With U.S. 10-year Treasuries yielding less than 2%, income-hungry investors are on the prowl for high-yielding investments. One asset class many investors are turning toward is master limited partnerships, or MLPs. For risk-averse investors seeking a steady and reliable stream of income, midstream MLPs should be one of the first places to look.
A primer on MLPs
There's no two ways about it. Over the past decade, master limited partnerships have been one of the best investments you could have made. MLPs have returned close to 16% annualized in the past ten years, compared to just 4%-5% for the Dow and the S&P500.
The allure of MLPs has a lot to do with their organizational structure; they're pass-through entities that are exempt from corporate income taxes. Hence, they are required to pay out the bulk of their income to shareholders -- or unitholders as they're called in MLP-speak -- in the form of quarterly distributions. With the average MLP yielding around 6%, it's clear why the asset class has attracted so much attention in recent years.
Most MLPs operate within the energy sector. However, there are also a few MLPs outside the energy space that may well be worth consideration. For instance, Terra Nitrogen (NYSE: TNH ) , a producer of nitrogen fertilizer products, is an MLP to check out, especially if you're bullish on the outlook for fertilizer stocks. Another non-energy MLP is StoneMor Partners (NYSE: STON ) , which offers products and services in the death care industry.
While some of our analysts have made convincing cases for investing in these non-energy MLPs, I still prefer MLPs within the energy space. And while some energy MLPs, such as those engaged in upstream operations, do have meaningful exposure to commodity prices, there are more defensive ways of playing the sector -- namely through the midstream operators.
The bullish case for midstream MLPs
The midstream industry sits comfortably between the upstream segment (the explorers and producers) and the downstream segment (the sellers and distributors). They're the guys involved in the transportation and storage of oil, natural gas, natural gas liquids (NGLs), as well as gasoline and other refined products.
One of the most attractive features of the midstream MLPs is their toll-booth-like business model. They simply act like toll collectors, charging operators fees for letting them use their pipelines. Roughly 65% of the MLP sector's revenue is derived from fees, many of which are tied to government-regulated rates. As such, they have highly monopolistic characteristics; their services are absolutely essential to a wide array of businesses, which makes them that much more attractive.
With the tremendous discoveries of shale deposits throughout North America and the commercial use of hydraulic fracturing and horizontal drilling to unlock their potential, it's no surprise that demand for midstream services has grown rapidly. In a nutshell, one of America's biggest problems with regard to our energy landscape is that we've been producing oil and natural gas at a breakneck clip, but there just aren't enough pipelines to transport all of those resources to where they're needed.
According to a recent study by the Interstate Natural Gas Association of America, roughly $10 billion per year in midstream infrastructure spending in required to meet growing demand over the next 25 years. This is where the midstream MLPs come in to play. Three names in particular are worth strongly considering.
3 companies to consider
I prefer the larger, well-capitalized, midstream outfits. One name I especially like is Enterprise Products Partners (NYSE: EPD ) . It yields 4.6%, which is admittedly below the average MLP's yield, but its prospects for growth are extremely strong. The company has increased its distribution for 32 straight quarters and has a very healthy distribution coverage ratio of 1.4 times. And over the past few years, Enterprise has improved significantly its organizational structure and currently has around $7.5 billion worth of growth projects that will support the further development of key onshore resource plays.
Another MLP investors should consider is Plains All American Pipeline (NYSE: PAA ) . Like Enterprise, Plains is also ramping up its spending on growth projects, many of which are exceptionally well-positioned to benefit from the strong infrastructure demand in key resource plays. The company yields 5.3% and has raised its distribution in 31 of the last 33 quarters. Going forward, Plains expects 8%-9% annual distribution growth, which it thinks can be maintained at a healthy 1.3 times distribution coverage ratio. Importantly, both Enterprise and Plains derive the bulk of their revenues from fee-based contracted assets, which greatly enhances the stability of cash flows.
Lastly, be sure to check out Linn Energy (Nasdaq: LINE ) . OK, I lied. Linn isn't in the midstream space. It's an exploration and production company structured as an MLP. But Linn's highly conservative hedging program makes it an extremely safe bet, in my opinion. The company has hedged most of its oil and gas production as far out as 2016 and 2017, respectively, locking in favorable prices for both commodities. Linn yields 7.2% and has consistently increased its distribution each quarter since its IPO. Overall, the company's quarterly distribution has grown by an impressive 81% since it went public.
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