Magellan Midstream Partners (MMP) is offering a huge 8.5% yield today. That's notably higher than many of its peers, suggesting that investors are worried that the distribution rate won't hold. There's good reason for that concern, too, given statements out of the partnership over the past year. However, it just did something that should help ease those worries. 

Not an easy time

Midstream-focused Magellan Midstream owns crude oil and refined products pipelines. Essentially, it helps companies move dirty carbon fuels, and the products (like gasoline and jet fuel) into which they get turned. Given the clean energy zeitgeist, some investors don't see that as a particularly great business model. In fact, for those with an ESG focus, the end goal is to essentially push energy-related companies like Magellan out of fossil fuels and into other business lines.

A person turning valves on an energy pipeline.

Image source: Getty Images.

This is part of the reason why Magellan's shares are under pressure today. However, it's not the only reason. While midstream giants like Enterprise Products Partners (EPD 0.48%) tout distribution coverage of 1.6 times, Magellan is only expecting to cover its 2021 payout with distributable cash flow of 1.17 times. While 1.2 times has historically been considered solid in the midstream sector, it is clear that Magellan is a bit out of step with some notable peers in an industry that is facing increasing scrutiny.

The thing is, master limited partnerships like Magellan are specifically designed to pass income on to unitholders. So distributions are very important and often the main reason why investors own the units. Which brings up another problem. Management's comments on the distribution haven't been too inspiring, with it stating that it "...expects to target annual distribution coverage of at least 1.2 times in future years now that refined products demand and commodity prices are trending more in-line with historical levels."

Does that mean no increases?

The fear from investors was that this statement, or similar ones that were made over the past year, was a warning that the distribution would be stagnant or, worse, get cut. Indeed, Magellan had a long history of making regular quarterly increases to its disbursement. But that ended in 2020, with the distribution sitting at the same level the entire year. Because there were increases in each quarter of 2019, the distribution was higher in 2020 and Magellan's annual streak of hikes (at 19 years) was extended another year. But that shift was a troubling sign, as such moves often precede cuts.

In the first half of 2021 the distribution stayed at the same rate, too, so concern that the partnership's annual streak was going to end started to increase. But with the third-quarter disbursement all of that worry has been, at least to some degree, put to rest. Magellan increased its distribution by one cent per quarter. 

The truth is that four cents per year, or about 1% higher than the previous payment, is not a lot to write home about from a financial standpoint. It doesn't even come close to keeping up with today's high inflation rate. But it makes a huge statement that management believes it can support the higher payout in the future while working within its 1.2 times coverage framework. After all, no board wants to increase a distribution only to come back and cut it in a quarter or two. And that should help ease investor concerns about the safety of Magellan's distribution today. 

MMP Average Diluted Shares Outstanding (Quarterly) Chart

MMP Average Diluted Shares Outstanding (Quarterly) data by YCharts

A notable help here is that the partnership has used this uncertain time, in which its unit price has been weak, to buy back $750 million worth of units. The board instituted another buyback plan of the same size, as well. But the real benefit for income investors is that fewer units means it costs less, in aggregate, for Magellan to pay its distribution, improving overall distribution coverage. So even if Magellan's business remains under pressure, socially and financially, it has shown there's a path forward for rewarding investors that stick around.

Breathing easier

Obviously, investors shouldn't take one small distribution increase as an all clear, given that the energy industry is adjusting to a major global shift toward cleaner options. Even though oil should remain a notable piece of the energy pie for decades to come, it still pays to monitor Magellan's business closely. Indeed, while buying back units is a good thing, at the right price, Magellan can only do so much to offset weakness in the underlying business. So the real takeaway for investors is probably that Magellan's distribution hike suggests that things are getting better, which should ease the worry. But unitholders should still pay attention over the next year or so to make sure that the top and bottom lines confirm that read.