The under-appreciated value of Midstream MLPs

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.

Has the market for MLPs provided us with a good entry point?

Now may be a great time to invest in MLPs. These partnerships provide superior yields, have a strong track record of increasing distributions and are poised for continued growth in income.

Historically, these partnerships have generally provided an average yield 2.5 percent higher than that of 10-year Treasury. Today, this gap is even higher, nearing 4 percent, as MLPs offer an average yield of roughly 6 percent. This differential could grow wider, as MLPs should increase their distributions by an average of 6 percent every year.

The entire MLP industry could soon receive a boon, as a Manhattan Institute whitepaper revealed that producers will soon by using big data to determine exactly where to drill, how far down to drill and when to leverage fracking.

The paper referred to this innovative use of information as Shale 2.0, and predicted that the method could double the production of a well when compared to Shale 1.0. Because of this breakthrough in output, areas that have projects with little infrastructure will see their demand for investment continue to rise.

As market participants sink more money into infrastructure, the number of MLPs will likely increase, and existing partnerships will probably expand. In addition, any such trend could help fuel consolidation within the sector.

If the industry experiences growth, MLP investors can expect it to produce rising income. While this potential outcome makes now a good time to buy MLPs in and of itself, investors should also keep in mind that now is a great time to buy because oil prices are historically low.

When this energy source falls in price, it is always a good time to purchase these partnerships. By perusing historical data, investors can observe that when oil prices fall, the Alerian MLP index declines as well, but not as much.

Then, after this initial pullback, the index will recover, because MLPs are transportation systems and get paid a fee for transporting energy sources. Even though these partnerships will see their prices take a hit when oil values fall, they will generate revenue on an ongoing basis as they move energy from point A to point B.

To give an example of how MLPs have held up even as oil prices failed to surge, let’s take a quick look at the period between June 2005 and June 2015. On June 30, 2005, WTI crude traded at $56.50 per barrel, and on June 3, 2015, it had a value of $59.62 a barrel.

As a result, the contract rose roughly 5 percent during that time, while the Alerian index has increased approximately 60 percent. After adjusting for compounded distributions, the total return is 222.1 percent.

While these returns may seem compelling, we at DeWitt are only interested in selecting the best MLPs for our clients, instead of merely taking a passive approach and investing in the Alerian MLP index. Because of this approach, we can potentially generate stronger results than the index, while still ensuring investors have all the tax benefits associated with direct ownership of these partnerships.

U.S. shift towards energy self-reliance bolsters MLPs

The U.S. currently holds a preeminent position in the Energy world, partially due to our ability to retrieve natural gas and oil from shale. There are four main criteria that have contributed to this unique situation:

  • Water
  • The property rights of individuals
  • Infrastructure
  • Drilling technologies (fracking and horizontal drilling)

The U.S. is unique in that we have all four essential elements to produce oil and natural gas from shale. The combination of factors has proved quite advantageous, as some industry experts estimate that roughly 90 percent of oil and natural gas is contained in shale formations, with the remainder held in pools.

While drilling for oil used to be hit or miss, the focus on shale – which can be located using sounding techniques and other methods – has made extraction more reliable. Our nation has abundant energy resources, and these make the U.S. strong.

A perfect example of how these resources can benefit a nation is the U.K.’s discovery of coal, which helped the nation lead the industrial revolution in the 1800s.

As America depends more on its own sources of energy and natural gas and grows less reliant on foreign ones, this shift will help the U.S. remain the preeminent world power. The nation’s transition toward being self-reliant in terms of energy has changed the country’s infrastructure needs.

Six years ago, before the shale revolution took place, we were building LNG (liquefied natural gas) import facilities. These are now being converted to export facilities! This is because MLPs have invested heavily in energy infrastructure to take advantage of the abundant supplies of natural gas the U.S. has unlocked over the last eight years.

This buildup of infrastructure has benefited investors in MLPs, and currently, they can get a 6 percent yield from MLPs with distributions that should rise between 6 and 7 percent this year. Generally speaking, many of these partnerships are undervalued, which provides a strong growth opportunity as the MLP Alerian index is down 20% from its high.

At DeWitt, we are looking to select the best MLPs for our clients, not just buy into a passive index. All the tax benefits of direct ownership of MLPs is preserved with our strategy along with the potential of out-performance. For more information, please don’t hesitate to call or email us.

Dave’s Thoughts of the Week – Week of May 18, 2015

Before the start of trading on May 13, The Williams Companies, Inc. (NYSE: WMB) announced it would buy its limited partnership, Williams Partners L.P., which trades under the ticker WPZ. Shortly after this announcement, WPZ opened 20 percent higher and WMB opened up 5 percent. This did not surprise us, as we think it is part of a larger trend that we can expect to see grow in the coming months.

Before the start of trading on May 13, The Williams Companies, Inc. (NYSE: WMB) announced it would buy its limited partnership, Williams Partners L.P., which trades under the ticker WPZ. Shortly after this announcement, WPZ opened 20 percent higher and WMB opened up 5 percent. This did not surprise us, as we think it is part of a larger trend that we can expect to see grow in the coming months.

The Williams Companies’ recent purchase is an example of general partners consolidating LPs. By doing so, GPs can have one entity instead of two, a situation which creates many cost reductions, improved capital efficiencies and greater ability to make acquisitions. Once a GP completes the process of buying its LP, it will look to acquire other MLPs that fit its structure and growth objectives.

You can expect this consolidation to affect energy transportation needs. The U.S. previously imported oil and natural gas from other nations, which created the need for pipelines going from the shores into the country. However, the nation has shifted to producing its own energy and spreading it out, which has fueled a need for domestic infrastructure. MLPs provide these pipelines, and sometimes the quickest way for a firm to obtain the required infrastructure is to buy an MLP in the area where it wants to grow and then build that partnership up.

Basically, what we are seeing is that the GP buys an LP – which creates a larger entity – and then the next stage involves larger MLPs buying smaller ones.

During our investment selection process, we are looking for smaller MLPs that would be a good fit for the larger players – such as Kinder Morgan and The Williams Companies. More specifically, we are seeking smaller MLPs that hold strong growth potential and exist in areas where the more sizeable partnerships want to expand. 


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