Inside the Alerian MLP Index: Gathering and Processing

It seems like every other day there's a new master limited partnership hitting the market. In fact, the energy MLP space has gotten to be downright cluttered. In this three-article series, I'm taking a closer look at the Alerian MLP Index ETF (AMLP -0.42%), a tool that gives investors the opportunity to simplify MLP investing. I've already covered the natural gas transportation component, so today we're looking at the gathering and processing MLPs that make up the fund. 

Gathering and processing
The Alerian MLP Index ETF is up more than 11% year to date, driven by the performance of the 25 MLPs that make up the index. At the end of the second quarter, approximately 26.1% of the index was comprised of energy players whose main revenue driver comes from gathering and processing natural gas and natural gas liquids (NGLs).

Today's gathering and processing MLPs differ from the G&Ps in days of yore largely by contract structure with exploration and production companies. In an effort to increase reliable cash flows, G&Ps have begun to favor fee-based contracts over so-called "keep-whole" agreements that would have them take possession of the hydrocarbons, exposing them to commodity risk.

That being said, the processing aspect of this business remains fairly exposed to commodity risk, particularly when it comes to NGL prices. The big revenue driver for both gathering and processing is volume.

Here is a breakdown of the eight gathering and processing partnerships and their respective weight in the fund as of August 2 (holdings can vary day to day):

Source: Alerian

MarkWest Energy is the largest processor of natural gas in the Marcellus Shale, a booming play that should continue to experience volume growth for some time. It also has significant assets in the Utica Shale, a play that has turned out to be much more about natural gas than oil, which is good for a gas gatherer and processor like MarkWest. All told, the partnership expects to have more than 4 billion cubic feet per day of gas processing capacity spread between the two plays by the end of next year. The partnership recently increased its distribution 5% year over year. On top of that, it is up more than 35% year to date.

The majority of Targa Resources operations are located in New Mexico, Texas, and Louisiana, and it has one of the biggest footprints at the Mont Belvieu NGL hub. Volumes were way up in the second quarter, as production in those regions -- especially in the Permian Basin and North Texas -- continues to climb. The partnership posted a distribution coverage ratio of 0.8 times payouts in the second quarter, which is not what investors want to see. However, management reiterated that it will reach a ratio of 1.0 times distributions by the end of the year. Targa Resources Partners is up more than 33 % year to date, despite the rough NGL price environment.

One of the index's smaller G&P components, Atlas Pipeline Partners, is also having a great year, up more than 18% year to date. Atlas' operations are concentrated in the Mid-Continent region and Texas, and is just one piece of the bigger Atlas Energy family, a connection which can drive future growth. After cutting its dividend in 2009, the partnership has slowly worked to build it back up to pre-recession levels. It just announced that it planned to increase its distribution by 5% quarter over quarter, hinting that a more stable future lies ahead. 

PVR Partners, another smaller component that couples gathering and processing with a coal-royalty business, is having a much rougher go of it this year. It's virtually flat year to date, as it slowly works its way back from a 15% free fall in February. Investors are intrigued by PVR because it is intent on growing its non-coal business, and can do so with a lower cost of capital than many other MLPs, having acquired its general partner in 2011.

Bottom line 
The Alerian MLP Index ETF performs well, and generates income without the paperwork headaches that come with individual MLP ownership via the K-1 form. Diversity mitigates risk, and that's what you get with the 25 different MLPs in this ETF.