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.

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