Recent Finance Matters columns have highlighted the vast expansion of the master limited partnership (MLP) asset class in terms of the increasing number of MLPs coming to market, as well as the broadening scope of the types of businesses incorporated as MLPs. What are the implications as the MLP sector grows and diversifies its types of operations?

In expanding beyond traditional pass-through operations, the MLP universe is no longer mostly composed of fee-based businesses such as pipeline and storage operations. It now includes more cyclical components of the energy value chain such as refining, fertilizer, frac sand services and drilling.

To be sure, MLPs involved in exploration and production, gathering and processing, coal, shipping, natural gas storage and the wholesale and retail distribution of gasoline and propane have existed for some time. All of these have varying levels of cyclical exposure to commodity pricing, weather and other macro conditions. But these MLPs, like their more stable pipeline counterparts, have some balance-sheet cushion to handle modest variability to cash flow, which enables them to at least plan, if not guarantee, minimum quarterly distributions for their unitholders.

The newer types of MLPs, however, offer a different value proposition with much higher yields compensating for much greater variability in distributions. For example, in mid November the new refining MLP Northern Tier Energy LP (NTI) announced its initial distribution of $1.48 per unit along with its third-quarter 2012 earnings report. The distribution only accounts for two months of the quarter, given Northern Tier’s initial public offering (IPO) in late July, but using the full quarter distributable cash flow implies a distribution of $2.15 per unit, which on an annualized basis, would imply a 39% yield at current levels.

Variable distributions

Refining is a notoriously volatile industry and thus, such high levels of distributions cannot be sustained going forward. But the variable-distribution rate could be misunderstood by retail investors, who, according to Citi analysts, hold more than 65% of the MLP sector's market cap. After all, when you look at Google Finance or any other web-based source of market data, you can see NTI as having a 30+% yield.

For most retail investors, aggressively trading MLPs is not tax efficient. As a result, they look to buy and hold, treating MLPs as long duration, stable assets. Investors will therefore want to know how variable-rate MLPs will trade in terms of normalized yields and spreads to C-Corporation multiples, but at present, it is too soon to make this assessment. Variable-rate MLPs may be more appropriate for institutional investors who can use basis management to minimize tax implications of active trading. But with newer types of MLPs struggling to find comparables, several of them are priced below their offering range, suggesting weak demand. What does this portend to, if anything, regarding the competition for investment capital that the new subset of variable rate MLPs will pose for more traditional MLPs?

One would think that the dearth of yield options in the marketplace and the Federal Reserve’s policies designed to keep rates low well into 2015 would support high demand for all income- oriented vehicles, such as MLPs. Interestingly, however, according to Wells Fargo, preliminary 2012 data from PricewaterhouseCoopers suggests that institutional ownership of MLPs has remained relatively steady and modest: institutional ownership accounts for only about 28% of MLP units versus 30% in 2011. This is surprising given recent trends such as more institutional funds, pensions and endowments allocating capital to the MLP sector, and it suggests that competition among traditional MLP issuers for institutional capital has remained tight.

Barclays argues that the central bank’s policies are not pushing investors into MLPs with higher yields and more risk but instead are pushing up the valuations of safer partnerships as their yields are still attractive relative to the market alternatives. According to Barclays, recent secondary-equity issuances of the traditional MLPs have garnered the interest of predominantly dedicated and conservative MLP funds, whereas the newer types of MLPs that have IPO’d this year have attracted a larger portion of more typical and higher beta C-Corporation investors.

While more time is needed to evaluate the impact of variable- rate MLPs on the broader MLP universe, reflecting on the history of the space highlights the fact that these “new”-category MLPs are not actually new. In the 1980s, the early years of the industry, the sector was filled with partnerships involving refining, fertilizer, timber and other cyclical businesses. Most of these MLPs failed as they were unable to maintain distributions when oil and gas prices dropped. As a result, the space has been dominated by pipelines and other stable midstream services until recently. Does this past year’s sharp rise in MLP IPOs, especially in more cyclical areas of the energy industry, signal a peak in margins or an MLP bubble?

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