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.
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.