Midstream growth seen as offsetting any 'knee-jerk reaction' to Fed rate rise

Expected growth in the economy and the oil and gas pipeline industry are likely to be enough for the energy master limited partnership sector to withstand any negative effects from the Federal Reserve's interest rate hike, according to analysts canvassed by S&P Global Market Intelligence.

The Federal Open Market Committee announced March 15 that it raised the target range of the U.S. central bank's federal funds rate by 25 basis points, potentially affecting midstream energy companies and partnerships.

"I think that there will probably be an initial knee-jerk reaction to higher rates that could actually be slightly negative," Ken Medlock, senior director of Rice University's Center for Energy Studies, said in an interview. Higher interest rates increase the cost of borrowing capital to finance the projects that generate future cash flow for MLPs, while the yield-focused nature of MLP valuations can put their equities in competition with fixed-income investments.

In the long run, however, experts expect MLPs to have a more neutral stance toward the rate increase.

"There is a clear interest rate risk for MLP equities given that they are yield-oriented securities, but the growth prospects that they've had and will continue to have, at least in the near term, I think will provide some support for them," CreditSights analyst Charles Johnston told S&P Global Market Intelligence.

"From an MLP sector perspective, rising interest rates are a headwind, all other variables held constant, for valuation and borrowing costs," Mizuho Securities USA Inc. analysts said in a Jan. 12 research note. "We believe MLP distribution growth and generally improving economic conditions during rising rate environments typically offset higher rates."

Rice University's Medlock said the response to interest rate hikes must also factor in the sector's outlook for stable growth. "When you look at the MLP space, you have to consider the opportunity it provides for capital against all other opportunities. ... When you look at how a hike might affect investments in other spaces, and given the current administration's push for infrastructure expansion and lower regulation, that might counterbalance everything to tilt the scale towards more capital flowing into that space."

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One area showing investor confidence in MLPs in the run-up to the expected rate hike is exchange-traded funds. Data for funds tracked by S&P Global Market Intelligence show that total net inflows to 11 midstream-focused ETFs amounted to just over $574 million in February. The Alerian MLP ETF alone pulled in $438.6 million of new money from investors in February.

The Alerian MLP index, a bellwether for the midstream sector, has been up and down over the past two years. Although the basket of the largest energy MLPs gained 41% in a year, the jump came after a 62% fall early between September 2014 and mid-February 2016. The index's yield spread against the 10-year Treasury was about 450 basis points as of the end of February, compared to a historical 10-year yield spread of 394 basis points, according to data from Alerian.