MLPs Come into Sharp Focus

 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.