The market sure doesn't take kindly to these Federal Reserve meetings, does it? Even though the Fed announced that things will remain more or less status quo until unemployment hits 7%, investors are starting to get nervous about the impact of rising interest rates and inflation on their stocks. There is special concern over the effects on master limited partnerships, equities that have attracted unprecedented levels of investment because their (typically) high yields make them great substitutes for depressed bond prices. Today I'll look at how rising interest rates and inflation affect MLPs.
What do rising interest rates do?
The master limited partnership business structure passes almost all of its cash through to unit holders in the form of distributions. That's why we love them. This means, however, that MLPs rely heavily on capital markets to fund growth. When interest rates rise, borrowing money becomes more expensive and could threaten the growth prospects for some MLPs. This is why, historically, MLPs have underperformed during periods of rising interest rates.
What does inflation do?
First, and perhaps most importantly, FERC ties its tariff rates to the Producer Price Index, adjusting it as needed on an annual basis. That means that inflation shouldn't have a meaningful impact on fees generated by interstate pipelines. What inflation can affect, however, is depreciation of assets. Depreciation is not adjusted for inflation, so replacing an asset like a pipeline becomes more expensive as inflation rises. This is still considered a low-risk problem.
How bad will it hurt?
First off, we've got more MLPs on the market than ever before, and they aren't all the same. Even the ones that look the same on the outside have different components that can be affected in different ways by either inflation or rising interest rates.
Let's start with MLPs like Linn Energy (NASDAQ:LINE) or BreitBurn Energy Partners (NASDAQ:BBEP). These are oil and gas exploration and production partnerships, and though this type of MLP is extremely exposed to commodity risk, commodity prices are tied to inflation, which in turn poses little threat to the partnerships.
You'll see the same effect at a traditional pipeline MLP that has some exposure to commodity risk, like Energy Transfer Partners (NYSE:ETP). Energy Transfer has taken it on the chin over the past few quarters as low natural gas liquids prices have squeezed earnings in its midstream segment. The same is true for Kinder Morgan Energy Partners (NYSE:KMP) in its carbon dioxide business, which is exposed to natural gas prices and oil prices. Management doesn't have to worry that inflation will make either of those situations worse, and FERC should take care of the big interstate pipeline systems, so that only leaves cost of capital to worry about.
Money gets more expensive
As the cost of capital rises, MLPs with the strongest balance sheets and the highest investment grade ratings will be in the best position to access the cheapest capital for expansion. But MLPs are limited by the ratings agencies right now and can only achieve a certain level of credit rating.
The ratings agency Fitch put out a press release in March that helps explain this:
We note that, while the basic analytical approach adopted for both MLPs and corporate credits is mostly the same, certain differences are noteworthy. MLP credit ratings are generally capped for practical purposes in the "BBB" rating category due to aggressive distribution and growth practices; corporate ratings have no similar ceiling. Also, some MLPs may be subject to greater event and capital market risk, given their aggressive growth strategies and external funding demands.
If ratings agencies were to raise that ceiling, it would certainly have an impact on MLPs when interest rates rise. This is a point that at least one CEO to my knowledge has raised. Let's flash back to February's fourth-quarter conference call at Plains All American Pipeline, when CEO Greg Armstrong made this statement:
We were pleased that we received upgrades from the rating agencies during 2012 to BBB and Baa2, which is currently the highest rating level for any MLP. We are hopeful that the rating agencies will expand the MLP eligible ratings to include BBB+, Baa1 rating level. We believe our size; scale, diversification, and performance through various cycles as well as our strong credit metrics and discipline adherence to our financial growth strategy should make us a candidate for the inaugural BBB+, Baa1 class of MLPs.
Since that time, Enterprise Products Partners (NYSE:EPD) has indeed achieved a Baa1 rating, handed down from Moody's this past March. It is perhaps the best positioned MLP for rising interest rates because it has no general partner, which means it pays no general partner stake and no incentive distribution rights, thereby lowering its cost of capital.
There is an important caveat to all of this, and that is that the energy sector is absolutely on fire right now. The U.S. is producing more oil than it has since 1991 and more natural gas than it ever has in its 100-plus year history of producing the stuff. This production is completely dependent on midstream infrastructure, and therefore, it's dangerous to assume that because MLPs have underperformed in periods of rising interest rates and inflation in the past, they will continue to do so going forward.
Investors have flocked to energy MLPs because of their high yields and lucrative distribution payouts. Some fear that as interest rates rise, investors will abandon MLPs and fall back in love with bonds. However, interest rates on bonds would have to climb pretty high to top many of the yields on these MLPs. Ultimately, the energy industry is firing on all cylinders, and it doesn't make sense to abandon ship based on economic theories about what might happen when the underlying business at these MLPs is so strong. However, not all MLPs are created equal, and it makes sense to take the time to evaluate your holdings now, especially in regard to cost of capital.
The Motley Fool recommends BreitBurn Energy Partners, Enterprise Products Partners, and Moody's. Try any of our Foolish newsletter services free for 30 days. 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.