Master limited partnerships and related exchange traded funds have surged back this month and are hovering around their short-term trend lines as investors revisit the battered yield-generating asset. However, there are still headwinds that could keep the sector pressured.
Since the September 29 low, both the JPMorgan Alerian MLP Index ETN (NYSEArca: AMJ) and Alerian MLP ETF (NYSEArca: AMLP) surged about 20%. The two MLP ETPs are bouncing around their short-term, 50-day simple moving average. [Here’s What’s Fueling The MLP ETFs Rally]
The broad market recovery, rebound in energy prices and renewed interest in yield-generating assets all helped lift MLPs – AMJ has a 7.64% 12-month yield and AMLP has a 9.43% 12-month yield.
However, MLP investors should not completely write off the potential risks that the sector faces, such as the Federal Reserve’s eventual interest rate hike.
“Rising interest rates, investors fear, could result in a greater cost of capital for MLPs and potentially lower distributions,” warned Robert Goldsborough, an equity strategies analyst for Morningstar.
Moreover, while MLP ETPs are seen as being more insulated than energy funds during periods of oil price volatility, the past year has shown that MLPs are not totally immune to the swings.
Unlike other energy sector stocks, MLPs primarily deal with the distribution and storage of energy products, so their business model is less reliant on the commodities market since MLPs profit off the quantity of oil and natural gas they are able to move around. Consequently, MLPs act more like energy toll roads. MLPs also operate under very long-term contracts, so any temporary short-term changes in oil or gas typically have little to no effect on revenue streams.
Currently, oil companies have been steadily increasing output in the U.S.. Morningstar analysts sees long-term growth in production on the prevalence of low-cost inventory.
“Greater U.S. energy production can be good for some MLPs because it means a greater need for new infrastructure,” Goldsborough said. “Because most MLPs collect fees for volumes, greater volumes typically result in greater cash flows for MLPs.”
However, traders did not differentiate the energy infrastructure MLPs from big energy names this time around, with AMJ down 23.0% and AMLP 16.5% lower so far this year. Goldsborough calculates that roughly one fourth of the industry’s cash flows are commodity-sensitive.
Potential MLP ETP investors should be aware the intricacies associated with the ETF or ETN structures. For instance, MLP ETFs like AMLP that hold more than 25% of their portfolio in MLPs are structured as C-Corporations in order to track an underlying MLP-related index. Due to the C-Corporation structure, they must pay corporate income tax on distributions before passing them to investors. Consequently, MLP ETFs may incur higher fees that would cut into overall performance.
MLP ETNs like AMJ are structured as an an unsecured debt instrument that replicates the return of the MLP index, the ETN vehicle is not subject to the double-taxation effects associated with a C-Corporation. ETNs, though, are subject to credit risk of the underwriting bank or issuer.
For more information on master limited partnerships, visit our MLPs category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.