Master Limited Partnerships Still Have Room to Deliver
Increased capital discipline fuels higher return on investment.
In this yield-starved world, it shouldn’t come as any surprise that master limited partnerships (MLP) have been enjoyed complementary outperformance and growth in popularity over the past few years. MLPs are required to generate 90% of their income in “qualified” investments and distribute a comparable amount of income in the form of distributions in exchange for mostly favorable, deferred tax treatment. MLPs must invest in energy-related assets; this mostly includes infrastructures such as pipelines, storage, or even drilling equipment.
MLPs are basically “toll road” businesses; fees are collected for the volume of traffic, whether it be gallons pumped though pipes, or lease rates on rigs or storage units. As such, they are less impacted by the underlying commodity price. The toll across a bridge does not fluctuate with gas prices; therefore, MLPs produce steady and predictable cash flow, which is turned into the relatively high yield distributions.
This triumvirate of qualities that investors are seeking include high yield in the 4%-8% range, true low volatility (something I talked about last week regarding the growth in low volatility ETFs), and a lack of correlation to both equities and commodities. This is a potent combination that has not gone unnoticed by the financial industry: MLPs are now one of the fastest growing products in terms of offerings and assets raised.
The creation of the MLP structure grew out of the Tax Reform Act of 1986, which allowed companies to pass all income, losses, gains, and deductions onto limited partners without corporate taxation. By providing a lower tax structure -- and therefore cheaper access to capital -- the goal was to encourage investment in energy infrastructure. Yes, it was part of the nebulous move toward the "energy independence" plan that has been brewing for nearly three decades. But the structure was seen as somewhat of a rigged game driven by accounting gimmicks to benefit the general partners -- and to a lesser extent, connected limited partners. A confluence of events and inputs over the last 20 years has brought into focus, validated, and accelerated the expansion of the MLP into a legitimate asset class.
The first turn for MLPs occurred in 1996 when Richard Kinder was supposed to succeed Ken Lay as the CEO of Enron. Instead that ill-fated company went in another direction with Jeffery Skilling who chose to emphasize exploiting the "new economy" and trading energy futures. We know how that turned out. In the meantime, Mr. Kinder, with his partner Bill Morgan, saw an opportunity to buy the hard assets that Enron was looking to sell and created Kinder Morgan Energy Partners (NYSE:KMP) in 1997.
The timing was great since many other large integrated energy companies such as Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX) were looking to shed older assets with little growth potential and whose operations were essentially out of their core competency. These companies were instead choosing to focus on exploration, drilling, and refining activities.
Kinder saw the value in the cash generation of these hard assets. Bringing more efficient and disciplined management, combined with the lower cost of capital and tax advantages afforded by the MLP structure, could turn the ownership into a business with improved profits and the prospects to grow as the infrastructure needs of the energy industry expand. Since its inception, a shareholder in KMP would have seen its value increase 1,788% as of December 2012 if cash distributions had been reinvested.
From Growth to Returns
One of the knocks on MLPs was that despite the return of capital, they did not tend to be overly share holder friendly. In many cases, management seemed more intent on empire building than on creating value. Some of this stemmed from the fact that executive pay was typically tied to the size of the company, and not necessarily profitability. Plus, distributions to the general partners are usually paid in the form of increased equity claims; therefore, the general partner is incentivized to simply increase size rather than quality of distributions.
One of the few beneficial byproducts of the near zero interest rate environment is the fact that it is helping impose new discipline on management. Yields on MLPs have tracked rates lower, but they are still very attractive. But even as more investors are clamoring for yield, they are demanding that management proves it can deliver the promised return if they’re seeking to raise capital for expansion. This has created a shift to emphasizing returns rather than growth. Still, that has not impeded the growth of MLPs as an overall asset class.
With the energy boom just getting underway in the US -- thanks to discoveries of large deposits of natural gas and technology such as fracking -- the need for infrastructure that supports the production and transport of the increased capacity bodes well for the industry and MLPs in particular.
Capital Raising a Red Flag?
In 2010, the first MLP exchange-traded fund (ETF) was launched by Alerian, the company that manages the benchmark Alerian MLP Index (NYSEARCA:AMU). The fund, the Alerian MLP ETF (NYSEARCA:AMLP), provides an even more basic access point for investors to benefit from the return of capital of MLPs, but without the complications of K-1 filings. That may have signaled the "Main Streeting" of MLPs, but it may have been just the beginning of its growth as an asset class.
The issuance of new MLPs and capital raising by existing MLPs has been picking up a head of steam in 2013. Last week, Phillips 66 (NYSE:PSX) filed an IPO for an MLP, to be called Phillips 66 Partners (NYSEARCA:PSXP), and it is expected to raise $300 million. It will focus mostly on owning and operating fee-based pipelines and terminals as well as other transportation and midstream assets. This is another example of dismantling of the vertically integrated majors -- remember, PSX itself came from a spin-off of ConocoPhillips (NYSE:COP)
Other names that have filed to raise capital -- or already had capital raises in 2013 -- include Kayne Anderson (NYSE:KYN), which raised $150 million in stock in early March; Enterprise Products Partners (NYSE:EPD), which sold $2.25 billion in senior unsecured notes; and Access Midstream Partners (NYSE:ACMP), which priced a 9 million unit offering at $39.86 per unit last Tuesday. This last offering is set to close the first week of April. After initially dropping below that level, shares recovered Thursday to finish at $40.37 per share.
In fact, MLPs have help up very well while absorbing some $4.8 billion raised thus far this year. The Alerian MLP Index is up 12.6% year to date as of March 29. While this may be indicative of the space getting crowded, it may also be that investors are encouraged that much of the capital is being used to retire more expensive debt or fund existing operations rather than acquisitions. Again, this speaks to the demand for capital discipline and return on investment.
Given the growth prospects for the energy industry, MLPs should be able to continue delivering steady and superior yields with lower volatility relative to stocks, only moderate correlation bond yields, and very little exposure to the underlying commodity price.
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