In Depth

Q&A: Direxion’s John Vaughan Discusses The Impact Of Oil Prices On MLPs

Feb 3 2015 | 10:05am ET

The impact of falling oil prices has been felt in many aspects of the economy, and we wondered how significant an effect it was having on master limited partnerships (a type of company that focuses on the transportation, storage and processing of natural resources and offers significant tax benefits to investors). To find out, we spoke with John Vaughan, SVP and portfolio strategist with Direxion Investments.

Vaughan has over 25 years' experience in the finance space, including a stint with Houston-based energy specialist Salient Partners. Direxion also has an MLP fund, so Vaughan knows the subject well. He spoke with FINalternatives recently by phone.

First of all, can you talk about what has been happening with the price of oil?

We've seen a number of factors come together, and one of them is the increase in the supply of oil. A lot of the press coverage about this has focused on fracking in North Dakota, but in addition to that, there's been tremendous technological innovation in the United States. For example, there's a group of basins called the Permian Basin in Texas, and it's one of the oldest places in the country where they've taken oil out of the ground—it’s been functioning for well over 100 years. And it was thought for some time that the capacity there was going down and that the peak extraction days had past. But one of the things that they've done there in the last 10 years or so is what's called “stacked” drilling, which is also being done in the Bakken Basin [in North Dakota and Montana]. Very simply, stacked drilling is a new innovative technology that sends one drill head down below, and when it gets to an area where they want to begin to extract, they can send out several smaller drills from the main drill that go out horizontally. You can have three, four, five or six levels of extraction from one drill head. That technology has really taken the Permian Basin to a spot right now where it's producing as much oil as it ever has.

Another important factor is the decrease in global demand for oil. We had a period where some of the global growth numbers were appearing to soften. We saw this in China, and there were ongoing concerns about Europe. The United States is progressing well, but we see much of the rest of the globe is softening. The result is that the oil supply is going up and the demand globally is appearing to soften. On balance this all leads to some downward price pressure.

The third point concerns the price of the dollar. Oil is priced in dollars and as the dollar goes up and the price of oil goes down, each dollar buys more oil. Although interest rates are low in the United States on a relative basis, money goes where it's treated best and European rates are at 200-year lows—and they are significantly lower than rates in the United States and Japan. As a result, we've seen international capital flowing into the United States and the dollar's been appreciating. So, if you consider this, along with the fact that our central bank is leaning towards tightening interest rates, which will also strengthen the dollar, we can expect all of this to lead to a sell-off.

What about OPEC?

An interesting point on OPEC is that their break-even points for extracting oil are very low, so a lot of the member countries—and I think Saudi Arabia would be one of them—use the profits from oil to balance their fiscal budgets. By some metrics the Saudis, and I think others, really need the price of oil to be substantially higher than where it is now, maybe closer to $90 a barrel, to balance their fiscal budgets. Being very wealthy nations, they can sustain this situation for a while, but at some point it's in their best interest that the price move back up.

What effects have falling oil prices had on MLPs?

There are approximately 125 MLPs and...they can be divided into a few categories. The first is called “upstream,” and these companies are largely exploration and production. Generally, the upstream companies tend to own the commodities and the rights to the commodities that are in the ground that they're going after, as well as the land, so they are exposed to commodity price risk. If they own the commodities and they go up in value, then that's good for them; if they go down, that's not so good for them.

The “midstream” companies, which are the preponderance of MLPs, are largely representative of the pipelines—we call them the “toll roads.” They tend to have longer-term contracts to basically just take products from Point A to Point B. Many of these contracts are called “take or pay,” which means that the companies that are taking the resources out of the ground have to pay the pipelines for the contracts—whether or not they actually use them, and regardless of how much they actually send. This tends to favor the pipeline companies. Additionally, many of the pipeline company contracts have what are known as “inflation adjusters” associated with them. These adjusters are oftentimes tied to the producer price index, so that if inflation rises, and therefore the PPI goes up, the amount of money that the companies pay for deliveries increases as well. It's like the contracts have floors, but no ceiling.

So, the midstream companies are in a pretty good situation, and they tend not to have as much commodity price risk because they're collecting the toll. However, we have seen that when the market moves, the midstream companies can go down in value as well, but often not quite as much as you might see with the upstream companies.

Lastly, the “downstream” companies are primarily refiners. The majority of their profits are derived from the spread between the cost that they pay for the hydrocarbons, and to refine it, and the price they can sell it for. So among the three, the upstream tend to be the most commodity-sensitive because they own what's in the ground and they can only control their profit margins by how efficiently they can extract the resources.

How should an investor interested in MLPs proceed?

At some point, the pressure will build on OPEC to actually cut production so they can get the profits to balance their budgets. The other thing to keep in mind is that this is not the first time the price of oil has dropped significantly. These episodes can be self-corrected. For example, some of the ways that oil is stored can be pretty expensive. If the price of oil is very high, you may profit even if you're storing oil in tanker ships offshore. That's a pretty expensive way to store oil, but if the price is high enough, you would do it if you could still make a profit. But right now, with oil at around $50 give or take $5, that type of storage is already coming down in price. So we're seeing some of the storage methods on the margin becoming less expensive already, and that's determined by the price of oil—it's really just Economics 101.

The other side of the equation is demand. If the price of gasoline goes down, which we're seeing now, and people are less conscious about saving on gas for driving, then maybe they decide to take extra trips. However, historically, we tend to see the demand side self-correct over time.

Also, there's always the potential for some sort of a geopolitical flashpoint. If something were to happen, for example, in the Middle East, which could be construed to impact the oil supply, then it’s more of a wild card. During these atypical times, a conscious approach is sometimes best. Perhaps if you've got $10 to invest, maybe you invest $2 now and in a little while you think about investing $2 more. A cost-averaging approach may be better than going all in at once.

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