After decades of fretting about energy imports, the U.S. is currently undergoing an energy boom that offers numerous opportunities for investors, with some of the most attractive coming from energy-oriented master limited partnerships (MLPs). These publicly traded entities, which own and operate energy infrastructure, enjoyed a strong year of performance in 2013 after rebounding from a lethargic end to 2012. Looking ahead, the prospect for MLPs remains attractive, driven by a visible and sustainable growth in cash flow that is a function of the increasing demand for critical energy infrastructure.
Steadily Building Momentum
MLPs have traditionally been owned by retail investors, but thanks to their strong total return characteristics, institutions like pension funds and mutual funds have become increasingly attracted to the asset class. The "hunt for yield," coupled with the more visible growth in yield, have brought MLPs closer to the mainstream, and their positive performance as an asset class continues to attract interest in the investment community.
Companies that focus on providing midstream energy infrastructure, such as pipelines and storage terminals, performed best in the past year, as yield-hungry investors rushed to buy into attractive and growing cash distribution yields. At the same time, strong demand for critical logistics assets due to a robust increase in energy production in the lower 48 states -- much of it in regions previously undeveloped for energy reserves -- continues to drive cash flow growth at well-positioned midstream MLPs. First-quarter earnings for 2014 reflect continued growth, driven in part by strong demand from the cold winter.
Key Factors Driving Growth
The Interstate Natural Gas Association of America (INGAA) estimated in 2011 that natural gas and crude oil infrastructure spending would average about $11 billion annually going forward; subsequently, it adjusted this figure upward to approximately $30 billion per year through 2035 based on growing demand. At the same time exports of propane, liquefied natural gas and other products are also on the upswing. That means an increased demand for infrastructure -- and opportunity for MLPs.
Additional factors boosting the growth of MLPs include:
- Positive overall fund flows into the MLP sector, boosted by growing institutional participation, the proliferation of investment vehicles that avoid K-1 accounting, and the basic maturation of the sector as it becomes more of a mainstream asset class;
- Performance-driving increases in industry consolidation and "drop-down" asset acquisition; and
- Compelling overall yields continuing to attract yield-hungry investors, despite a lack of cheap valuations.
Considerations for Investors
While the outlook for 2014 remains bright, driven by booming energy production, volatility is likely to increase. Potential headwinds exist from rising interest rates, continued low natural gas and natural gas liquids prices, and continued large new equity supply. And since not all MLPs are created equal, company selection is more important than ever.
Midstream MLPs, which own assets with fee-based, "toll-road" attributes and reduced commodity price exposure, offer different investment opportunities than upstream MLPs, which focus on exploration and production and have depleting assets and higher commodity price exposure. The more attractive midstream MLPs have:
- A strong organic growth profile or a clear line of sight toward asset acquisitions;
- Balance sheets that are not over-levered;
- Coverage ratios in excess of 1x; and
- Dominant positions in the most prolific shale basins (Marcellus/Utica, Bakken, Eagle Ford and Permian).
These companies are best positioned for annual distribution growth in the high single- to low double-digit ranges, creating an attractive total return proposition for investors.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.