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Energy Stocks

Five Reasons MLPs Are Still a Buy

By Roger S. Conrad on Oct. 1, 2014

Editor’s Note: Roger Conrad and Elliott Gue will share their expertise with investors at the upcoming World MoneyShow Toronto, which will take place Oct. 16 to Oct. 18 at the Metro Toronto Convention Center. Roger will give a presentation on one of his favorite themes for income investors. Registration for this must-attend conference is free. Sign up at MoneyShow.com or call 1-800-970-4355 and tell them that Roger Conrad and Elliott Gue sent you.

The Alerian MLP Index’s 406 percent return since late 2008 is a once-in-a-generation gain. Enterprise Products Partners LP (NYSE: EPD), the largest MLP by market capitalization, has enriched its unitholders to the tune of 560 percent over the same period.

But with a distribution yield of 3.6 percent, Enterprise Products Partners’ price moves resemble a momentum stock more than a stable income investment. The same goes for other high flyers like Magellan Midstream Partners LP (NYSE: MMP), which yields barely 3 percent after returning almost 900 percent since late 2008.

Investors shouldn’t buy a security class based on its previous returns—nor should they dismiss it outright.

The key to outperformance is to understand the upside catalysts for a specific sector or industry and focus on the best individual growth stories.

Unlike pundits who have cornered the market on uninformed opinions, my colleague Elliott Gue and I have covered MLPs for over a decade and we track every energy-focused name in Energy & Income Advisor’s MLP Ratings table.

Here are five reasons that MLPs still offer outstanding opportunities for savvy investors.

Reason No. 1: Shale Boom Creates Demand for Infrastructure

Despite what you may have heard, the best MLPs should continue benefit from the US shale oil and gas boom, as surging production drives demand for supporting infrastructure to process these hydrocarbons and transport them to end-markets in the US and abroad.

Let’s start with the more than $600 billion in new infrastructure that will be needed to support growing US hydrocarbon production over the next decade.

And the potential upside could be even bigger if Schlumberger (NYSE: SLB) and other oil-field services firms manage to increase the recovery rates on shale oil wells, which today hover around 5 percent.

Reason No. 2: Expanding Universe Creates Opportunity

The universe of publicly traded partnerships continues to swell, giving investors unprecedented options and creating more opportunity for differentiated returns.

The July issues of Energy & Income Advisor dug into recent and forthcoming initial public offerings of new MLPs; subscribers should check out The MLP IPO Class of 2014, Part 1 and Part 2 for our picks and pans from the latest debutants. And there are more to come.

Within the pipeline of prospective publicly traded partnerships, Shell Midstream Partners LP (NYSE: SHLX) shows particular promise and stands to benefit from an extensive pipeline of potential drop-down transactions from its parent, energy giant Royal Dutch Shell (LSE: RDSA, RDS B; NYSE: RDS A, RDS B).

Given the elevated valuations for well-positioned midstream assets, we wouldn’t be surprised if other integrated oil companies opted to monetize some of their North American pipelines, either by selling them to existing partnerships or spinning off their own.

Reason No. 3: Tax Advantages

Investment taxes have increased significantly since late 2008. Not only has the top tax rate on dividends and capital gains jumped to 20 percent, but also investors in higher income brackets face a 3.8 percent surcharge on dividends and capital gains to help fund the Obama administration’s health care reform.

Investors looking for legal tax shelters have few options. Detroit’s high-profile bankruptcy and local governments’ tenuous financial positions underscore the risks associated with municipal bonds—a security class that traditionally has been viewed as a safe tax haven. Moreover, the paltry yields offered by municipal bonds off scant compensation for these risks.

In this low-yield environment, the tax-deferring powers of MLPs become more compelling than ever.

And despite fear-mongering about potential changes to MLPs’ tax status, the odds of the government revoking or modifying the tax treatment of these entities remains low.

Not only do MLPs enjoy support for their tax status on both sides of the aisle, but also the revenue that the government would gain by pulling the rug out from under these names remains paltry.

Consider that the Alerian MLP Index’s total market capitalization is less than $300 billion, compared to Exxon Mobil Corp’s $400 billion market cap.

History also appears to be on MLPs’ side. When Finance Minister Jim Flaherty announced the end of Canadian income trust’s favorable tax status on Oct. 31, 2006, these securities represented a whopping 20 percent of the Toronto Stock Exchange’s market capitalization.

And from a practical perspective, we don’t expect the government to pursue a policy that could curtail investment in the infrastructure needed to support the shale oil and gas boom.

Reason No. 4: M&A Activity Accelerates

In mid-August, Kinder Morgan Inc. (NYSE: KMI) announced plans to absorb the two MLPs under its purview: Kinder Morgan Energy Partners LP (NYSE: KMP) and El Paso Pipeline Partners LP (NYSE: EPB). This transaction resulted in windfall gains for unitholders.

This transaction effectively lowers the Kinder Morgan family’s cost of capital and gives the company more firepower for accretive acquisitions of other MLPs. In particular, Markwest Energy Partners LP (NYSE: MWE) and Targa Resources Corp (NYSE: TRGP) would fit well with Kinder Morgan’s existing assets. (See More Thoughts on the Kinder Morgan Mega Deal and Its Implications.)

We expect more consolidation in the MLP space, as operators look to add scale, fill gaps in their asset portfolios and build strategically for the future. Other transactions will involve private-equity or C corporations acquiring weaker MLPs as a means to monetize their assets. (See MLP Takeover Talk.)

Reason No. 5: Fear of Rising Interest Rates Will Create Buying Opportunities

Fears of rising interest rates will spark occasional selloffs in the MLP space, as unsophisticated investors mistakenly assume that inflation will undercut the value of their distributions.

But given the group’s growth prospects, this concern appears to be unfounded.

And consider that when the yield on the 10-year Treasury note surged by 72.3 percent last year, the Alerian MLP Index still delivered a 27.6 percent return.

MLPs are equities, not bonds. These stocks tend to do track the broader market and economy—not interest rates. Take advantage of investors’ irrational fear of rising interest rates and buy our favorites on the dips.

Opportunities Where Others See None

Where are the best opportunities in MLPs space? We’re focused on several areas:

  • Initial Public Offerings: MLPs tend to grow their distributions at an accelerated rate in the first few years of their existence, one of the reasons that recent initial public offerings (IPO) tend to dominate the annual list of top-performing MLPs. We tend to focus on high-quality names that will help investors to build wealth over the long term and nontraditional MLPs that the market doesn’t understand right away.
  • Yield Compression Plays: Income-seeking investors often gravitate toward the highest-yielding names. But the lion’s share of the Alerian MLP Index’s average annual return of 14 percent comes from capital appreciation. Yield compression occurs when price appreciation outstrips the rate of distribution growth and can create real windfalls for investors. We’re always on the lookout for undervalued MLPs that are moving close to growing their distributions after a prolonged fallow period. Two of our favorite turnaround stories continue to gain traction in the market and still offer significant upside for savvy investors.
  • Takeover Targets: Consolidation in the MLP space looks set to continue. Blue-chip MLPs continue to eye strategic acquisitions to round out their portfolios and drive distribution growth, while smaller operators look to build the necessary scale to compete. Private-equity funds looking to monetize their energy assets have also entered the fray, acquiring underperforming names and restoring their growth prospects by dropping down assets.
  • Special Situations: Do you know the difference between SeaDrill (NYSE: SDRL) and SeaDrill Partners LLC (NYSE: SDLP)? My colleague Elliott Gue sold SeaDrill from Energy & Income Advisor’s Model Portfolio over a year ago and highlighted SeaDrill Partners as a way to profit from the pain in the deepwater drilling market. Since then, SeaDrill Partners has increased its distribution by 29.9 percent, while SeaDrill’s stock has plummeted by 36 percent. Our in-depth coverage of the MLP market and energy sector enables us to identify the best opportunities and the money pits.
  • Short Squeezes: Short sellers of MLPs have been badly burned over the past year. (See The Short End of the Stick.) And although we take all informed opinion seriously, it’s a good bet the shorts will once again be treading in areas we know better than they do—giving us a good opportunity to benefit from another short squeeze.

These are the opportunities that are on our radar today. By staying flexible and digging deep into individual companies and sectors, we’ll be able to spot the emerging opportunities and exit stale ones.

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Roger S. Conrad needs no introduction to individual and professional investors, many of whom have profited from his decades of experience uncovering the best dividend-paying stocks for accumulating sustainable wealth. Roger b