As low interest rates persist, investors have sought new avenues for yield. Master limited partnerships are attracting attention as a way to invest in energy infrastructure while receiving attractive yields and favorable tax treatment. MLPs aren't well known to most investors, despite having outperformed the broad equity market for years.
Since the 2008 financial crisis, MLP yields have increased significantly and fundamentals are still intact. This could represent a good buying opportunity for financial advisers and their clients.
The MLP market no longer is considered a fringe sector. There are more than 80 publicly traded MLPs, with a total market capitalization in excess of $300 billion.
Over the next five to 10 years, the MLP market is expected to grow significantly as energy demand rises and more assets are purchased from large oil companies, liquid and gas volumes continue to increase and investor interest grows.
Although MLPs generally are an attractive and growing sector, there are some issues to consider before jumping into the market full bore.
Here are three crucial factors that advisers should consider when investing in MLPs for client portfolios.
Business mix. When evaluating the viability of an MLP's business, it is important to examine the business mix and geography of assets. Significant discoveries of crude oil and natural gas in Canada and the United States have yielded a windfall of resources in North America in recent years. This has created an enormous opportunity for participants in the energy sector to provide our economy with fuel in an efficient manner from locations much closer to home than in years past.
MLPs provide a crucial piece of the puzzle in this process, transporting oil and natural gas from recent shale discoveries in the Eastern Great Lakes region, North Dakota, Western Canada and Texas. Access to these key regions and the ability to quickly, safely and effectively transport and store petrochemicals distinguishes outperformers from laggards in the MLP industry. In evaluating individual MLPs, it is essential to analyze trends in the discovery of new resources and evaluate the ability of different MLPs to operate effectively in new and existing production fields.
Also look for companies with assets diversified among crude oil, dry gas and natural-gas liquids to provide more-diverse revenue streams.
Company fundamentals. Another important consideration in the selection of MLPs is the nature of their contracts with customers. MLPs have been touted as a part of the energy value chain that generally is immune to commodity price movements. As the price of crude oil has dropped to the mid-$90s from more than $110 per barrel in February, this consideration has become even more important for investors. We favor MLPs that derive a majority of revenue from longer-term, volume-based contracts that don't fluctuate wildly with the price of petrochemicals. Detailed analyses of different MLP assets and the nature of contracts with customers on those assets are necessary to ascertain the exposure to commodity prices. Although this process may be time intensive, it is critical to find opportunities that insulate investors from the volatility of commodity prices as much as possible.
Valuation. Finally, when evaluating MLPs for potential inclusion in a yield-seeking portfolio, a major concern is the sustainability of the distribution. We look for MLPs that are expected to pay out attractive yields (some of our holdings have yields in excess of 7%) and have the ability to increase those distributions through higher operating-cash flows. A useful measure is the distribution coverage ratio. It subtracts capital expenditures from operating-cash flows generated by assets and divides that number by the distribution per unit.
Although evaluating individual MLPs is complex, the sector's performance has rewarded investors.
The Alerian MLP Index returned investors 17.6% annually on a total- return basis (dividends reinvested) between January 2000 and this past March, compared with 2.5% annually for the S&P 500.
MLPs offer investors a compelling way to invest in the energy structure while receiving attractive yields in a tax-advantaged manner.
Investing through a mutual fund may increase the diversification and lower the risk of a portfolio invested in MLPs and could present the best way to add exposure to this sector in your clients' portfolios.
James Wong is a principal and co-portfolio manager of the domestic-large-cap and global-equity portfolio strategies at Payden & Rygel and a portfolio manager of the Payden Value Leaders Fund (PYVLX), which invests in MLPs.
