MLP funds, once seemingly immune, show signs of frailty as energy prices fall

Popular category for yield-starved investors posts first quarterly decline in two years

Jan 21, 2015 @ 12:08 pm

By Trevor Hunnicutt

Mutual funds and closed end funds invested in energy-infrastructure partnerships, which had been a lifeline for advisers looking to amplify returns for retirees and other income-starved clients, reversed course last quarter and delivered negative performance for the first time in two years.

Mutual funds invested in “master-limited partnerships” — a company structure used widely to hold firms such as fee-collecting oil and gas transporters and distributors — fell 9% last quarter, according to Morningstar Inc.

Closed end funds invested in MLPs, which can use financial leverage more liberally than mutual funds to magnify their positions, fell faster and harder, losing 11% of their value (though their market price fell by less, 8.3%). Closed-end funds, unlike mutual funds, trade on exchanges at premiums or discounts to their net asset value.

The disappointing result for master-limited partnerships comes as the steep slide in global oil prices began to weigh on a popular, and seemingly immune, corporate structure for yield-hunting investors.

“Investors seem to be underestimating the risks of MLPs,” wrote portfolio manager and former Merrill Lynch & Co. Inc. chief investment strategist Richard Bernstein in a note this month. “A 50% drop in oil prices seems to certain to have a negative impact on MLPs because of the sector's overvaluation and increased dependency on external capital for funding.”

The price of oil has faced pressure from flagging demand due to spotty global economic performance and increased sources of supply since last summer, according to analysts. A widely used benchmark for crude oil futures hit a low for the year, at $46.47 at the close of trading Tuesday, down from more than $100 last June. That price moved back up 2.8% during trading Wednesday.

MLP investments account for about 10%, or $22.6 billion, of the money in closed-end funds. Another $27 billion tracks MLP mutual funds.

The underlying businesses owned by MLPs — frequently so-called “midstream” companies — generally assess toll-like fees to oil and gas distributors, limiting their reliance on volatile commodity prices. But they are still sensitive to those market dynamics. And in order to generate their lofty cash distributions to investors, the funds tend to rely on capital markets for fundraising, which may erode and become more expensive if interest rates rise, as expected, this year.

Among the largest distributors in the fund space are ClearBridge Investments, which is owned by Legg Mason Inc. The firm's largest strategy, the $1.8 billion ClearBridge Energy MLP (CEM) is up 3.33% over the 12 months ended Tuesday. But over the last three months, it's down 6.6%.

Chris Larsen, director of closed-end funds for Legg Mason, said it's too early to buy into the “conventional wisdom” that MLPs have entered a bear market. He said his firm expects the volume of oil, an important contributor to fees for midstream companies, to increase, along with distributions.

“It's probably too early to make that assumption,” he said in an interview. “Energy prices are likely to be higher than they were and over time MLPs will be fine.”

Last week, Wells Fargo & Co. strategists told the firm's financial advisers to keep “fears in perspective” on the risk that MLP holdings would cut their cash distributions.

“The vast majority of MLPs participate in the so-called midstream sector of the energy industry which is involved in the storage and transportation of oil, gas and [natural gas liquids],” wrote the firm's co-head of real asset strategy, Mark Litzerman, in a note. “The recent market turbulence and news of distribution cuts can be unsettling for investors, but, in our opinion, high-quality MLPs that are engaged in storage and transportation, have little risk of distribution cuts in the current environment.”

Mr. Larsen said that right now, fluctuations in price are due more to “technical” market factors, such as the fact that retail investors dominate in demand for MLPs. When those investors sell, fewer institutional investors are able to step in and take up the slack than in other markets in the short-run, he said.

About three-quarters of the debt across Legg's closed-end MLP funds is reliant on long-term debt with locked in financing costs, he said.

But he said the leverage used by the closed-end funds was likely to amplify volatility in down-moving market just as it had when markets moved up. He said that was a likely reason that closed-end funds had underperformed their open-end counterparts.

“Most closed-end funds in the MLP space do use leverage, [making them] more volatile,” said Cara Esser, an analyst for Morningstar.

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