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.”