Growth in the Pipeline
The UBS E-TRACS Alerian MLP Infrastructure ETN (NYSE: MLPI) finished Monday at a new record high, marginally exceeding the one it set on May 22.
That was the day the market began worrying in earnest about the Fed’s stated intention of reducing its bond purchases, possibly as early as this fall.
The yield on the 10-year Treasury note ran up from 1.63 percent on May 2 to a two-year high of 2.71 percent by July 5, before cooler heads and soothing words from Federal Reserve Chairman Ben Bernanke prevailed.
Real estate investment trusts remain well off their springtime highs, not surprising given the big effect interest rates can have on real estate prices.
But while MLPs also pay (a generally nicer) yield, and while they certainly compete with fixed income for investor dollars, the recent action serves as a reminder that MLPs are businesses with all the inherent risks and opportunities and not merely an alternative to junk bonds.
Many are pipeline operators with a huge growth opportunity in front of them. Advances in drilling techniques have unlocked the energy potential of new resource basins. And many of these are in desperate need of new pipes to process and transport the swelling streams of oil and gas they’re producing.
Moreover, this domestic bounty is rapidly transforming America into a low-cost producer and exporter of processed fuel. The financial incentives now in place will assure rising export volumes for the foreseeable future and in turn require huge infrastructure investments, such as are needed, for example, to liquefy natural gas or to crack condensate into naphtha.
These are not trends that will reverse simply because the 10-year yield has rebounded to 2.5 percent.
These are projects that will provide solid returns years into the future for the partnerships that pick the right opportunities and execute well.
If you kept all this in mind and bought when the weakest hands where dumping their MLPs three weeks ago you’re now up about 10 percent on those purchases, the equivalent of nearly two years of distributions at the current yield.
If not, consider adding MLPs on the next correction. There are manifestly fewer screaming bargains than were on offer in the space a year ago. But few other investment categories offer the same attractive combination of present yield with growth potential based not on financial engineering but on the real-world needs of real customers.
Like any investment, MLPs come with many hazards. The focus on yield can blind investors to excessive borrowing or other unsustainable business strategies that can maintain the appearance of profitable growth for a time.
Better to buy based on well-defined business opportunities and to know that if these are grasped the distribution growth will follow. There are no low-risk 10 percent yields, but plenty reasonably secure 5 percent ones that could grow over time.
The tax advantages of MLPs are much more modest than investors commonly assume, unless they’re held until death and passed on to heirs. But they’re there all the same, and can be of tremendous value to patient holders in the highest tax brackets. Just know that if you sell your MLPs the next time the group drops 10 percent, you’re likelier to incur a tax bill than a lasting benefit.
All of this is an argument in favor of the most financially stable MLPs with the brightest growth prospects, and thankfully there are still some that are fairly valued. Many have weathered numerous booms and busts while vastly outperforming the stock market. They’ll be around and building the pipelines we badly need long after interest rates have marched much higher.
Energy Transfer Equity (NYSE: ETE)
The June issue of MLP Profits highlighted how incentive distribution rights can boost the income stream of the general partner over time, to the corresponding detriment of limited partners. IDRs are especially lucrative after a long period of steady growth, which is exactly what’s taken place among MLPs in the five years since the financial crisis hit.
One upshot was our new recommendation of ETE as a general partner poised to capitalize on lucrative IDR streams from several subsidiary partnerships.
ETE is the general partner of Energy Transfer Partners LP (NYSE: ETP), the fourth-largest MLP by market value and operator of natural gas gathering and transportation pipelines with a combined length of 47,000 miles. ETE is also the general partner of another pipeline operator, Regency Energy Partners (NYSE: RGP). And ETP is itself a general partner of another MLP, Sunoco Logistics (NYSE: SXL). All of these MLPs owe incentive distribution rights, directly or indirectly, to ETE.
During its recent acquisition spree, ETE agreed to forego IDR payments from some of the businesses taken over by its affiliates, moves that will cost it $245 million next year but less thereafter with the prospect of a big spur to growth once these waivers expire in a couple of years. Barclays recently estimated that after the waivers ETE’s income stream could growth at a 15-percent annually compounded rate for five years thanks to subsidiary IDRs.
So today’s relatively modest 4.2 percent yield could be markedly higher in a few years without any change in the unit price.
ETE is a stable, financially secure MLP with visible growth catalysts and the tailwind of affiliated IDRs. With units trading right around our initial price target, we’re raising it to continue taking advantage of this opportunity. Buy ETE below $69.