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AAM Viewpoints – Higher Yields Can Deceive – Are MLPs Flashing a Danger Sign?

Energy Master Limited Partnership (MLP) shares have generally fared poorly this year. Against a backdrop of generally higher equity prices and low bond yields, this asset class has suffered. Taking a closer look, based on the Alerian MLP Index, prices have declined 5.06% year-to-date (YTD) through the end of September compared with positive results for Real Estate Investment Trusts (REITS)** of 6.6%, Utilities* 5.2% and the S&P 500 at 7.7%. With an average yield topping 7.7%, could the fall off in prices indicate that there is danger in this asset class? Are the unusually high distributions signaling more bad performance to come? We in fact see compelling value and believe a case can be made for allocating capital to this group. We think these high yielding laggards are worth a closer look.

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Source: Alerian MLP Fact Sheet 9/29/17 | Past performance is not indicative of future results.

MLPs are an asset class comprised of a number of different businesses and can therefore be expected to perform very differently.  One thing they all tend to have in common is that they provide transportation for energy. Some MLPs specialize in gathering and processing oil and gas; some are pipelines transporting oil or gas. You can even buy MLPs that own gas or oil tankers and deliver products globally. As with many asset classes, if you are not an expert in each of these segments it might be better to find a managed fund of MLPs that apply expertise, diversification and allocation skills to maximize long-term results.

MLPs for individual investors can provide tax challenges and benefits because their distributions can be partially tax-deferred return of principal. This advantage is huge for high net worth investors. However, some investors don’t like receiving K-1’s at the end of the year versus normal dividends (1099). Those not wanting to deal with the additional tax considerations can buy managed portfolios of MLPs in Closed End Funds (CEFs) and receive a 1099. There are Unit Investment Trusts (UITs) available that are professionally selected that can provide a portfolio of CEFs adding even more diversification yet still issue 1099s. You should consult your tax advisor to determine what your best option is for your situation.

CEFs are professionally managed and at the time of this article may be purchased at a discount to the underlying net asset value (NAV). Examples of these funds are Kayne Anderson MLP (KYN) which is selling today at a 3.4% discount to the market value of the underlying portfolio and Cushing Renaissance Fund (SZC) selling at an 8.125% discount to the underlying assets.

MLPs came under fire in 2014 when the crude oil market fell out of bed. As you can see from the graph provided below, MLPs were on a track handily beating the S&P 500 as measured from 2007. Then the big correction ensued. Most MLP businesses have little connection to prices of the transported commodity, but as energy sold off, MLPs sold off in tandem. As these prices dropped, the yields on these companies paid to investors increased. A closer look at MLPs reveals that the industry is growing earnings and cash flows. In the 3rd quarter of 2017, Yorkville Asset Management reports that MLP distributions grew by an average of 7.8% over the same period in 2016.

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Source: Alerian MLP Fact Sheet 9/29/17 | Past performance is not indicative of future results.

From a global view of energy, demand is growing and inventories are dropping. The growth in demand globally bodes well for these types of distribution networks. With choreographed cuts in production in crude oil by OPEC (Organization of the Petroleum Exporting Countries) together with demand growth tied to global growth. We can see the changes in the commodity futures markets where both Brent and West Texas Intermediate (WTI) term structures have gone from “cantango” (price of spot below price for future delivery) showing over supply to “backwardation” (price of spot higher than future delivery price) showing a balanced market. More demand has the potential to result in more development of supply and increased need to move the energy.

The story is especially good for U.S. energy producers. Over the past decade energy technology has provided a boom in energy production and transportation. The 40-year ban on the exporting of crude oil was lifted last year, giving birth to a new need for distribution. In addition to exporting crude oil, we now export America’s vast production of liquefied natural gas. The first of many export facilities was completed in Texas this year. Continued expansion of the energy complex in the United States is very bullish for MLPs.

In short, sometimes fat dividend yields signal a bigger problem with the underlying business while other times it simply reflects the flow of funds by investors that have mispriced the asset. We are value investors and constantly look for opportunities that meet the latter and not the former.  In short, we conclude that the MLP business is experiencing growth and not demise. Earnings and cash flows appear to be rising, not falling. As an industry, MLPs are growing yet their market prices are still being lumped in with other energy companies. We believe the nearly 8% current yield is compelling and the asset class should be over allocated in an income portfolio.

*Utilities are represented by the S&P 500 Utilities Index, **Real Estate Investment Trusts are represented by the Real Estate 50 Index, a supplemental benchmark to the FTSE NAREIT U.S. Real Estate Index Series.

 

CRN: 2017-1106-6245R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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Effective, June 10, 2016, please note that Gene Peroni left Advisors Asset Management (AAM) to become President of Peroni Portfolio Advisors, Inc. Peroni Portfolio Advisors, Inc. ("PPA") is an investment advisor independent of AAM.