Pipeline companies can persevere in a rising interest rate environment

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With rates rising, investors are wondering what that could mean for their midstream energy investments and other yield-oriented securities.
A combination of an accommodative monetary policy and stimulative fiscal policy has driven trailing inflation to historicalhighs. While the persistence of this inflation continues to be debated, the result remains a clear preference for inflation protected holdings including commodities and real assets.
MLPs and pipelines companies outperformed bond returns in 13 of 16 periods of rising rates since 2001 by an average margin of 11.7% and 10.7%, respectively. Pipeline companies have typically fared better than bonds and other yield-oriented securities during a rising interest rate environment, but it is important to remember that they are not immune.

Time periods with rising rates since 2000	10-year Treasury yield change	MLP Index returns	Pipeline company returns	Bond returns	Equity returns
Averages	1.0%	9.5%	8.5%	-2.2%	6.3%

Time periods with rising rates since 2000

10-year Treasury yield change

MLP Index returns

Pipeline company returns

Bond returns

Equity returns

Averages

1.0%

9.5%

8.5%

-2.2%

6.3%

10-year Treasury yield change source = Bloomberg. MLPs = Tortoise MLP Index®. Pipelines = Tortoise North American Pipeline IndexSM. Bonds = Bloomberg Barclays U.S. Aggregate Bond Index. REIT returns source = FTSE NAREIT Equity REIT Index. Equities = S&P 500® Index. It is not possible to invest directly in an index. Past performance is no guarantee of future results.

Let’s take a look at both the potential direct and indirect effects of rising rates on pipeline companies.

Direct effects

The direct relationship is fairly simple as it reflects how increasing interest expenses can affect variable or floating rate debt held by companies. The key mitigating factor is that pipeline companies have historically been very conservative in terms of their debt structure. Midstream companies, including long-haul crude oil, refined product and natural gas pipeline companies generally utilize 70 to 100% fixed-rate debt, making their cash flow growth and longer-term performance less sensitive to higher rates. In short, we believe the direct impact of rising rates on pipeline companies is minimal and in our view will not significantly hinder growth.

Indirect effects

The indirect effect of higher interest rates on midstream energy relates to their impact on total return. There are three main factors that can provide a buffer to rising rates:

ability to pass through inflation in tariff rates or benefit from increased demand
focus on internal growth versus external growth - this has shifted significantly in recent years as companies are
now free cash flow positive and any spending comes from internal cash flow from operations
excess coverage can allow for slightly lower returns on invested capital

First, it’s important to distinguish the catalyst for rising rates – typically either rising inflation or an improving economy. Both have potential benefits for midstream energy:

A strengthening economy benefits pipeline companies transporting energy because an increase in aggregate demand typically leads to more volumes transported.
If inflation is the catalyst, liquids pipeline companies can receive a boost in their tariff rate by an amount based on the change in the producer price index (PPI).

We believe both a stronger economy and inflation are catalysts for rising rates in the current environment. If so, pipeline companies stand to benefit.

History as teacher

MLP and pipeline companies, like all distribution-paying entities, can experience some short-term volatility during periods of rising rates. Historically, midstream energy companies have experienced short-term volatility when interest rates increased, followed by a rebound and solid long-term performance. The following table reflects our analysis of the past 16 periods of one or more consecutive months with a 50 basis point or more increase in the 10-year Treasury since 2000. During those periods, the 10 year treasury yield change has averaged 1.0%, MLPs returned 9.5% and pipeline companies returned 8.5%, compared to -2.2% for bonds and 6.3% for U.S. equities.

Impact of rising interest rates on pipeline companies

Time period	10-year Treasury yield change	MLP returns	Pipeline company returns	Bond returns	Equity returns
3/2001 - 6/2001	0.5%	11.0%	-1.4%	1.1%	-0.9%
11/2001 - 3/2002	1.2%	0.8%	1.7%	-1.9%	8.9%
10/2002 - 11/2002	0.6%	0.2%	2.7%	-0.5%	15.2%
6/2003 - 8/2003	1.1%	7.3%	2.6%	-2.9%	5.1%
4/2004 - 5/2004	0.8%	-8.6%	-2.8%	-3.0%	-0.2%
9/2005 - 6/2006	1.1%	-0.2%	5.0%	-1.2%	5.7%
4/2008 - 5/2008	0.6%	8.3%	11.5%	-0.9%	6.2%
1/2009 - 6/2009	1.3%	32.9%	10.9%	1.9%	3.2%
12/2009	0.6%	6.9%	7.0%	-1.6%	1.9%
9/2010 - 3/2011	1.0%	24.6%	32.1%	-0.8%	27.8%
5/2013 - 8/2013	1.1%	-0.9%	-2.6%	-3.7%	3.0%
2/2015 - 6/2015	0.7%	-5.1%	-1.9%	-2.2%	4.4%
8/2016 - 1/2017	1.0%	9.4%	10.6%	-3.0%	6.0%
9/2017 - 4/2018	0.8%	-4.2%	-3.5%	-2.3%	8.4%
10/2020 - 3/2021	1.1%	57.2%	39.1%	-2.7%	19.1%
8/2021-6/2022	1.8%	12.9%	25.7%	-11.3%	-12.7%
Averages	1.0%	9.5%	8.5%	-2.2%	6.3%

As of 6/30/2022 *Time periods are determined using end of month yields and returns. Periods shown are those where the 10-year Treasury yield increased by at least 50 basis points over one or more consecutive months. Returns are period-specific and are not annualized. 10-year Treasury yield change source = Bloomberg. MLP returns source = Tortoise MLP Index® (as of 1/1/2000). Pipeline returns source = Tortoise North American Pipeline IndexSM (as of 1/1/2000). Bond returns source = Bloomberg Barclays U.S. Aggregate Bond Index. REIT returns source = FTSE NAREIT Equity REIT Index. Equity returns source = S&P 500® Index. It is not possible to invest directly in an index. Past performance is no guarantee of future results

Looking ahead

We believe pipeline companies remain attractive long-term investments in both periods of economic growth and uncertainty. If higher interest rates are a result of accelerating economic growth and / or increased inflation, pipeline companies are well positioned to benefit through greater volumes transported and / or higher tariffs.

Disclaimer:

This commentary contains certain statements that may include “forward-looking statements.” All statements, other than statements of historical fact, included herein are “forward-looking statements.” Although Tortoise believes that the expectations reflected in these forward looking statements are reasonable, they do involve assumptions, risks and uncertainties, and these expectations may prove to be incorrect. Actual events could differ materially from those anticipated in these forward-looking statements as a result of a variety of factors. You should not place undue reliance on these forward-looking statements, which speak only as of the date of this publication. Tortoise does not assume a duty to update these forward-looking statements.
The views and opinions in this commentary are as of the date of publication and are subject to change. This material should not be relied upon as investment or tax advice and is not intended to predict or depict performance of any investment. This publication is provided for information only and shall not constitute an offer to sell or a solicitation of an offer to buy any securities.

MLPs are subject to many risks, including those that differ from the risks involved in an investment in the common stock of a corporation. Holders of MLP units have limited control and voting rights on matters affecting the partnership. Holders of units issued by an MLP are exposed to a remote possibility of liability for all of the obligations of that MLP in the event that a court determines that the rights of the holders of MLP units to vote to remove or replace the general partner of that MLP, to approve amendments to that MLP’s partnership agreement, or to take other action under the partnership agreement of that MLP would constitute “control” of the business of that MLP, or a court or governmental agency determines that the MLP is conducting business in a state without complying with the partnership statute of that state. Holders of MLP units are also exposed to the risk that they will be required to repay amounts to the MLP that are wrongfully distributed to them. In addition, the value of an investment in an MLP will depend largely on the MLP’s treatment as a partnership for U.S. federal income tax purposes. If an MLP does not meet current legal requirements to maintain partnership status, or if it is unable to do so because of tax law changes, it would be treated as a corporation for U.S. federal income tax purposes. In that case, the MLP would be obligated to pay income tax at the entity level and distributions received by an investor generally would be taxed as dividend income. Furthermore, MLP interests may not be as liquid as other more commonly traded equity securities.

The Tortoise MLP Index® is a float-adjusted, capitalization-weighted index of energy master limited partnerships (MLPs). The Tortoise North American Pipeline IndexSM is a float-adjusted, capitalization-weighted index of pipeline companies domiciled in the U.S. and Canada. The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable rate mortgage pass-through securities), commercial mortgage-backed securities (agency and non-agency) and asset-backed securities. The FTSE NAREIT Equity REIT Index is an unmanaged capitalization-weighted index of all U.S. equity real estate investment trust. The S&P 500® Index is an unmanaged, market-value weighted index of stocks that is widely regarded as the standard for measuring large-cap U.S. stock market performance. It is not possible to invest directly in an index.

The Tortoise MLP Index® and the Tortoise North American Pipeline IndexSM are the exclusive property of Tortoise Index Solutions LLC, which has contracted with S&P Opco, LLC (a subsidiary of S&P Dow Jones Indices LLC) to calculate and maintain the Index. The indices is not sponsored by S&P Dow Jones Indices or its affiliates or its third party licensors (collectively, “S&P Dow Jones Indices”). S&P Dow Jones Indices will not be liable for any errors or omissions in calculating the Index. “Calculated by S&P Dow Jones Indices” and its related stylized mark(s) are service marks of S&P Dow Jones Indices and have been licensed for use by Tortoise Index Solutions LLC and its affiliates. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (“SPFS”), and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”).