Where Is the Best Opportunity in MLPs?

Looking for income and exposure to bullish energy markets? Consider the master limited partnership.

Jun 18, 2014 at 8:57AM

Investors looking to buy into a master limited partnership (MLP) are often able to capture significant benefits when interest rates are low and stock markets are trading at elevated levels. MLPs offer the tax benefits of a limited partnership (money is taxed after distributions are received by unit holders and not at the corporate level) along with the added liquidity of a company that is publicly traded.

MLPs generate regular cash distributions, so they can be highly attractive vehicles for investors looking for income and growth opportunities as businesses look to expand their operations and increase their distributions. Given that we will likely remain in an environment of low interest rates well into next year, it is increasingly likely that MLPs will start to receive more attention from the market. MLPs are characterized as having consistent cash flow streams, and nearly all of their income is returned to unitholders as distributions.

Supportive energy trends
MLPs generally operate in the energy space (owning things like storage tanks, pipelines, and other types of energy infrastructure), and there are several important arguments for why this area of the market should see continued upside in coming quarters. Positive surprises in emerging market growth have led to upwardly revised growth figures in Chinese GDP. These positive trends in emerging markets are encouraging for those bullish on energy as China is now the world's largest oil importer, and will continue to drive demand for commodities.  In 2015, oil demand in China is expected to rise by 14%, creating added opportunities for American MLPs that gather, process, and transport these materials to Asia.

Combine this with the supportive underlying evidence of a sustained economic recovery in developed markets (steadily rising GDP numbers, broad declines in unemployment) and the total picture suggests that energy prices will continue pushing ahead in their long term rallies. As long as the market sees rising energy demand, there will continue to be a need for added infrastructure that can be used facilitate both the production and delivery of crude oil and natural gas. MLPs offer a unique way of gaining exposure to the companies that operate in these areas, and positions here can provide some attractive risk-to-reward benefits when used as part of a diversified investment portfolio.

The fundamental supply and demand picture in energy points to continued strength in the MLP space. But in addition to the bullish arguments for rising energy demand globally, companies here could also benefit from Congressional intentions to ramp up oil production as a means for increasing exports to regions with supply deficiencies (i.e. the Ukraine). These measures should support the outlook for instruments with exposure to U.S. companies that operate drilling, storage, and transportation facilities for liquid energy products.

MLPC: A new name to watch

MLPC Chart

MLPC data by YCharts

All of these factors are highly encouraging for the MLP space. But perhaps the best way to assess the market's biases here is to monitor the performance of some of the sector's newest entries. One of the best examples here is the C-Tracks Exchange Traded Note (MLPC), which was launched by Citigroup last September and has already generated very strong returns year to date (12.4%). The C-Tracks Exchange Traded Note tracks the broader market trends seen in the Miller/Howard MLP Fundamental Index (MLPMH). Total returns here are based on the activities of 25 energy MLPS, with a strong focus on the midstream oil and gas space (making up roughly 85% of the index). Investments with MLPC come with an annualized yield of 4.8% and an expense ratio of 0.95%. Annual payouts this high are attractive enough on their own, given the fact that the Fed has clearly stated its intentions to keep interest rates low well into next year.

Continued rallies in MLPC will depend heavily on the performances seen in large caps included in MLPMP.  Specifically, 15 of the 25 stocks in the index fall into this asset category and this includes names like EnLink Midstream Partners (NYSE:ENLK) and the Energy Transfer Equity LP (NYSE:ETE).  Over the last year, these two stocks have doubled on several occasions and there is little to suggest these trends will be ending anytime soon. Large caps are given weightings of 5% in the index, so investors are able to capitalize on substantial growth prospects that are also well-diversified.

Positive sector trends
But investments in instruments like MLPC offer the added advantages that come with diversified exposure to the energy space. Industry innovations in areas like hydraulic fracturing and horizontal drilling have led to massive improvements in production efficiency in U.S. oil shale extraction. Output levels have reached their highest levels in 30 years, following the strongly bullish trends that have been seen in the natural gas space, where output numbers have already hit all-time records.  

Since MLPs are needed to create the distribution infrastructure that will transport these materials, assets like MLPC are positioned to outperform well into next year. Attractive payout ratios, relatively low operating fees, and extra tax benefits provide added reasons to gain exposure to the MLP space. The bullish trends over the last five years help to confirm the outlook, as the Standard & Poor's MLP Index (SPMLP) has shown yearly gains of almost 30% -- soundly beating the performance of the broader S&P 500, even during its latest bull run to new record highs.

With all of this in mind, it becomes clear that investors should include exposure to MLPs as part of a truly diversified long-term portfolio.

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Richard Cox 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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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't 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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