After three consecutive years of solid investment returns, master limited partnerships (MLPs) have sold off in the last few months. According to Alerian, the largest exchange-traded fund tracking MLPs -- the ALPS Alerian MLP fund -- is down 6 percent since the beginning of the year, and down from about 9 percent since its peak in February. The selloff could be attributed to a handful of factors, ranging from the warm winter, expected drop in U.S. energy demand and the recent fall in the price of oil and natural gas. If investors believe that these factors are short term, and are interested in an investment yield of about 7 percent, then perhaps MLPs may be worth a look.
MLPs are publicly traded partnerships that have shares, or "units" which are traded on a stock exchange. MLPs are primarily energy-related businesses. These businesses can be broken into three segments -- upstream, midstream, and downstream. MLPs operating in the exploration and production of oil and gas are "upstream." Businesses that refine and distribute products are "downstream." Both of these segments have a great deal of exposure to commodity prices, as the rising cost of fuel can be a boon to profits, but falling prices can have the opposite effect.
Most MLPs operate primarily in the "midstream" segment, which involves the transportation and storage of oil, natural gas and other refined petroleum products across the United States. Midstream MLPs have less direct exposure to commodity prices than upstream and downstream MLPs because their revenue is based on volumes and government-regulated fees. Short-term changes should have little effect on a midstream MLP's profitability. However, a long-term reduction in energy demand will decrease volumes, thus reducing midstream profits.
MLPs have certain tax advantages for the investor. Approximately 80 to 90 percent of an MLP's distribution to the investor is tax-deferred. The tax-deferred portion of the distribution is not taxable until the unitholder sells the security. MLPs also have tax advantages related to estate planning and transferring ownership to heirs.
The market for MLPs has grown tremendously in the last 10 years. In 2002, there were 25 MLPs with a market capitalization of $25 billion. Today there are approximately 80 MLPs with a total market value of $300 billion.
Midstream MLPs operate pipelines throughout much of North America and are crucial to providing energy to the U.S. Their heavy infrastructure in strategic locations gives them a natural monopoly, creating need for federal regulation over fees charged for use of their pipelines. Federal regulators allow MLP fees to increase in step with the Producer Price Index (PPI). This creates an inflation hedge for the MLP, which is passed on to investors.
According to Alerian, the MLP index is yielding about 6.76 percent, slightly below its historical average. Perhaps what's more relevant is that the yield spread between it and the 10-year treasury rate is over 5 percent, indicating MLPs are historically cheap relative to the risk-free rate.
MLPs also offer diversification benefits because their historical correlation with the S&P 500 is relatively low.
While history is no guarantee for future results, MLPs have outperformed the S&P 500, Dow Jones Industrial Average, real estate investment trusts (REITs), and utilities in many multi-year periods. As of April 2012, the 5-year annualized return for the MLP index was 11 percent, while the S&P 500 has returned 1 percent. Much of the superior performance can be attributed to their historical dividend growth, which, according to Alerian, has averaged an annual rate of approximately 7 percent over the past ten years.
MLPs present real risks for investors. In shaky markets, they can demonstrate price volatility similar to stocks; however, relative to REITs they have shown to be more stable. In addition, because MLPs are required by statute to pass most of their profits to shareholders in quarterly cash distributions, equity doesn't build up on the balance sheet. As a result, they often must go to the capital markets to fund new projects which can be difficult to do in bad markets.
Investors can hold MLPs in an IRA, but the tax-deferred benefit is essentially wasted. Also, income from an MLP in an IRA may be subject to Unrelated Business Taxable Income (UBTI).
Investors might want to consider adding MLPs to their portfolio to get tax-deferred income along with opportunity for capital appreciation. However, one should be cautious if energy prices to continue to decline and U.S. energy consumption stagnates.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Travis Flenniken is a certified financial analyst with Campbell Asset Management LLC. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at email@example.com.