Better Understanding MLPs

Master Limited Partnerships spend money to make money, so don’t be put off by “negative free cash flow” – these vehicles still provide income

Reviewed by: Michael John Lytle
Edited by: Michael John Lytle

A recent comment on this website noted the so-called “negative free cash flows” from midstream Master Limited Partnerships and questioned their ability to pay out in future. However, this negative cash flow is evidence of MLPs’ continuous investment to ensure distributions are paid out now and in the years to come.

In this article I will explain how MLPs work and why investors shouldn’t be spooked into selling their MLP investments due to falling energy prices.

What Are MLPs?

MLPs are publicly traded partnerships, which provide similar exposure to traditional equities. The difference is that MLPs are traded partnership interests, making them a particularly tax-efficient means of investing in U.S. energy infrastructure. Unlike commercial corporations, MLPs do not pay corporate income tax – currently 35 percent in the U.S. – on their profits, as long as they agree to pay out almost all of those profits as dividends.

There are currently just over 100 MLPs, with a total market capitalisation of around $450 billion, with the majority falling within the midstream energy sector. These companies have enabled investors to access a remarkable revolution in U.S. energy over the last five to 10 years as a huge amount of infrastructure has been built out to access shale gas across the country.

Attractive For Income Investors

Midstream companies are able to generate stable cash flows based on “toll-road” models – a pipeline-owning MLP will lease out capacity on a fixed-fee, long-term basis and will be less exposed to volatile oil and gas prices than traditional energy investments.

As mentioned, a high proportion of these untaxed cash flows is paid out to investors via partnership distributions. Distribution yield in the space has generally been in the region of 6 percent, with 6 percent annual growth, making MLPs potentially very attractive for income-seeking investors.

Concerns Over Falling Oil Prices

The business models of midstream companies have effectively shielded their cash flows from the impact of volatile oil and gas prices. MLP prices show less than 50 percent correlation to the oil spot price – around the same as the S&P 500 Index, and significantly lower than traditional energy investments.

The recent climate of falling energy prices has, however, spooked some investors and led to price declines – particularly for those MLPs closer to sectors like exploration, production and processing, where the oil price can have a higher impact. Within the midstream space, we see the average MLP as having just 10 to 15 percent direct exposure to the oil price.

Worries About Broader Energy Outlook

Some investors remain concerned over the broader outlook for U.S. shale oil and gas production. This year and next may see some reductions in capital expenditure – known as capex – by energy and production companies but this is unlikely to faze midstream companies, which can rely on existing assets to maintain their cash flows.

Furthermore, the International Energy Agency has suggested shale oil production growth is set to continue through 2020 and production pullback will be limited. Continued growth should pave the way for more infrastructure projects and the continuation of stable cash flows for midstream MLPs.

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MLPS Spend Money To Make Money

As I mentioned earlier, a commentator noted the negative free cash flows exhibited by midstream MLPs and questioned their ability to maintain distributions on this basis. However, a look into the history of MLP free cash flows shows that they have been persistently negative over the last 10 years.

The explanation is simple – free cash flow is calculated as net income of a company less capex. In a growing industry, capex figures include investment in new assets that are yet to produce income. A healthy midstream company that has made significant investments into constructing new pipelines would be expected to have negative free cash flow.

Distributions Still Paid Out

MLPs and their analysts use instead a different metric on which to base distributions – distributable cash flow (DCF). Rather than discounting income by capex as a whole, DCF generally considers only maintenance capex – i.e. what is spent making sure existing assets can continue to provide income.

This metric gives more insight into the profitability of existing assets. The ratio of DCF to gross distributions represents the buffer that can be eaten into before the company is forced to cut distributions. As an example, Energy Transfer Partners, one of the largest companies in the space, posted negative free cash flow over 2014 due in part to large investments in a subsidiary company. However, on a DCF basis, the company showed a coverage ratio of 1.3, meaning distributions were paid out comfortably.

This case shows how traditional methods of analysing equities can be misapplied to MLPs – and perhaps gives a reason as to why certain investors have been selling off robust midstream companies along with the rest of their energy portfolio.

[Disclaimer: Please note that past performance is not a reliable indicator of future performance.]


Michael John Lytle is chief development officer at ETP provider Source