Like many stocks in the energy sector, master limited partnerships, or MLPs, remain out of favor. These companies generally focus on transporting, processing and storing oil and natural gas, with revenues based primarily on commodity volumes rather than on commodity prices, explains George Putnam, editor of The Turnaround Letter.
They differ from most stocks because they are structured as publicly traded partnerships, and therefore are not subject to federal income taxes at the company level.
With their focus on stable, cash-producing operations and free from the burden of federal income taxes at the partnership level, MLPs often pay generous distributions to unit holders, resulting in attractive yields that have averaged 7% or more in recent years.
Of course, as with any investment, there are downsides to be considered. With high payouts to unit holders, MLPs often must rely on borrowing and additional equity offerings to fund their growth.
Unit holders receive K-1 tax statements instead of 1099s, and tax-deferred accounts may be subject to UBTI (unrelated business taxable income), among other tax complexities. Also, as interest rates increase, the relative attractiveness of MLP yields may diminish, adding a source of pressure to the traded unit prices.
What has pushed MLPs to be so out-of-favor today? When energy prices began their steep decline in mid-2014, many MLPs belied their reputation for stability, angering their unit holders. They suffered from the symptoms of over-zealous growth in response to the earlier energy boom: too little retained cash, too much leverage and too much investor exuberance.
Several MLP indices dropped by 40% or more, and previously generous distributions often had to be slashed. More recently, a pending rule change by the Federal Energy Regulatory Commission (FERC) could force multi-state pipelines to reduce prices.
Now many MLPs are returning to more conservative policies. Some have eliminated their incentive distribution rights (IDRs) and simplified their complex structures. Distributions are now more in line with cash generation, meaning future cuts are less likely. Critically, investor expectations are much lower today.
Fundamentally, strong energy demand along with healthy production growth means increasing volumes of crude oil and natural gas flowing through pipelines and a brighter future for many MLPs. Listed below are five MLPs that look particularly interesting to us right now.
Energy Transfer Partners LP (ETP)
While first on our alphabetical list, this stock is probably not for investors new to MLPs. The company carries considerably more risk than many other MLPs, reflected in its high 11.8% yield and beaten-down share price.
A major issue is its governance. Billionaire Kelcy Warren is chairman of both the MLP and its General Partner. Other problems include the company’s $34 billion debt, thin distribution coverage due to high IDR payments and the risk of another dilutive equity offering.
However, pressure may be mounting on chairman Warren to restructure the two companies’ relationship, which could lead to a share price boost. The company has an impressively large and valuable asset base and trades at a discounted valuation.
MPLX LP (MPLX)
Formed in 2012 by Marathon Petroleum Corporation, MPLX operates over 10,000 miles of oil and natural gas pipelines, along with storage, processing and other facilities primarily in the eastern United States.
MPLX has steadily increased its cash distribution and has guided to a 10% increase this year. It continues to have ample growth opportunities, particularly in the prolific Marcellus/Utica basins.
With Marathon’s acquisition of refiner Andeavor, the Andeavor-related MLP will likely be combined with MPLX, providing access to western U.S. opportunities. Governance appears healthy: Marathon Petroleum owns 64% of the MPLX units, helping to align interests, and MPLX eliminated the IDR conflict earlier this year.
Plains All American Pipeline LP (PAA)
Sponsored by management and an investor group, Plains operates one of the largest and most integrated midstream systems in the industry. Recent struggles at the company’s Supply and Logistics unit, which bets on energy prices, have weighed on the shares.
Also not helping: an overleveraged balance sheet, weak flows at its Capline pipeline and other issues that have led to asset sales (curtailing growth) and sharp cuts in its distribution to preserve cash.
However, investors appear to be ignoring a number of very positive features: the company’s strong position in the prolific Permian Basin in Texas, its elimination of IDRs, the now-lower debt levels and its well-covered distribution.
Shell Midstream Partners LP (SHLX)
Shell Midstream Partners holds a diversified portfolio of onshore and Gulf of Mexico pipeline assets, product terminals, storage facilities and natural gas gathering lines in the Permian Basin.
Distributions have nearly doubled in the past three years. Its parent, Royal Dutch Shell, offers a steady stream of additional properties that Midstream Partners anticipates purchasing, providing future growth.
A much-needed equity raise was completed in February, which will help improve the balance sheet and finance acquisitions. Another positive is that much of its pipeline system won’t be subject to upcoming federal regulatory changes.
The company may undertake an expensive transaction to eliminate its IDRs, but this should enhance its otherwise high quality. With its recent share price weakness, largely related to its dilutive equity offering, this MLP appears likely to provide a rewarding return.
Western Gas Partners LP (WES)
Western Gas owns natural gas gathering and processing facilities, as well as a promising water gathering network and other assets, in the Rocky Mountains, Pennsylvania and Texas. Distribution growth is likely to remain healthy, at about 6-7% over the next few years, as it expands its operations in sponsor Anadarko Petroleum’s robust Delaware and DJ basins.
With its heavy capital spending likely to taper next year, the company is evaluating whether to distribute much of the increased cash flows or reinvest in new projects. Last year, Western Gas converted Preferred Units to common stock, removing a cash drain.
Anadarko, the MLP’s high-quality sponsor, holds a relatively high 34% of the units, which reduces the likelihood of conflicts of interest. The company also appears to have only limited exposure to the pending change in FERC regulations.
