From the July 2012 issue of Research Magazine • Subscribe!

MLPs Come into Sharp Focus

In today’s market environment, yield-starved investors have more reasons than ever to look at master limited partnerships

 Following the global financial crisis, in particular, MLPs generated great interest because of their orientation to income and stable returns.

Over the last 15 years, MLPs have chalked up an annualized total return of 16.6% — highest of all the major asset classes, including stocks and bonds, as measured by the benchmark Alerian MLP Index (AMZ), a composite of the most prominent MLPs in the energy space. In that period, MLPs increased 9% on an annualized basis. Last year, the group’s total return came in at 13.88%.

Since 1996, these partnerships have produced a 290% total return versus the S&P 500’s 90%. In fact, MLPs have outperformed the S&P on a total-return basis in 11 of the past 12 years, according to a Baird Equity Research report on MLPs published in late January of 2012.

Certainly, with today’s continuing low interest rates, investors are ever-seeking yield. Enter MLPs, which compared to other equity securities, deliver an indisputably higher yield. Right now, measured by the Alerian MLP Index, MLPs are yielding 6%. That’s especially appealing when contrasted with today’s low U.S. Treasury bond rates.

“This is a group of companies that pay out very healthy cash distributions to investors each quarter,” says Columbus, Ohio-based Jason Stevens, director of energy research for Morningstar, in an interview. “When you get 6% or 7% annual yield on your distribution, plus prospects for 5% growth, you’re talking about a low double-digit return. In this market, that has a pretty strong appeal to investors who are getting less than [2%] on a 10-year Treasury.”

One reason that the majority of investors are relatively unaware of MLPs and what they offer is that the asset class is still emerging: The total market capitalization of energy-related MLPs comes to $350 billion, according to Kenny Feng, CEO and president of Alerian in Dallas.

Of the 100-plus MLPs trading in the stock markets, 80% are companies that operate in the energy arena, with most of them in the midstream portion of the energy chain. Business is booming for these firms — which emphasize pipeline and storage operations, as well as gathering and processing — as a result of the U.S. bonanza in natural gas and oil production. A big plus to investing in midstream MLPs is that there is little direct price exposure to the commodities themselves and therefore far lower risk, experts say.

“In midstream, MLPs are more or less where the action is,” Stevens says, in an interview. “With their partnership structure, they pass through earnings and losses to unitholders instead of paying taxes. This effectively results in a lower cost of capitalization for MLPs. It’s essentially a tax subsidy for the industry to build infrastructure and help promote cheaper oil and gas prices.”

Energy Renaissance

The renaissance of America’s energy industry clearly helps MLPs. “The U.S. has been growing natural gas and oil volumes, and as we do that, we need more gathering systems, more transportation systems and more processing systems to move those hydrocarbons to where they’re needed,” says John Dowd, manager of Fidelity’s Select Energy Portfolio, based in Boston, in an interview. “MLPs in the midstream space profit from that. These [units] have done well in the past decade, not because their price/earnings ratios or dividend yields have gone in their favor, but because their opportunities have actually grown — and that’s real.”

MLPs pay investors — the limited partners — quarterly dividends called distributions. That term is used instead of “dividend,” because MLPs are structured differently from corporations, which pay dividends.

With direct investment in an MLP, a portion of the yield is considered a return on the original investment, as opposed to a return on capital. This means limited partners pay no tax on distributions until they sell their MLP shares, or units.

Investors receive “compelling value, with secure distributions and attractive yields,” notes Wells Fargo Securities in its MLP Monthly Equity Research Report for May 2012. “A certain subset of the MLP sector offers ‘rock-solid’ distributions with predominantly fee-based cash flows and minimal (or no) direct commodity exposure. Median yield: 6.0%.” These MLPs, Wells Fargo says, include  Magellan Midstream Partners (MMP) and  Spectra Energy Partners (SEP).

But the MLP story isn’t only about income. A high level of capital appreciation also occurs as a result of that income. “The income grows — the distribution yield grows,” stresses Ashley Lannquist, investment research analyst at Segal Rogerscasey in Darien, Conn., in an interview.

What drives that capital appreciation, Lannquist continues, is “growth of the underlying MLPs — whether organic or acquisitive. Both 2010 and 2011 were record years for MLP acquisition activity. Organic growth comes from building out infrastructure, such as pipelines and processing facilities — new energy opportunities around the country.”

Thus, MLPs offer not only stability in distribution payments over a prolonged period, but also the ability to raise distributions. This constitutes the security’s total return.

“For the past 10 years, ending December 2011, MLPs have generated an 18% annualized total return,” notes Feng. “Of that 18%, 7% has been distribution growth; 7% has been yield; and 4% has been valuation compression.”

Since 1995, the average yield on the Alerian MLP Index has been about 7.8%. For 2002-2011, average distribution growth was between 0.3% and 10.8%, for an annualized average of 5%. For 2012, analysts are forecasting distribution growth to range between 5% and 8%.

“MLPs have performed very well since 1996. The Alerian Index has returned an average [total return of] over 16% a year. The returns have been great. The track records have been great,” says Andy Pusateri, a senior utility analyst with St. Louis-based Edward Jones, in an interview.

For the past couple of years, MLPs’ performance also has been excellent. “These investments have performed very well on a price basis and a total return basis,” says Darren Horowitz, a managing director of energy equity research at Raymond James in Houston, in an interview. “For 2011, this is an asset class that delivered about 7% versus 2010 just on price and almost 6% on distribution growth. So, you’re talking about 13% total return in 2011.”

“That’s a function of the boom in unconventional energy production. A  lot of crude oil, natural gas and natural gas liquids are coming from areas that are very prolific but need the infrastructure to get those hydrocarbons to market,” Horowitz continues. “Doing that are the pipeline, storage and other midstream companies. The North American infrastructure footprint is the cardiovascular system of the U.S: It takes the hydrocarbons from the areas of production to the areas of highest demand and consumption.”

With today’s lower cost of capital and low-interest-rate environment, a great deal of money is being deployed to create new infrastructure. “That’s a good thing” for MLP investing,” Horowitz notes. “By our models, we think anywhere between $8 billion and $10 billion per year has been spent over the past few years. And going forward over the next decade, in order to keep pace with a lot of the production trends coming from areas that have been underinvested, [billions] more will be spent on additional infrastructure.”

Baird Research analysts note that these partnerships “own and operate the core of American infrastructure, without which other key infrastructure assets, such as roads, bridges, hospitals and power plants could not function … MLP pipelines [are] providing the wholesale distribution of motor and jet fuel, the natural gas that heats homes and increasingly generates cleaner power, and the natural gas liquids that are precursors to many petrochemical activities.”

 Energy Infrastructure

To be sure, investing in midstream MLPs is investing in the U.S. energy infrastructure and the country’s ability to produce energy for its own consumption, as well as for future export, experts stress.

“As the U.S. continues to [increase] domestic development and production of natural gas to even petroleum and other forms of energy, you need to distribute it and transport it to where it needs to be,” says Alex Ashby, a research analyst with Global X Funds in New York, in an interview.

Exporting domestic energy is clearly on the agenda. “As the U.S. perhaps becomes more of an energy exporter, you need to figure out ways to get that energy from where you drill it — say, in North Dakota — to the coast, where you can then ship it out,” Ashby explains. “So, MLPs are really a play on increased flow and transportation that will be required to meet this greater domestic production.”

The first MLP, Apache, debuted in 1981, according to Baird Research. Since 1987, Congress has generally limited companies that qualify for the MLP structure to those deriving their income from natural resources and energy activities, and to certain types of real estate and financial-services firms.

By March 31, the number of publicly traded energy MLPs totaled 81, according to Feng. Of these, 72 are limited partnerships; seven, general partnerships and two, institutional shares.

“Starting in the 1990s and going into the 2000s, the pipeline industry found that MLPs worked really well for them: They had a lower cost of capital because of their lack of corporate taxation,” says Mary Lyman, executive director of the National Association of Publicly Traded Partnerships, based in Arlington, Va., in an interview.

“Pipelines are very capital intensive — it takes a lot to build a pipeline and get it into the ground,” she explains. “Once you do that, there’s a steady, fairly modest return generated by the fees [exploration & production] companies pay to send their products through the pipeline. That kind of steady income supports the distributions to MLP investors.”

Since most of an MLP’s cash flow is paid out in distributions, access to external capital is critical. “Acquisitions as well as organic growth are dependent on the company’s ability to raise debt and equity from the eternal market,” notes Pusateri of Edward Jones.

To be sure, in order to grow either organically or acquisitively, MLPs must be able to obtain such capital. “They pay the majority of their earnings in cash flow, so when they have a new project, they need to go to the equity and debt markets to raise money to finance it,” Dowd says.

During the financial crisis, when it was difficult to raise money, the sector’s valuation fell, coincident with pressure on the corporate bond market. But the great news was that at the height of the crisis in 2008, most MLPs continued to pay out distributions. Further, “most of them increased their distributions, and the Alerian Index bounced back hard in 2009, up 76% —  a bigger bounce than the S&P 500 had,” Lannquist says.

Because MLPs did not stop making distributions and recovered from the crash more quickly than other securities, investors stuck with their MLPs, while many others took notice of this atypical asset class.

“In 2008, clients held onto their MLPs because of the strong cash flow component and because the fundamentals were sound. So we were able to ride through the volatility and benefit as the asset class recovered,” says financial advisor Michael Bollinger, a managing director with Morgan Stanley Smith Barney’s private client wealth-management business in Houston, who has been actively investing in MLPs since the 1990s.

After the peak of the global crisis, much attention was given to securities capable of providing highly stable income yield, along with some inflation protection and diversification. “MLPs fall into that category,” says Linda McDonald, a vice president of hard assets with Segal Rogerscasey in Dublin, Ireland, in an interview. “The high and stable yield has been very important. Also, investors were interested in liquidity. And with MLPs, you get liquidity. You’re investing in a real asset but have liquid exposure to the asset class — you’re not locked in.”

The main driver of unit-price performance in the sector is distribution growth, experts underline. “MLP investors generally are very focused on the income side, and they look for distributions that are both stable and have growing cash flow,” Feng says.

Faster distribution growth “almost always leads to better share performance,” Pusateri adds. “Other drivers include commodity prices, interest rates and access to capital.”

MLPs’ cash-distribution growth means not just absolute percentage growth year over year, but also, according to Horowitz, “the financing, integration and execution risk associated with driving that cash distribution growth.”

Steady MLP Rollout

There’s been a consistent introduction of new MLPs over the years. “The sector keeps growing in incremental chunks, and it continued to grow through the financial crisis,” Lannquist notes. Right now in the wings are eight new MLPs set for IPOs, according to Lannquist.

“Investor thirst for dividend yields is driving the proliferation of MLPs, and that will continue as long as interest rates stay low,” Dowd says. “MLPs are basically competing with bonds in a portfolio. When bond yields rally, MLP yields rally, and vice-versa.”

Still, investors have to take commodity-price exposure into account as well. And the associated volatility can make some MLP distributions less stable.

“I prefer midstream, because overall it provides more stable cash flows,” Pusateri says. “But there are definitely going to be times when the upstream MLPs outperform. When commodity prices are doing well, they will have high cash flows and may be able to raise their distributions faster. But when it’s a tough environment, the midstream companies are better positioned to raise their distributions.”

Historically, investors have been focused a lot on midstream — infrastructure — MLPs because they are less affected by the commodity-price movement. “It’s easier to wrap your mind around investing in a company that’s a little more stable,” Feng says.

Diversity in MLPs

In the past five years or so, a number of different types of businesses have moved into the MLP space, including propane distribution companies, coal companies, shipping companies and various logistics businesses.

There are five coal MLPs, according to Lannquist, and some coal MLPs have strong financials and growth profiles, she says. At any time, there will most likely be one or two coal MLPs with good growth potential, for instance, like Alliance Resource Partners (ARLP).

Some experts have a generally positive take on coal MLPs going forward. “Natural gas prices have been below coal recently, so we’ve seen natural gas gain market share and coal lose market share,” Dowd says.

While that has been a negative to coal-related MLPs in the recent past, now there’s “much less growth of natural gas production, and coal prices are so low that companies are shutting down production and shrinking volumes,” explains Dowd. This means that the supply of fuels we use to make electricity is shrinking. And that’s fairly bullish. What the future is for coal over the next five or ten years, we don’t know. But it’s bullish today for coal.”

Recently, more E&P MLPs have started to pop up. They have improved business models when compared with some upstream MLPs launched in the early 1980s, Pusateri points out.

“Those were relying on risky drilling and had really high debt levels. But now, there’s less drilling risk,” he explains. “Reserves in certain areas are more appropriate. At the same time, some of these partnerships that are drilling for oil and gas are also hedging some of their production — buying or selling natural gas or oil futures in the financial markets. That reduces a little bit of the commodity price exposure.”

A new trend in midstream MLPs may be on the way with the anticipated introduction of a rising number in the commodity-storage business. “A lot of analysts are predicting that excess production this summer or fall will test the capacity limits of natural gas storage facilities,” says Ashby. “Therefore, this could be an area where you might see new MLPs or increased investment in some existing ones.”

More activity also may be en route in transportation MLPs, which have to meet the needs of America’s energy-exporting business. “If the U.S. continues to increase production and builds the infrastructure to actually export to big consumer countries — like China and the rest of Asia — this would be another area that might get focus,” Ashby notes.

For 2012, experts look for continued excellent performance in the entire MLP sector. Forecasts at Raymond James, for instance, call for the asset class to appreciate between 5% and 8% this year vs. 2011. Total return should be in the 10%-15% range. Other analysts estimate a 12% or 13% total return. 

Baird’s optimistic report states: “We expect 2012 growth to be limited only by capital availability. Look for strong M&A volume and enormous secular growth opportunities.”

The popularity of MLPs is likely to continue “as long as we see interest rates this low and a lack of other good income investments,” Lyman predicts.

For the medium term —  2013 to 2015 — the outlook is just as upbeat. “MLPs’ robust yields and attractive fundamentals should continue to drive performance,” according to a recent Wells Fargo report. “Our positive outlook for the MLP sector is supported by (1) continued positive fund flows, (2) a strong fundamental backdrop, and (3) investors’ continued preference for yield-oriented securities. We should not be surprised to see more periods of consolidation in the group, which we would use as opportunities to increase positions in favorite names.”

The beauty of the MLP model has always been stability and consistency in cash flow with minimal associated risk in achieving growth. “We think the target of a total return in the 10%-15% range over the next few years is achievable,” Horowitz says.

Other analysts agree that all indications are “go” for MLPs’ ongoing appeal. “The outlook for the next couple of years is very positive from the investor demand perspective, and also because of organic growth opportunities from infrastructure shortages in the new natural gas shale-producing regions,” shares Lannquist.

“There are also a lot of growth opportunities for MLPs that gather and process natural gas liquids, and that will continue for the next couple of years …” the analyst notes. “A lot of institutional money is going into the MLP asset class.”

For example, the pensions of the Missouri State Teachers Association and the University of Texas Investment Co. invest in MLPs.

“The new supply in shale areas provides a great opportunity now and during the next few years for new projects for MLPs,” Pusateri adds.

In addition, master limited partnerships dovetail nicely with America’s increasing energy independence. “Over the long term,” Feng says, “MLPs are an investment in the longer-term build-out of the energy infrastructure of the United States.” J

 

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