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.