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Understanding the Commodity Exposure of MLPs

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A key argument for investing in energy-industry master limited partnerships (MLPs) is that they provide exposure to the energy sector while avoiding commodities’ price gyrations. That’s been true historically and it continues to hold.

Wells Fargo Securities recently re-examined the correlation between MLPs and crude oil price movements and published the results in the July 2011 issue of its “MLP Monthly” research bulletin.

“Over the past three years, MLPs have exhibited a 0.47 correlation with crude oil prices. Although MLPs’ exposure to commodity price risk varies, the perception of commodity price risk can influence stock prices (over the short term), in our view. The four Wells Fargo MLP sub-indices that have exhibited the highest correlation to crude oil over the last three years include upstream (0.55), coal (0.48), gathering and processing (0.45), and crude oil logistics (0.43).”

MLP-investors who want more or less commodity exposure than the historical averages can find it in the sector, however.

Quinn Kiley, senior portfolio manager with Fiduciary Asset Management, or FAMCO, of St. Louis, Mo., notes that MLPs have a broad range of commodity-price sensitivity.

For example, federally regulated long-haul pipelines have very little commodity-price sensitivity, because the majority of their revenues come from the fees or tariffs they charge to provide shippers access to their infrastructure capacity.

Consider a pipeline, says Kiley, which may have a cost associated with natural gas because it needs natural gas to run the compressors that compress the gas as it flows through its pipeline. That means there is some marginal exposure there but many of the pipelines’ contracts allow for a pass-through of fuel costs so that’s eliminated.

Consequently, the portfolio manager said, “You’re talking about 85, 90, 95% of that business having fixed fees and very little chance for commodity price swings to negatively impact them.”

The analysis shouldn’t stop at the sector- and sub-sector levels, though, Kiley cautions. “You have to look through the assets that they own and the contractual exposure that they have to really get a sense of that (exposure),” he explained.

The reality is that these MLPs are in various businesses,” Kiley continued. “Many of them are quite diverse and depending on where they are in the energy value chain, they may have more or less commodity price exposure. Our view is that about 27% of MLP cash flows have some sort of commodity-price sensitivity, whether that’s because they produce a commodity or because their contracts pay them either in kind or as a result of commodity price moves.”

That variability in business models allows investors to take on greater commodity-price exposure within the MLP structure if they want it. Upstream MLPs — those that produce oil and gas — have direct exposure, although they often hedge part of the exposure.

The coal market lacks the liquid futures market available in oil and gas, but producers do have contracts that stabilize cash flows over the medium-term.

Another sub-sector to consider: natural gas processors, which Kiley says are often overlooked as commodity plays. These businesses remove liquids like propane and ethane from the extracted gas to make the gas suitable for pipeline transport.

In many cases, the MLP receives a percentage of the liquids it processes in cash payment or in-kind product. That arrangement gives the MLP significant commodity price exposure to the value of those liquids.

“The interesting thing is in today’s environment, when you look at an MLP that does that, they have revenue exposure to crude oil because most of these liquids price off crude oil,” said Kiley. “(It’s) not dollar-for-dollar but call it $.60 on the dollar currently versus natural gas which is at relatively low levels today. So, the revenues are on the oil side which is strong, the cost is on the gas side which is weak — it’s a great margin environment for people who want to own real assets infrastructure but would like some commodity price exposure as well.”

MLPs that Kiley likes for commodity exposure include Alliance Resource Partners LP (ARLP) and EV Energy Partners LP (EVEP).*

He notes that ARLP just announced a record quarter and has one of the best balance sheets and cash flow coverage ratios on their distribution. EVEP has exposure to some of the non-conventional gas plays, specifically the Utica Shale, which has the potential to become a significant natural gas resource.

* Individual securities are identified for illustrative purposes only and are not intended to be a recommendation to buy or sell any particular security, according to FAMCO.