Resilient Business Model
During periods of economic uncertainty, MLPs remain a solid source of income. In 2008-2009, 78% of all energy MLPs either maintained or increased their distributions. In comparison, 85% of real estate investment trusts (REITs) either cut or suspended dividend payments.
Now, a note of caution is in order. Despite the excellent income track record, MLP share prices stumbled as they became more correlated to the general market. However, the investors who held them through the difficult times saw the share price rise again. MLPs returned to January 2008 levels in early 2010; the S&P 500 did not do the same until 2013.
The same plunge could happen again if a severe economic crisis hits. As we said, MLPs may move with a falling market. The fact that more investors are aware of MLPs now than a decade or two ago adds to this risk. As investors have searched for yield, MLPs have become more mainstream; however, they are by no means your average S&P 500 stock.
Also, there are two immediately positive outcomes to the higher investor awareness of MLPs: higher liquidity and access to more capital. In the Money Forever portfolio we look for the best and safest available and then protect our downside with protective stop losses.
Principal Risk Areas
With any investment offering a reward, there is a corresponding risk. Here are the key risks of MLPs.
Risk #1: Economic downturns. If the US economy is hit by a severe economic crisis that drives the demand for energy products down, MLPs will take a blow. Like a trucking business that transports products for which the demand is going down, if less product is shipped through a pipeline owned by an MLP, their revenue may decrease.
This, however, is where some investors may get confused. If a pipeline MLP has a contract with an energy company, the price of the transported product may increase or decrease, but at the same time, the MLP may have a fixed-fee arrangement with the energy company. So, if the volume flowing through the pipeline remains steady, its revenue should not fluctuate.
Risk #2: Access to capital and interest rates. As a general rule, MLPs return 100% of their distributable cash flow (DCF), less a reserve determined by the general partner, to the unit holders. Unlike real estate investment trusts that must give away a certain share of their cash flow every quarter, MLP distributions are governed by individual partnership agreements, so the terms vary.
However, the majority of cash an MLP earns will be distributed, so it’s only natural that they turn to issuing debt or equity to finance growth projects. When their interest costs rise MLPs that need capital right away will be at a disadvantage. We prefer companies with enough internally generated capital to finance growth, and no major ongoing projects that require billion-dollar loans and thereby run the risk of being underfunded or funded at an unfavorable interest rate. We also prefer companies with fixed-rate debt to floating rate.
Risk #3: Management and execution. Management should have a track record of successful investment in new assets and cash generation to finance distributions.
We also look for companies that have 5- to 10-year capital plans as part of the write-up, and a history of following those plans. They tend to fare better when it comes to keeping capital costs under control.
Risk #4: Sustainability of cash distributions. The above three risks boil down to whether or not an MLP will be able to churn out cash for its unit holders. The distributions should be sustainable, and should grow year after year. The primary reason for buying an MLP is income. We need to make sure the cash keeps coming in.
A company’s track record of cash payments is a good, but not perfect, indicator of how it will perform in the future. Variable-rate distributions tend to, well, vary more significantly than those of traditional MLPs. Distributions in the midstream sector tend to be more predictable; natural gas pipelines and storage generate the most stable cash flows while refining/upstream MLPs do so to a lesser extent. We carefully consider these factors when evaluating our investment options.