Master Limited Partnerships for Income (WSJ, AP)

WEEKEND INVESTOR APRIL 10, 2010

Big Yields, Big Risk in the Oil Patch
Master Limited Partnerships Are Luring Investors for Their Yields and Growth Potential, but Can Plunge When Rates Rise
By TOM LAURICELLA
(See Corrections & Amplifications item below.)


Associated Press

Shares of the master limited partnership have risen more than 11% so far this year.
Yield-starved investors are piling into a small corner of the financial markets sporting big payouts: master limited partnerships. But they should tread carefully. While these energy-related plays are seen as having strong prospects, they also are volatile, and have a history of being tripped up by higher interest rates.

Master limited partnerships, or MLPs, are essentially energy companies that own and operate pipelines and storage facilities for natural gas and oil. They generate revenue by essentially collecting fees from energy exploration and production companies that use their properties.
While the securities issued by MLPs are technically stocks and trade on exchanges, MLPs are unlike most other publicly traded companies. Rather than being structured as corporations, they are partnerships, which means they generally pay out all the cash they generate to shareholders as income.
Those yields are central to MLPs' appeal. On average, MLPs are yielding roughly 7% right now, an unusually high level of income in today's market. In contrast, the stocks in the Standard & Poor's 500-stock index generate dividend yields of only 1.9%, on average. Also central to MLPs' appeal: the increasing development of oil and natural-gas infrastructure in the U.S.

Those two factors have helped fuel the main MLP benchmark, the Alerian MLP Index, to a 19.6% annualized gain over the past decade and a 10.8% rise so far this year. The combination of the high yield and big returns has investors pouring money into the sector. The JPMorgan Alerian MLP index exchange-traded note, launched in March 2009, has attracted $1 billion already.

But in the short-term, external factors can make MLP prices volatile. Because of their big yields, "Many people mischaracterize them as a bond replacement, which they are not," says Shawn Rubin, an adviser at Morgan Stanley Smith Barney who has used MLPs for some clients for a decade. "Although they have a yield component, and hopefully a growing yield … the price fluctuations definitely look more like stocks than bonds."

To a large degree MLPs are creatures of Congress's whims and the tax code. As a result, they have changed over the years. In their early days in the late 1980s, the underlying businesses were all over the map, from hotels to the Boston Celtics. MLP laws were soon tightened. Today they are limited to energy firms, mainly pipelines and storage for natural gas, oil and biofuels.


The universe of MLPs remains relatively small, with 69 publicly traded companies today, up from fewer than 30 a decade ago, according to Alerian. MLPs carry a total market capitalization of $150 billion, and just five companies account for more than 40% of the sector's value, according to Alerian's data. By contrast, Exxon Mobil's market value alone is more than $300 billion.

The long-term bullish case for MLPs centers on expectations for a boom in pipeline and storage in the U.S., especially as new natural-gas fields come into production. That in turn could lead to increases in MLP payouts.

But a look at their history shows the short-term damage that can come from rising interest rates. During MLPs' relatively short history—most didn't exist a decade ago—investors have tended to suffer sharp losses when the Federal Reserve began raising rates, as it is expected to do beginning later this year. For example, in late January 2004 the Fed signaled that an interest rate rise was on the way. The Alerian index fell 4% in a little over a week, recovered and then went into a swoon that took it down 12% from its January high. MLPs also sank after the Fed tightened in 1999 and lost 14% for the year.
One reason for their interest-rate sensitivity is that MLPs increase yields by adding assets, either through acquisition or building from scratch. In either case, MLPs must raise funds for their expansion by tapping the stock or bond markets. As a result, higher interest rates can increase their cost of capital. And if higher rates lead to a slowing economy, that in turn could damp their growth.
But over long periods in which the Fed has raised rates, MLPs have generally recovered well. During the two-year tightening cycle of 2004 through 2006, the Fed raised the federal-funds rate to 5.25% from 1% and MLPs gained 48% between May 2004 and July 2006, data compiled by Kayne Anderson show.

Morgan Stanley's Mr. Rubin says that he is stressing yield-paying investments and, as result, in cases where he might normally recommend 5% of a portfolio be in MLPs, today's he is recommending a 10% stake.

"I'm willing to deal with the variation in price," Mr. Rubin says. Given the potential for long-term increases in MLP yields, "I'd use those interest-rate sensitive pullbacks as moments in time to be a buyer."

Corrections & Amplifications

Master limited partnerships pay out cash they generate to shareholders as ordinary income. A previous version of this article incorrectly described their payouts as dividends.

Write to Tom Lauricella at tom.lauricella@wsj.com