In what was a difficult year for alternative investment strategies, Master-Limited Partnerships can be viewed as a bright spot.
Granted, that bright spot is not a large one: the total market capitalization of the benchmark Alerian Index is about $300 billion or, as Jason Lioon, an MLP specialist at Diversified Trust, likes to say, “smaller than Apple.”
And despite a recent spate of IPOs (and 2013 was a banner year for MLP IPOs, about which, more later) the MLP universe remains sparsely populated, consisting of roughly 100 companies that are structured like limited partnerships, trade on public exchanges (chiefly the NYSE and the NASDAQ) and derive 90% of their revenues from resources.
It must also be said that December wasn’t particularly kind to MLPs—both the Alerian and Cushing 30 indexes were down over 4% at one point during the month, which Libby Toudouze, president of Cushing MLP Asset Management, attributes to a combination of factors—including MLPs “being in a 'post distribution period,' some fundamental misses by several MLPs resulting in reduced guidance, and the impact of 13 secondary offerings since November 1st”—all of which, she told FINalternatives, have “weighed on the space.”
But for those who understand this small space and know how to play it, 2013 brought some satisfying returns. The Alerian Index may have been down on December, but it was up 25.5% as of end-November, virtually tied with the S&P 500, which was up 26% over the same period and well ahead of the average hedge fund, which was up 8.31%, according to Hedge Fund Research's HFRI Fund Weighted Composite Index.
MLPs have historically been the darlings of income-oriented investors and Lioon said they still offer attractive distribution yields of 6%—and much more for some names. And the tax benefits remain appealing. According to Hinds Howard, a research analyst with CBRE Clarion Securities—and the man behind the MLP Market Update blog—“The LP structure allows MLPs to avoid corporate income tax, instead flowing income and losses through to the limited partners. As a result of large cash distributions and large depreciation expenses, the cash received by investors of MLPs is typically greater than 80% tax deferred, as the allocated net income is typically much less than distributions received.”
Most MLPs, Lioon told FINalternatives, “focus on the transportation, storage and processing of natural resources—by and large they do not actually own the commodity directly. This has allowed them to be direct beneficiaries of the boom in North American energy production.”
The U.S. has seen oil production rise nearly 35% over the last 24 months alone—a situation both Lioon and Toudouze characterized as a U.S. “Energy Renaissance”—creating “a very attractive operating environment for MLPs.”
Moreover, said Lioon, much of the new production is coming out of relatively new fields in Texas, the Dakotas, Ohio and Western Pennsylvania, areas not traditionally associated with oil and gas exploration. “As a result, a tremendous amount of new infrastructure is required, providing MLPs with a plethora of new growth opportunities.
“Most MLPs operate on long-term contracts with the actual producers of the oil and gas, providing them with a great deal of cashflow certainty. This has allowed MLPs to consistently increase their distributions, even during 2008-09. With the robust growth opportunities available, distributions have grown between 6-8% the past few years and look poised for a similar increase in 2014.”
And while admitting that the small size of the MLP universe and their being held by individual investors makes them subject to spikes in volatility, Lioon believes that ultimately “investors with a longer time horizon should be rewarded handsomely.”
There's no denying the MLP space is small but there's also no denying that in 2013, it grew. There were 20 MLP IPOs this year, beating the previous record of 13 set in 2007, and raising $7.5 billion in equity combined with their initial offerings.
The biggest IPO was that of Plains GP Holdings, which raised $2.8 billion in October, although it should be noted that, although structured as an MLP, this offering will be taxed as a corporation as management gave up 'pass-through' status at Plains GP.
But in addition to being numerous, the MLP IPOs of 2013 were also varied. While the bulk (38%) represented mid-stream companies, 10% were marine companies, 14% terminals, 5% refining and 5% exploration and production. A significant 29% of MLPs are classified as “other” and, according to The Motley Fool's Aimee Duffy, range from “the obscure trona miner and soda ash producer OCI Resources to the metallurgical coke producer SunCoke Energy Partners.”
The best-performing of those new MLPs in 2013 is Emerge Energy Services, which produces sand for hydraulic fracturing and processes and distributes transportation fuels, and was up almost 130% for the year as of mid-December.
But don't necessarily expect the IPO trend to continue in 2014; although there are a few in the pipeline, Duffy predicts 2014 will be more about consolidation in the space than IPOs.
And speaking of 2014...
MLP performance in recent months has been affected by rising interest rates which could also be a factor in 2014. The long-awaited tapering of the Fed's qualitative easing program announced in December could lead to higher interest rates, said Lioon and “MLPs certainly could come under some additional short-term pressure as a result.”
Toudouze thinks in the short term, the tapering announcement (and the positive market response to it) means MLPs will not see “much more of a pullback,” and what pullback there has been may have a positive effect:
“Fear of high MLP valuations have kept many new investors out of the space all year long. Because of the December pullback, some of that concern should be eased.”
Jeff A. Baehr of New York-based Empiric Asset Management, who oversees a long/short fund focused on energy MLPs, told FINalternatives that stock selection will be the key to success in this space in 2014, with several themes differentiating between winners and losers.
One theme, he said, would be the glut in natural gas liquids—particularly ethane. “We believe certain MLPs have been overly aggressive with guidance as a result. Several MLPs have lowered expectations to incorporate the NGL environment going forward and we expect this trend to continue.”
Baehr has grown somewhat bearish on third-party acquisitions, which he said have become increasingly expensive, and believes MLPs with “organic” growth opportunities in “key areas”—like the Utica Marcellus, Bakken and Eagle Ford shale formations—will outperform.
Empiric Asset Management has also noted that certain MLPs “have accelerated growth by lowering their distribution coverage ratio. While this is usually done in conjunction with an acquisition or organic growth project, we believe this can be dangerous if conditions change. As a result, we prefer companies that are able to achieve above average growth while maintaining a healthy distribution coverage ratio,” said Baehr.
And last but not least, Baehr is betting on oil, predicting that “MLPs focused on crude oil/refined products infrastructure will continue to outperform given the current supply/demand dynamics of natural gas in the U.S.”
Toudouze expects January to be a good month for MLPs because it generally is “and all MLPs seem to benefit from the beginning of the year surge.
“We see no reason for that to change in 2014. However, we continue to believe that as the industry matures, not all MLPs have the same opportunities (as evidenced by those who had to bring growth numbers down) and the dispersion of returns by company will once again widen out as it has in 2013.
“The MLP macro story is so strong that the long term, mid-teen annualized return potential continues to exist,” said Toudouze. “The value of the MLP companies enjoying a visible growth path over the next decade, and beyond, is very attractive. When you add the current distribution component, MLPs continue to offer a strong value proposition. We believe that in 2014, even more investors will adopt that view.”