Historically, publicly traded master limited partnerships (MLPs) have been an obscure asset class, used mostly in individual retirement accounts, where they have been prized for their tax-advantaged distributions. Despite their benefits, these securities typically had a limited ownership base, comprised of mostly retail investors with almost no participation from the institutional investment community.

In 2010, however, energy-related MLPs, which are the biggest component of the MLP universe, raised approximately $13 billion in equity capital, exceeding the amounts issued in each of the prior two years. Institutional allocations accounted for an increasing percentage of these issuances, with several deals even expanded to accommodate institutional interest.

A major source of this demand came from new MLP exchange-traded notes (ETNs) and exchange-traded funds (ETFs)—which themselves saw capital inflows of approximately $2.4 billion—and from actively managed MLP-focused closed-end mutual funds. Among the 15 largest MLPs across all the energy subsectors, Thomson Reuters saw net institutional inflows of $1.6 billion during third-quarter 2010 alone. The money raised by MLPs financed record-high levels of M&A activity in 2010 and increases in capex programs.

The capital-markets activity among MLPs during 2010 reflects growth in the underlying energy-infrastructure business in the U.S., as well as these companies' success in tapping the public markets for funding. While secondary offerings diluted unit prices of some of the issuing MLPs, the MLP sector as a whole still managed to outperform the broader markets in 2010. In fact, energy MLPs are one of the few areas of the oil and gas complex that have outperformed the broader markets over a variety of extended time periods, including the past three-, five- and 10-year periods.

Over 2010, the Alerian MLP Index rose 27%, while the S&P 500 rose 13% and the yield on the 10-year Treasury note fell 14%, indicating the appetite for yield in a low-interest-rate environment as well as the broadening ownership base of MLPs by both retail and institutional investors. Interestingly, however, MLPs lagged the S&P 500 during the third and fourth quarters, perhaps reflecting profit-taking or an increased appetite for risk going into 2011.

The best-performing MLPs on a total return basis for the year were the general partners (+65%) and the natural gas gathering and processing partnerships (+60%), particularly those levered to natural gas liquids. The general partners were buoyed by a wave of mergers and restructurings, while the gathering and processing partnerships benefited from widening fractionation spreads between natural gas liquids (NGLs) and natural gas.

Front-month Henry Hub futures fell 21% for the year, while West Texas Intermediate (WTI) oil prices gained 15%. The strength in oil prices relative to natural gas helped NGL prices, which trade at a 50% to 60% ratio to oil.

In response to the weak natural gas prices, gas producers shifted drilling activity away from dry-gas shale toward oil and liquids resources. Development of the liquids shales, which lack infrastructure and are located at a distance from petrochemical end markets, supported demand for companies that provide pipeline, fractionation and processing capacity. Analysts estimate that MLPs' planned gas-processing plants for 2011 will add approximately 3 billion cubic feet per day of processing capacity.

The widespread expectation in the investment community is for the oil/gas multiple to remain elevated and natural gas prices to remain weak for the foreseeable future, while domestic production continues to expand. These factors would support large fractionation spreads, and in turn, benefit gathering and processing partnerships. There is far less consensus, however, regarding the growth rate of the U.S. economy and the outlook for interest rates. If growth is stagnant and, as a result, rates remain relatively low, we would expect that the appetite for MLPs would increase due to their cash distributions. The ML

It will be interesting to watch whether institutional ownership of MLPs continues to expand, and how this will affect trading of the units on the public markets. With a historically limited investor base, MLPs have been thinly traded securities. If institutional ownership increases significantly, the MLPs will perhaps be more liquid, with greater pricing efficiency; however, they might also become more volatile, if they attract high-turnover investors armed with large portfolios.

—Tamar Essner, associate director, Thomson Reuters Advisory Services

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