Eileen Gunn
11/01/2004
Those of us seeking to capitalize on positive trends in the oil and natural gas markets, but who are hesitant to own such fickle commodities for 10 years, may opt for more liquid, publicly traded investments in the energy sector. Master limited partnerships (MLPs) are one such option. They are publicly traded companies (we own units, not shares) that deal in natural resources such as oil, gas and timber.
MLPs are not quite a stock and not quite a bond. “They are their own asset class,” explains Mark Easterbrook, an analyst with RBC Capital Markets in Dallas, and that creates some management issues. However, with their reliable income, relative liquidity and limited direct exposure to commodity prices, they offer a different energy investment vehicle.
The best MLPs are in businesslike pipelines that benefit from the strong demand that is spurring oil and natural gas prices upward, but that are not dependent on those high prices to do well. According to Easterbrook, these companies pay no taxes and hand out up to 90 percent of their cash flow to investors via quarterly distributions. Consequently, they are attractive to those of us interested in energy’s upward trends and who want substantial current income from our investments.
Like many energy-related investments, MLPs have done well lately. RBC reports its MLP index returned 22.7 percent over the 12 months ending July 9 (the most recent data available), compared with the S&P 500, which gained 13 percent, and the 10-year Treasury index, which lost 1 percent. Meanwhile, cash distributions for the group rose 4.2 percent in the first half of 2004.
MLPs differ greatly, says Easterbrook, who recommends those that store and transport refined products (gasoline, jet fuel, heating fuel) bound for end markets. These MLPs benefit from the long-term demographic trends—such as America’s shift toward bigger homes and cars—that are boosting demand for fuel, and they tend to remain the most stable through commodity price swings. “Look for partnerships focused on geographic regions where there is population growth, like the Southwest, the Southeast or the Rockies,” Easterbrook says. Two firms that top his recommended list, Kinder Morgan Energy Partners and Magellan Midstream Partners, fall into this category.
Other companies own pipelines that carry raw oil and gas away from the wells. While their volume-based fees stay the same regardless of what commodity prices do, should those prices fall low enough that people cut back on drillings, these companies could see demand for their services fall. One such company, GulfTerra Energy Partners, a Houston-based firm Easterbrook tracks, owns a network of oil and gas pipelines and maintenance platforms across the Gulf of Mexico.
At the riskier end of the spectrum, a few MLPs handle propane, which is very volatile and seasonal (it does better in winter), Easterbrook says.
When sizing up an MLP, consistent growth in the quarterly cash payout is a sign of a robust business. “Only one MLP that cut its distribution came back and did well. Usually when they do that, it’s the first step toward filing for bankruptcy or being acquired at a low price,” Easterbrook explains.
Investing in MLPs in a rising interest-rate environment can be tricky. “Rising rates usually signal that the economy is good, which tends to mean the companies are piping more oil and gas and doing well,” Easterbrook says. That often means increasing their distributions. The trouble is that when Treasury rates go high enough, the income-seekers flock from MLPs into bonds, which pushes down the companies’ unit prices and drags down overall returns. “Bonds are safer and simpler, so why not do that instead?” asks Christopher Edmonds, director of research at Pritchard Capital Partners in Atlanta. “As long as you hold a bond until maturity, you don’t have the price risk that you have in MLPs.”
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