy is brilliant until a pair of black swans create a three standard deviation move that risk managers assumed would never happen. Since carried MLP strategies entail leverage or margin, the three standard deviation move in MLPs created forced selling, which fed on itself in a negative feedback loop. This forced selling is exactly what happened to Kayne Anderson and countless other professional institutions including Goldman Sachs where leveraged MLP strategies suffered massive forced selling and disastrous declines - even though the underlying securities should only see a modest decline in cash flows, and therefore their stock price decline had nothing to do with their actual financial strength. This forced selling and liquidations have created exceptional value in fee-based midstream energy assets.
Herein lies the opportunity. Knowing the value of a security and not just the price is what creates investment opportunity.
Specific MLPs and MLP Closed-End Funds:
Kayne Anderson MLP/Midstream Investment Company (KYN) share price $4.58 as of 4/17/2020.
NAV $5.37 14.7% discount. Yield 30.5% $1.44/4.58.
Kayne Anderson Midstream/Energy Fund (KMF) share price $4.08 as of 4/17/2020.
NAV $4.83 15.5% discount. Yield 22.0% $0.90/4.08.
Both of these funds have had to reduce their leverage during this market rout. After they report their distributions on April 31, 2020, we will be reviewing their balance sheets to see if they are re-instituting the carry trade which is so compelling at current spreads. Like closed-end funds, these securities can be held in retirement accounts which could be a tremendous opportunity in this low-interest rate environment.
Extraordinarily high yields like these are often a sign of financial distress; however, in this case - with MLPs - it is not. Midstream MLP energy assets are high-quality defensible franchise assets. A key aspect of midstream investing right now is that there should be minimum immediate cash flow changes from the drop in oil prices.
An MLP contract's with companies for a specific fee to use the MLP's oil or gas pipeline. As an example, a contract with Occidental Petroleum would stipulate that it must pay that $300k/day in order to be allowed to transport 100,000 barrels of oil a day, even if it doesn't transport that much oil a day. Regardless of how much volume it moves through the pipeline, it pays $300,000 a day. That cash flow is secure, barring something like bankruptcy, for the duration of the contract. That’s why, in the short term, cash flow remains secure.
In the long run, the risks get much more unpredictable. The three main long-term risks that midstream companies face from a decline in oil prices are lower volumes, contract length, and potential customer bankruptcies.
For the next few years, companies like KYN will be fine. However, starting in a few years, barring no price recovery, when it comes time to renew those contracts, companies like Occidental Petroleum will no longer need 100 thousand barrels/day, now they’ll be looking for 60-70 thousand barrels/day. That means that in 5-10 years, if volumes don’t recover, the billions that companies spent on infrastructure might no longer be fully utilized.
The other long-term risk worth paying attention to is bankruptcies. For those who don’t know, the common bankruptcy process that upstream oil and gas goes through is a “Chapter 11 bankruptcy.” That’s not a disappearance, it’s a restart. It basically provides a way for a company to continue its operations while forcing a restructuring of the company’s debt load. In terms of continuing its operations, that normally means continuing to pay its midstream deals.
However, two things are likely to happen in an upstream bankruptcy proceeding. The first is that, if the company is paying above-market rates for its midstream take-or-pay contracts, it will likely readjust those contracts so that they’re now at market rate. Secondly, if the company isn’t using the full volume of the contracts, then that also is likely to be readjusted. With prices as low as they are currently, bankruptcies are likely earlier than later, so investors should pay attention here.
But Kayne Anderson MLP started in 1998 and has survived through multiple market cycles and has always paid a dividend.
So the question is, whether volumes will remain high enough to maintain midstream demand. We personally believe they will. We’re expecting a recovery in oil prices by the second half of 2021. The oil break-even cost curve essentially highlights that we need ~$50-60 WTI (~$5/barrel high Brent) to maintain production and support midstream producers.
Therefore, these long-term risks will only come true if WTI prices haven’t recovered to that level in 3-5 years.
Further with distribution coverage of 1.58, any distribution cuts on average will be modest. The opportunity here is in the exceptionally high yield supported by high-quality cash flows. To capitalize on this opportunity, one must understand the factors which have driven this decline in MLPs: MLPs have been hit by two black swans and a financial accident.
The coronavirus caused the country to be locked down, and so people stopped driving and demand for gas, and therefore oil dropped, but this is only temporary.
MLP yields are extremely attractive compared to REITs, Utilities, S&P 500, as well as US Treasuries. As normalcy returns to the markets, money will flow to MLPs due to their exceptionally high yield and their stock prices will rise.
The leading pandemic model used by the CDC and FDA in their forecasting indicated that there would be 2.2 million deaths in the United States. Today, the US is estimating fewer than 60,000 deaths. The CDC and FDA model was off by a factor of 25x. Areas in the United States are now planning on reopening on a staggered basis. People will be using their cars earlier than forecast and this will help firm oil prices, and thus benefit KYN.
The oil black swan is concluding, too. Russia, Saudi Arabia, OPEC+, and the United States have agreed to production cuts, and now, it is a matter of time until the supply glut is absorbed.
We are cautious on equities as terrible corporate earnings, guidance, and mind-numbing unemployment rolls must be digested over the coming quarters.
But MLPs are Cheap.
Based on our experience through previous declines, MLP yields should return to their historic normal yield levels below 5% as the price of the MLP's stock price recovers. The price implication for this sector is double or triple. Not only is the price appreciation extraordinary, but the yield profile is also one of the most compelling we have seen during our career for a group of stable business franchises.
These securities can be held in retirement accounts which could be a tremendous opportunity in this low-interest-rate environment.
The sharpest MLP declines, before this current one, occurred in 2008 and 2016. Those MLP declines occurred concurrently with equity and oil market declines like the current crash. Those previous MLP bear markets rebounded with remarkable strength due to the yield spread compression typical of market normalization. We think these investments each could double or triple in price.
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