On May 6 the broader market averages were headed for a sizeable
decline, but the selling was orderly.
What happened over the space of about 15 minutes was
extraordinary: The Dow Jones Industrials Average plunged from about
350 points down to almost 1,000, and the S&P 500 sliced through
a key support at 1,100, hitting a low of 1,065. Soon thereafter,
the market recovered, rallying back to roughly where it was before
the precipitous drop.
No one can say with any degree of certainty why this mini-crash
occurred. The most common explanation is a so-called "fat finger
trade"--that is, a trader keyed in a sell order denominated in
billions rather than millions. Such a mistake tends to snowball;
stop-loss orders are activated, and the quick selloff triggers
institutional sell programs.
But regardless of the cause, one thing is certain: The quick
selloff did not represent normal market trading behavior and had
nothing to do with underlying market fundamentals or any piece of
news. Liquidity dried up at the lows, and very few shares changed
hands--even in prominent large-cap names.
Take the case of Procter & Gamble (
), a safety-first stock that tends to be less volatile than the
broader market. At the height of the selloff, P&G traded under
$40 per share, down 37 percent from the prior day's close, even
though no news came out that would have precipitated such a
Only a little over 26,000 shares of P&G actually traded at
between $39.37 and $43. That's next to nothing when you consider
that P&G trades more than 11 million shares on average and
traded nearly 29 million shares yesterday. In short, the market
simply stopped functioning.
It's no surprise that a day which features extreme moves in a
highly liquid stock like P&G would produce even more examples
of aberrant trading in less-liquid and more thinly traded stocks.
As I mentioned in yesterday's Flash Alert, many of the MLPs we
recommend in this publication suffered from the anomaly.
For example, Aggressive Portfolio Holding
Linn Energy LLC
) tumbled to an intraday low of $12.60--down 50 percent from the
prior day's close--before recovering most of those losses by the
close. The graph below tracks this unusual price movement.
Linn's units dropped substantially at the height of the
financial crisis, but that selling was orderly. Note that the
intraday range for Linn on May 6 is the biggest gap in its
Just as P&G had no liquidity near those lows, scant trading
occurred near Linn's lows. The MLP's units traded in 218
transactions at prices between $12.60 and $17 yesterday, a total
volume of about 51,000 units. On a normal day roughly 1.6 million
units of Linn change hands; yesterday the volume was closer to 7
When Linn traded at that level, the bid-ask spread--the
difference between the price at which you can buy a stock and the
price at which you can sell it--expanded to well over $1. In a
normal trading environment, the bid-ask spread would be around 5 to
10 cents. Linn's units likely would have traded lower on May 6 in
sympathy with the broader market, but a price of $12.60 suggests
the market wasn't functioning properly.
Although the trading action in Linn and other MLPs was
unrealistic and dysfunctional, this drop had real implications for
some investors, particularly those who set stop orders or trailing
stops. Stop orders instruct a broker to automatically liquidate a
position once the stock breaches a certain price. In most cases,
traders use stop market orders; as soon as the stop is activated
your broker will execute a market sell order to get you out of a
stock at whatever the prevailing price might be.
Undoubtedly, there were plenty of investors in Linn, P&G and
a long list of other stocks that got stopped out on the vicious
intraday decline on the May 6. To make matters worse, liquidity was
at a premium at the height of the selloff; many stop orders would
have been executed at extraordinarily depressed prices.
Stop-related selling not only cost investors a lot of money
yesterday but also contributed to the broader selloff.
Ownership of MLP units tends to be concentrated among individual
investors rather than institutions. Because individuals are more
likely to set stops, prices of MLP units dropped more than shares
of other companies.
Since Roger and I started
, we've advised subscribers not to use stop-loss orders or trailing
stops for these companies. Roger reiterated this point in the April
2, 2010, Viewpoint
Rating MLP Safety
Although no one could have anticipated a 100 percent roundtrip
move in Linn Energy's units in 15 minutes, several MLPs have
experienced wild intraday action over the past few years. These
gyrations were undoubtedly caused, to no small extent, by the
activation of scores of stop loss orders at around roughly the same
price levels. Invariably these quick selloffs and recoveries will
result in investors getting knocked out of an MLP at the worst
When trading stocks, stop losses can be an outstanding way to
reduce risk--I recommend stops on some positions in
, the sister publication to MLP Profits. But stops don't make
sense for MLPs.
Your best bet is to keep on top of the fundamentals underlying
our favorite MLPs.
If a partnership's business is sound and its distribution
secure, we'll continue recommending the MLP; if an MLP has
fundamental problems, we issue a sell recommendation in an article
or Flash Alert.
Whenever the market heads steadily higher, hosts of investors
hope for a pullback as an opportunity to buy. But when the
correction actually hits, these erstwhile dip-buyers often
disappear; the panic and fear that drive every correction take
These panic-fueled bouts of volatility are an enormous
opportunity. The current market environment offers plenty of
chances to accumulate our buy-rated MLPs at attractive prices.
The broader market selling has been driven by concerns
over about Greece's sovereign debt. In the grand scheme of things,
Greece's economic woes wouldn't have a huge impact on the global
economy in isolation. But investors fear that the contagion could
spread; Greece's credit woes have already impacted Portugal, Spain,
Hungary and other countries on Europe's periphery, and some fear
that it could spread to larger economies such as the UK or US.
Another fear is that sovereign credit woes will infect the
interbank lending market, touching off another global credit crunch
akin to what happened after Lehman Brothers declared
Credit woes are a problem for MLPs because these companies use
debt and credit lines to fund new projects and to make
acquisitions. But the risk of a 2008-style credit collapse is
remote. Check out the graph below.
This graph tracks the TED spread back to 2005. The TED spread is
the London Interbank Offered Rate (LIBOR) minus the yield on a
three-month US treasury bond. LIBOR is the rate banks charge to
lend to one another, while the three-month US bond yield is
considered a risk-free interest rate. The spread is typically
measured in basis points, equal to 1/100 of a percent.
When LIBOR rises relative to government bond yields, it
indicates stress in the interbank lending markets. In other words,
high TED spread readings reflect a credit crunch.
As you can see, the TED spread soared in 2007 and 2008 as the
credit crunch and financial crisis worsened. You can also clearly
see the improvement in this market since early 2009; in fact, the
TED spread was at record lows just a few months ago. This trend has
enabled MLPs to raise significant capital for expansion--a huge
tailwind for the group.
The TED spread has spiked a bit recently but still indicates
that interbank credit markets are extremely healthy right now--the
spread is at even lower levels than it was in 2005 and 2006.
Another severe credit crunch appears unlikely, but most of our
favorite MLPs already have raised significant capital via debt and
share issues, providing plenty of capital to fund current growth
plans even if debt markets do constrict.
Against that backdrop, any weakness in our favorite MLPs is a
great opportunity to jump in and buy.
Although the market continues to focus on macro-level risks, we
also keep a close eye on the financial performance of the
individual MLPs we recommend.
As we noted in a
earlier this week, units of
Encore Energy Partners
) were hit hard after the partnership trimmed it distribution and
its general partner (GP) announced plans to sell its 46 percent
stake in the firm.
Encore Energy Partners was originally created by an exploration
and production (E&P) company called Encore Acquisition as a
vehicle to hold some of that company's mature oil and gas-producing
properties. Encore Acquisition owned a 46 percent stake in the MLP
and controlled its GP.
This type of arrangement isn't uncommon. In many cases, E&P
firms are valued based on their ability to grow production, and
mature fields don't generate much production growth. But mature
fields do generate copious amounts of cash; steady cash flows make
these fields ideal for the tax-advantaged MLP structure. By
creating the MLP, Encore raised some capital and enhanced the value
of its mature properties, which are worth more inside a
high-yielding MLP than buried inside a corporation like Encore
On March 10, 2010,
) acquired Encore Acquisition in a $4.1 billion cash and stock
deal. This meant that Denbury Resources also acquired Encore's
stake in Encore Energy Partners and ownership of the GP.
Denbury's proposed sale of Encore Energy Partners has weighed on
the MLP's unit price, as investors interpreted the announcement as
a decision not to support MLP.
Bear in mind that Denbury didn't form Encore Energy but acquired
it recently as part of its purchase of another company. It's not
uncommon for an E&P firm making a major acquisition to
rationalize its portfolio by selling off some of the properties
owned by its target. In fact, I can't recall a single E&P
acquisition in recent memory where the acquirer didn't do a
strategic review of the target's properties and make at least a few
In this case, three factors appear to be driving Denbury's
decision to sell Encore Energy Partners.
For one, Denbury's focuses on tertiary oil recovery, or the use
of carbon dioxide floods to produce oil from older fields. Most of
the Encore Energy Partners' properties aren't appropriate for
carbon dioxide flooding. The only exception identified during the
first-quarter conference call was the MLP's Elk Basin field in
Wyoming and Montana. This field might be amenable to carbon dioxide
flood production, and Denbury might be interested in retaining
Second, in early April Denbury sold off about $900 million worth
Encore Acquisition's properties. These were mature properties that
Encore Acquisition's management had envisioned as drop-downs for
the MLP. In a drop-down transaction the GP sells properties to the
limited partner, usually at a price that allows the MLP to
immediately boost its cash payout. After the sale of those
properties, Denbury may have concluded it doesn't have many
properties left that would be suitable for drop-down to Encore
This makes sense because most of the properties Denbury buys
would be fields appropriate for tertiary carbon dioxide flood
production. And carbon dioxide floods require a huge up-front
capital commitment relating to the infrastructure needed to acquire
carbon dioxide and transport it to the field in question. This sort
of capital would probably be too much to bear for Encore Energy
Partners; the large upfront costs and uncertain payback period
would threaten distributions.
Without potential drop-downs from its GP, Encore Energy
Partners' growth opportunities would be limited.
Finally, Denbury is seeking to sell Encore Energy Partners
because the MLP is likely to fetch a good price. Encore's
oil-focused properties in regions like the Permian basin of Texas
are ideal in the current environment of sky-high prices for oil and
natural gas liquids.
Although the MLP isn't that valuable to Denbury because of its
strategic focus and lack of drop-down potential, its assets are in
areas that have seen a lot of acquisition activity in recent
MLP Profits recommendations Linn Energy and
) are just two examples of partnerships that have acquired
properties in the regions where Encore Energy operates--it wouldn't
be a big surprise if both Linn and Legacy made a bid for
Bottom line: The proposed sale of Encore Energy Partners likely
isn't bad news and doesn't reflect some major problem with the
partnership's asset base.
Encore Energy Partners also reported results this week. Broadly
speaking, the distribution cut was a bit of a disappointment,
though management did make it clear that it would adjust the payout
to reflect commodity price realizations.
Although Encore Energy Partners is heavily hedged--100 percent
for 2010 and 90 percent for 2011--some of the hedges that expired
in the fourth quarter of 2009 were struck at much higher oil and
gas prices. These were likely hedges likely date back to when oil
and gas were hit their highs in 2008. The expiration of those
hedges is why Encore LP had lower commodity price realizations for
As for the decline in production the MLP reported, this was
expected; the mature fields the partnership decline natural slowly
and steadily over time.
Encore Energy Partners posted decent results, and the
market has overreacted to the news that Denbury is looking to
sell the MLP; we're upgrading the MLP to a buy under 19.
Conservative Portfolio holding
Spectra Energy Partners
(SEP) announced solid results on May 5. The MLP reported quarterly
distributable cash flow of $0.67 per unit and boosted its
distribution to $0.42, a solid coverage ratio of 1.55 times.
This payout represents a 13.5 percent increase over the $0.37
Spectra paid in the same quarter one year ago. Distributable cash
flow was up 23 percent.
Spectra offered updates on a couple of major organic expansion
projects currently underway. First, the MLP completed a deal with
the Tennessee Valley Authority (TVA) to transport 150,000
dekatherms of natural gas per day to the TVA's new gas-fired power
plant. The project involves a $135 million capital investment to
expand Spectra's NET pipeline in Eastern Tennessee.
In addition, the MLP announced it won approval from Federal
Energy Regulatory Commission (FERC) for the Phase V expansion of
its Gulfstream pipeline. The project will go into service in May of
A focus on high-quality fee-based assets, low debt and extremely
high distribution coverage make Spectra among the safest MLPs in
our coverage universe. In addition, the partnership has myriad
growth opportunities from organic expansion projects and the
potential drop-downs transactions.
Article Republished with permission from <a href="http://www.KCIinvesting.com" rel="nofollow">www.KCIinvesting.com</a> and <a href="http://www.rukeyser.com" rel="nofollow">www.rukeyser.com</a>