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If Energy Stocks Want to Reverse Their Slump, They Must Do This 1 Thing

By Matthew DiLallo – Mar 26, 2018 at 11:34AM

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An oversupply issue of a different kind.

Energy stocks have vastly underperformed the market and oil prices in the past year. On average, energy stocks are down about 2% compared to a more than 10% gain for the S&P 500 and a nearly 30% rebound in crude prices. Even harder hit have been energy MLPs, which have lost a quarter of their value over that time frame.

While a variety of problems have held down energy stocks in the past year, one overlooked issue is that there has been a dramatic increase in equity supply in recent years, which the market seems to be having trouble absorbing. The MLP space, in particular, has seen a flood of IPOs and additional equity offerings, which have dramatically increased the number of units floating around. Investors initially gobbled up this supply, but a combination of recent factors, including underperformance and rising interest rates, have reduced investor demand for this equity. Because of that, the industry needs to trim its numbers to spark more demand, which it could quickly accomplish via a consolidation wave.

A recovery and growth bar chart drawn on a blackboard.

Image source: Getty Images.

What goes up...

Low interest rates and the shale boom drove investors to feast on newly issued units of MLPs earlier this decade. That hot demand enticed more energy companies to begin carving out their midstream assets and create new MLPs, which they did in droves, completing 66 initial public offerings from 2011 through 2014. For comparison sake, the industry only brought 71 new MLPs to market in the decade before that.

Several companies even created multiple vehicles to take full advantage of investor demand. Natural gas producers EQT and Antero Resources were among those that cashed in on the MLP boom by creating vehicles to house their midstream assets: EQT Midstream and Antero Midstream. They both followed that up by unleashing another entity to hold the general partner and lucrative management fees of these MLPs: EQT GP Holdings LP and Antero Midstream GP LP.

On top of that, companies completed wave after wave of secondary offerings to secure more funding. Antero Midstream closed public secondary offerings of 8 million units in 2016 and 16 million units last year in two deals that increased its publicly traded unit count 46 million to more than 70 million since the IPO. Those were in addition to a private placement of nearly 24 million units in 2015 to institutional investors and Antero Resources. Many others followed that same pattern, unleashing a steady supply of new equity in recent years.

A handshake with an oil platform in the background.

Image source: Getty Images.

Now must come back down

While these moves initially captured premium values for MLP assets, too much of a good thing has proven to be too much for the market to handle. That's something oil and gas companies have discovered over the past year, which is why many are turning to share repurchases to trim supply and boost valuations, which has worked out well thus far.

The problem for MLPs is that they need to distribute the bulk of their spare cash to investors, making buybacks unlikely. However, that's not stopping them from looking at taking other actions to enhance their valuations. EQT recently announced plans to separate its midstream business into a stand-alone entity while combining two of its MLPs -- EQT Midstream Partners and Rice Midstream Partners (the latter of which it acquired in an acquisition last year) -- into one company. Meanwhile, Antero and its MLPs Antero Midstream and Antero Midstream GP recently announced the formation of a special committee within their board of directors to "explore, review, and evaluate potential measures to address the discount in trading value." Several other energy franchises have also have announced similar steps in that direction this year. These internal restructuring moves will help eliminate some of the redundancy in the market and could pave the way for more external consolidation among MLPs like the EQT and Rice Midstream combination. 

While a wave of unit-for-unit deals like that wouldn't necessarily trim the supply of equity on the market, it would help cut down on the number of relatively redundant companies. Add in the benefit of the cost savings that come with increased scale, as well as other potential synergies, and these moves should help bolster valuations. 

A big wave could be just over the horizon

The energy market seems to be struggling under the weight of too much equity supply, which appears to be holding down valuations in the sector, especially as fewer investors are willing to pump more money into the industry. Because of that, I think we'll see a rising wave of M&A activity hit over the next year as companies like Antero and EQT begin unwinding some of the redundant supply and others join them. That makes now seem like a good time to consider buying MLPs to benefit from what looks like a potential M&A-fueled bounce.

Matthew DiLallo has the following options: short June 2018 $25 puts on Antero Midstream Partners. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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