The Alerian MLP Index booked a total return of 14% in 2011, vastly exceeding the 2% produced by the S&P 500 and marking 12 consecutive years of MLP outperformance relative to the broader markets. Looking at other yield-oriented indices, we see similar outperformance vis-à-vis the wider equity market—the MSCI US REIT Index returned 4% while the S&P 500 Utilities Index produced a whopping 20%.
The paramount strength in utilities, a low beta and high yield sector, underscores what has been observed for some time now: widespread risk-aversion combined with demand for stable yield amid macro volatility and low interest rates.
In as much as master limited partnership (MLP) holders benefited from year-over-year cash distribution growth of some 5% to 6%, MLPs' total return was also positively impacted by broadening ownership of the asset class by both retail and institutional investors. The creation of new MLP-focused exchange-traded funds, exchange-traded notes and open-ended funds supported this trend.
According to U.S. Capital Advisors, the market value of MLP-related funds increased by $7.6 billion to $21.2 billion in 2011 and the number of MLP products grew by 43%. These funds provide diversification within the sector and enable MLP ownership in an individual retirement account without K-1 tax or unrelated business taxable income complications.
Three trends
On a total return basis, the best MLP performers by segment were the mirror image of 2010 with the general partners (+35% total return) and gathering and processing MLPs (+25% total return) outperforming all other midstream segments. This reflects two recent trends.
First, investors prefer MLPs with a strong asset drop-down potential, meaning access to a general partner with a sizeable pool of cash-generating pipeline assets that can be sold into the tax-advantaged limited partnership to support distribution growth to the unit holders.
Second, there is a bifurcation between those MLPs with exposure to natural gas liquids resources, which is the sweet spot in the midstream space, and those MLPs exposed to the areas of midstream space currently confronted with broader challenges, such as natural gas pipelines and storage, retail propane distribution and refined oil products pipelines, especially gasoline. The latter has been affected by declines in U.S. driver mileage, though this is partially offset by decent diesel demand.
A third, emerging trend is that of the U.S. becoming a significant exporter of refined products, which should sustain demand for terminal operators with access to coastline export channels.
Record raises
Last year was notable not only for MLP performance but also for the record capital raised—some $18 billion in primary and secondary equity—surpassing the prior record of $14.5 billion reached in 2010.
Specifically, 11 energy MLPs held initial public offerings (IPO), garnering an aggregate of $2 billion in equity, versus six MLP IPOs in 2010, which raised about $1.7 billion. And more MLPs are expected to go public in 2012 amid the mushrooming organic growth in the country's energy infrastructure needs and as E&P companies carve out midstream assets to capitalize on their higher valuations and cheaper access to capital.
With MLPs valued at all-time highs, the critical question for the market is whether investors should be cautious about adding incremental capital to the sector. On the one hand, with major infrastructure projects announced in 2011, it is likely that 2012 will see yet more capital raises, which should provide some attractive entry points as unit prices usually decline when new equity is issued.
On the other hand, projections for performance in the broader equity markets are muted. Thomson Reuters' 2012 mean estimate for the S&P 500 is 1,308.33, which is only 4% higher from where the index ended in 2011. Given the lack of yield alternatives in this low-interest-rate environment and amid expectations for modest stock performance, MLPs might see ongoing support and attract new capital from large institutional investors.
Uncorrelated growth
Importantly, MLPs' secular cash flow growth is considered uncorrelated from macroeconomic conditions and from other risk investments. This is significant because one of the major problems for fund managers in 2011 was the high correlations of performance within asset classes, despite different underlying risk-reward profiles.
An important wildcard to mention is the potential for corporate tax reform and the possibility that part of this reform will entail the imposition of taxes on corporations structured as nontaxable businesses, such as MLPs. While MLPs do enjoy bipartisan Congressional support for their role in fostering domestic energy development, the increasing prevalence of MLPs in a variety of sectors is cited as a contributing factor behind why federal corporate tax collections are on the decline.
Tamar Essner is associate director of energy advisory services for Thomson Reuters Advisory Services and can be reached at tamar.essner@thomsonreuters.com, 646-822-3646.
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