Consider MLPs for Oil & Gas Plays

What's your take on the vitality of the oil and gas pipeline companies, considering all the recent success in this sector as a whole?

This is a fairly specialized group within the broader oil and gas sector - industry players that own and operate the country's oil and natural gas pipelines, storage tanks, and terminals. These are hard assets that generate steady fee-based earnings and cash flows. As such the group's results are not directly tied to commodity prices and can be viewed as defensive plays.

Just as a brief background on the group, you may recall a number of industry players ventured into other areas in search of growth during the late 1990's. These forays into unrelated businesses stretched their balance sheets and dragged them down when the economy went south.

However, not everyone in this space succumbed to the lure of asset-light business models (Enron was fond of touting its asset-light business model); quite a few remained focused on their core businesses and shielded their shareholders from a lot of pain. The first group includes those who diversified and are now restructuring their way back to the core business, and second, those who remained committed to the energy transportation and infrastructure business and enjoy strong financial health.

Those that restructured include high-fliers of the recent past, such as El Paso (EP) and Dynegy (DYN), while the latter group includes names such as Kinder Morgan (KMI). In addition to these two groups, there is a third group in this space that we find more interesting and attractive. Securities in this group have a unique corporate structure called a master limited partnership (MLP) that exhibit hybrid financial features (fixed income as well as equity).

How did these MLPs come about?

Most of these partnerships have been created by companies in the oil and gas industry, as this structure enabled them to monetize cash flow-generating infrastructure assets on a tax-efficient basis. These partnerships have stable and predictable cash flow, as their income depends primarily on the volume of products transported, not on the current price of oil.

Ownership interests in the partnership are divided into publicly traded units, which are comparable to shares in other publicly traded companies. These partnerships offer potential tax advantages, as a portion of the payouts, termed 'distributions,' can be tax-deferred.

Do these companies provide good dividend yields, as well?

Yes, MLPs are yield plays. A good way to think of MLPs is like a hybrid of equity and fixed income. So, an MLP will have features that are similar to common stocks, but it has behaves a lot like bonds.

Yields of publicly traded pipeline MLPs tend to track the yield of the 10-year Treasury bond, with the spread between the MLP yield and the Treasury yield averaging roughly 300 basis points over the last ten years. More specifically, the MLP pipeline group's yield spread has averaged closer to 200 basis points, while the MLP propane group's spread has been closer to 400 basis points.

Are these MLPs good investments during economic downturns, generally?

Partnership units tend to trade inversely with interest rates such as fixed-income instruments. But unlike bonds, MLP units, which already offer tax advantages, may be used to hedge against inflation through distribution growth.

Over the last few years, publicly traded pipeline partnerships have significantly outperformed the broader market indexes. We believe that the favorable acquisition and growth environment that has prevailed during this time period is the primary catalyst for this performance. This supportive environment is characterized by divestitures of non-core assets by major oil companies and troubled merchant energy companies, and by a more favorable funding environment.

With that said, what is your outlook for this group?

We believe that there are three critical factors that will impact MLP performance over the next 12 months.