The MLP Sector
As income investors, we are always looking for investments that can provide a steady and generous stream of dividend income. One sector that provides plenty of such choices is the mid-stream MLP space. As can be seen in the chart below of the yield of the Alerian MLP ETF (AMLP), which tracks the Alerian MLP index, shows how much income potential there is in the mid-stream MLP sector.
Averaging around 8%, the MLP sector has proven to be a good source of dividend income. Oil prices are well above their lows from a few years ago even though Natural gas prices are once again visiting new depths. While economic growth is likely slowing, the economy is still growing and will need more gas and oil. The recent issues with Iran are also likely to increase the global price of oil and LNG. We continue to think that the mid-stream MLP sector is a good candidate for growth and sustainable dividends. There are a number of very attractive investments in this sector.
So Why MIE ?
Closed-End Funds [CEF] have the benefits of simplicity and diversification. In addition, using a closed-end fund, one avoids any of the complications of getting a K-1 from your investment. One can also often get a better yield from these products, as these can trade at discounts to fair value. This improves yield on cost.
Let’s take a look at one such fund we have recommended in the past. Cohen & Steers Income & Energy Opportunity Fund (MIE), currently yielding 9.5%.
This first breakdown shows that MIE is invested about equally between MLPs that operate in a diversified set of markets, those that primary transport crude oil or refined products, and those that are involved in gather and processing output from wells. Those MLPs that exclusively ship natural gas or natural gas liquids are only a very small percentage of the portfolio.
Source Cohen & Steers
Enterprise Product Partners (NYSE:EPD) is an excellent MLP and represents the fund’s largest holding at just over 14%. Kinder Morgan (NYSE:KMI) once the premier MLP is also one of the top 10 holdings. Now that it has resolved the issues that resulted in a dividend cut and even begun to increase the dividend it pays, it should provide plenty of cash to the fund over the next few years. Buckeye Partners (NYSE:BPL) was recently bought out for a big premium and should disappear from the fund shortly.
Above we can see the details of the leverage the fund uses. The average rate charged on this leverage, 2.8%, shows one advantage a CEF has over most investors. Few if any individual investors would be able to get so favorable a rate.
Total fees don’t look to be too bad, less than 2% for management and then just under 1% for interest for the leverage. Also remember that fees come out before the yield, so the yield is net of fees.
One reason to use a CEF is that it provides better performance than a benchmark index. So we want to see either more total return, more income and ideally, both,from any CEF we invest in. So how does MIE stack up against a sector index?
We used Portfolio Visualizer to determine returns for both MIE and some benchmarks. Our first benchmark is AMLP an ETF based on the Alerian MLP index. Our second benchmark is a combination of AMLP and ETRACS 2xMonthly Leveraged Alerian MLP Infrastructure Index ETN Series B (NYSEARCA:MLPQ) in a 70/30 ratio to approximate the amount of leverage MIE is using. Including this allows us some insight into how the performance of MIE is impacted by its use of leverage. We start the comparison on December 1, 2016, which is the start of the month where we first recommended MIE.
Source Portfolio Visualizer
So over the studied period, MIE did quite a bit better than the index and had a higher Sharpe ratio. So not only did MIE give better returns than the index (as represented by AMLP but it also delivered better risk-adjusted returns as well. So what about the benchmark that had approximately the same leverage as MIE uses? It did even worse than AMLP. So it’s safe to say that leverage alone is not what produced superior returns for MIE.
As an income investment, it’s nice that MIE beat its index on total return. But, we want income primarily. So how did MIE do on that metric? As can be seen in the chart above, MIE handily beat the index and edged out the combination of funds that had similar leverage. The above chart shows the results with dividends reinvested, but keeping the income shows fairly similar results.
So what about other funds that invest in the MLP sector?
So, MIE beats the index, but how does it compare with other CEFs in the space? The somewhat crowded YChart® shows the total return performance of MIE and five other funds: Center Coast Brookfield MLP (CEN), Kayne Anderson MLP (KYN), First Trust Energy Income & Growth (FEN), Goldman Sachs MLP and Energy Renaissance Fund (GER), and First Trust New Opportunities MLP and Energy Fund (FPL). MIE clearly does better than any of these other funds, and that has been the case since the start of 2018.
MIE does have the lowest yield, but that is largely due to the poor share price performance of the other funds. Currently, two have cut their dividends since the end of 2016, while the others have left their dividends unchanged.
Again using Portfolio Visualizer to get an idea of the income that would have been generated since we first recommended MIE, the comparison above is of MIE, equal weights in the 5 alternate funds, and equal weights in the 4 alternate funds excluding CEN. CEN is the only fund that consistently outperformed MIE on an income basis when dividends were reinvested but it did so with a significantly lower Sharpe ratio (a measure of risk where higher is safer).
Why Does MIE Outperform?
MIE is managed by Cohen & Steers, one of the best CEF managers, if not the best. Cohen & Steers actively manages their positions for outperformance. They have the best track record and we like many of their funds. When investing in CEFs, investors should always look at management because it counts!
Risks with MIE
One risk to an investing in the midstream sector is investors' perception that the performance of this sector is highly correlated to oil price. Note that most MLPs do not have operation results tied to the price of oil (they are a toll collector), the share price of the MLPs has been impacted by the price of oil. So if the price of oil drops precipitously, the share price of the MLPs are likely to drop too, including the share price of MIE.
A second risk to keep in mind is the safety of the dividend. While investing in MIE has a huge advantage because it is highly diversified which mitigates the dividend risk. However, if for some reason, multiple MLPs have trouble paying their distributions, MIE could be hard pressed to continue with the same dividend payout. EPD is a large holding and has some big growth plans, but if those don’t work out as management expects, that could result in reduced payouts from them.
The chart above shows the impact of one significant risk, not just for MIE, but for any midstream MLP. Currently, all MLPs have contracts that pay a fixed rate based on volume shipped for using their pipelines. However, before oil and gas prices crashed in 2015, many MLP usage contracts had at least some dependence on the price of the product being shipped. With high priced oil and gas, that was very lucrative for them. However, that resulted in a large reduction in cash flow when oil and gas prices crashed. So most MLP’s cut their distributions, which resulted in MIE having to cut as well. MIE has kept distribution constant since March 2016.They did switch from quarterly payments to monthly payments starting in October 2016, as this is an added benefit that most CEF holders have come to expect from their funds as well. Today the situation is very different than it was back in 2015. Most midstream companies carry much less leverage and are much less dependent on the price of oil. It is also worth to note that this sector is currently oversold due to negative investor sentiment. This has created a unique opportunity in the sector, and we believe there is a nice upside potential in addition to the high dividend yield.
Price and Valuation?
Right now MIE trades at a discount of just under 3% (based on closing price from June 28th), which is less than average but better than its highest price to NAV ratio. Given the tensions with Iran and the growing economy, we expect the MLP sector to see upward share price movement.
Currently, MIE looks to be a good buy at any price below $10.75. At that price, the yield will be 9%, which is very good.
MIE is a CEF that invests in the midstream MLP sector. The biggest advantage that MIE brings to the table are the managers Cohen & Steers, which are one of the best CEF managers. The midstream sector has underperformed since oil prices crashed in 2015 and 2016. With the economy and energy production, growing, the midstream MLPs should do very well. This is perhaps one of the most undervalued sector in the high yield space. Coupled with rising tensions in the Middle East, which will likely push up oil prices and MLP share price, we think there is a significant chance for immediate share price appreciation as well as producing a very good income. At the current market price, the yield is 9.5%. This is a bargain that is unlikely to last.
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Disclosure: I am/we are long MIE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.