In my last article, How to Play the Oil Crash, I reported on the current state of the oil market and described the potential investment opportunities that exist within the different oil & gas sectors.
To be sure, not every stock in this sector has become a bargain. The ugliest businesses have become even uglier and should be avoided, no matter the price. However, many sector-specific investors have fled to the largest and best players, which has kept their prices slightly higher than where they probably should be.
The net result is the need for diversification within the most attractive energy segment: the midstream sector.
ETRACS Alerian MLP Infrastructure Index ETN (NYSEARCA: MLPI)
The name may be a mouthful, but this security is a pure play on the midstream sector.
The ETRACS Alerian MLP Infrastructure Index ETN, from UBS, is “designed to track the performance of the Alerian MLP Infrastructure Index (the “Index”) and pay a variable quarterly coupon linked to the cash distributions paid on the Master Limited Partnerships in the index, less investor fees.”
The Alerian MLP Infrastructure Index
The Alerian MLP Infrastructure Index is a capitalization-weighted index whose 25 constituents earn the majority of their cash flow from the transportation, storage, and processing of energy commodities.
For more information on the index, please refer to the fact sheet here.
MLPI Historical Performance
As an Exchange Trade Note, MLPI is not exposed to tracking errors. As you can see in the chart below, MLPI’s return is very consistent with the Index’s return, with the only difference caused by the 0.85% fee (accrued daily).
The chart below shows the performance of MLPI and the S&P 500 over the past two years. Since 9/1/14, the S&P 500 has gained 2.5% while MLPI has declined by 14.0%.
As energy infrastructure firms, the companies in the Index are involved in the transportation, processing, and storage of oil and natural gas.
Just like it sounds, transportation MLPs move energy commodities like oil and natural gas from one place to another. Most North American energy travels through a pipeline, but it can also move via truck, railcar, or ship. Transportation MLPs are the cornerstone of the asset class.
Processing encompasses any business that transforms the raw product into a useable form. It could involve removing impurities like water and dirt, as well as separating raw energy into pipeline-quality natural gas and natural gas liquids (NGLs), which are used as heating fuels and industrial feedstocks.
There are tanks, wells, and other storage facilities both above and below ground. They provide flexibility to the energy economy, so there is propane available for winter heating, gasoline for summer driving, and jet fuel for the holidays.
Independence from Oil Prices: Investors’ avoidance of all things oil has caused the Index/MLPI to be irrationally undervalued. Here is an explanation of the MLP business model from Alerian’s MLP University:
MLPs typically operate toll road or fee-based business models. Just as the company that owns the toll-road makes a set fee per mile driven, regardless of the cost of the car, MLPs earn a set fee for each barrel of oil, cubic foot of natural gas, or ton of coal that is processed, transported, or stored, regardless of the cost of the hydrocarbon. […] This is because MLPs typically do not own the oil or gas, just as the toll road does not own any cars. MLPs generally sign long-term contracts (5 to 50 years in length) with their customers, which makes for a very stable business.
Extending this example, the MLP revenue equation is fairly simple. It’s just price multiplied by volume.
Growing Supply and Demand for Oil in the U.S.: If the drop in oil prices had been caused by a sharp decline in demand (like in 2008), then this would be another story. But the crash in oil prices was instead caused by a glut in the supply of oil, meaning that someone will still have to process, transport, and store the commodity. The International Energy Agency recently stated it expects nearly one million barrels a day of extra oil to be pumped around the world in 2015. And although global economic growth remains sluggish, economists predict U.S. GDP to grow 3% in 2015, which will continue to drive demand for oil. Low oil prices will also translate into lower prices for oil’s end products, also helping to sustain demand. Furthermore, the U.S. energy market is insulated from changes in global demand because U.S. oil exports are currently banned. Lifting this ban would only add to total demand for U.S. oil, even if foreign demand declines.
Yield: The current yield on MLPI is 4.9%. While not guaranteed, MLPs typically pay out between 80-100% of their cash flow.
Flight of Yield-Hungry Investors: There is some risk that the price of MLP stocks may drop once the Fed starts to raise interest rates, as investors who were searching for yield in MLP stocks move to other assets. While this risk is potentially real, it is mitigated by the facts that: (i) the effects of the Fed’s moves on yield-hungry investors has probably already been felt (for example, junk bond yields are at record lows), (ii) the tumult in the oil markets has scared away regular investors and yield-searching investors alike, and (iii) most MLPs only trade at a modest P/E premium when compared to the broader overall market.
Potential for Overcapacity: If the sector becomes overcrowded, delivery prices and fees will become depressed. This risk is small because of politics (anecdotally, a pipeline that was to be built near my parents’ house was recently killed off due to staunch public opposition), regulations (permits, rights of way, environmental issues, etc.), and available capital (don’t look for any of the upstream or downstream oil companies to get into pipeline construction as their capital spigots are currently turned off). Additionally, new pipelines would likely be built in unserved areas, rather than in locations where pipelines or adequate oil transportation already exists.
Reduction in Supply: If oil prices continue to fall, more oil producers may finally cease operations and total oil supply would decline. This risk is small, as many E&P firms have committed to continue drilling, oil prices are expected to rebound slightly or, at a minimum, to remain around current levels over the next 1-2 years, and total supply is expected to rise over the next few years (as mentioned above, the IEA predicts total supply to rise in 2015; more specifically, the U.S. Energy Information Administration (EIA) expects non-OPEC production to grow by 0.7mm barrels/day in 2015 and 0.5mm bbl/d in 2016, with the United States as the leading contributor, and U.S. consumption is projected to increase by 0.3mm bbl/d in 2015 and 0.1mm bbl/d in 2016).
There are other options to get exposure to the midstream sector, including other Indexes and other ETFs/ETNs. I chose the Alerian MLP Infrastructure Index over other Indexes (e.g., the Alerian MLP Index) and over other ETFs/ETNs (specifically the more well-known Alerian MLP ETF (NYSEARCA: AMLP)) because the Index excludes E&P firms and because of MLPI’s low expense ratio (0.85% vs AMLP’s 8.56%).
UBS also offers the ETRACS 2xMonthly Leveraged Long Alerian MLP Infrastructure Index ETN(NYSEARCA: MLPL), which uses leverage to produce twice the gain or loss of MLPI. Its current yield is 12.0%. I do not recommend a large investment in this ETN, but if you feel strongly about the above thesis then a small portion of your portfolio could be allocated here. Just remember: leverage is a double-edged blade. Proceed with caution.
Information on MLPs
For everything you’d ever need to know about MLPs, check out Alerian’s MLP University here.
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Full Disclosure Policy: As of the time of writing, I do not hold any long or short positions in any of the securities mentioned in this article.