For investors seeking higher yields in a dismal low interest rate environment, master limited partnerships (MLPs) of midstream energy companies are one viable alternative.
These MLPs are involved in the business of transporting oil, primarily though pipelines, as well as storing and processing various other commodities related to the production of petroleum or for the storage and transmission of natural gas.
This investment is currently undervalued because the worsening trade situation with China and last year’s oversupply of oil drove down petroleum prices. Many midstream MLPs got caught in the oil stock selloff.
As a result, many are now selling far below their previous valuations. At their current depressed price levels, and because of their generous dividend distributions, this group provides above-average yields as well as the potential for ample total returns.
Midstream companies are businesses that store, transport and process energy commodities in the United States. Normally they are insulated, to some extent, from price variations in the world petroleum market.
Nonetheless, a 40% drop in oil prices in 2018 took their toll on most stocks involved in the oil business as investors indiscriminately punished all energy stocks, even tertiary companies that service the overall energy sector.
Indeed, Greg Reid, president of the MLP complex at Salient, a Houston investment firm, says that “the group is reacting more to energy prices than it should.”
The energy-pipeline industry, meanwhile, is probably in its best shape ever due to growing cash flow as well as increasing domestic energy production.
Reid is favorably disposed to the sector because of its ample dividend-coverage ratios, lower leverage and greater use of free cash flow to finance capital projects.
The following are some midstream energy MLPs worthy of consideration:
Energy Transfer (ET) and Enterprise Products Partners (EPD) are the two largest and most diversified MLPs in the midstream pipeline sector.
Both of these MLP’s are involved in the pipeline sector
JPMorgan analyst Jeremy Tonet favors both of these firms because both recently exceeded expectations and both enjoy “full integration, franchise positions, footprints in advantaged basins, and financial flexibility.”
Midstream firms are not totally immune from price declines in the world oil market, yet at current price per barrel levels the group has a safe margin.
Some analysts believe that the midstream group can survive oil price drops as far down as $45 a barrel. Current oil prices are above analysts’ break-even level for midstream MLP’s risk assessment.
Some closed-end MLP funds dropped by as much as 30% last year, making them appealing. At $2 billion, Kayne Anderson MLP/Midstream Investment (KYN), the largest in the midstream pipeline sector, fell a whopping 28% last year. At $12.80 it currently yields 12%.
The smaller Salient Midstream & MLP (SMM) also was hit hard in 2018, dropping 33%. At $7.10 its current yield is close to 9.63%.
Risks
Investing in MLPs isn’t for the faint of heart. Total returns in these investment vehicles have been weak for years; the Alerian MLP Index has lost more than a third of its value over the last five years, including distributions.
MLPs have had notoriously complex ownership structures that often times, when cash flow decreased, inured to the benefit of the general partners to the detriment of the limited partners.
However, the governance/ business entity tide is turning. Several MLPs have simplified their ownership structures in recent years; others have converted to traditional corporations.
That has helped expand their ownership base to include more funds and indexes that exclude limited partnerships. Changes to the tax laws also gives tax breaks to corporations, making the partnership structure less appealing as a tax-advantaged vehicle for high net-worth investors.
Given these positive changes and given MLPs high yields, investors with higher risk tolerance should consider whether they would be a suitable addition to their portfolios.
