The master limited partnership is a young, dynamic asset class directly linked to strengthening U.S. economic growth and the country’s historic energy boom. A partnership structure, the MLP is used mainly by energy companies that transport, gather, process, distribute and produce natural gas, crude oil and natural gas liquids. Many MLPs are in the “midstream section” of the energy chain, meaning that they move natural resources between “upstream” exploration and production activities and “downstream” operations, like refining, processing and distribution to end-user markets.
Over the past few years MLPs, which have a growing market capitalization of nearly $400 billion, have provided outstanding returns that have far exceeded those of other yield-producing investments. With their high yields—5-8% on average—MLPs are ideal investments for generating income, experts say.
In 2012, MLPs chalked up total returns of close to 5%. Through the first half of the year, the partnerships have soared. In the first quarter, for instance, the benchmark Alerian MLP Index (AMZ), composed of the 50 largest MLPs, was up about 20%. The outlook for the entire year is just as positive. What’s more, over the long term, analysts forecast annualized double-digit returns.
“MLPs certainly look very compelling as they relate to other alternatives in today’s market. They offer 10%- 12% total returns,” says Darren Horowitz, managing director and energy analyst, Raymond James Financial in Houston, in an interview.
The fortunes of MLPs are closely tied to the U.S. renaissance in oil and natural gas production, which has been made possible by technological innovation that uses drilling techniques—including hydraulic fracturing—to obtain natural resources heretofore inaccessible or difficult to access. Plus, in today’s yield-parched environment, MLPs are a highly attractive way for investors to obtain a stable source of income. They can buy individual MLPs or invest in the asset class via mutual funds or exchange-traded products, such as ETFs and ETNs.
“Investors are clamoring for MLPs and are piling into the funds. They’re very hungry for them,” says Abby Woodham, a fund analyst with Morningstar in Chicago, in an interview. “I’ve seen billions upon billions of flow into ETFs over the past couple of months.”
Global X Funds recently launched the Global X Junior MLP ETF, for instance. It is comprised mostly of mid-cap and smaller-cap energy MLPs, including BreitBurn Energy Partners, Crosstex Energy, Exterran Partners and Holly Energy Partners.
Many partnerships that use the MLP structure are pipeline companies that transport oil and gas from the source to locations of demand and generate income from this “toll-road model.” Because the United States has not invested heavily to build or enhance this infrastructure since the early 1980s, the need for new pipelines and associated equipment is immense.
The ramifications of the significant build-out we’re seeing “are great,” says Horowitz. “It’s creating a lot of jobs, a lot of out-of-state and local taxable income and, most importantly, it’s giving us a significant push that allows the U.S. to be further down the path of becoming more energy independent.”
A study released in 2011 by the Interstate Natural Gas Association of America showed that $240 billion will be invested in North America’s gas infrastructure over the next 25 years, says Kenny Feng, CEO and president of Dallas-based Alerian.
Part of the evolution of the MLP space is tied to the broadening of the types of companies qualifying for the MLP structure, which the Internal Revenue Service is guiding via Private Letter Rulings. To meet the income threshold for an MLP, at last 90% of gross income must come from activities associated with natural resources, including oil, natural gas, coal, minerals, certain renewable fuels and industrial-source carbon dioxide.
Now, in addition to the midstream part of the energy value chain—mostly pipeline MLPs—there are more upstream and downstream companies going public as non-traditional or unconventional master limited partnerships. These include three nitrogen fertilizer companies, like CVR Partners, two refineries and one chemical company. There’s also SunCoke Energy Partners, an MLP that makes metallurgical coke, sponsored by SunCoke Energy.
Because their businesses are seasonal, some of the new MLPs pay quarterly variable-rate distributions, as opposed to the predictable quarterly distributions of traditional MLPs. In the last two years, six companies went public as variable distribution payers, bringing the current total to eight, according to Feng.
“Variable payers are riskier and have more volatility, but their yields are higher,” notes Greg Reid, a managing director of Salient Partners in Houston, as well as CEO and president of Salient’s MLP business, in an interview.
Most variable-rate MLPs—65% to 70%—are institutionally owned, Feng says. These investors aren’t seeking the stable income that traditional MLPs afford; they simply believe in a fundamental story or are looking for a secular trend in the asset class. For example, they may believe in the use of nitrogen fertilizer for farmland.
Indeed, one of the biggest new trends in the MLPs arena is the increase in institutional investors buying the partnerships. “MLPs are becoming more popular with institutional investors, because it’s an asset class that has had an amazing track record,” says Andy Pusateri, a senior utilities analyst with St. Louis-based Edward Jones, in an interview.
“To some degree, institutional investors are just waking up and learning about MLPs,” Reid explains. “More consulting firms are recommending MLPs to their clients. Once the consultants get behind these long-term recommendations, you can see really attractive allocations coming from some of the large pension plans.”
To be sure, pension plans are increasingly investing in MLPs. “That makes it easier to raise capital, and the shares are more liquid,” notes Mary Lyman, executive director of the National Association of Publicly Traded Partnerships, in Arlington, Va., in an interview.
Strong Investor Appeal
As for the retail landscape, where the bulk of MLP investors are, these partnerships are extremely well suited for many portfolios. The MLP is a long-term investment that can be depended upon not only for stable income, but also for growing distributions and tax deferral: Taxes are paid only when the units are sold.
Over the past 10 years, annualized MLP distribution growth has been nearly 7%, which has been the case for the first quarter of this year, as well. “MLPs offer a way to get a lot of current income and then defer paying taxes on them until you sell the shares,” says Pusateri. “And they’re a great way to transfer wealth, because under current tax law, you get the step-up of cost basis upon death. So if you hold them and pass them on to an heir, you never have to pay tax on the lower cost basis.”
MLPs are indeed appealing for a buy-and-hold investing strategy. “There are three pillars of attractiveness,” Reid notes. “They are yield, growth of distributions and inflation protection. With MLPs, you own real assets: pipelines, storage facilities—not a paper asset. And some of the contracts for MLPs are indexed to inflation, so you have a nice inflation component to grow the investment. It’s really a unique asset for many people.”
Historically, distribution growth has outpaced increases in the Consumer Price Index, writes Ashley Lannquist, a senior analyst of investment research at New York-based Segal Rogerscasey, in a recent report. “The Federal Energy Regulatory Commission grants many tariff-based MLPs the ability to annually increase their pipeline fees according to the Producer Price Index. This [escalator] allows MLPs to pass inflationary costs on to their customers and to potentially increase cash flow to investors,” she notes.
Last year, because of fourth-quarter uncertainty about the fiscal cliff and unfounded fears that MLP tax advantages would diminish, the space underperformed the S&P 500 for the first time in more than a decade. But as soon as January 1 arrived, MLPs quickly rebounded.
“The MLPs led off this year with a bang, and the prospects continue to look very strong given demand for their services,” says John Dowd, research analyst and portfolio manager with Fidelity Investments of Boston, in an interview. “The tailwinds are the growth in U.S. oil and natural gas production, which will remain robust for several years.”
An MLP’s performance—distributions—pivots on the company’s growth, both organic and stemming from acquisitions. This year, M&A activity continues to be strong. “Distributions for the group are moving higher, because these companies are investing aggressively to grow the pipeline infrastructure. With that, they’ll be able to growth cash flow,” Dowd says.
When compared to other yield-producing investments, MLPs are superior, experts point out. For example, “When you benchmark the type of return you get with the REIT subgroup, bonds or the utility sub-group, MLPs stack up very favorably,” Horowitz notes.
Bonds, with about a 6% yield, do not offer growth, experts add. REITs offer only about a 3.5% yield. MLPs, with dependable growth in price and distributions, also surpass utlities, they stress. “MLPs generally have a yield that’s higher than that of utilities. They are growing their distributions at a faster rate on average than the utilities, and their tax advantages are more attractive,” Dowd says.
It is MLPs’ total-return profile on a risk-adjusted basis that has drawn so much institutional attention. The increase in institutional investing is giving MLPs more liquidity, which is beneficial. Recent Morgan Stanley research states that 39% of MLP investors are institutional, according to Lannquist. In 2008, during the financial crisis, she says, that number was 33%; back in 2001, institutional investors represented just 14% of MLP investors.
“The institutional trend has created a strong tailwind for MLPs, and we expect it to continue to do so,” Lannquist says. “Now, MLPs are no longer a retail-only asset class. Institutional money is sticky money and should make MLPs less volatile.”
The boom in oil and natural gas allowing these resources to be extracted from shale in the Marcellus, Bakken, Permian, Niobrara and other basins creates a major need for infrastructure to move the hydrocarbons. “The shift to unconventional drilling created something of a heyday for midstream companies and a tremendous opportunity to invest in new projects. This infrastructure spending is the primary driver for the rapid growth among MLPs and their cash flow,” says Jason Stevens, director of energy research and an analyst with Morningstar in Columbus, Ohio, in an interview.
“They can’t build the pipelines fast enough,” adds Lannquist. “As a short-term solution, they’re transporting the gas and oil by rail.”
MLPs’ investments in infrastructure are huge. “The asset class will probably spend between $8 billion and $12 billion per year for the next few years on additional infrastructure,” Horowitz says.
MLPs that are focused on storage facilities are benefiting from the boom, too. “Storage MLPs are well positioned, because they are a business with consistent cash flows,” explains Pusateri. “Right now, especially with low natural gas prices and warm weather when we were expecting it to be colder, storage levels have moved higher—and that is positive for the MLPs.”
With MLP growth and diversification, membership in the National Association of Publicly Traded Partnerships has been expanding at a steady pace. In 2012, there were 65 members representing 73 MLPs. Some of the MLPs that have been formed recently are in new areas, such as oil-field services, industrial-sand production (used for fracking) and offshore-drilling platforms.
“It’s interesting to see how the industry has evolved,” Feng remarks. “You’re starting to see greater diversification up and down the supply chain in terms of the MLP structure and also in relation to investors. They’re becoming more sophisticated.”
The IRS continues to expand the scope of companies qualifying as MLPs, and legislators could do so as well. “As a result, more types of assets are being housed in the MLP structure,” shares Feng. In fact, there’s now a backlog of MLP initial public offerings that numbers in the double digits.
When it comes to non-traditional MLPs, yield may not always be the chief reason to invest. “One research analyst calls this ‘The Diamond Age of Refining’,” notes the head of Alerian. “You might believe that a particular refining asset is well positioned and will continue to generate great cash flow year after year, so you’re looking for a good company for a long-term trend.”
Non-traditional MLPs, such as those in the refining space, have a fair degree of commodity sensitivity, but they’re able “to pass through windfall flows to owners when opportune,” says Stevens.
In addition, MLPs are still an excellent way to diversify a portfolio. “They now have a higher correlation to the broader market than in the past,” partly because of the increase in institutional investing, Feng explains. “But because of the underlying fundamentals, cash flow and the fact that MLPs are continuing to grow, we believe they’re still a great addition to a diversified portfolio.”
Some MLPs that analysts consider poised for growth are Energy Transfer Partners, Enterprise Products Partners, Magellan Midstream Partners and Plains All American Pipeline. “King Daddy of them all in my book is Enterprise Products Partners,” Stevens says.
“This is an MLP that has integrated across every link of the midstream value chain and is in a position to offer services to producers, petrochemical end users—everyone involved in oil and gas. It’s a company with many opportunities to add assets to its map that integrate with existing assets and increase the value of the whole network,” the Morningstar analyst explains. “What Enterprise is doing with natural gas liquids will continue to produce strong cash flow growth in coming years.”
Energy Transfer Partners is another winner. “It has diversified its business mix away from natural gas and now is also involved in natural gas liquids,” explains Stevens. “It bought the refiner Sunoco last year. The company has worked hard in terms of both M&A activity and organic growth to adjust its asset portfolio to the current market.”
There’s also Magellan. “We like how it’s linked up. Its pipelines run up and down the middle of the country, it brings crude oil from the Gulf to Cushing, Okla., and to the Gulf from the Permian, and it connects with literally every refinery in the mid-continent,” he says. “That kind of connectivity is irreplaceable, and it really gives them a very strong position. I expect them to continue to invest money at narrow spreads above their cost of capital in attractive projects and to raise distributions.”
Horowitz sees a compelling total-return potential in Enterprise Products Partners over the next few years. “It’s one of the largest MLPs in terms of geographic footprint and is certainly one of the most vertically integrated in that it touches almost every different aspect of the midstream value chain. When you put those two attributes together, along with having one of the most flexible and transparent balance sheets and one of the best management teams, we see a lot of opportunity for value creation,” he says.
“Enterprise will spend roughly $7.5 billion in organic growth capital expenditure and place those projects into service from 2013 till 2015,” explains Horowitz. “The majority of them are fee based, and that paves the way for roughly 6% compound annual growth in cash distributions from 2013 out to 2016. Enterprise has a track record of doing very well. This is a partnership we think should be able to generate a 10%-11%, or possibly even a 12% return, year in and year out.”
Another MLP that Horowitz singles out is Plains All American Pipeline. “It is slightly smaller in market cap but nonetheless has a tremendous amount of growth opportunity in front of it,” he says. “The majority of its business is focused around crude oil, transportation, storage and also supplying logistics for marketing crude oil. This is a partnership that has assets that are very well connected to some of the most unconventional, prolific crude oil-producing plays within North America.
“It also has excellent vertical integration, one of the best management teams in the business, a very flexible balance sheet and a large degree of retained cash flow to help fund a lot of that organic growth,” Horowitz adds. “It’s a partnership that, from a visible perspective, has a very transparent opportunity set of projects. This partnership should be able to generate a total return in the low-to-mid teens for the next several years and do so with less associated risk.”
A key part of the MLP story is its major role in America’s march to become energy independent. “As we move toward energy independence, a big piece of that is going to be developing the infrastructure to transport and store the natural resources,” shares Alex Ashby, a research analyst with New York-based Global X Funds, in an interview.
“Investing in MLPs is a low-risk way to invest in the U.S. energy renaissance that’s going on,” notes Reid. “It’s low risk, because MLPs typically own hard assets like pipelines and storage facilities.”
MLPs should also benefit from the expected exportation of natural gas liquids, crude oil and liquefied petroleum; a number of MPLs have applied for permits to export. “There’s a push to export liquefied natural gas,” Stevens notes. “One company has a permit to export to any and all buyers. There are 20-plus applications sitting at the Department of Energy pending review. We think they’ll [issue] a few permits and then wait to see the impact on prices.”
Exporting is viewed as a huge growth opportunity. One reason is that the construction and operation of export terminals is an MLP-qualifying activity. “It will stimulate more domestic production,” says Ethan Bellamy, a managing director and MLP analyst with Robert W. Baird & Co., in Denver, in an interview.
MLPs are already moving further along toward oil and natural gas exportation. “Enterprise has recently expanded its Houston crude oil storage facility for future exporting,” explains Feng. “Our gut feeling is that exporting will be approved, with the appropriate degree of regulation. MLPs will be a very important part of this revolution.”
Also, petrochemical companies are talking about building brand-new facilities, which could affect MLPs. “Over the next several years, you’ll see demand-side infrastructure, like ethylene plants, constructed and the likes of Dow and DuPont chemical companies focus their growth plans and capital on maximizing this domestic resource potential,” Horowitz says.
“This is a structural shift as it relates to the cost curve for ethylene products, because it has firmly moved the U.S. into the driver’s seat for having some of the most abundant supply and the lowest cost feedstock for ethylene and, ultimately, polyethylene (used to make plastics and consumer durables) production. This is going to be a game-changer for the global petrochemical industry and will require more infrastructure build-out. So it’s not just the boom in NGL supply growth; it’s also the boom in U.S. crude oil production.”
Environmental pressure and lower prices for natural gas (which is trading at less than half of its 2008 level of $8.90 per million British thermal units) have given coal MLPs, in general, a bumpy ride of late. But performance varies widely among companies, and some of the partnerships have performed significantly better than others.
There are four coal MLPs, according to the NAPTP—including Alliance Resource Partners, which analysts particularly like because of its business model, balance sheet and strong fundamentals. A positive trend for coal-related MLPs is that some are diversifying, making them less dependent on one resource for most of their revenue. For instance, Natural Resource Partners has acquired oil and gas reserves, as well as crushed stone, sand and gravel properties.
“Burning coal for power generation looks to be in the money for a large number of generators at $4 gas. So we will likely see a rebound in coal consumption this year, and that should be supportive of cash flows for the MLPs,” Stevens says.
China and India are expected to use the majority of the world’s coal for the next 20 years. Though China is attempting to develop its own natural gas production, the country is “still growing coal demand fairly aggressively,” according to Dowd. “It’s going to be at least five years before natural gas growth out of China is a relevant issue. The size of the U.S. natural gas industry and our ability to frack just swamps that of China. We have advantages in shale gas production other countries don’t have. Also, we don’t know how productive the China shale resources are going to be. It’s still an exploration effort there.”
Though interest rates, which have been near zero for some time, are anticipated to begin rising, this may not adversely affect many MLPs in the capital-intensive asset class. “Even in a rising interest rate environment, a lot of MLPs are retaining more cash flow beyond what they distribute,” Horowitz says. “That’s very important because to a certain degree, they can use a lot of it to help self-fund some of their organic growth projects over the next several years and to minimize their capital markets exposure. That way, they aren’t at the mercy of the market and paying a higher interest rate on incremental debt.”
The 2013 outlook is for a strong year, with MLP returns in the high teens or rising even to 20%, experts say. Plus, distributions should grow 5% -7%, which in turn, represents 5%-7% price growth.
The forecast is just as optimistic through 2015, largely because of “very visible growth that you can see, the need for infrastructure and the increased demand from institutional investors,” Lannquist says. “Analysts can see over multiple-year periods the growth that’s going to occur, such as in pipeline construction. There’s a big backlog of capital expenditure. Analysts have been told by management that these projects are underway and that there should be a lot of growth.”
Investing in MLPs means investing in one of the most dynamic areas of today’s market. “There are billions in assets out there that aren’t in MLPs but that can migrate into the space over time,” Bellamy says. “We’re in the middle innings in the MLP space in terms of new areas of both growth and potential M&A.”
What’s more, “MLPs are a long-term investment in the build-out of our domestic energy infrastructure,” Feng notes. “It will drive continued stability and growth in cash flow this year and onward.”
Many analysts are what can only be described as passionate about MLPs. “I’m a huge believer that without the MLP structure, we would not have had the success we’ve had in pushing back on crude oil imports and massively lowering the cost of natural gas,” Bellamy says.
“The MLP is a very efficient funding mechanism and allows billions of dollars of capital infusion into domestic infrastructure, all of which ultimately results in lower prices to consumers,” the analyst concludes. That’s a strong public good and a cornerstone—the main goal—of the original legislation for the MLP. And you can’t argue—it’s been wildly successful.”