1 Volatile Midstream MLP to Skip and a Better Alternative

Studies show that lower volatility companies that pay high and growing yields perform best over the long-term. Midstream MLPs allow investors to participate in America's recent natural gas bonanza while maintaining low volatility and high yields.

Apr 7, 2014 at 1:48PM

My goal is to help investors learn to maximize long-term performance. The energy sector is a favorite of retirees who are drawn to energy MLPs (master limited partnerships) to provide income in retirement. Today, I'd like to explain how all investors, retirees included, can achieve both maximum returns and maximum secure income. 

A 2011 study by Harvard Professor Malcolm Baker analyzed stock returns from 1968 to 2008 and found that low-volatility companies outperformed higher-volatility "growth" stocks. In addition, countless studies show that dividend-paying companies outperform their non-dividend paying counterparts.

Energy companies, particularly MLPs, represent a great way for investors to partake in three investment catalysts:

  • high yield
  • low volatility
  • the energy boom as a catalyst for strong distribution growth (and capital gains)

Investing is never done in a vacuum. Investors cannot blindly buy into any MLP and hope to do well. This article will point out one partnership to avoid and another that offers the trifecta of investing: low volatility, high yield, and a strong catalyst for distribution growth. 

Energy Transfer Partners (NYSE:ETP) is a very large and diversified midstream MLP. It is the largest pipeline provider in Texas with 7,800 miles and 14 Bcf of gas storage capacity. It also owns 12,800 miles of interstate gas pipelines, including a 50% stake in the Florida Gas Transmission Company (5,400 miles of pipeline from Texas to Florida). It is the general partner (and owns 49.95% of incentive distribution rights) of Sunoco Logistics Partners (and owns 32% of the units).  

Its major pipelines service the major shale areas, including the Marcellus, Eagle Ford, Permian Basin, and Barnett shales. The company has $2.1 billion in investment projects that have come online within the last year. So far, investors might be wondering why I would advise avoiding what sounds like a well-located MLP. The answer is two-fold.

First, the partnership has been struggling when it comes to operating efficiencies and profitability, especially compared to its peers.

Company ROA ROE Operating Margin Net Margin
ETP -0.2 -0.1 3.3 -0.2
WPZ 2.9 6.4 20.1 9.1
IND Avg 2.4 8.8 8.2 3.4

Data from Morningstar

The second reason is that this MLP has higher volatility and struggles growing its distribution. This is likely to cause long-term total returns to underperform the market. 

Company Beta Yield 5 Year Distribution Growth Rate (CAGR Predicted Total Returns
ETP 1.04 6.8 0.58 7.38
WPZ 0.45 7 7.76 14.76

Data from Yahoo Finance, Fastgraphs

Beta is a measure of volatility. A beta of one means that a stock is as volatile as the S&P 500. From the table, we can see that Energy Transfer Partners is far more volatile than Williams Partners and has grown its distributions far slower. The rule of thumb for total returns is yield + distribution growth. The stock market's 1871 to 2013 historical return has been 9% CAGR; this indicates that Energy Transfer Partners is likely to underperform the market and Williams Partners.

Williams Partners (NYSE:WPZ) has faced severe headwinds recently. In 2013, the MLP's net income declined by 13.4%. The weakness was due to depressed prices of propane and ethane. Propane and ethane are both natural gas liquids (NGLs) that are transported in Williams' pipelines. An explosion at the partnership's Geismar facility in Baton Rouge, LA also resulted in $500 million in business interruption costs. The plant is scheduled to resume operations in April 2014.

This weakness has resulted in seven consecutive quarters of Williams Partners not covering its distribution (the current coverage ratio is .9). Its general partner has waived its IDRs, allowing the partnership to continue growing its distribution quickly. 

Investors might be wondering how I can recommend such an MLP, one that seems on the verge of a distribution cut. The answer lies in well-placed and strategic investments coming online soon that will secure the distribution and allow it to continue to grow quickly.

The partnership has invested $3.3 billion in 2013 in expanding service to the Marcellus and Utica shale areas. This includes the Blue Grass NGL pipeline, which is a joint venture with Boardwalk Pipeline Partners and is scheduled to come online in 2015. The company is also investing $5 billion in its Transco pipeline (which runs between Texas and the Northeast) through 2017. Management states that it sees the potential for a total of $26 billion in investments through 2018. 

The net result of this investment is a projected $200 million increase in DCF through 2015 (a 60% increase). This will more than cover the current yield and allow for strong future distribution growth.

Bottom line
Long-term investing in high-yielding, low-volatility companies with track records of strong, consistent growth in distributions is the key to market outperformance and solid income. Williams Partners satisfies these criteria and is blessed with strong-growth catalysts. Energy Transfer Partners is an "ok" investment, but with limited investing resources, why buy hamburger when you can have steak?

3 stock picks to ride America's energy bonanza
Record oil and natural gas production is revolutionizing the United States' energy position. Finding the right plays while historic amounts of capital expenditures are flooding the industry will pad your investment nest egg. For this reason, the Motley Fool is offering a look at three energy companies using a small IRS "loophole" to help line investor pockets. Learn this strategy, and the energy companies taking advantage, in our special report "The IRS Is Daring You To Make This Energy Investment." Don't miss out on this timely opportunity; click here to access your report -- it's absolutely free. 

Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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