MLPs: Profit In The Pipelines?

March 10, 2009

This often-overlooked asset class can help you tap into the coming infrastructure boom.

  • High yields, low risk
  • Oversold and undervalued?
  • The risks and challenges

Despite conservation efforts, the U.S.' existing energy infrastructure just can't keep up with our ever-increasing thirst for energy. By 2030, Americans will require an estimated 131.2 quadrillion BTUs of energy - up 33% from 2005. We need repairs, upgrades and expansions, and we need them fast.

Many investors have already started piling into energy infrastructure, looking for ways to tap into its inevitable market surge. But the best play may be one you've never even heard of: the master limited partnership (MLP).

MLPs are limited partnerships, specializing in mineral and natural resource development, that can be traded on securities exchanges. Investors buy and sell MLP "units" just like shares of stock, but instead of receiving dividends, "unit holders" get cash distributions typical of a partnership structure.

Poorly understood and often overlooked, MLPs are the Rodney Dangerfield of asset classes: Even after 20 years, they still can't get no respect. But as interest in infrastructure swells, their combination of liquidity and tax efficiency - not to mention their historically high returns - make MLPs a promising way for investors to jump into the coming energy infrastructure boom.

MLPs: A Different Kind of Partnership

Established by Congress in the 1980s, MLPs were originally developed to spur investment in energy and natural resource projects. According to the Revenue Act of 1987, only companies engaged in "the exploration, production, mining, processing, refining, marketing or transportation" of mineral and natural resources may use this structure.[1]

Today, there are about 100 MLPs, more than 75% of which are energy infrastructure companies. These partnerships run a variety of business - including pipelines, refineries, processing plants and more - for a range of natural resources: oil, coal, propane, natural gas, timber - even "alternative" fuels like ethanol and biodiesel.

Because most MLPs own physical assets that operate independently of the commodities transported, processed or refined, the income of these companies depends less on energy prices and more on energy demand. And since demand is much less volatile than pricing, MLP income remains relatively stable even when energy prices go haywire. So unit holders usually see a steady, predictable increase in their cash distributions.

MLPs offer other advantages, too, including:

  • Consistently high yields that outperform other assets.
    In the past, the average current yield of MLPs has ranged anywhere from 7-10%, and currently it hovers above 8%, according to industry leader Kayne Anderson Capital Advisors.

    That's not to say MLPs were immune to last year's market implosion-they weren't. But historically, they have outperformed other asset classes, such as stocks; between 1998 and 2007, MLPs beat the S&P 500 seven out of 10 years.
  • Low correlation to other asset classes.
    Historically, MLPs have only weakly correlated with other assets, making them a good diversification tool.

MLP Correlations With Other Asset Classes

Asset 2007 July 2007-July 2008 3-Year 5-Year
S 0.43 0.43 0.43 0.40
Natural Gas 0.02 0.10 0.13 0.14
Crude Oil 0.26 0.34 0.31 0.31
10-Yr. Treasury 0.24 0.36 0.19 0.07
Utilities 0.36 0.29 0.41 0.40
REITs 0.35 0.21 0.30 0.32
Corporate Bonds 0.03 -0.01 0.00 -0.07

Data: Wachovia

Of course, in 2008, correlations between all asset classes skyrocketed, including MLPs. But history suggests this rise may be short term, and as the markets settle down, MLPs may adjust back into their historical patterns.

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