A Mid-Year MLP Check-Up

Ethan Bellamy of Robert W. Baird discusses the current prospects facing investors in master-limited partnerships

Master limited partnerships (MLPs) have been generating solid price gains and distribution yields recently.

For a broad outlook on the sector, AdvisorOne.com turned to Ethan Bellamy (left), Robert W. Baird & Co.’s Denver-based senior MLP analyst. (Also, see the July 2011 Research Magazine Guide to Master Limited Partnerships for additional information on the industry.)

What’s your overall outlook on growth and possible risks for MLPs?

We typically think about MLPs in two ways. First, what are the prospects for and the risks for distribution growth? In that silo we don’t see any problems.

There’s a huge secular growth opportunity for MLPs that we think should drive 4 to 6% average growth for the MLP sector for the coming decade (producing) significant out-performance from an income generation and distributable cash flow generation perspective.

That’s really a derivative of the shift in domestic oil, gas and natural gas liquids resources created by hydraulic fracturing and horizontal drilling. They have massive new resources so there’s a very strong infrastructure and capital need around those domestic resources.

I don’t think that there is any real risk to that secular growth opportunity. So, for dividend or distribution increases, I think we’re pretty solid there.

On the capital side, the outlook is a little less clear. We’ve got historically low U.S. Treasury rates that are artificially low because of Federal Reserve policies.

The range of estimates for where the 10-year Treasury is going to be next year are fairly wide, but if Treasury rates move up substantially, that is a negative headwind.

The second thing is that the uncertainty with respect to the short-run and long-term deficit has increased investor concerns about potential legislative risks to the MLP asset class.

We think that ultimately they won’t receive any type of tax change. We think the sector has been very good at doing exactly what Congress intended in the late ‘80s, when the tax code was put in place -- which is to foster domestic energy development, which is a positive public good.

The MLPs have been a great conduit for efficiently applying capital to the market. However, with Congress basically saying everything is on the table, that is going to create some psychological barriers for some investors at the margin in terms of allocating or over-allocating capital to the MLP sector.

On the capital side, that could negatively impact valuations. We’ve said there is and always has been and always will be some legislative risk for any asset class that has a different tax structure like MLPs do.

We don’t think it’s big, but you definitely want to keep that in mind when you’re thinking about portfolio allocations.

The potential environmental risks of fracturing are receiving more media attention. Do you see any possible problems there in the near-to mid-term?

I don’t. I think that what will happen and probably what should happen are enhanced industry best practices and standards for the use of everything from the hydraulic fracturing process itself, the management and processing and cleaning of the flow back fluids, and surface-level issues with respect to water.

It is already taking place and that would include also things like disclosure of what chemicals are used in the process.

Let’s say we had what the kind of environmentalist’s wish list would be, which is strong EPA regulation.

I don’t think that there is a likelihood of some sort of general prohibition on hydraulic fracturing because there just isn’t the scientific evidence to support that.

Fracturing has been going on for a long time and most of the issues that have come up have been surface level issues and things like well casing, which I think can be addressed by best practices. This is an industrial process that involves humans and so, just like plane crashes and truck crashes, we are going to have some incidents.

But I generally think that they can develop these resources without negatively impacting the environment.

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