Sometimes, a correlation can tell you as much about an investment as the price.
Take master limited partnerships. The prices of MLPs and WestTexas Intermediate Oil, historically, have marched almost in lockstep only about 40% of the time.
But during the first half of 2016, when oil prices first plummeted, then climbed from the depths of the selloff, MLPs did the same, and the correlation between the asset classes rose to about 70%. The higher correlations may be influenced by concerns about MLPs. An oversupply of oil, excess pipeline capacity, counterparty risk and the high cost of equity capital have perhaps tarnished the sector's reputation as a haven from the volatility of petroleum prices.
If many planned projects prove uneconomic in today's environment, where will the growth or maintenance of distributions come from?
In recent weeks, MLPs and oil have decoupled somewhat, as petroleum prices have dropped and partnerships have remained steady. This divergence will hopefully continue. The decoupling reflects investor confidence that the MLP business model is not broken, as many have posited over the past year and a half.
The best time to buy MLPs, however, was in early to mid-February just as they started to emerge from the depths of an 18-month collapse. Market psychology had turned so negative that investors were panic selling anything related to oil, even MLPs.
Since then, with the robust recovery in the Alerian MLP index, it's easy to assume that the opportunity in the group has passed. The index, however, still would need to appreciate nearly 50% from current levels to get back to the highs of August 2014.
Moreover, based on the low valuations of high-quality, midstream MLPs, clear growth potential exists. Capital markets, both debt and, to some degree, equity are open again to MLPs. Distributions for quality MLPs mostly have been maintained or raised.
The key to owning MLPs during this period is to be selective. Seek out strength while waiting for a turnaround to materialize fully. Ensure those companies have the staying power to participate in the sector's recovery.
It's best to own midstream partnerships with low commodity price exposure and strong balance sheets that can carry them through what continues to be a down cycle.
It's also best to invest with MLP management teams that have long understood the implications of counterparty risks and have dealt with them in past contract negotiations.
How should retail investors new to the sector buy MLPs?
Indexing is in vogue today, and it's easy to jump on the MLP bandwagon by buying an ETF like the Alerian MLP ETF. It's preferable to have active managers and analysts at mutual funds doing their homework, building a diversified portfolio and buying the strongest companies with the best managements, stable cash flows and solid balance sheets. Consider Maingate MLP Fund or Tortoise MLP and Pipeline Fund.
Remember: We're still in the midst of the deepest, longest MLP downturn in history, and uncertainties about both price and correlation remain.
So, too, though, do opportunities.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned. Debra Silversmith is the chief investment officer for First Western Trust in Denver.