After a period of sustained growth, master limited partnerships (MLPs) have underperformed compared to the Standard & Poor's (S&P) 500 in the second half of 2013. The Wells Fargo MLP Index was down 6.2% from July 15 to September 16, compared to a 0.1% gain for the S&P 500 during the same time.

Much of the upstream MLP segment's negative outlook was due to an 11% downturn in the price for Linn Energy, which accounts for 30% of the segment. As demand drivers have been improving throughout the fall for crude oil and natural gas liquid (NGL) prices, upstream MLPs are also gaining strength.

According to Wells Fargo Securities, a primary reason for the sector's underperformance involves investor concerns over higher interest rates' effect on MLPs. “In all likelihood, the market has exited an unprecedented period of low interest rates, which we believe has provided an accommodative backdrop for MLP sector growth over the past 10 years,” the investment firm said in a recent research note.

The average interest rate is expected to increase from the current 2.9% to 4% in 2016 and 5.1% by 2018. Despite this notable headwind for the MLP sector, Wells Fargo anticipates it should be fairly easy to overcome, as long as interest rates increase at a measured pace and distributions grow steadily to maintain investor interest.

While the MLP market is more closely tied to commodity prices and the broader equity market, Wells Fargo noted that when the 10-year Treasury rate has risen more than 50 basis points in a month, the MLP market has underperformed the S&P 500 by 2%.

“This implies that although MLP performance is not meaningfully impacted by gradual movements in interest rates, sharp changes in interest rates can materially impact MLP performance,” the report said. Even though the industry typically secures debt with fixed rates, companies in the sector issue large amounts of debt, and drastic increases in interest rates would have a negative impact.

According to Wells Fargo Securities, a 1% increase in rates would result in the compound annual growth rate deteriorating by 80 basis points for upstream and small-cap pipeline MLPs, 60 basis points for gathering and processing MLPs, 40 basis points for propane MLPs, and 40 basis points for large-cap pipeline MLPs.

The report noted that this analysis is largely theoretical, since interest rates have trended downward for much of the past two decades—the same period of time MLPs have existed. Thus, MLPs have not yet operated in an environment with a cycle of increasing interest rates. At the same time, the sector has grown to include companies that have higher-risk assets, such as E&Ps, processors and refiners, rather than just pipelines.

This growing risk has caused upstream MLPs to underperform in the overall sector. According to a separate research note from Wells Fargo Securities, upstream MLPs underperformed in the overall market by 5.2% in August compared to the full MLP segment, which was down 3.5% for the same time frame.

—Frank Nieto

For more coverage of MLPs, see and MidstreamBusiness.com.

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