Investing in Master Limited Partnerships (WSJ)

AUGUST 10, 2010 Frenzy in Energy Partnerships
Investors Stick Billions of Dollars Into a Stock-Market Niche Known as MLPs
By TOM LAURICELLA And CAROLYN CUI
Lured by hefty yields, investors are pouring billions of dollars into a small corner of the stock market—energy-focused master limited partnerships—which has seen a huge rally of 15% this year. And that makes some people nervous.

MLPs are mostly companies that own and operate pipelines, primarily for natural gas and oil. Benefiting from the tremendous expansion of energy infrastructure in the U.S., MLPs essentially collect rent from energy producers who use their facilities.


Over the past decade, the Alerian MLP index, the main benchmark for the group, is up about 11% a year. That is a handsome payoff compared with the Standard & Poor's 500-stock index, which is down 2.6% a year. Their major appeal is payouts to investors these days averaging around 7% a year at a time when bond yields are at all-time lows. MLPs are expected to increase those distributions by another five percentage points or so a year.

But the recent surge in popularity of MLPs may be adding a new element of risk to the group. The Alerian index, including distributions, has returned 21% in 2010 without any meaningful change to the sector's fundamental outlook. Instead those gains are seen as being fueled by the rush of new money into the sector. Meanwhile, most MLP funds concentrate their portfolios in a handful of the same stocks. The end result is MLPs could be growing vulnerable to a decline in prices.

"We think the sector is a bit frothy in the short run," said Ethan Bellamy, an analyst at Wunderlich Securities Inc.

The big yields of MLPs are the result of their corporate structure. While they trade like stocks, the companies generally distribute all their profit to shareholders because of their limited partnership status. Better yet, those distributions usually aren't taxable until investors sell the shares.

Another selling point for MLPs is their diversification. They have low levels of correlation to the rest of the stock market and to U.S. Treasurys. In June, for example, when the S&P was down 5.2%, the Alerian index was up 5.6%.
MLPs have changed markedly over the years. In their early days in the late 1980s, the underlying businesses ranged from hotels to basketball's Boston Celtics. But concerns were soon raised that some companies were exploiting MLPs to avoid taxes. Laws were tightened and MLPs are now limited to energy and certain natural-resource companies, mainly pipelines and storage for natural gas and oil.

The proliferation of MLP funds started with the launch in June 2009 of the J.P. Morgan Alerian MLP Index Exchange Traded Note, which has pulled in $1.6 billion. On March 30, SteelPath Advisors, an offshoot of Alerian, opened the doors on three MLP mutual funds that have taken in nearly $300 million.

But the floodgates have really opened in the past two months. Legg Mason's Clearbridge unit and MLP veterans Tortoise Capital Advisors each launched MLP closed-end funds and attracted more than $2 billion from investors. With leverage, the funds will be investing some $2.7 billion. And still more funds are in the works, including an exchange-traded fund.

All this money is pouring into a small space. There are roughly 70 MLPs with a total market value of about $200 billion. Only about three dozen of those names trade actively. And the Alerian benchmark is heavily concentrated; the top five names comprise 41% of the index.

At Tortoise, for example, the firm's new $1.1 billion Tortoise MLP Fund, which hasn't yet disclosed its holdings, will specialize in natural-gas MLPs. But its two other biggest funds already have about 52% of their combined $2 billion in assets in natural-gas MLPs. And many of those names are big holdings in the Alerian index.

"Everybody's buying the same top 10," says Jason Stevens, who follows MLP stocks for Morningstar.

Meanwhile, the performance of MLP stocks has been extremely uniform, suggesting little differentiation by investors among individual MLPs. Among 10 oil-pipeline MLPs tracked by Wunderlich Securities as of Aug. 4, seven are up 29% to 41% in the past year, and another two are up 20% or more.

Jerry Swank, founder of Dallas-based Swank Capital LLC, which manages an MLP portfolio of $1 billion, says he is concerned about "a temporary imbalance between supply and demand" that could potentially reverse into a selloff.

The rally already has pushed down yields. A year ago, MLPs on average yielded 8.8%, but that has dropped to 6.3%, Wunderlich Securities says.
Michael Blum, an MLP analyst at Wells Fargo Securities LLC, figures MLPs are trading at a multiple of 11.8 compared with 12 over the past five years using discounted cash flows, the standard metric for valuing MLPs.

"MLPs look fairly valued," Mr. Blum says.

But valuation concerns mightn't prove a deterrent as investors chase distributions and growth that have yielded far more than other investment options.

"We see the typical MLP increasing its distributions by 5% a year," said Morningstar's Mr. Stevens. "And if you've got securities yielding 6% to 8% … you can lock up a 12% gain."

Supporting that optimism is that MLP clients sign long-term contracts, often for 10 or 15 years. Those contracts often contain clauses that increase the fees paid to MLPs to adjust for inflation.

Still, the longer-term outlook for MLPs isn't risk-free. MLPs increase their distributions one of two ways: They either build or buy new pipelines and storage facilities. Both avenues require tapping the stock or bond markets to pay for their expansion. Any interest-rate increase will result in higher borrowing costs and potentially smaller payouts for investors.

And their tax-deferred appeal could be at risk if Congress revisits their tax status. Says Christopher Eades, a portfolio manager on the Clearbridge Energy MLP Fund: "An investor in MLPs has to watch what's going on in Washington extremely carefully."
Write to Tom Lauricella at tom.lauricella@wsj.com and Carolyn Cui at carolyn.cui@wsj.com