MLPs Become More Attractive As Markets Sell Off

| About: ALPS Alerian (AMLP)
Yields on the 10-year US Treasury have had a slight uptick in recent days, but still remain at the lowest levels in a decade, as investors continue to eschew risky assets. That’s hardly surprising because investors remain anxious about both US domestic economic woes and the sovereign debt crisis in Europe.

Source: Bloomberg

As I’ve written on several occasions over the past few months, I believe there will be continuing volatility in the market, but I don’t expect an economic contraction.
The US will have a tough time producing robust economic growth given high unemployment, the need for further deleveraging and the continued unwinding of the real estate bubble. It’s a pattern I expect to see in the rest of the developed world. Nevertheless, I expect US gross domestic product (GDP) to continue slowly drifting higher.
Business sentiment, as measured by the past few readings of the Purchasing Managers Index, remains consistent with slow growth. But business spending remains strong and has room to grow once companies start to deploy the huge amounts of cash idling on their balance sheets. And US exports remain at their highest levels in decades due to a relatively weak US dollar. Meanwhile, American consumers are still spending.

Source: Bloomberg

Given such positive data points, I don’t expect a recession any time soon. However, growth will remain sluggish and the market will continue to be volatile.
In this low interest rate environment, it’s been tough for income investors to find worthwhile payouts that don’t entail inordinate amounts of risk. But there’s one income-producing sector that has become increasingly attractive as the markets have sold off.
Midstream master limited partnerships (NYSE:MLP) operate the pipeline and storage infrastructure for our oil, gasoline and natural gas resources. They’re an extremely attractive way to play both growing energy demand and the need for greater investment in the US energy infrastructure. Even better, midstream MLPs avoid direct exposure to volatile commodity prices because they’re paid based on the volumes they move rather than on the price of oil or natural gas. As a result, most MLPs are able to pay extremely attractive dividends both in terms of absolute yield and consistency of payout.
When I first surveyed this sector in May for my advisory service, Global ETF Profits, most MLPs were yielding a bit more than 4 percent. While those yields were certainly attractive, the MLP sector seemed a tad overvalued at that juncture, as yield-chasing investors were pushing the sector’s prices ever higher.
Since then, the MLP sector has experienced a sell-off of around 10 percent, despite the fact that second-quarter earnings were quite strong. Additionally, distribution growth--a measure of how much cash MLPs have to pass along to investors--across the MLP universe ran in the high single digits.
Those numbers hardly merit such a decline. Anxious investors have unfairly punished the sector out of fear that another recession could take a toll on energy demand.
As a result, MLPs now offer enough value for me to be long the ALPS Alerian MLP ETF (NYSE: AMLP).
The fund holds a capitalization-weighted portfolio of 25 midstream MLPs, including names such as Enterprise Products Partners (NYSE: EPD), Kinder Morgan Energy Partners (NYSE: KMP) and Magellan Midstream Partners (NYSE: MMP).
While obviously energy-focused, the operations of most midstream MLPs are fairly diversified. Enterprise Products Partners operates both onshore and offshore natural gas and crude oil pipelines and storage facilities, 25 natural gas processing facilities and two natural gas import and export facilities. Kinder Morgan Energy Partners owns more than 35,000 miles of pipeline and 180 crude, natural gas and bulk materials terminals. Both companies operate in the largest and fastest-growing energy-producing regions in the US. Find out more about MLPs by reading Master Limited Partnerships Revealed, a free guide on MLP investing.
ALPS Alerian MLP ETF is currently the least volatile exchange-traded product tracking the MLP space; its standard deviation runs at 8.07 percent and its beta is 0.63. By comparison, the S&P 500’s standard deviation is currently in excess of 21 percent.
The fund currently yields 6.4 percent, one of the highest yields in the ETF universe. The reason for such an impressive payout is the structure of MLPs; they’re not subject to corporate-level income tax, so most of their income is passed along to investors. But this isn’t a case of questionable companies making higher distributions just to attract investors; these are strong companies that take advantage of a unique structure to maximize unit-holder returns.
I expect the MLP sector will benefit greatly from America’s energy infrastructure demands. As Elliott Gue explains in his recent article, The Natural Gas Oversupply and How to Play it, the major reason natural gas prices in the US are so low - currently around $4 per million British thermal units - is that the infrastructure is not yet in place to easily move excess supply to areas of the country where demand is greatest. Crude oil supplies in the US face a similar lack of mobility.
As a result, there are a number of new pipelines in the works, and MLPs are in the best position to build them. Even during the darkest days of the financial crisis, most MLPs were able to tap the capital markets and secure financing at favorable terms. They should be able to secure the funding necessary to complete pipeline projects regardless of the economic climate. That will be a major boon for the sector as energy demand continues growing.

Disclosure: I am long AMLP.