New Conundrum: MLP Yields and Energy Prices
I can understand why our MLPs had been falling back
when crude oil was shooting toward $150/barrel. At some point, rising energy prices reduce consumption,and with it pipeline and propane volumes (even if this force is offset and then some by per-barrel price
hikes). But when oil began to beat a hasty retreat—a net positive for those energy businesses that depend on volume rather than price—capital fled the entire energy sector regardless of individual merit. The sellers
can’t have it both ways: If rising energy prices are bad, how can falling energy prices be bad too? Of course, there are other factors to consider. Some investors surely worry that a new government next
year might tinker with MLP taxation. There is some risk here, but simplification of the tax code is no sure thing no matter who’s in charge. If this happens,I would expect existing MLPs to be grandfathered in
(as occurred back in a 1986 tax reform act).
Another worrisome point: SemGroup Energy Partners SGLP was crushed after its parent and general partner, SemGroup LP, saw a series of unauthorized commodity trades take it into bankruptcy court.
Yet this risk is relatively easy to avoid. Several small MLPs exist quite plainly to serve the operating and financial interests of the general partner; for this reason alone I wouldn’t own them, and I don’t. Seven of our eight MLPs either have publicly traded general partners or are themselves general partners.And the parent of the eighth, Kinder Morgan,
is under Rich Kinder’s direct control. I don’t think he’s likely to bankrupt himself with SemGroup-like activities.
Then there is the cost of capital issue. When LP unit yields are this high, issuing new equity to fund new construction projects and acquisitions becomes awfully expensive—diminishing the growth potential such expansion permits. If yields stayed this high indefinitely, I’d have to reel in my long-term forecasts for distribution growth. But history suggests yields won’t stay this high (and prices this low) for long. The deep discounts at
which our MLPs are trading relative to their fair value estimates (29% on average) is one source of support, but I also put together an index to measure the historic relationship between yields on a basket of LP
units and those of 10-year Treasury bonds. You’ll
find the resulting chart at the bottom of this page. (have to get the newletter to see it)
In the past, this basket has traded at a yield premium between 0.8 and 4.4 percentage points, 2.5 points on average. Where are we today? 4.2 points. For this basket to return to the average spread, either 10-year Treasury yields would need to shoot to nearly 6%, or MLPs would have to rise nearly 30% across the board (and even faster if distributions continue to
grow). Naturally, such statistical relationships can and do evolve over time, and today’s sector bears little resemblance to that of 1993. But this indicator has generated buy signals before, even when the outlook
was cloudy. I think it’s doing so again. So while we wait for a rebound in prices, our MLP distributions keep on growing: Kinder Morgan
(payout up 16.5% from the second quarter of 2007),
Crosstex Energy LP (+10.5%), Buckeye Partners
(+6.2%), Buckeye GP Holdings (+24.0%), and Magellan
Midstream Holdings (+22.3%) all furnished the quarterly increases I anticipated. With handsome growth continuing, I’m delighted with the role these firms play in the Harvest’s pursuit of large, rising income.
