High Income Investments Reduce Exposure To Europe, Increase Returns: Part III

Includes: EPB, ET, MMP, PAA, RGP, SEP
by: The Wall Street Transcript

>>See Part I, Part II

Master Limited Partnerships (MLPs) control the main pipeline systems that distribute natural gas from source wells throughout United States to domestic utilities and provide a sheltered source of investment income for both corporations and investors.

The demand from new production areas for storage and distribution facilities is a principal driver for the increasing values for MLPs. An experienced analyst in the space, Darren Horowitz of Raymond James & Associates, details this growth aspect:

Shale plays are much more productive versus conventional resource plays, and are on pace to account for about 50% of overall natural gas production in the next five to seven years. That is a big number. Looking at the plays that represent the most opportunity to drive that trend, you have to consider the composition of production, or the breakdown between dry gas, natural gas liquids or NGLs, crude oil, and condensate.

Over the past year we've seen rigs slowly migrate out of the older gas shales - such as the Barnett, Fayetteville and Woodford - and move into the more liquids-rich plays, such as Granite Wash, Eagle Ford, Marcellus and Cana Woodford. This makes sense given the financial incentive for producers to focus more on oil or liquids relative to dry gas.

Looking forward, we see a lot of opportunity on the horizon, as supply is always shifting. While the Haynesville shale will likely show a large ramp in gas production based on the large backlog of uncompleted wells eventually being hooked up, areas such as the Utica shale in West Virginia/Ohio are starting to get a lot of press.

Out West, areas such as the Jonah/Pinedale, Piceance/Uinta basins and San Juan Basin also hold a lot of opportunity for increased gas and NGL production. Additionally, we remain focused on the Granite/Colony Wash, Eagle Ford, Marcellus shale and Woodford plays as it relates to incremental NGL growth.

From an oil perspective, in addition to the Granite Wash and Eagle Ford both having an oily component, the West Texas Permian Basin - and associated Avalon/Bone, Spring/Wolfcamp - Niobrara and Williston Basin/Bakken shale continue to draw attention. So you continue to see more and more focus on a lot of these emerging plays, and ultimately that's what's going to drive incremental production and the need for additional infrastructure.

In a May, 2011, interview Mr. Horowitz recommended several investment vehicles that would benefit from these trends.

On the crude oil and refined product side, both transportation and storage, we very much like Plains All American (NYSE:PAA) and Magellan Midstream Partners (NYSE:MMP). Both reflect very good geographic distribution of assets, enhanced optionality across the midstream supply chain, excellent balance sheets and top-notch management with a proven track record for enhancing value.

In addition, we like El Paso Pipeline Partners (NYSE:EPB) and Spectra Energy Partners (NYSE:SEP). Both have very stable, risk-averse underlying cash flow profiles, great visibility intwo future organic growth initiatives and a lot of upside from potential drop downs from their respective parent corporations.

Finally, Energy Transfer Equity (ETE) remains one of our favorite general partners, benefitting via the incentive distribution leverage on underlying limited partner cash flow growth at both Energy Transfer Partners (ETP) and Regency Energy Partners (NYSE:RGP).

Interest rate risk is always a concern regarding high yielding securities. Yves Siegel, CFA, is a Managing Director at Credit Suisse. In a recent interview with The Wall Street Transcript, Mr. Siegel addressed the risk of inflation and rising interests on MLP yields:

One thing that we get asked a lot is, "What happens if interest rates go up, what happens if inflation were to rear its ugly head again, how would that impact the MLPs?" I should touch on that quickly. Number one, on the inflation side MLPs historically have been able to raise distributions at a clip that exceeds inflation, and part of that is you have an indexing methodology on the crude and refined petroleum products pipeline side, plus typically as you have contracts roll over they tend to roll over at higher rates. So as an inflation hedge MLPs seem to have worked out pretty well.

As it relates to interest rates, the major concern that I have there is if interest rates were to rise quickly, MLPs would take it on the chin because the distribution growth wouldn't be strong enough to offset the impact of a quick rise in interest rates. However, if interest rates were to gradually move higher, then again, the growth in distributions should largely be able to mitigate the impact of higher interest rates.

These MLP investments have many of the characteristics required by long term investors -- stable yields relative to other income producing securities, growth in demand and protection from international economic volatility. The tax advantaged nature of the returns for US investors is also a positive consideration. Clearly, an important new area of financial planning for investment advisors will be the capacity to develop a portfolio of MLPs for risk averse investors seeking stable current returns with the potential for growth in capital value.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.