MLPs: Past, Present and Future

Includes: KMP, SNMP
by: Avi Morris

MLPs just came through a terrible year, mirroring stock market averages, even though their long term record of growth has excellent.

Their pipelines move energy products, primarily oil and gas, around the US, a national priority. In more than a dozen years, they've grown from a modest industry by building thousands of miles of pipelines. Equity financing has been available aided by favorable tax incentives for investors. The Alerian MLP Index, composed of leading MLPs, started December 31, 1995. After an initial value set at 100, the index had fairly steady growth (with a very low beta) to 342 by July 2007.

Then its world collapsed when the financial crisis began. In less than three weeks it plunged below 300, a new floor which was shorty to become its new ceiling. Other securities experience gyrations, but such a sharp downturn was unprecedented for MLPs. The index began 2008 at 301 and stayed near 300, first trying to rally a little above. After a pullback, it then fell and tried to rally up to 300. Meanwhile the popular averages were under pressure from the financial crisis followed by the steep decline in September and October caused by the worldwide financial meltdown. It seemed like stock markets would never stop falling!

The index began September at 273; five weeks later it closed at 163. A chunk of decline was caused by fire sales of MLPs following the demise of Lehman (OTC:LEHMQ). In the last two months, the index has been struggling by trading under 180, down 40% (similar to many averages) in 2008.

MLPs have entered a new world like the rest of securities. But they are still considered utility type investments with growth potential. As yield securities, they were expected to have a 200 basis point premium over the Treasury bond rate. Now, with a spread of 1000 basis points, they trade like junk bonds. Increases in MLP distributions had become routine but that concept will be put to the test in 2009. Constellation Energy (CEP) is already the first to pre-announce a significant distribution cut for 2009. A dozen are considered to have very shaky distributions with an additional half dozen facing possible distribution cuts.

MLP long growth prospects remain excellent even though the global recession has brought energy into a new light. Demand continues strong for more pipelines to move oil, gas and other energy products around the US. This is a national priority, the reason for its tax incentives. But energy has entered a new world with the global recession. Thoughts have turned negative on energy and oil represents the core product. Oil rose to record levels before crashing to multi year lows where it is may continue until the global slowdown ends.

Strong MLPs will persevere. Building pipelines is long term expansion with long term financing in place. Kinder Morgan (NYSE:KMP), the largest MLP, recently raised almost one billion dollars for future expansion. The industry will continue but low energy prices might bring a bumpy year in 2009.

The securities are traded as junk bonds requiring correspondingly high premium rates of return. When investors accept lower yields, they will bid up MLP share prices. Such change could be linked with lower rates on other high risk securities (i.e. junk bonds and REITs). Even at today's depressed level, the Alerian MLP Index with reinvestments has had a compounded annual growth rate of almost 12% over 13 years. Long term investors who select strong MLPs may have to endure a rocky road this year, but should be rewarded in the long term.

Disclosure: no positions