Global oil markets are going through a tough time. A surge in US oil production and declining demand due to global economic slowdown has resulted in significant downward price pressures in recent months. Adding to the woes of the commodity was the OPEC decision last Friday to maintain their existing oil production levels.
As the group of major petroleum exporting countries, led by Saudi Arabia, failed to agree to a production cut, oil plunged further, thanks to growing excess supply concerns. Many analysts suggest that OPEC move targets US shale oil producers, which have a higher cost of production compared with traditional oil producers.
Even though oil has fallen more than 30% in the last five months, the trend doesn’t appear to be reversing anytime soon. Even if the cartel does agree to cut production anytime in near future, producers in the US will likely increase their output. With improving exploration and production technologies, domestic operators will likely be able to ramp up production, keeping the pressure on prices.
In this scenario, it would be safer to avoid oil stocks and ETFs that are directly correlated with the commodity price. Smaller operators in particular are more vulnerable to oil price decline. At the same time, oil prices will have to decline much further to put significant pressure on the US energy boom. There are some oil related securities like MLPs that have low correlations with oil price and can still thrive in low oil price environment. In the longer term, they remain major beneficiaries of the US oil boom. But they have been crushed of late with across the board losses in the sector. Within the MLP space—midstream operators that are primarily involved in transporting oil and gas—are best positioned to withstand the decline in oil prices. The recent decline in this popular space provides a very attractive investment opportunity to long term investors, looking for growth and income. Why Have MLPs Been So Popular? Master Limited Partnerships (MLPs) represent an attractive investment option for income-focused investors in the current environment. In addition to high yields (~4% to 6% currently), MLPs have relatively stable cash flows and solid growth potential. Energy production boom in the US remains the long-term growth driver for MLPs. With their spectacular returns of 321% during the last 10 years (Alerian MLP Index return), it is not surprising that MLPs have surged in popularity in recent years. However MLPs are complicated structures and investors need to understand them properly before investing. Why Invest in MLPs? Most MLPs are in involved in processing and transportation of energy commodities such as natural gas, crude oil, and refined products, under long term contracts. So, effectively they are like toll-takers, whose revenues depend on the volumes flowing through the pipes and not on the commodity price. As such they have relatively consistent and predictable cash flows, unlike exploration and production (E&P) companies, whose profits are highly correlated with commodity prices. As MLPs are structured as pass-through entities—they do not pay taxes at the entity level and are thus are able to pay out most of their earnings to investors. Further, MLPs have low correlations with many other asset classes including equities and commodities and thus add diversification benefits to the portfolios. As the energy industry continues to evolve and grow with revolutionary developments in the field of unconventional energy, MLPs represent a great way to benefit from the growth. MLPs and Rising Rates Like all high income products, MLPs react negatively to rise in interest rates at least initially. But research shows there is no material correlation between 10-year treasury rates and Alerian MLP index performance in the longer-term. One of the reasons is that many MLPs use fixed rate debt for majority of their borrowings. At the same time, MLP asset class does not have a long history and we have not seen materially rising interest rates since MLPs have been in existence. MLP Tax Issues MLPs come with complicated tax issues and many investors avoid investing in them only due to daunting tax requirements. MLPs issue complicated K-1s and further, since the pipelines run through several states, the investors may be required to file tax returns for all those states, in some cases. Thankfully for the investors, some of the tax complexities can be avoided by owning them in ETP form. The payouts by the ETPs are reported as ordinary income on Form 1099, and therefore the K-1 forms are not required.
MLP ETFs or ETNs? Funds that have more than 25% of their assets invested in MLPs are treated as C corporations for tax purposes. Further, the assets are required to be marked to market and a deferred tax liability for the unrealized gains needs to be recorded. As a result, MLP ETFs have 63.38% since inception, while the underlying index returned 114.95% during the same period (as of September 30, 2014). As a result of the adverse tax issues, AMLP’s expense ratio before deferred taxes is 0.85% but gross expense ratio is extremely high at 8.56% currently. Despite its underperformance relative to the index, investors have continued to pour money into the fund, which has accumulated more than $9 billion in AUM so far. One advantage of investing in AMLP is its lower volatility compared with MLP ETNs. Lower volatility results from its ability to reverse some of deferred tax liabilities when the market is down. ETNs typically eliminate some of these complex tax consequences as they do actually not hold any securities. However the investors should remember than ETNs are unsecured debt instruments and carry credit risk.
Below we have highlighted three popular MLP ETNs. JPMorgan Alerian MLP Index ETN (NYSEARCA:AMJ) Launched in April 2009, AMJ is the most popular ETN in the MLP space with about $5.9 billion in assets under management. This ETN tracks the performance of 50 largest companies in the midstream energy MLP sector. The note charges investors 85 basis points a year in fees for its services and pays out an attractive yield of 4.78% currently. The investors should note that the ETNs are subject to maximum issuance limit and this ETN stopped issuing new notes in June 2012. Investors who buy this ETF at a premium to its NAV incur the risk of loss in case they sell when the premium is no longer present. However as of now, the ETN is trading close to its NAV. UBS ETRACS Alerian MLP Infrastructure ETN (MLPI) MLPI focuses on the infrastructure space within the MLP world. The note tracks the Alerian MLP Infrastructure Index, which is comprised of 25 mid-stream energy infrastructure MLPs. The product has attracted $2.3 billion in AUM. This note also charges 85 basis points a year for expenses and pays out a yield of 4.32%. Credit Suisse Cushing 30 MLP Index ETN (MLPN) MLPN tracks the Cushing 30 MLP Index, which holds MLPs owning mid-stream energy infrastructure assets in North America. It is an equal weighted index, rebalanced on a quarterly basis. The ETN was launched in April 2010. The note has so far attracted $950 million in assets. This note also charges 85 basis points a year for expenses and pays out a yield of 4.11% currently.
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