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

Investing in Energy using ETFs (from Investopedia.com)

ETFs Provide Easy Access To Energy Commodities
by Rich White

If you fill up a car with gasoline or heat a home with oil or natural gas, you know that rising energy costs have put a dent in your budget. But do you also know how easy it is to buy shares in a brokerage account or IRA that can help you hedge energy commodity price increases?
This article will help investors understand the benefits of investing in energy commodity ETFs and detail choices available to interested investors. It specifically covers investments that seek to track commodities prices - not ETFs that invest in energy sector stocks, in which investment returns are influenced by the overall direction of the stock market and do not always mirror energy commodities prices.

Welcome to the World of ETFs
In recent years, thanks to the growth of exchange-traded funds (ETFs), ownership of energy-sector commodities has become more accessible for individuals. For example, buying one share of the U.S. Oil Fund ETF (AMEX:USO) gives you exposure roughly equal to one barrel of oil. If oil prices rise by 10% in a given period, your investment should theoretically appreciate by about the same percentage. You can own oil through this ETF without incurring the cost normally associated with storage or transport. The only costs that you will pay include brokerage fees to buy and sell shares plus a modest ongoing management fee.
USO is not mentioned as a specific investment recommendation. It is significant because it was the first energy commodity ETF introduced, in February of 2006, and remains one of the most popular by asset size and trading volume. Since USO's introduction, ETF energy commodity choices have greatly expanded.
Why invest in energy commodity ETFs?
ETFs are traded on exchanges (like stocks), and shares may be bought or sold throughout the trading day in large or small amounts.
At the heart of the "energy complex" is crude oil and products refined from it, such as gasoline and home heating oil. Natural gas is a by-product of oil exploration and a valuable product in its own right, used throughout the world for heat and power generation. Lesser products in the energy complex include coal, kerosene, diesel fuel, propane and emission credits.

Energy commodity ETFs can be useful tools for constructing diversified investment portfolios for the following reasons:

1. Inflation hedge and currency hedge potential - Energy has recognized value all over the world, and this value does not depend on any nation's economy or currency. Over time, most energy commodities have held their values against inflation very well. For example, the spot price of a barrel of crude oil increased at an average annual rate of 6.5% per year from 1950 through 2007. Over the same span, the annualized increase in the U.S. Consumer Price Index was 3.9%. Energy prices tend to move in the opposite direction of the U.S. dollar - prices increase when the dollar is weak. This makes energy ETFs a sound strategy for hedging against any dollar declines. (To read more on currency ETFs, check out Currency ETFs Simplify Forex Trades.)

2. Participation in global growth - Demand for energy commodities keeps growing in industrializing emerging markets such as China and India. In 2007, as in most years, the U.S. consumed about 25% of the world's 85 million barrels of total daily oil production, and U.S. consumption has been increasing by about 3% per year, according to the International Energy Agency. Some experts believe that it will be difficult for global oil production to grow in the future due to dwindling reserves, especially in Saudi Arabia. In addition, several of the world's leading oil export nations (ex. Russia, Iran, Iraq, Venezuela and Nigeria) are politically volatile and could be unreliable as future sources of supply.
3. Portfolio diversification - According to modern portfolio theory, investors can increase portfolio risk-adjusted returns by combining low-correlating assets in which returns do not tend to move in the same direction at the same time. However, few asset classes accessible to individual investors have consistently produced low correlations with U.S. stocks. Correlations are measured on a scale of 1 (perfect correlation) to -1 (perfectly negative correlation). Oil is among the few asset classes that have consistently produced very low (or negative) correlations with U.S. stocks. According to FactSet, the correlation between oil futures and the S&P 500 Index was -0.31 for the five-year period 2002-2007. For this reason, investors can expect oil commodity holdings to help diversify and balance stock-heavy portfolios.


4. Backwardation - Backwardation is the most complex (and least understood) benefit of some energy commodity ETFs. These ETFs place most of their assets in interest-bearing debt instruments (such as short-term U.S. Treasuries), which are used as collateral for buying futures contracts. In most cases, the ETFs hold futures contracts with the least time left to delivery - so-called "short-dated" contracts. As these contracts approach the delivery date, the ETFs "roll" into the next shortest-dated contracts.

Most futures contracts typically trade in contango, which means that prices on long-delivery contracts exceed short-term delivery or spot prices. However, oil and gasoline historically have often done the opposite, which is called backwardation. When an ETF systematically rolls backwardated contracts, it can add small increments of return called "roll yield", because it is rolling into less expensive contracts. Over time, these small increments add up significantly, especially if backwardation continues.
Although this explanation may sounds highly technical, roll yield historically has been the dominant source of investment return in oil, heating oil and gasoline futures contracts. According to an analysis by author and analyst Hilary Till, long-term annualized returns of these futures contracts exceeded spot prices significantly, as shown in Figure 1, below, and the major reason for this differential was backwardation roll yield.


Annualized Returns from 1983 to 2004
- Futures Contract Spot Price
Crude Oil 15.8% 1.1%
Heating Oil 11.1% 1.1%
Gasoline (since Jan. 1985) 18.6% 3.3%
Source: "Structural Sources of Return and Risk in Commodity Futures Investments" by Hilary Till(Commodities Now, June 2006)
Figure 1


It should be noted that these energy contracts occasionally move from backwardation to contango for intervals of time. During such times, roll yield may be lower than shown in the table; they may even be negative. Historically, natural gas has not shown the same tendency toward backwardation and roll yield benefit as the three contracts listed in the table.
Types of Energy ETFs
Energy ETFs can be divided into three main groups:

Single contract - These ETFs participate principally in single futures contracts. For example, the iPATH S&P GSCI Crude Oil Total Return Index (NYSE:OIL) exchange-traded note (ETN) participates in the West Texas intermediate (WTI) light sweet crude oil futures traded on the New York Mercantile Exchange. Note: An ETN is an exchange-traded note, a structure that works much the same way as an ETF. PowerShares DB Oil Fund (AMEX:DBO) participates in the same WTI contract.

USO, the pioneering energy commodity ETF, is a subject of some controversy because it nominally participates in a single contract (WTI), while also dabbling in several other energy complex contracts. Therefore, most investors do not consider it be a pure single-contract ETF.
Multi-Contract - These ETFs offer diversified exposure to the energy sector by participating in several futures contracts. The iShares S&P GSCI Commodity-Indexed Trust (NYSE:GSG) has about two-thirds of its total weight in the energy sector and the remaining one-third in other types of commodities. It tracks one of the oldest diversified commodities indexes, the S&P GSCI Total Return Index.

PowerShares DB Energy Fund (AMEX:DBE) is a pure energy sector fund diversified across commodity types. It participates in futures contracts for light sweet crude oil, heating oil, brent crude, gasoline and natural gas. The ETF seeks to track an index that optimizes roll yield by selecting futures contracts according to a proprietary formula.

Bearish - Energy sector commodities can be volatile, and some investors may want to bet against them at times. The first "bearish" energy commodity ETF is Claymore MACROshares Oil Down tradable Trust (AMEX:DCR). It is designed to produce the inverse of the performance of WTI oil. This ETF is one-half of a pair of MACRO shares, a concept through which two ETFs are issued together but traded separately to track, respectively, the up and down movements in a commodity. (The other half of this pair is Claymore MACROshares Up tradable Trust (AMEX: UCR).
Final Points
While ETFs have made energy sector commodities more accessible to investors, it's important for investors to understand the mechanics of how individual ETFs work. Specifically, investors should realize that virtually all of these ETFs participate in futures contracts, and the "roll yield" of these contracts can be a major source of positive or negative return, depending on patterns of backwardation or contango. Multi-contract ETFs such as GSG and DBE can be a good way to add broad energy exposure across multiple contracts. But at times, some of these contracts may be in backwardation (producing positive roll yield) while others are in contango (producing negative roll yield).
For investors who own stock-heavy portfolios denominated in U.S. dollars and wish to increase diversification and inflation-hedge potential, some energy sector exposure may be advisable. However, it's a good idea to have a long-term horizon for such investments because they can be volatile over brief periods. Crude oil can be an especially valuable commodity for adding diversification because it has consistently produced negative correlations with U.S. stocks.

Exchange Traded Notes (ETNs) from Tradingmarkets.com

ETNs vs ETFs - Which Fits You Best?
By Dave Goodboy | TradingMarkets.com

A relative newcomer to the world of exchange traded products, Exchange Traded Notes (ETNs) were first created by Barclay's in 2006 and have become an interesting alternative to Exchange Traded Funds (ETFs).

ETFs and ETNs are very similar in the fact that they both trade on an exchange like a stock, follow an underlying product and are easily accessible to investors. However, they differ remarkably in the way they are designed. This article will explain the differences between ETNs and ETFs as well as provide examples of ETNs so that you can choose which exchange traded product fits your investment criteria.

ETNs are issued by Morgan Stanley, Barclays, Credit Suisse, Goldman Sachs and UBS. There are approximately 56 ETNs currently trading, including the iPath ETNs such as Crude Oil (OIL ), Dow Jones Commodity Index (DJP ), EUR/USD Exchange Rate (ERO ).

More exotic underlying products for ETNs are being added all the time. These exotic tools presently include the VIX Mid-Term Futures (VXZ.P) and Global Carbon (GRN).

Let's start by taking a closer look at the actual built of an ETN as compared to an ETF

ETNs are a structured products created as a senior debt note by the issuing banks. In simple language, this means that the ETN is dependent on the credit of the underlying bank. Therein lays the first design difference. ETFs represent a stake in the actual underlying product and are not subject to the same credit risk. For the investor, there is more risk in ETNs due to the above and actual market risk. ETFs, on the other hand, are subject only to market risk. Although, ETNs are issued by major, top rated banks, if their credit rating is cut, it will negatively affect the ETN regardless of the underlying market move.

In the current environment of surprising negative bank news occurring almost daily, this is becoming a critical factor in choosing to invest in ETNs. On a more positive note, ETN track the underlying product/indexes exactly unlike ETFs. The reasoning behind this is a bit odd, but makes sense if you think about it. ETNs are guaranteed to track the underlying product tic for tic by the issuing bank. They replicate the performance exactly; wherein ETFs often have limits imposed making an exact replica impossible.

Of course, the exact tracking is minus the management fee imposed by the ETN. The management fee is the only payment or distribution in the ETN, which brings us to the next difference -- Taxes. ETFs are subject to make yearly capital gain and income distributions which are taxable events for the holder. ETNs do not make these distributions so the investor can defer taxation until the ETN is sold or matures.
In a sense, the ETN is more like a bond, and ETFs are more like stocks. If you are confident in the long term viability of the issuing bank, ETNs offer advantages not found in ETFs.

David Goodboy is Vice President of Business Development for a New York City based multi-strategy fund.