Can MLPs Be The Calm In Energy's Storm?

Key Takeaways

• Oil has hit energy stocks hard, but MLPs could still deliver needed income amid a broader market selloff.
• One strategy: aligning with a basket of companies that aren't critically tied to the price of oil.

It’s been a rocky stretch for oil-related investments recently, with little evidence to suggest the price of oil itself is about to help industry stocks rebound significantly higher.

Master limited partnership stocks, for example, have had their share of bumps as oil prices have slid.

One broader investment alternative, the Energetic MLPs motif, has dropped 40.7% over the past 12 months. In the past month, the motif has lost 17.4%; the S&P is down 7.9%.

As a recent Barron’s.com piece pointed out, after brief period of stability in the last half of December, MLP stocks again followed oil prices lower after the new year. That revived concerns among many investors that a recent dividend cut by Kinder Morgan Inc KMI would play out among companies in the MLP space.

However, several analysts believe there is room for MLPs to recover in 2016. In a research report last week, DA Davidson analyst Poe Fratt remarked that the market now appears to be discounting slower distribution growth.

“For the third straight year, MLPs are off to a weak start,” Fratt wrote, “but distribution announcements from the better positioned MLPs (three MLPs increased distributions last week) should begin to have more of a lasting positive impact.”

Fratt pointed to the sector’s 9% dividend yield — well above the 20-year average — as a sign that downside risk seems limited.

“Concerns about distribution stability, commodity prices and access to reasonable priced growth capital haven’t faded yet, but the risk/reward profile of the MLP group remains skewed to the positive,” he wrote.

Fratt’s top two picks in the sector are Enterprise Products Partners L.P. EPD, which increased its distribution 5% last week, and Magellan Midstream Partners L.P. MMP both of which are among the top holdings in the Energetic MLPs motif.

Interestingly, optimism about MLPs hasn’t necessarily required an expectation for a significant rise in oil prices.

Indeed, for Brian Watson, a portfolio manager for two Oppenheimer energy funds, the worst-case-scenario for crude prices has been part of his strategy.

“Our philosophy has always been that the price of crude is inherently volatile and that it will have an impact on the sector under some conditions,” Watson recently told Barrons.com. “We run bull and bear cases stress-testing our companies for commodity exposure. Also, even when it was much higher, we were still using $80 for hose tests as the long-term price of crude. Now we use $75 for the next three to five years for our base case. For the next two years, we’re using $45 crude for our bear case.”

As a result, Watson says his funds have managed to avoid MLPs that were tied too critically to the price of oil, including many exploration and production MLPs that are now “down 90%.”

He also likes Enterprise Products Partners EPP, which he said is a “large, diverse company that has been able to maintain distribution growth. It has a very broad and healthy asset base.”

Watson added that EPP is a very “conservative” company in regard to its use of leverage and covering its distribution. “It’s sneakily attractive, even though it is enormous,” Watson said. “Today you’re getting it for a good price for the risk you’re taking. It’s a great core holding.”

Watson also likes Sunoco Logistics Partners SXL, another holding in the Energetic MLPs motif. Watson said the company has been “one of the best growers in a while. It has very visible growth ahead due to its backlog of projects. It’s very healthy and stable.”Energetic MLPs motif. Watson said the company has been “one of the best growers in a while. It has very visible growth ahead due to its backlog of projects. It’s very healthy and stable.”

Watson’s emphasis on more stable companies with a wider industry footprint was recently echoed by analysts at Deutsche Bank, who touted four “higher-quality” MLP stocks in a recent report, while emphasizing that the sector’s bottom may still lie ahead.

In addition to joining the consensus on EPP, Deutsche recommended EQT Midstream Partners LP EQM, MPLX LP MPLX, and Phillips 66 Partners LP PSXP, all three of which are Energetic MLPs motif holdings.

Deutsche noted that MPLX made a “very well-timed and strategic” purchase of MarkWest Energy last year for approximately $1.28 billion. The combination created one of the largest MLPs, which is expected to generate a mid-20% compound annual distribution growth rate through 2019.

While certain companies may have consistently paid dividends in the past, there can be no assurance or guarantee that they will be able to continue paying dividends in the future.

Investors should be aware of unique risks and tax consequences involved with MLPs. Distributions are treated differently than stock dividends. Income distributions received from MLPs are typically reported on a Schedule K-1. Certain MLPs that have operations in multiple states may need to file tax returns within each state, based on income limits. Income limits may also make investments in MLPs inappropriate within retirement accounts. Investors may wish to consult with their tax advisor prior to making an investment decision.