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.