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One of the biggest questions surrounding MLPs is how interest rates and recent index declines will affect the future of oil and natural gas production and prices. This has led to confusion about the issues facing MLPs following the economic collapse in Greece, which led to a year-to-date Alerian MLP Index decline to 11 percent. This drop kept in line with recent declines as the Alerian Index has dropped over 25 percent since August 2014. However, these drops were felt across the market as comparative returns for stocks and bonds continued to fall over the last year. Although most importantly, despite the declines, MLPs have significantly outperformed other asset classes over the last 12 months, which is a reminder that there is tremendous value for investors in the midstream MLP sector.

MLPs continue to infrastructure build-outs
Despite some critics in the investment community calling it a bear market, midstream MLPs have reported high level returns in the first two quarters of 2015. Results, distribution outlooks and new project prospects continue to grow. In fact, with export-focused projects growing with the abundant supply of natural gas in North America, there is a clear demand for significant increases in infrastructure support to distribute oil and gas to the market.

Companies like Kinder Morgan Inc. now have a project backlog comprised of $18 billion in cap-ex across North America, and confirmed their previous guidance of 10 percent distribution growth for the next five years. Enterprise Product Partners has maintained its previous plans to spend $2.5 billion in new development this year with a reported project backlog of $7 billion in cap-ex for the next two to three years. Meanwhile, Plains All American Pipeline Partners re-confirmed plans to spend $9 billion through 2020 on crude oil infrastructure projects, with expected distribution growth around 7 percent. Similarly, Energy Transfer Partners just announced that the company will increase its scale in the Northeast with $1.5 billion cap-ex into new projects in the Marcellus region. Like most other high-performing MLPs in the midstream sector, ETP explained that the firm will continue to spend on new projects as the capital costs because they will be supported in the long-term by fee-based agreements. Ultimately, these are just some examples, but a common theme among these midstream partnerships is that while there is reason for caution in the short-term for oil and gas supply and demand fundamentals, MLPs expect long-term prices to trend higher as global demand will inevitably continue to grow in the next two years.

Supply outpacing demand
According to recent reports from the Department of Energy, Q3 of 2015 is expected to see a rise in demand for oil supply with a strong summer driving season. This is good value in the short-term as refineries work through their North American oil inventories. However, more excitingly is the fact that there is an emerging global shift in natural gas supplies, which places North America at the forefront of the next infrastructure boom. It is also a reminder to investors that MLPs have one of the most significant long-term prospects throughout alternative asset classes. In fact, a recent BP report found that there will be a significant rise in global demand for natural gas for the next 20 years. However, in order to meet this demand, U.S. shale gas production will need to grow to 4.5 percent on average per year till 2035. All told, BP expects demand to grow from 92 million barrels per day to 111 million barrels per day by 2035, with 50 percent of this increase in supply extracted and transported from North America.

Long-term value is a theme among MLPs
​​With the need for new midstream infrastructure in North America, MLPs have a positive outlook for yields over the next two decades. Particularly now with valuations lower following the 25 percent decline since 2014, MLPs are showing that they deserve a risk premium. Relative to other asset classes, spreads of MLPs have widened to historic levels compared to Treasuries, REITS, corporate bonds, and high yield bonds, making them extremely attractive for investors focused on the long-term. Compounding these spreads is the fact that the distribution yields of the Alerian MLP Index are currently 6.4 percent, but with oil and gas supply outpacing global demand for oil infrastructure projects at the moment, MLPs have the potential for very attractive total returns.

 

A common misconception among the investment community is that all MLPs have been severely hurt across the board. While it is true that upstream and downstream MLPs have been on a rough ride due to the bear market for crude oil and natural gas, pipelines in the midstream sector have held their own. So while there may be choppy waters ahead for upstream and downstream MLPs due to direct exposure to commodity price volatility, the midstream sector is dependent on domestic energy activity, which has the potential for significant growth with the demand for infrastructure projects.

Bright future for midstream MLPs
Despite recent declines, the future continues to be bright for midstream MLPs. For evidence of that, investors simply need to observe the recent market trends as larger MLP entities have begun acquiring smaller companies in the sector while they wait for the inevitable demand increase for natural gas. In fact, according to a recent report by Neuberger and Berman on natural gas, the current global demand for natural gas is 65 billion cubic feet per day, but this demand is expected to grow 2 percent by 2025. As pipelines are the most efficient and cost-effective mode of transport for liquids and gas, the midstream sector is positioned for a significant growth period in the coming years. Therefore, MLPs have premium value at bear market gas prices as the majority of midstream companies will continue to maintain and exceed current income levels.

MLPs for yield hungry investors
MLPs frequently beat out other asset classes, so they are ideal for investors looking for yields. In fact, with the Alerian MLP ETF Index at $8.4 billion and now offering top-ranking yields at 7.5 percent, MLPs are delivering handsome returns. However, their value is magnified by the fact that the balance is a deferred income tax expense. So for shareholders who are hungry for income from dividends, MLPs offer value because of their keen predictability. 

MLPs offer alternative investment value 
MLPs offer tax advantages because they pass on tax deferred distributions as dividends to investors. Ultimately, any way an investor can look at MLPs, they offer great value. Similar to the upstream and downstream sectors in offering high dividend yields, midstream MLPs are not exposed to the dangers of distribution cuts. This is due to the fact that high yields from midstream companies can overcome high capital depreciation because of their attractive yields, unlike the upstream and downstream sector.

With oil and gas prices slipping, rumors among the investment community about the demise of MLPs have surfaced. However, after an exciting windfall of recent transactions in the MLP market, there is a clear signal to investors that there is money to be made in the midstream MLP energy sector.

The current environment has presented a prime opportunity for investors focused on long-term assets, as fear and uncertainty in the investment community have left many scrambling out of the energy sector. This market irrationality has opened up opportunities to buy key assets at great discounts compared to other asset classes. Therefore, the 2015 energy market has favored MLPs because an oversupply of crude oil and natural gas will mean a greater need for transportation pipelines and storage terminals in the near future.

Although following 20 years of steady growth, MLPs are no longer the emerging assets of the investment landscape. With attractive distribution growth from six years of very low interest rates, MLP investors have now come to expect not just yield, but yield plus growth.

Transactions raise optimism
After the recent deal-making on the MLP market, there is a clear indication of low valuations. Among these deals, the most notable included MPLX’s acquisition of MWE, which offered a 32 percent premium, WMB’s rejection of a takeover bid from ETE, and rumors of several smaller-scale deals, the MLP sector is booming.

This recent flurry of M&A illustrates an undervalued sector due to the drop in energy prices in 2014. Although the energy sector has rebounded somewhat in recent months to lift MLP prices, these recent large acquisitions have gotten the attention of investors. Particularly considering that even when the price dropped last year, the Alerian MLP ETF yielded 7.3 percent compared to a 2.2 percent average for 10-year U.S. Treasuries.

Low valuations and low prices
With recent increases in the prices of larger MLPs, most entities on the market are still trading at historical discounts. There is still an abundance of discounted options that could get even cheaper with increasing interest rates. As MLPs are a step removed from price volatility of the energy sector, they do not feel the hit of price volatility. For instance, between 2014 and 2015, crude prices dropped 60 percent while MLP prices only fell 20 percent. Although MLP yields increased because production did not slow down. With production expected to increase, M&A in the midstream MLP market is will accelerate. This is due to the fact that the larger firms are using the short-term economic downturn to buy assets at discounted rates and consolidate their positions. 

With prices falling last year, production did not drop as companies identified cost-effective production strategies. This meant that cap-ex remained at healthy levels, which is expected for the next three years. Furthermore, with the rumored rate hikes, MLPs are more likely to experience short headwinds that will not significantly affect future performance as it will for higher-yielding equities and equity-like securities.

The primary reason for its low volatility to rate hikes is that most MLP dropdowns have minimum volume commitments, which offer investors a clear outlook on future cash flows. However, MLPs are also attractive because GPs will continue to collect incremental cash flow from MLPs, and as the MLP grows, it will generate a multiplier effect on distribution growth.

Market volatility is a short term risk for MLPs as opposed to other high yield asset classes because they are not directly tied to oil exploration and production. So for long-term investors, the midstream market is in the in-between stage with many entities expected to have record distributions within the next two to three years. Prime examples of this buy-low growth potential include WMB, which has a forecast three-year CAGR expected to be 15 percent, ETE is expected to raise distributions by 31.2 percent within three years, and a new company like ENLC is expected to grow dividends by 16 percent per year for the next three years.

Reason for optimism
The MLP pull-back has created significantly lower valuations for high quality firms. As the U.S. shale and natural gas industries continue to become a game-changer in global energy, there will need to be more infrastructure build-out. So with the recent sub-par performance of MLPs, there are opportunities in steep discounts to net asset value for income-oriented investors. Ultimately, between the high dividends, tax-deferred status and capital appreciation of MLP units, MLPs should continue to be among the top performing asset classes.

With the Federal Reserve’s rumored interest rates hikes, many investors are wondering how MLPs will be affected. Historically, MLPs have outperformed other high-yield assets during rising rate environments. This is due to the fact that rates go up in strong economies, and these economies consume more energy, which is beneficial for MLPs.

MLP performance in rising rate environments
With the market concerned about the Fed’s move toward interest rate increases, investors are seeking higher fixed income yields. This is where MLPs can become a valuable portfolio asset because they have performed well in both rising and dropping rate environments, only falling under extreme rates changes. In fact, unlike other high yield assets, MLPs can offset rising rates by growing distributions. According to Mark Litzerman, co-head of Real Asset Strategy at Wells Fargo, MLPs have beaten REITs, utilities and other fixed-income products as interest rates have risen.

“We continue to favor large, diversified, fee-based midstream MLPs with limited commodity exposure,” Litzerman explained. “The reliable distributions of these investment-grade partnerships are expected to continue to grow, even at current energy prices. Meanwhile, we remain cautious about MLPs with more significant commodity exposure, particularly those in the upstream segment.”

While MLP distributions may have more rapid dividend growth than other income investments in low-rate environments, there is still comparative value in higher rate environments. High yield investments like MLPs will become relatively more valuable with rate hikes because of increases in oil and gas production at a time of higher consumption. So although there is no guarantee that MLPs outperform other fixed-income products, that does not mean poor returns. 

Rates hikes may increase the cost of capital for MLPs and reduce their distributions, but not to the same extent that other high yield assets have been hit in the past. In fact, throughout the bond sell-off in 2013, MLP prices temporarily dropped but quickly recovered to post strong returns for both 2013 and 2014.

What MLP investors need to consider
Investors should be less concerned about MLP performance in a gradually increasing rate environment, and more focused on sharp changes in interest rates. These extreme increases may cut off the debt markets and drive up operating costs for MLPs, but they are also indicative of strong index performance across all asset classes, which means more energy consumed.

MLPs offer the most diversification and lowest volatility
History has shown that MLPs have the potential to grow in rising rate environments, except for extreme fluctuations. Although MLPs are still a relatively new asset class, their performance during the previous ten rate increase periods showed an average gain of 4.7 percent, with positive returns in seven of the ten years.

Takeaway
Ultimately, if the Fed gradually increases interest rates, MLPs should continue to perform as well as expected. Particularly with significant increases in domestic oil and gas production, MLPs should continue to generate revenue growth and dividends for investors.

Midstream MLPs have been perennial favorites among savvy investors due to their unique tax advantages and high yields. In fact, MLPs have outperformed the Standard & Poor’s 500 for 14 out of 15 years since 2001.

MLPs performing well

The reason for this success is that MLPs can distribute over 80 percent of cash flows to investors because they are financed by issuing new shares and debt. Their fee-based “toll” models enable them to negotiate long-term contracts with year-over-year price changes indexed for inflation hikes in the future. This affords MLPs the benefit of sustaining their distribution growth for investors even under higher interest rates and inflation. It also explains why so many MLPs have gone public in recent years and now have a market cap of more than $600 billion.

These pipelines, toll roads and various transportation elements give investors an advantage during inflation hikes as user fees increase at a rate higher than operating expenses. So with inflation protection clauses in long-term contracts, cash flows will remain reliable and recession-proof when compared with most traditional asset classes. This is more true than ever with energy prices recovering in 2015 due to the explosion in U.S. drilling for natural gas and shale oil.

MLPs historically inflation-resistant

The U.S. energy infrastructure is estimated to grow to more than $250 billion in the next 25 years, which prompted the Internal Revenue Service to expand the types of energy assets that qualify for MLP status in 2015. This new rapid growth and expansion demand in the energy sector positions MLPs as a premium asset allocation for investors in the near future. However, midstream MLPs like Kinder Morgan and Buckeye Pipeline have been historically recession-proof as they have stood the test of time due to limited exposure to oil and gas price fluctuations.

Since their origination in 1991, MLPs had 16 percent total returns on average with dividends reinvested. In fact, during the financial crisis MLPs steadily increased dividends as the price of oil and gas had little impact on the fee-based model. An example of this came in 2013 when the Algerian MLP Index generated a 27 percent total return against the 70 percent increase in 10-year Treasury yields, which followed a 13 percent average total return during a 12-year drop in interest rates.

This type of growth went against conventional wisdom to sell off dividend-paying stocks during interest hikes because inflation would erode the value of payouts. MLPs beat the interest rates because they are equities that deal with the infrastructure of the energy sector, and thus have more potential for dividend growth than fixed-income vehicles. All told, the average total returns of MLPs are tied more closely to the stock market than interest rates or inflation.

Why MLPs benefit from inflation

The nature of the MLP business model demands high capital expenditures, which leads to companies operating on debt. However, given that MLPs virtually monopolize their operating areas for both suppliers and consumers, they have the distribution and operating pricing power, enabling them to effectively operate on debt and maintain earnings at a rate faster than the rate of inflation.

One of the main reasons MLPs are particularly attractive right now is that the income they receive is tax deferred. MLPs are partnerships, so they are not subject to state and federal income tax as a corporation would be. This means the tax responsibility is shifted to the partners, who are then taxed at standard income rates. Therefore, as income tax rates for investors are lower than the rates of corporations, quarterly distributions from MLPs are shielded from income taxes into tax-deferred accounts.

So with yields currently at six percent, which have historically increased by five to six percent annually, investors receive 80-90 percent of the income earned from MLPs. According to David Grecsek, Director of investment strategy and research for Aspiriant LLC, these are significantly higher returns than utilities and REIT indexes, and 2.5 percent higher than the ten-year Treasury.

“No other asset class has the combination of above-market yields, growth in distributions and tax-deferral benefits,” Grecsek explained. “They’re a slam dunk for long-term client portfolios.”

Tax deferred
The right MLP plays can provide tax-advantaged cash flow for investors seeking strong fundamentals. These investors receive 85% of an energy MLP’s distribution on average as non-taxable return of capital, with only 15% subject to tax under current IRS rules. Although distribution proportions are subject to change over time, the return of capital distributions lower investor taxes, which increases the cash flows when MLP units are sold. Therefore, if investors are patient with their MLP units by holding on to them to receive steady distributions, their tax basis could reduce over time as well.

One of the primary drivers for MLPs is that investors receive 80-90 percent tax deferred income on average. However, if their distribution is less than their basis, the distribution is 100 percent tax deferred. The way this works is that an investor’s share of the net taxable income is approximately 20 percent of the tax deferred cash distribution.

Ideal estate planning vehicle
MLPs are also estate tax-free, making them an ideal estate planning vehicle for high net worth families. All income earned from MLP distributions is deferred due to the current IRS tax laws, which means that heirs pay no income tax on the accumulated deferred growth of the assets.

As with most securities, MLP units receive a basis step-up to current market value in the event of the investor’s death. This means that heirs receive the MLP units with fresh fair market value basis, and all previous distributions remain tax deferred. These MLP units then have the potential to become completely tax free for heirs with the step-up in cost basis.

What investors need to know about MLP tax status
MLPs avoid state and federal income taxes as long as they are held by investors, but the distributions turn into cash when an investor sells their shares. Therefore, this income earned from selling off assets is subject to traditional income and capital gains taxes, meaning that MLPs are not tax efficient for short term investors. 

Takeaway
MLPs are an ideal investment vehicle because they offer the tax benefits of limited partnerships and the liquidity of exchange traded securities. These tax benefits make MLPs strong additions to portfolios for high net worth investors seeking to transfer wealth to the next generation through their estate. The investor receives the benefits of steady yields with growth opportunities, while the income tax is deferred for their heirs.

Having invested in MLPs since 1991, I have seen an interesting evolution take place which I believe helps explains the market volatility of the “MLP asset class” recently.

Early Days.

The early days began in 1987 when Penn Central spun off is pipeline business into a company now known as Buckeye Pipeline.  It was structured as a Master Limited Partnership which meant that it was publicly traded on a national exchange and was not taxed at the corporate level, so that tax benefits such as depreciation and tax deferral would flow directly to the investor.  At the time it was not considered very sexy, as the sector was too small for money managers and Wall Street brokers to pay any attention to.

By 1990, we were up to 7 MLPs in existence which included Teppco, Northern Border, Enron Liquids, and Buckeye.  In 1995, UGI Corporation spun off its Amerigas propane distribution business as an MLP.  After a few years, Amerigas began to do what every MLP investor had hoped: distributions that increased quarter over quarter.

The Year 2000

By 2000 there were 17 MLPs which were mainly owned by retail investors, with very little institutional money involved.  That all changed when Lehman Brothers and other investment bankers began seeing this as a money maker and MLP IPOs picked up. With Lehman leading the charge, institutional ownership picked up as well.  The benefits to hedge funds managed by Lehman Brothers and their clients became apparent: Cash distributions that were tax deferred, price stability with gradually increasing distributions, and resultant increasing prices.  It was a great investment to lever up and why not?  One could borrow money at low money market rates, invest the borrowed money at three times cash flow, and lever it up 20 to 1.  By 2007, Lehman and associated hedge funds held 25% of the highest quality MLP names.

2008 and Lehman Brothers

Then came the mortgage debt crisis with which Lehman was intimately involved.  As Lehman declared bankruptcy, it liquidated its MLP holdings in a fire sale.  MLPs came down rapidly in 2008 before rebounding 76% in 2009 and 35% in 2010 to gain back their losses.

2014 and 2015

Today MLPs are considered an asset class into themselves, as there are now about 140 MLPs.  They have become much more volatile as asset managers rotate in and out of the “sector”.  As a sector, it is not huge in comparison to others, so movements in and out can cause dramatic changes in price. I believe the latest decline in price reflected a shift out of MLPs in anticipation of a drop in oil prices.  Our theory is that on the second drop in oil, the “smart” money would then move back into MLPs realizing that the majority of MLPs are fee-based transportation and processing companies, not oil companies.  The “dumb” money seeing the prices fall would exacerbate the drop in MLPs while the “smart” money waited for the oil sell-off as the trigger point to get back into the steadily profitable transportation business again.

What’s Next

If I am right, we will see a further disconnect between the price of oil and MLPs.  Over the last few months, MLPs fell while oil prices rose and then remained steady in May and June.  Now that oil has dropped in July, it will be interesting to see if MLP prices bounce back up over the next few months!   And why not?  With valuations back at 2012 levels and MLP distributions still rising, this would seem to be a great time to either get in, or continue to build a position for the long run.

Energy-related MLPs are often viewed as income alternatives to traditional fixed-income vehicles, and are fundamentally mispriced as a result. However, these misunderstood MLPs offer several ways for investors to receive best-in-class yields due to the stability and consistent growth of distributions.

MLP Misconceptions
There are several misconceptions about MLPs, but among the most common are:

• Energy-related MLPs are tied to crude oil and natural gas prices
• MLPs are plays on the U.S. economy
• MLPs are plays on interest rates

These are misconceptions about MLPs because they have limited exposure to volatility in commodities price. This is due to their long-term contracts that use a “toll road” business model, which generates fee-based revenues at regulated rates of return by the Federal Energy Regulatory Commission. All told, MLPs will generate highly consistent cash flows in high and low commodity price environments.

However, the returns on MLPs are also not tied to U.S. economic activity, as slight declines in volumes and throughput’s from 2007-2009 did not jeopardize MLP distributions. In fact, MLP pipelines actually profited during this period, despite being in the worst financial times since the Great Depression. Although it is additionally important to note that MLPs are not fixed-income securities, meaning that they are not valued on a yield spread to Treasury basis points. Therefore, while interest rates are important for the cost of financing project expansions for MLPs, they are not directly tied to interest rates.

MLPs are undervalued
Since July of 2014, dropping crude oil prices pulled down energy-related assets across the board, which means MLPs have been temporarily undervalued. This is out of step with their real market value, but it offers a discount to net asset value because MLPs are expected to return to premium over time. Given that MLPs typically increase their distribution prices each year, their payouts will continue to grow with it.

One important note on MLPs is that they did not take as hard of a hit as other energy-related sectors because their fee-based revenues are dependent on the volume of oil and gas traveling through pipelines. This made them more defensive to price drops in the energy sector because they are energy-related infrastructure assets. These “toll” charges on pipelines are based on distance and volume, so even though MLPs will see their prices take a hit when oil values fall, they will generate revenue on an ongoing basis as they transport energy.

Valuations are at the right time right now
MLP valuations last summer were high, then they came down 22-23 percent. However, the hallmark of MLPs is that they have no problem maintaining or increasing distribution rates, particularly in this domestic production boom. Currently, the U.S. is positioned at the forefront of the energy boom because of its advanced capability to extract shale oil and natural gas resources. This is particularly valuable for MLPs because industry experts believe that 90 percent of the world’s oil and gas reserves are contained in shale formations, meaning there is an immediate need for more domestic infrastructure to export oil and natural gas internationally. According to Dave DeWitt, CEO of DeWitt Capital Management, as domestic production increases, the distribution fees paid by MLPs are expected to accelerate over the next four to five years.

“This is because MLPs are equities in monopolistic positions in regions that are resource-dominant like North Dakota, Texas, Pennsylvania, Virginia and Ohio,” DeWitt noted.

Ultimately though, the most important value driver for investors is that 80 percent of MLP payouts are classified as a return of capital, which shields cash flows from current income taxes. In turn, that return of capital decreases the cost basis, leading to higher capital gains in the long-term.