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ETF Specialist

Are MLPs Going Down the Tubes?

A look at the largest ETPs available for investors in this battered corner of the market.

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A version of this article was published in the August 2015 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.

The first half of 2015 was rough for holders of exchange-traded products devoted to energy-oriented master limited partnerships, which have been battered by lower commodity prices and some tough quarter-over-quarter comparisons. Most recently, investors have been spooked further both by currency concerns and by interest-rate jitters. Rising interest rates, investors fear, could result in a greater cost of capital for MLPs and potentially lower distributions.

And while MLP ETPs long have been viewed as being more insulated than energy funds when it comes to energy-price volatility, the past year has shown that MLP ETPs are certainly not immune to such volatility. Now, with continued uncertainty in energy prices, concerns about growth in emerging markets, still-growing U.S. energy production, and interest-rate increases on the horizon, MLP ETP investors who have enjoyed solid returns over the past few years--including valuable income in an environment where interest rates have hovered near zero--may find themselves at a crossroads. Looking ahead, while some dynamics--interest-rate movements and commodity prices--will always be difficult to forecast over the longer term, MLP ETP investors should be well prepared for the impact from such dynamics on the funds they hold.

This article will provide an overview of several broad themes affecting the MLP space and then explore several strong ETP options for investors interested in MLPs.

U.S. Energy Production Up...And Likely to Stay Up
Energy-oriented MLPs own and operate liquid and gas pipelines along with the storage facilities and processing plants that bring product to market. As such, MLPs depend on the volume of oil and gas that travels through their pipelines and plants. And in recent years, MLPs have had much to be thankful for. United States energy output has continued to grow, and, despite a popular belief that lower energy prices will prompt producers to shut down some production, what's actually happening is that energy producers have been curtailing their poorest-performing facilities.

As a result, Morningstar's equity analysts continue to forecast rising U.S. energy production at least through 2020. For oil, unconventional drilling is expected to continue to fuel supply growth, making the U.S. a critical source of incremental supply for global oil markets. In natural gas markets, a reduction in oil-directed drilling might slow U.S. gas production in the near term, but our analysts anticipate long-term growth in production due to the prevalence of low-cost inventory in areas like the Marcellus Shale.

Greater U.S. energy production can be good for some MLPs because it means a greater need for new infrastructure. Because most MLPs collect fees for volumes, greater volumes typically result in greater cash flows for MLPs. And for some fee-based MLPs with low break-even costs--because, for example, they're close to Gulf Coast refineries and their gathering systems are close to wellheads--higher production is a plus. However, not all MLPs benefit equally from greater energy production. To cite a different example, higher energy supply might hurt an MLP with a higher break-even price, because more supply equals lower prices. 

Lower Commodity Prices: A Double-Edged Sword
While MLPs are less affected by commodity price volatility than, say, exploration and production firms, that's not to say that there's no impact. Roughly one fourth of industry cash flows are commodity-sensitive. So as oil prices decline relative to natural gas prices, gas processing margins contract, weighing heavily on cash flows for MLPs with non-fee-based gas processing businesses.

Over the longer term, however, commodity price volatility shouldn't have an impact on MLPs. Prolonged lower prices for crude oil and natural gas should stimulate demand, which ultimately should be good for MLPs. In addition, while lower energy prices may slow project development and may limit energy MLPs' ability to keep their project backlogs full, the vast majority of MLPs' cash flows are linked to long-term, fee-based contracts, supporting relatively stable cash flows despite market tumult. Because midstream firms create value by building new assets, as long as lower oil prices don't hinder project development, MLPs' growth prospects should not be affected.

The Latest Blow: Rate Jitters
For quite some time, the timing of an interest-rate hike has felt like something of a moving target. Certainly, however, the U.S. Federal Reserve Board--at least until the recent deterioration in the Greek debt situation--had been resolute that an interest-rate hike would happen sometime in 2015. And no matter when an interest-rate increase comes, it generally would be bad for MLPs, as higher rates mean a higher cost of capital and potentially lower distributions--which would be a major disappointment to the many investors who hold MLPs and MLP ETPs for income.

In recent weeks, investors have shown increased concerns over an interest-rate hike. That has continued to pressure the MLP space. Investors interested in MLP ETPs should continue to closely monitor investor sentiment regarding interest-rate activity.

Consolidation in the MLP Space
Somewhat overshadowed by recent commodity-price movements and interest-rate jitters have been some recent consolidations in the MLP space that have removed some players from MLP indexes altogether. The consolidations began in November, when, in a $44 billion deal,  Kinder Morgan Inc. (KMI), long a C corporation holding company (and not an MLP), consolidated energy MLP affiliates Kinder Morgan Energy Partners, Kinder Morgan Management, and El Paso Pipeline Partners into a single publicly traded corporation that is the largest energy midstream firm. The rationale for the deal was to increase Kinder Morgan Inc.'s distribution growth rate, which is a move that benefits investors. MLP investors reacted favorably to the Kinder Morgan news, which triggered a special index rebalance for the two principal Alerian MLP indexes that many MLP ETPs track. With this transaction completed, index providers have elected to keep Kinder Morgan Inc. out of key MLP indexes, as Kinder Morgan Inc. is not an MLP. As a result, for better or worse, MLP-oriented ETPs now do not reflect the performance of the nation's largest midstream energy firm. Prior to the deal, Kinder Morgan Energy Partners had made up 9%-9.5% of the two Alerian indexes, while El Paso Pipeline Partners had comprised another 2%-3% of the two indexes. (Kinder Morgan Management and Kinder Morgan Inc. had not been held in either index previously.) The deal did create a taxable event for unitholders in Kinder Morgan Energy Partners and El Paso Pipeline Partners but did not create a taxable event for investors in MLP ETPs.

Will the Kinder Morgan deal change underlying industry dynamics? Our equity analysts don't think so, given that its affiliates long have had deep existing connections to the Kinder Morgan parent. However, we did expect that the consolidation could spark other similar corporate reorganizations for similar reasons. Indeed, in May, natural gas pipeline firm  Williams Companies (WMB) announced that it would acquire its MLP,  Williams Partners LP (WPZ) also as a way to support higher dividend growth for longer for Williams. Similar consolidations may make sense for several other MLPs, including  ONEOK (OKE) potentially rolling up its MLP,  ONEOK Partners LP (OKS), and  Plains GP Holdings LP (PAGP) conceivably bringing its MLP,  Plains All American Pipeline LP (PAA), into the fold. However, our equity analysts don't envision a rash of such deals.

Investor Options
ETP investors have a wealth of MLP options, with fully 26 exchange-traded funds and exchange-traded notes available. Below is a look at the four largest MLP ETPs, all covered by Morningstar and all of which have at least $530 million in in assets. As a result, each of these ETPs has sufficient trading volumes.

Far and away the largest MLP ETP is  Alerian MLP ETF (AMLP). However, AMLP is not particularly suitable for most investors. The fund's index, the Alerian MLP Infrastructure Index, is well-constructed, containing 25 pipeline and processing MLPs--it isn't the problem. Instead, the fund's efforts to simplify its investors' tax burdens have resulted in the fund lagging its underlying index by a staggering amount (4.6% annualized since inception through June 30, 2015). MLPs issue IRS K-1 tax forms, which normally arrive late in tax season and are complicated. The fund's sponsor, ALPS, attempts to lessen this burden by sending investors a much easier-to-handle 1099 form for the fund. However, because of legislation forbidding open-end funds from devoting more than 25% of their portfolios to MLPs, AMLP is structured as a C corporation. The upshot is that corporate tax liabilities mean AMLP's actual gross expense ratio is 5.43%, making it one of the most expensive ETPs on the market after taxes (its advertised management fee is 0.85%).

The next-largest MLP ETP,  JPMorgan Alerian MLP (AMJ), is an ETN and thus avoids some of the problems found in AMLP. As an ETN, AMJ perfectly tracks the market-cap-weighted Alerian MLP Index, which is made up of the 50 largest MLPs and targets capturing some 75% of the available MLP market capitalization. At tax time, AMJ investors receive 1099 forms. AMJ's 0.85% annual fee actually is path-dependent, meaning that depending on the volume-weighted average price of each MLP component in the ETN's benchmark, the actual cost could deviate from 0.85%. And AMJ has some other problems of its own--namely, that in 2012, J.P. Morgan capped creations of new shares in AMJ, likely because of the bank's hedging costs. That move effectively rendered AMJ a closed-end product. With no ability to create new shares, AMJ saw supply and demand become unbalanced, and its shares traded at premiums during 2013. More recently, its bid-ask spread has been tighter, and it's been a solid choice for MLP investors. Should AMJ again trade at a premium at some point, new investors should consider a similar MLP-oriented ETP instead.

Another option is another MLP ETN,  UBS ETRACS Alerian MLP Infrastructure ETN (MLPI), which like AMLP tracks the Alerian MLP Infrastructure Index. MLPI also charges a path-dependent, 0.85% annual fee. MLPI has less than half the assets of AMJ, and as a result, it still has the ability to create new shares.

Still another MLP ETN worth considering is  Credit Suisse X-Links Cushing MLP Infrastructure ETN (MLPN), which also charges a path-dependent 0.85% annual fee. MLPN takes a different tack toward offering exposure to MLPs. It perfectly replicates the equally weighted Cushing 30 MLP Index, which contains midstream MLPs. In addition, MLPN's index also has the ability to include some MLP general partners. For instance, while the index does not contain Kinder Morgan (which no longer has any MLPs), it does contain both Williams Companies and Williams Partners, and it includes both Plains GP Holdings and Plains All American Pipeline. Of the four ETPs, MLPN has had the best performance over the past three years, with an annualized return of 8.4% through July 31, 2015. The performance of all four ETPs is closely correlated, however.

 

 

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Robert Goldsborough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.