High-yield MLPs at bargain prices

Oil and natural gas MLPs in the midstream sector generate returns by transporting the commodities, so they are much less affected by the price of oil. Still though, market speculators have overreacted to the decline of MLPs this year, despite their steady returns, thus putting many midstream companies to be on sale.

Comparing the performance of midstream and upstream sectors
Midstream companies are the MVPs of the MLP sector because they operate on long-term fee-based contracts that act as toll-roads. This business model enables them to not only get paid, but to make steady distributions. In turn, as midstreams are removed from oil prices, they are concerned with the volume and distance oil travels through pipelines. Oppositely though, upstream companies are not as resistant to oil commodity prices. According to a Rig Zone interview with Hinds Howard, CBRE Clarion Securities’ vice president and senior financial analyst, upstream companies have higher volatility.

“Hedges rollover and higher levels of debt catch up with cash flow,” Howard explained. “Reserve redeterminations based on lower commodity prices create more cash flow constraints. All of that leads to distribution cuts. After almost every upstream MLP cut its distribution, it will be hard for any MLP to regain the confidence of the market. So, I would say they are structurally challenged and increasingly irrelevant for MLP investors.”

Further, Howard noted that the midstream companies that experienced the oil rout have as good a chance of recovering nicely after rebounding but without the same level of risk as upstreams.

Two prime examples of midstream companies performing well are Enbridge Energy Partners LP and Plains All American Pipeline LP. Enbridge Energy Partners has underperformed in the last 12 months, as it dropped 15 percent over the previous month. Despite these dropps, though, Enbridge is still offering unitholders an 8 percent yield. Two advantages Enbridge has on the midstream market are that it can deliver both light and heavy crude through its pipelines, and it has a vast network of pipelines that afford it the opportunity to transport oil to a wide range of markets including eastern Canada, the Northeast U.S., the Midwest and the Gulf Coast. So while it is down 25 percent this year, the company generates 80 percent of its income from fee-based contracts, and the rest of its revenue is hedged with storage facilities. These factors combine to ensure steady cash flows for investors.

On the other hand, Plains All American Pipeline is down 14 percent this month, but still offers a 7.6 percent yield. One of the primary benefits Plains All American has in the midstream sector is that it transports crude oil and natural gas through its pipelines from the most productive basins in North America. Although, it also has a diversified revenue stream by storing oil and natural gas, which positions it for a competitive advantage in a market with a glut of cheap energy supplies. In turn, Plains All American benefits from volatility in oil prices because it generates revenues on the spreads between commodities prices in North America.

Cramer sees bullish markets for midstream MLPs
Mad Money’s Jim Cramer speculated recently that midstream MLPs were attractive, even as the Alerian MLP ETF Index hit four-year lows. Cramer commented that a combination of stabilized oil prices and the slowing world economy – that could force the Fed to hold off on rate hikes – have made midstream MLPs an intriguing investment opportunity now. One of the reasons for MLPs is that they offer generous returns as compared to bonds, as the average yields are 7.8 percent. Although Cramer noted that MLPs, even midstream companies, rebound strong after they drop. For instance, since the recession, midstream MLPs have provided a 40 percent return after hitting lows. So, while midstream companies are significantly undervalued, it is important to pick the right companies. Fortunately for investors, the sector has plenty to offer.

Bottom line for investors
Ultimately, investing in high-yield securities may seem to have an excess of risk attached to the assets, especially when they are in volatile markets like energy commodities. But there is no shortage of market overreactions when it comes to the midstream MLP sector. Particularly when most companies have steady cash flow and expect to continue to cover distributions in the near-term. This is why some market analysts are turning bullish on MLPs because even as upstream and midstream companies melted down, there was still plenty of value in the midstream sector. In fact, it is expected that the higher performing midstream MLPs will benefit from rate hikes, which makes the low prices they are trading at now look like bargain buys. The reason for this continued profitability of midstream companies is that as the economy gets healthier, these MLPs will transport and store higher volumes of crude oil and natural gas, thus passing down higher income to investors from their increased cash flows. This is not a benefit that bonds, with fixed coupons, can provide.

A good time to look at MLPs

With uncertainty in the market comes market irrationality. However, bearish markets also bring out savvy investors that are looking to make gains on discrepancies in price volatility. So for those looking for high yields in a down market, midstream MLPs are the way to go.

There are five factors that make MLPs in the midstream sector particularly attractive. Their prices are not historically volatile, their performance is only minimally tied to energy prices and interest rates, and they are not overly sensitive to commodity price volatility, meaning that they will continue to provide steady income with strong growth potential in bearish markets.

This is due to the unique position of midstream MLPs with respect to correlation with long-term profits and the expected boom in U.S. oil and natural gas activity. With the immense growth in domestic shale oil and natural gas production, midstream MLPs have been blessed with a golden opportunity. As energy drilling and production grows, transportation and storage will grow with it. This is why: midstream MLPs have toll-based contracts for which they collect fees. So with long-term projects expected to boom, so too will the number of long-term contracts, positioning midstream MLPs as the center piece to meet global demand. Therefore, it does not matter whether oil trades at $40 or $140, midstream MLPs will still make money.

Therefore, it does not matter whether oil trades at $40 or $140, midstream MLPs will still make money.

MLP optimism
As many energy commodities have dipped in prices, yields for midstream MLPs have continued to climb. Although MLPs have seen their shares fall in anticipation of rate hikes and the Alerian MLP index has dropped 16 percent in 2015, the Index still yields 6.96 percent, representing an increase from 2014. Comparatively, other alternative investments such as REITs, utilities and 10-year Treasury Bonds did not stack up to MLPs, as they yielded 3.6 percent, 3.5 percent and 2.2 percent, respectively. So while the sector has slumped due to a short-term decrease in the domestic demand for oil, some investors feel that production may stall and volumes through pipelines may fall. This would of course reduce the growth rates for MLPs in the midstream sector if prices remained low for an extended period. However, despite these pressures, MLPs continue to be uniquely positioned for long-term growth potential. According to an interview with Institutional Investor, Martin Fridson, chief investment officer at Lehman Livian Fridson Advisors, explained that MLPs should be viewed differently than other alternative asset classes because they are more focused on long-term income with significant yields, instead of quarterly performance.

Tax advantaged status
Another key aspect for investors to keep in mind is that approximately 80 percent of MLP distributions are classified as return of capital, while only 20 percent is standard income. Therefore, while investors are taxed on that 20 percent of income, the return of capital is tax-deferred until they sell the stock. This advantage is due to the fact that midstream MLPs are structured as C-Corps that pay corporate taxes on distributions before income is passed down to investors, representing a prime opportunity for long-term investment.

Bottom line
In the current low price, low rate environment, investors can invest in blue-chip MLPs in the midstream sector and wait for their distributions to materialize as the energy sector rebounds. With limited exposure to price volatility and demand expected to grow, midstream MLPs are less vulnerable to cuts in production. According to an interview with Kiplinger, David Chiaro, portfolio manager with Eagle Global Advisors, only upstream (production) and downstream (sales) MLPs will have their cash flow directly affected by low prices and production cuts.

“The further you get from the wellhead, the less risk you have of volume and price declines,” Chiaro explained.

Investors should consider the energy sector

There is growing concern among investors following the MLP sector that today’s low energy prices are indicative of a much larger trend. Depending on the interpretation of the market, investors either view the MLP sector as the best of times or the worst of times due to recent volatility. However, despite collapses in crude oil and natural gas prices, the fundamental of MLPs are not nearly what the market has indicated in recent months.

Market volatility creates a buyer’s market
Many investors think energy prices have much further to go before they hit bottom. With oil prices falling 44 percent and natural gas prices dropping 37 percent since June 2014, several valuations for MLPs have crashed with it. This has scared many investors out of the sector, but according to Jerry Swank, managing partner, founder and portfolio manager of Cushing Asset Management, the market has hit bottom and now is the time investors should make their way back in.

“Today we are nervous, but we would say we have seen the bottom,” Swank explained. “The fundamentals are not nearly what the market has been telling us in the last few weeks.”

Swank noted that plus fundamentals and a bear market make MLPs a premium investment right now.

Yield plays in the MLP sector
As of June 30, midstream MLP yields were listed at 6.4 percent, compared to 2.4 percent for 10-year Treasuries and 4 percent for utilities and real estate investment trusts. A primary example of midstream success recently was Cushing’s MainStay funds that produced 12-month yields at 13.8 percent for upstream funds, 7 percent for midstream funds and 2.7 percent for downstream funds. However, Swank emphasized that although upstream MLPs have the potential for high yields and distributions, they are exposed to more price volatility because they track exploration and production companies. Midstream MLPs, on the other hand, track transportation and storage companies, which has enabled them to maintain their yields and distributions over time.

Investors favor midstream MLPs
The fallen prices of MLPs in the midstream sector have produced market irrationality. With Q2 earnings in line with expectations going into 2015, energy experts are confused over the pessimism of midstream MLPs on Wall Street. Swank noted that as new pipeline and transportation projects continue to grow with more cap-ex invested into the sector, the midstream MLP market is performing as expected.

“These are great stocks that are down 30%, and there’s been no change [in how they do business],” Swank commented. “They continue to stage IPOs, for instance, and do mergers and acquisitions.”

Therefore, with fundamentals intact and distribution growth expected for the next three years, current market valuations for strong MLPs are coming at discounted prices. Midstream MLPs in particular should bounce back as they have done in the past because demand for oil and natural gas are persistent enough that prices will stabilize and begin to rise. So while there is limited short-term volatility in the sector, midstream MLPs have a long-term horizon with significant upside.

The wrong metric: Why some investors may miss out on a great investment

The main reason some investors prefer MLPs as alternative investments is their stable and generous cash distributions. However, MLP unitholders need to put in extra work with their accountant to ensure that the additional income from MLPs remains tax-friendly each quarter. Due to the fact that income from MLPs is filed with Schedule K-1 tax forms as well as standard income tax returns, investors can be turned off by the additional paperwork at tax time. Although, the focus of these investors should not be on the complexities of tax returns, which an accountant can easily handle for unitholders, it should be targeting the right MLPs to invest in. This proves more tricky as many investors use traditional metrics to evaluate MLPs, which are simply inapplicable to this type of alternative investment.

Investors are using the wrong metric
Investors are leery about MLPs because they evaluate the investment opportunity using the debt-to-equity ratio. This metric is used primarily for traditional asset classes because it measures a company’s financial leverage by dividing total liabilities by shareholder equity. However, this metric does not adequately apply to MLPs because of how they operate and fund their companies.

MLPs raise fresh capital from debt markets for funding new projects, so by the very nature of their business model, they incur debt. This can be misleading for newcomers to the MLP space because they may think the companies operate deeply in debt.

For example, Emerge Energy Services’ debt-to-equity ratio has risen in the last 12 months from 0.89 to 1.82 times, but the company has no plans to slow down capital spending on new projects to repay debt obligations. The reason for the company’s comfort with its debt level is that MLPs evaluate themselves with the debt-to-EBITDA ratio. This is the primary ratio for MLPs because while book equity is flat or down nearly every quarter, distributions exceed their earnings. Therefore, unless MLPs issue new equity, their book equity account will remain flat or down, meaning that the debt-to-equity ratio is not applicable because debts will appear high while equity is stagnant.

MLPs pay out all earnings as distributions. So for investors to look to the debt-to-equity ratio in evaluating an MLP’s value proposition, it may appear worse than it actually performs.

Why investors should focus on the debt-to-EBITDA ratio
MLP investors should focus on the debt-to-EBITDA ratio because the companies themselves use it to evaluate the profitability of their projects. For instance, if a project has a one-year or two-year payback, it makes for a valuable investment. The same applies for investors because it presents an opportunity to buy low on a company that will bring massive oil and natural gas supply to a market in demand for it. Particularly in the midstream sector where pipelines and storage operations function on fee-based contracts, meaning they will continue to accrue distributions even in down markets.

Although the debt-to-EBITDA metric is paramount for MLPs because it measures their debt against underlying cash flow, it serves as a better measurement of how growth projects can be viewed. For instance, an MLP is content with letting its debt ratio go a little higher in order to fund a project with a quick payback, which will inevitably bring the ratio back down to its target range. In turn, organic projects with strong and quick paybacks will lower debt-to-EBITDA ratios for MLPs over the long-term.

Ultimately, investors will need to take the debt-to-EBITDA into context for finding the right MLP to buy, because it is a more accurate indicator of value than the debt-to-equity ratio. But finding the right MLP is the most important focus because while some MLPs with less long-term cash flow security prefer lower ratios, others that operate with long-term fee-based toll contracts are comfortable with higher ratios. Therefore, an investor needs to evaluate the security of a company’s cash flow before determining if its leverage is too high.

Bottom line for MLP investors
Many investors pass up MLPs because the value is not clear. However, with the right metrics, MLPs represent a premium long-term investment opportunity, particularly with the current low rate environment, fallen oil and gas share prices and double-digit yields.