Energy Investors Will Love This "New Breed" of MLPs
I’ve been recommending master limited partnerships (MLPs) to oil and gas investors for years now.
In fact, I track every single one of them. Several have become mainstays in both my Energy Advantage and Energy Inner Circle investment services
So why do I love MLPs so much?…
It’s simple. They allow energy investors to win two ways: First with high income and second with their significant growth potential.
In today’s markets, that’s an unbeatable combination – especially since MLPs pay very high yields – typically 5% to 12%.
Just try to get that from your bank or favorite “Blue Chip.”
Now a “new breed” of MLPs is about to hand out even more cash
Investing in Master Limited Partnerships
Currently, there are 48 of these partnerships providing an equity side through which average retail investors can participate. By law, MLPs must provide a pass through of the profits to directly to their partners. This avoids having to pay corporate taxes.
So when the general partners decide to float a portion as an equity offering, they are able to pay much higher dividends than the market average.
The growth side of the equation largely stems from the asset class upon which most MLPs are based. These are midstream in general and pipelines in particular. While natural gas, crude oil, natural gas liquids, and oil products are represented in these assets, gas still leads the list.
And as long as prices for gas and oil remain high enough and demand does not suffer a radical contraction, MLPs are a good offset for direct production and processing plays in an overall investment portfolio.
Today, the price side shows no signs of declining appreciably anytime soon, while demand is slowly building, especially on the gas side because of a range of increasing needs for volume extending from electricity generation, through petrochemical feeder stock, to the advent of liquefied natural gas (LNG) export.
On the oil side, the rise in unconventional U.S. production has led to an acceleration in midstream requirements from basins like the Bakken and Eagle Ford with the Utica basin likely to shortly follow suit. That means there will undoubtedly be additional demand for midstream products , increasing the revenue potential for MLPs.
Dramatic Changes…Big Opportunities
It is the advent of a major push in tight (often labeled shale) oil that is transforming American energy prospects. We have become accustomed to the largess of shale gas, resulting in vast new internal reserves guaranteeing that the U.S. will both meet all of its domestic needs while beginning a rising export curve.
But it is on the oil side that changes have been most dramatic. Only a few years ago, the U.S. was experiencing an increasing decline in crude oil production with over 60% of all daily extractions coming from stripping wells (producing on average 10 barrels or less) while some 70% of demand was being met from imports.
Now all of that has changed. This year, I now expect that domestic oil lifting will come in higher than any year since the late 1970s, allowing the U.S. to challenge both Saudi Arabia and Russia for the global lead in production. At the same time, imports are undergoing a major cut and may come in at less than 55% of needs.
That is quite a cut in a very short period of time, with prospects pointing toward an even bigger import decline in short order. Projections now indicate that the U.S. will require imports for only 30% of domestic demand by 2030 (or perhaps even earlier) with all of that coming from Canada. In fact, estimates are now emerging that North America as a whole could become essentially energy independent by 2020.
Such starling changes in the energy balance require that major shifts occur in infrastructure. Basic to this change is the need to move and store production.
And here, the midstream component is decisive.
The Bakken has the potential for considerably higher production levels, while the oil component in south Texas’ Eagle Ford along with the Niobrara in northeastern Colorado and the Utica in eastern Ohio point toward an intensification of crude midstream demands there as well.
All of this is a clear indication that MLPs will be increasing in importance on the oil side to mirror an already strong presence with natural gas.
The important point to remember in all of this revolves around the price of the raw material. MLPs no longer are making money simply because the market price of crude or gas is rising. The widening end user applications and diverse basin sourcing means midstream services are now in greater demand.
So long as the demand side remains constant and basically in balance with new supply, MLP profitability is not dependent merely on prices rising. Range pricing is sufficient.
What we are beginning to witness on the oil side a dimension already well experienced with gas. There, MLPs make money whether operating companies need to move or store production. For some time now, a majority of pipeline capacity in many areas of the country are actually used for storage rather than transit of produced gas. Now The same development is taking place in oil.
Here, MLPs are increasing capacity by an apparently inefficient approach. They are putting loops in pipelines. This does increase the length of pipe through which transmitted volume must pass, which seems counterintuitive. Unless, of course, you consider how much capacity is available for storage.
Both sides of the issue – transport and storage – are now requiring an absolute quickening of new midstream asset construction. That bodes well for MLPs.
A Whole New Way to Make Money
But MLPs are also changing in structure. The next stage in MLP development will include three new developments. The first will see MLPs move from reliance only on a pipeline asset base to include other midstream applications (terminals, initial gathering, processing, fractionating and transshipment) and then quickly jump into ownership positions upstream (wellhead production and land leasing) and downstream (refineries, wholesale and retail distribution networks).
This is already underway – and in both directions. In addition to MLPs based on the addition of new sector assets, they are also being the spun off from previously held assets.
It used to be that companies wanted to become vertically integrated operations, controlling assets upstream, midstream, and downstream. The idea was that transfer pricing could be employed, reducing effective costs and thereby increasing bottom line profits, if assets in all three sectors were part of the same corporate structure.
Well, those days are largely gone. Companies are divesting and streamlining to improve their returns. What has resulted is a new departure for MLPs.
For example, several refineries have spun off midstream assets into new MLP offerings. The latest includes Western Refining (NYSE: WNR) creating Western Refining Logistics (NYSE: WNRL). Similar moves had already been undertaken by Phillips 66 (NYSE: PSX), Tesoro (NYSE: TSO), and Holly Energy (NYSE: HEP).
Yields on these new MLPs remain to be seen. Yet, there is no question that the divesting side is a major new direction in MLP formation.
However, it is the next stage that I find even more interesting. There are already MLPs in electricity generation and distribution, tankers and shipping, and oil product distribution. We will also begin to see the first MLPs that combine current partnerships in genuine cross sector energy holdings.
That will open up an exciting new way to make money. I’m calling it “Energy Balance Investing.” I’ll have more on this in future issues.
So stay tuned.