Spicing Up MLP Portfolios

Variety is the so-called spice of life, and some MLP investors may be looking to savor a little extra seasoning in their portfolios.

After seven variable distribution-rate MLPs were created in a flurry of filing, Yorkville Capital Management last year went to work to study the phenomenon and developed an index to track the partnerships’ progress, both historically and rolling forward.

What they found was that the variable rate MLPs—while not designed for those who are more risk-averse—could generate a lot of cash when commodity prices are right. And there may be more opportunities to get in on the action this year.

A variable rate MLP differs from a traditional MLP in the sense that there is no bottom line for quarterly distributions. That regular income is a key selling point for some in the space, but analysts say variable rate MLPs have other charms.

“When you saw the growth in the last couple of years, a number of [entities] were coming public in MLP wrappers, but not committing to a minimum distribution,” Darren Schuringa, Yorkville’s founder, told Midstream Business, adding that for companies that don’t have hedging instruments in place, commodity pricing exposure is more pronounced, and it has more impact on the entity’s bottom line.

Commodity risk

As such, when an MLP opts for a variable rate, the company still distributes a majority of its cash flow from operations, but investors pick up commodity risk in addition to operations risk, he said. That can move the needle significantly, setting the table for a feast-or-famine distribution.

With commodity exposure, an investor variable distribution MLP is also looking for income, which may be very high one quarter, and then zero the next quarter, Schuringa said.

“That’s not ideal for any investor. That’s the weakness,” he said. “Now, here’s the strength, the opportunity: If an investor has an opinion on commodity prices—and that’s a tough opinion to come to, we’re professional investors, and we find it hard to forecast the direction of commodity prices—then what a variable distribution MLP will provide them with is potentially better exposure.”

For investors on the right side of commodity prices, there will be a benefit based on the cash it will provide. From a total return perspective, the majority of MLP cash flows back to investors. Consequently, in addition to the cash flow produced as part of an investor’s overall return, there is additional price appreciation at play.

“The underlying assets become more valuable as the cash flow increases,” Schuringa said.

A minimum quarterly distribution MLP is able to hedge its commodity exposure, either through long-term contracts under infrastructure names such as MarkWest Energy Partners LP and Enterprise Products Partners LP or through the hedging programs in place at most upstream companies.

But it’s not just commodities exposure and hedging practices that separate distributions at the minimum rate and variable rate MLPs, Schuringa said.

A different profile

“Variable distribution MLPs are not the traditional infrastructure MLPs that you buy and put in your portfolio and you hold for a number of years,” he said. “That’s not their profile. They have a completely different risk profile than a pipeline operator.”

To be sure, the variable rate MLPs are expected to draw strong returns in the coming years. In a recent white paper, Yorkville estimated that the total return performance on variable rate MLPs three years out would reach 48.1%, more than double that of all MLPs’ expected 22.4% and four times as much as the S&P 500’s 12.8%.

Those estimates drop in subsequent years, but the variable rate index remains within the single digits of the universal MLP index or substantially higher.

Variable rate MLPs currently make up a small segment of the total MLP market cap, just 4.3%. But when you put dollars to the percentage, it comes out to a whopping $18 billion. Refining and fertilizer account for the vast majority of variable rate MLPs, 45% and 38%, respectively.

“We've seen a slowdown in IPO activity ... but variable distribution MLPs actually did quite well in the first quarter so I think what will end up happening is the markets will remain supportive of the segment,” Schuringa said.

But not all of the analysts agree that variable rate MLPs will surge this year. Hinds Howard, the MLP chief at CBRE Securities, said in a market update that while variable distribution MLPs have their place, and their niche of the overall MLP sector will continue to grow in 2014, more than one or two new filings is unlikely.

“The buzz in the marketplace around the structure when it was new and interesting is just not there anymore, but the market is still there as an exit option for owners of non-traditional MLP assets,” he said. “Fertilizer MLPs have started very strong so far this year, and they may perform well enough to spark more variable distribution IPO activity in 2015, but not in 2014.”