Financial markets have shown remarkable stability since 2009, causing many to wonder if there are any bargains available. However, pipelines and storage facilities designed to transport and hold oil and natural gas have been trashed this year, following the descent of oil prices. These companies are typically organized as MLPs (master limited partnerships). According to the website MLP Data, the 20 largest ETFs and ETNs trafficking in the space are down at least 20% for the year through December 4. Many are down over 40%.

For clients who don’t have exposure to this corner of the market, it could be worth a look. However, potential investors must consider two things—transporting oil is more tethered to the price of oil than previously advertised, and the various products holding them function in radically different ways.

What Are MLPs?

Master limited partnerships are not unlike REITs that own property, collect rent and pass profits through to shareholders in exchange for tax-free status at the corporate level. MLPs similarly are “toll collectors” for the commodities passing through their infrastructure, and they pass their profits through to unit holders. Like REITs, they also don’t pay tax at the corporate level.

The two main reasons for the recent declines are the drop in the price of oil and fears among investors of rising interest rates. MLPs pay hefty yields, and investors have gravitated to them for that reason. A rise in rates will cause other, safer investments such as U.S. Treasury and corporate bonds to compete for investor dollars seeking current yield.

Not Immune From Commodity Price Fluctuation

The prospect of rising rates is something that every income-producing asset must confront. But the first problem—the drop in the price of oil—is something from which some MLPs were supposed to be immune. The theory (and the selling point for the asset class) was that pipelines get paid a toll to push oil and gas through, from one place to another, regardless of the commodity’s price. As long as there is demand for the commodity and a need for it to be moved or stored, the tolls collected by the businesses and the income distributed to investors theoretically remain intact.

Unfortunately, things turned out to be more complicated. While it’s true that there is some immunity from commodity price declines, this decoupling isn’t total. In an interview, Morningstar ETF analyst Robert Goldsborough estimates that 25% of MLPs’ cash flows are dependent on the price of oil in the form of subsidies. Goldsborough doesn’t think Americans are using any less energy than they have in the recent past; oil is still being pushed through the pipeline system. But some revenue subsidies for the infrastructure have been cut now.

Morningstar strategist Josh Peters added more color in an interview on the Chicago research firm’s website in August. Arguing that lower oil production would naturally hurt pipelines, Peters said:

Certainly the promoters of the industry on Wall Street had a vested interest in describing these as toll roads that are going to throw off lots of cash flow and pay these big distributions no matter what happens to energy prices. That really was never true, because the simplest way to think about it is that the midstream energy companies—pipelines, storage, gathering and processing, these kinds of activities—their clients effectively are the producers of oil and gas as well as the consumers.

Well, the producers and the consumers at each end of the pipeline, they are affected by the price of the commodities flowing through it. So how can you expect the literally middle-of-the-stream midstream businesses not to be affected too? … Even as the S&P energy sector has been under a tremendous amount of pressure since the end of the summer of 2014 on the lower oil price environment, midstream MLPs, using the Alerian MLP Index, [are] down by roughly the same amount—depending on the day, it may be even a little bit more. I think that shocked a lot of people, but it’s got something to do with the group just having been oversold and perhaps partnerships getting access to capital that ought not to have had that happen under a more sane environment for the industry.

Samuel Lee of Severian Asset Management in Chicago, concurs with Peters. Lee notes, “If the price of oil declines, some fields become uneconomical to produce from, so volume will shrivel up. That means the oil price does affect the pipeline volume eventually. Production can be shut off quickly, leaving pipelines stranded, without much volume pumping out.”

Lee also says that some of the MLPs were highly levered and aggressively distributing cash flow. When share prices were high, they were doing a kind of private-public arbitrage, using the capital raised from issuing expensive publicly traded shares to buy private pipes at a discount. That has largely run out now.

MLPs depended on high share prices for cash to fund asset purchases, as Lee explains it. So a decline in share price hinders their ability to fund acquisitions.

Interest Rates

In addition to being prolific share issuers, MLPs are heavy users of debt. And expectations of rising interest rates—translating into higher cost of capital for MLPs—have contributed to price declines in the asset class. For example, Enterprise Products Partners LP (EPD) has $29 billion in long-term debt against $47 billion in total assets. Magellan Midstream Partners LP (MMP) has total liabilities of $3.6 billion against total assets of $5.5 billion. If interest rates rise, the firms’ debt costs will increase, and the firms will become less profitable.

The second reason interest rate increases will hurt is that the 6.59% yield of Enterprise Products and the 4.84% yield of Magellan will look worse against a 10-year Treasury yield of, say, 3% or 3.5%, rather than the 2.3% yield the government delivers to lenders now. But since the prices of MLPs have declined so much, their yields look a lot better than they did a year ago.

How To Get Exposure

Although it may be time to start nibbling at the asset class, the other vexing thing about MLPs has to do with the various methods of gaining exposure. According to an article by Goldsborough, there are 26 exchange-traded products, divided between ETFs and ETNs (exchange-traded notes). These two iterations function in meaningfully different ways.

Goldsborough says the largest MLP exchange-traded product is the Alerian MLP ETF (AMLP), but this one isn’t worth owning. Unfortunately, it has a whopping gross expense ratio of 5.43%, causing it to lag its underlying index by an annualized 4.6% since inception through June 30, 2015, which makes it unsuitable for most investors. 

The fund’s management fee is 0.85%, but it’s organized as a C corporation instead of as a ’40 Act fund. This helps it avoid the prohibition against funds having more than 25% of their assets in MLPs, and it allows the fund to pass a 1099 tax form on to shareholders instead of individual K-1 tax forms for all its holdings. Unfortunately, this structure also gives it some difficult tax burdens, which are reflected in its gross expense ratio. 

The next-largest MLP ETP, Goldsborough says, is the JPMorgan Alerian MLP Index ETN. Because this is an exchange-traded note, it avoids some of the tax issues found in the AMLP fund. As an ETN, the JPMorgan Alerian MLP (whose ticker is AMJ) perfectly tracks the market-cap-weighted Alerian MLP Index. It’s made up of the 50 largest MLPs and seeks to capture some 75% of the available MLP market capitalization. Its investors also receive 1099 forms.

The AMJ product has some problems, though. Its 0.85% annual fee depends on the volume-weighted average price of each MLP component in the ETN’s benchmark rather than on the index level. That means, “The actual cost could deviate from 0.85%,” says Goldsborough. Also, in 2012, J.P. Morgan capped creations of new shares in the product. The result is that it trades as a closed-end fund, with spreads between market price and net asset value. Supply and demand for the AMJ product became unbalanced, and its shares traded at premiums during 2013.

If bid-ask spreads widen again, Goldsborough’s suggestion is for new investors to consider another MLP-oriented ETP such as the UBS ETRACS Alerian MLP Infrastructure Index ETN (MLPI), which, like the AMLP fund, tracks the Alerian MLP Infrastructure Index. The MLPI note also charges a path-dependent, 0.85% annual fee. With fewer assets than the AJM product, this one can still create new shares.

Another MLP exchange-traded note that Goldsborough favors is the Credit Suisse X-Links Cushing MLP Infrastructure ETN (MLPN), again with a path-dependent 0.85% annual fee. Rather than tracking the Alerian MLP Index, the MLPN product tracks the equally weighted Cushing 30 MLP Index, composed of midstream MLPs. This index also includes some MLP general partners.

Investors should remember that ETNs contain counterparty risk because an ETN is essentially a debt instrument issued by a bank. So while an exchange-traded fund’s fees might be prohibitive, exchange-traded notes come with their own risks. Banks seem safer now than they were during the financial crisis, but investors should be aware of the possibility of institutional failure and its potential adverse effect on an ETN it has issued.