Yes, for value-biased investors, energy master limited partnerships (MLPs) are (somewhat suddenly) more appealing than they have been in several years.* Energy MLPs generally own pipelines and other energy-infrastructure assets and have benefited from the shale oil & gas boom. Yields north of 7% plus reasonable long-term growth potential are hard to come by in today’s markets. (Of course, they don’t come without risks, which we will briefly discuss as well.)

Last summer, with oil & gas producers frantically extracting hydrocarbons from US shale deposits, MLP unit prices (similar in concept to equity share price) were frothy, and the Alerian MLP yielded a paltry 5.21%. More than a year later, US oil production growth is slowing sharply and the fundamental outlook for MLPs is cloudier, but unit prices have collapsed. The acute pain started last fall with partnerships that have hefty direct exposure to oil prices, but is now spread widely. Yields in early August hit 7.30%, the highest in more than five years. In fact, today’s 7.30% level is in the 83rd percentile of yields over the past ten years (double-digit yields were typical during the worst months of the global financial crisis).

Of course, in yield-oriented asset classes, price declines are often a harbinger of future dividend cuts. Could today’s 7.30% yield become tomorrow’s 4% yield, even with no unit-price change? We think this is unlikely. However, if oil & gas prices were to remain at current levels or below for several years, MLP revenues and distributions (the dividend portion of MLP investments) could come under significant pressure. The distribution stream for the full Alerian index has declined by 8% already since last November’s peak level, with the cuts mainly coming from exploration and production–oriented partnerships that have subsequently been removed from the index. Like the weary runners passing the Mile 20 sign in a marathon, the partnerships that remain in the index today are likely more durable than those that were booted last winter. Consensus estimates for the largest ten partnerships in the index, which together account for two-thirds of its market value, bake in full-year distribution growth averaging about 6% for 2015, with further 7% growth penciled in for 2016. Consensus forecasts made back in June 2014 were rosier, unsurprisingly, at 8% and 9% growth for 2015 and 2016, respectively.

Looking beyond 2015 and 2016, what are the risks and opportunities for MLPs and their investors? Historically these partnerships have often generated mid single-digit annual distribution growth because they control key infrastructure used to gather, process, and transport oil and natural gas from booming US shale regions to market. However, the crash in oil prices and rapid drilling slowdown seem likely to pressure the medium-term growth prospects. Regulated pipeline fees typically increase at low single-digit rates, and perhaps the medium-term outlook for MLP distribution growth will skew closer to that level. A rise in interest rates could put moderate pressure on MLPs as well, given their debt structures and the yield-seeking nature of their investor base.

Investors also face some risk of asset obsolescence and overcapacity. For example, portions of North Dakota’s Bakken Shale are highly economic with crude oil at $100/barrel but considerably less so at $50/barrel. If prices were to remain at current levels for several years, volumes and thus partnership revenues would eventually wither.

Bruised share prices for energy MLPs have pushed yields up from 5.21% last June to 7.30% today, substantially increasing their appeal. However, investors should not assume that these partnerships will quickly resume their go-go historical pace of distribution growth.

* MLPs tend to be most appealing for investors subject to US income tax, because they throw off chunky yields, yet unlike most high-yielding investments they do not tend to generate substantial near-term tax liabilities. They may also be appealing to US investors not subject to income tax (such as foundations), provided these institutions are comfortable either (a) with investments that generate unrealized business taxable income or (b) with complicated and sometimes expensive investment vehicles specifically designed to block the generation of said taxable income. Onerous withholding taxes tend to limit the appeal for non-US investors. For more information on the asset class, please consult our 2011 research report, Master Limited Partnerships.
 

Sean McLaughlin is a Managing Director on the Cambridge Associates Global Investment Research team.