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.