The year began with a surge of optimism. Energy-related MLPs, particularly those with exposure to booming demand for new midstream infrastructure, benefited from frenzied buying activity in the stock market. Meanwhile, the group's long-term growth prospects appear sanguine.
The combination of ready access to inexpensive capital and the pressing need for additional takeaway capacity to support robust drilling activity in shale plays promised to fuel distribution growth in coming years. Meanwhile, mergers and acquisitions also surged, as upstream MLPs sought to purchase underpriced acreage and midstream MLPs vied for pipeline assets.
Then commodity prices began to tumble. Natural gas prices, which were already weakened by the glut of production from prolific shale gas plays, sank even further after the no-show winter of 2011-12 sapped demand and increased the volume of gas in storage to record highs. With producers beating a hasty retreat from gas-focused basins, critics questioned the demand for additional midstream capacity in these plays. Meanwhile, MLPs that own natural-gas storage capacity - a business line that depends on seasonal price differentials - were absolutely mauled.
By May, oil prices had started to slip, undone by rising concerns about global economic growth and Europe's ongoing sovereign-debt crisis. The price of natural gas liquids (NGL) - a group of hydrocarbons that tend to track oil prices - also tumbled precipitously.
Although many MLPs limit their sensitivity to oil and gas prices through extensive hedging programs, a lack of liquidity has hampered efforts to protect cash flows against weak NGL prices. Across the board, energy-focused MLPs have felt the pinch from the recent decline in NGL prices.
Throughout this period of uncertainty, I've emphasized that strong MLPs would recover from these temporary hiccups as long as their underlying businesses continued to support their distributions.
Several of my top picks sold off earlier this summer, only to soar again in July. These trends were also manifest in the second-quarter performance of the 21 closed-end funds in our coverage universe. Offerings with midstream-heavy portfolios managed to eke out gains during the quarter, likely because this segment of the MLP universe has the least exposure to commodity prices. Investors also tend to buy these safer names when market sentiment begins to recover.
This explains the recent price action in units of Enterprise Products Partners (NYSE:EPD), Kinder Morgan Energy Partners LP (NYSE:KMP), Magellan Midstream Partners LP (NYSE:MMP) and Sunoco Logistics Partners LP (NYSE:SXL) tumbled during the growth scare earlier this summer and have resurged in July.
Closed-end funds with substantial allocations to the midstream sector have generally fared better than offerings that branch out into parts of the MLP universe that have greater sensitivity to fluctuations in economic growth and commodity prices. For example, Cushing MLP Total Return (NYSE:SRV) and Cushing Royalty and Income (NYSE:SRF) allocate sizable portions of their investable assets to upstream MLPs.
Two outliers defy this generalization: Kayne Anderson Energy Development Company (NYSE:KED) and Tortoise Capital Resources (TTO), both of which own private securities and real assets in addition to stake in publicly traded partnerships. I prefer to steer clear of these funds because it's difficult to gauge the value of their underlying holdings.
My long-standing investment philosophy, which calls for a diversified mix of names with varying levels of exposure to the economy and commodity prices, informs my approach to selecting my favorite MLP-focused closed-end funds.
Although commodity prices could continue to languish in the back half of the year, investors must remember that these conditions are far from permanent.
In fact, the supply-demand balance in the global oil market remains tight, while the eventual construction of additional export capacity could eventually bolster the domestic price of natural gas. NGL consumption will also receive a boost in coming years as Dow Chemical (NYSE:DOW) and other firms finish building world-scale petrochemical plants in the US.
Accordingly, I favor Kayne Anderson Energy Total Return (NYSE:KYE), which boasts a diversified portfolio that also includes a 12 percent allocation to US royalty trusts and a 17 percent allocation to names in the marine transportation industry.
In the first half of 2012, the closed-end fund outperformed the Alerian MLP Index by about 6.6 percentage points, though this return lagged the gains posted by offerings that invest primarily in companies that own pipelines.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.