Most MLP investors are attracted by the regular distributions paid out by midstream infrastructure businesses. Some though, are wary of a repeat of the heightened volatility of 2015 even though evidence increasingly supports our analysis from early last year that an improbable confluence of circumstances was responsible (see The 2015 MLP Crash; Why and What’s Next).

I had just this conversation with a financial advisor last week, and I offered him the following perspective: if MLPs are too volatile to be an income substitute, an alternative approach is to consider them as a replacement for equity sectors that have similar volatility and with whom they share a meaningfully positive correlation.

Many advisors recommend an allocation to Emerging Markets (EM). The theory behind this is that because developing countries have faster GDP growth than developed countries, they should offer commensurately higher equity returns. The problem with this theory is that the transmission mechanism from GDP growth to equity returns is not uniformly effective all over the world. Weak corporate governance and property rights, uncertain contract law and government corruption can all interfere with a foreign investor’s GDP insight translating into appreciation of stock holdings.

Since 1996 (the inception of the Alerian Index, AMZX) the correlation of monthly returns on the MSCI Emerging Markets Index (MSCI-EM) with AMZX is 0.42. But it’s been rising, and over the past ten years it’s 0.53 and for the past five 0.55.Because the U.S. High Yield bond market is dominated by Energy issuers, when investors flee more risky borrowers their actions tend to ripple across Energy as well as EM. Asset class correlations generally have been rising, diminishing the benefits of some types of diversification. MLPs also have only around 80% of the volatility of EM. Moreover, since 1996 AMZX has returned 13.2% annually, almost four times the MSCI-EM’s 3.4% even though 2015 was a terrible year for the energy sector. Switching out of EM and into MLPs offers just this type of opportunity for a portfolio upgrade that doesn’t increase overall risk.

Some years ago when I was with JPMorgan, I was in India and had the opportunity to chat with a senior member of the Reserve Bank of India (RBI), the country’s central bank and securities market regulator. We had been meeting with Indian hedge fund managers while we considered the wisdom of adding an Indian investment to our portfolio.

“How many insider trading cases does the RBI prosecute in a typical year?” I casually enquired. “Oh none. There is no insider trading in India.” was the barely credible response. To which the only rational conclusion is that if your Indian investment manager isn’t actively using inside information, you’re unlikely to make much money. A JPMorgan due diligence questionnaire that sought an affirmative response on this question would have taken internal meetings with Compliance in a wholly unhelpful direction. We did not invest in India.

Most global companies have revenues and profits linked to EM. They have to allocate capital where they see the best opportunities, and navigate their way through each country’s business practices, laws and taxes to realize an appropriate return. The collective capital allocation decisions of the management of the S&P500 companies is almost certainly far better than that of any EM money manager screening locally listed stocks. If Coca Cola, P&G, Nike, Apple and so on in aggregate seek 3% exposure to Brazil, it takes a substantially mis-directed degree of self-confidence to assume one knows better. Therefore, many investors can hold their large cap equity positions and consider their optimal EM exposure achieved as well.

The S&P500 has generated an annual return of 8.6% since 1996, handily beating the MSCI-EM return of 3.4% noted earlier. In fact, the EM index is still 30% below its high from 2007, before the Financial Crisis. The figures clearly show that the relatively faster GDP growth of Developing Economies doesn’t translate into higher equity returns. Those investors seeking direct exposure are getting severely penalized.

Given the history and figures listed above, switching EM into MLPs is pretty compelling. The lower volatility of MLPs combined with their increasing correlation with EM means that the switch is likely to improve your portfolio’s risk characteristics. More importantly, it should substantially improve your return profile. MLPs regularly beat EM; since 1996, the one year trailing return on MLPs has beaten EM by at least 10% fully 48% of the time (the reverse statistic is only 24%). By contrast with EM, your domestic energy infrastructure investment benefits from attractive valuation, the tailwinds of America’s path to Energy Independence and a White House that is clearly supportive. Disputes over trade, a strengthening dollar or the overthrow of a foreign potentate are all challenges for the EM manager that will leave the MLP investor blissfully unharmed.

So if you’d like to participate in the secular growth in U.S. energy infrastructure that is driven by the Shale Revolution but are wary of classifying it as an income generating investment, use your EM bucket and improve your overall portfolio quality. If the K-1s put you off, look for a RIC-compliant mutual fund that provides 1099s.

Long time subscribers will recall that back in 2015 this blog sought ever more creative and different ways to communicate the same message, which was that MLP prices had fallen far enough and represented compelling value. Bear markets have an unfortunate tendency to last longer than their opponents would like. Although the sector rebounded strongly in 2016, some of those 2015 blog posts were premature.

One lesson is that if you’re going to write constructively during a bear market, marshall your arguments and prepare to spread them over more weeks than you might anticipate. Last week MLPs and crude oil rediscovered their once close relationship, to the detriment of investors in energy infrastructure. Forewarned, your blogger will not expend all his constructive thoughts right away.

Prior to the Shale Revolution, MLPs were fairly described as having little correlation with commodity prices. Pipelines were a toll-like business model whose returns were driven by volumes. Today, much of the point of investing in the sector relies on the growth prospects made possible by the Shale Revolution. Ten years ago the need for new investment was limited; today it’s clear that to exploit newly accessible hydrocarbons, infrastructure needs to support these new locations. North Dakota was not known for oil, nor was Pennsylvania known for natural gas.

Therefore, the returns on energy infrastructure investments are nowadays more sensitive to growing domestic production and the consequent utilization of existing as well as planned infrastructure. To take one example, Plains GP Holdings (PAGP) anticipates a substantial increase in EBITDA if growing oil production absorbs more of its available pipeline capacity. Oil production reacts to prices; PAGP’s prospects are linked to those of its customers.

Last November’s strategy shift by OPEC to cut production was an ignominious admission that their prior effort to bankrupt the U.S. shale industry through low prices had failed. It represented a watershed event, the moment when it became clear that a new paradigm was in place, as we noted in The Changing Face of Oil Supply.

“Short-cycle opportunities” are what every oil company needs. Shale now counts the biggest integrated oil companies among its proponents. Exxon (XOM) CEO Darren Woods recently noted that a third of their capex budget is devoted to such opportunities. The key here is the liquidity of the oil futures market. If your project’s timeframe extends beyond the availability of hedge instruments, your IRR is going to be driven by things you can estimate but not control. The real revolution of shale is its short capital cycle; numerous wells are drilled cheaply, with fast but sharply declining production. Capital invested is returned with a year or two and risk can be hedged. Conventional projects require huge upfront commitments with long payback times and consequently uncertain economics.

The recent sharp drop in oil prices hasn’t been pleasant for producers anywhere. But consider the planners of a conventional project – a Final Investment Decision to proceed is a little less certain. Once capital is committed beyond a certain point, there’s little choice but to press on and accept whatever outcome markets deliver. Whereas shale producers, the group whose success ostensibly caused the 2015 crash, can cut back activity with comparative ease. They can just stop drilling, and wait. They can take advantage of even brief rallies in crude futures to hedge production and increase output.

This is why capex on conventional projects continues to fall, as shown in the attached chart from a recent presentation by Lars Eirik Nicolaisen of Rystad Energy. The longer term problem is shaping up to be insufficient investment in new supply to offset depletion of existing fields and new demand (estimated to require around 6% of new supply annually, about 6MMBD, or Millions of Barrels a Day).

The recent drop in crude demonstrates no shortage of supply currently, but also makes providing new supply less attractive in the long run.

MLP investors easily recall the 50.8% drop in the Alerian Index from August 2014-February 2016, its low coinciding to the day with that for oil. We don’t know where crude prices will go over the short term, but it’s becoming increasingly clear that the U.S. is set to gain market share because its short-cycle opportunities represent a substantially more attractive risk/return than conventional projects.

Reaching the long term requires navigating the short term. While you’re doing that, consider how you’d seek your company’s Board approval for a conventional oil project requiring ten years of output to recover its upfront cost. Those shale guys in the Permian could wreck your assumptions, and then protect themselves from the damage they’d wrought by quickly cutting their own capex and production. Without an adequate response, you might feel like moving to West Texas.

We are invested in PAGP

A few weeks ago I did an interview with friend Barry Ritholtz for his Bloomberg series “Masters in Business”. It was just posted online, so for those that are interested you can find it here. Comments on MLPs are at the 65 minutes mark.