After master limited partnerships (MLPs) put in a strong performance in the first quarter, handily outperforming the S&P 500, the path ahead for MLPs is projected to be positive but not without the occasional speed bump. Longer term—beyond 2013—one analyst suggests keeping a watchful eye on that dashboard oil light, it may be blinking a warning even as your car rumbles on for many more miles.

In April, the relative performance of MLPs cooled—hardly surprising after a first quarter in which the sector chalked up a total return of 19.5% versus 10.5% for the S&P 500. With MLPs edging up a further 0.7% in April versus the S&P’s 1.8%, yearto- date MLP performance still comfortably outpaces that of the broader market with a total return of 21% versus the S&P’s 12.7%, as measured by the Wells Fargo Securities MLP Index.

The strong first-quarter MLP performance is credited to a number of factors, including MLPs catching up after their relative underperformance in 2012 ahead of tax-related concerns (also known as the “fiscal cliff ”), as well as signs of a U.S. economic recovery. Other factors are strong funds flow based on the attractive yields offered by MLPs, the sector’s visible distribution growth driven by the energy sector’s ongoing infrastructure buildout and stable or modestly improving commodity prices.

In the wake of the strong year-to-date performance, Wells Fargo senior analyst Michael Blum adopts a more cautious tone, expecting “some sector consolidation in the near term,” according to the May Wells Fargo Securities MLP report. MLP valuations “look a bit stretched,” he says, pointing to the sector trading at a median yield of 6.6% and a median EV-to-EBITDA (enterprise value to earnings before interest, taxes, depreciation and amortization) of 12.9x. The five-year average metrics, by comparison, are a yield of 8% and an EV-to-EBITDA of 10.6x.

Also holding back April’s performance was a projected slowdown in GDP growth, seasonal weakness for MLPs and, importantly, the upcoming calendar of equity issuance. Secondary equity issuance by MLPs was expected to pick up after the firstquarter earnings season, and Wells Fargo estimates that names under its coverage will raise $21.9 billion in secondary equity issuance in 2013. Some $7.8 billion had been raised through part of April. The initial public offerings backlog is set to add at least $3.9 billion in additional equity issuance.

Even so, Blum maintains a long-term positive outlook on the group, projecting a median sector total return of approximately 9% for the next 12 months. This reflects the MLPs’ still attractive yields as well as solid fundamentals afforded by the ongoing crude oil and natural gas liquids (NGLs) midstream infrastructure buildout. These fundamentals provide the basis for a projected 5% median 2013 growth in distributions for MLPs under Wells Fargo coverage in 2013.

The Wells Fargo report identifies three names—Enterprise Products Partners, Magellan Midstream Partners and Plains All America Pipeline (PAA)—as names it believes should be considered when constructing a longterm portfolio of MLPs. It notes that these core holding names may not necessarily correspond to current ratings, which are based on 12-month valuations. Of the three, Enterprise Product Partners is currently rated Outperform, with the other two rated Sector Perform.

Common characteristics

However, the three core holdings all share common characteristics: They “offer investors an enviable mix of a topflight asset base, stable cash flow stream, excellent track record of delivering consistent earnings, visible growth, strong coverage ratio and conservative balance sheet and capital structure,” according to the report.

Of its Outperform-rated stocks, names highlighted by Wells Fargo in its report as top picks include: Access Midstream Partners, Atlas Energy LP, Energy Transfer Equity, Linn Energy LLC , MarkWest Energy Partners, Energy Partners LP (NGL) and Williams Cos. Wells Fargo provides a subsector listing of its top picks, with Energy Transfer and Williams being categorized as general partnerships.

In terms of latest trends by subsector, crude oil MLPs underperformed the Wells Fargo Securities MLP and gathering and processing indices for a good part of April. Mostly this may have been simply a matter of “rotation/ profit taking following very strong performance over the past two-plus years,” according to Wells Fargo. In addition, notes the report, “crude oil management teams have been almost unanimous in forecasting margin to narrow this year as new pipelines are placed in service.”

Barclays Capital managing director Rick Gross offers a positive message in the near term along with a word to the wise as far as keeping an eye on developments over the longer term. In the near term, the Barclays MLP research team led by gross projects that MLPs will enjoy a 7% growth in distributions in 2013. And the team’s 12- month target for the Alerian MLP index generates a 13.7% implied return for the MLP sector over the next year, according to a May MLP Quarterly Monitor.

Are there reasons for pause? After the very strong first quarter performance, “our sense is that we probably have come a little too far, too soon,” says the report. “A pullback is possible,” but one likely “muted” by strong funds flow for the remainder of the year. Also balanced against a steeper correction are underlying fundamentals that are still favorable, and valuations that are viewed as reasonable in absolute terms and cheap versus the cost of credit.

So what is an investor to do?

“Long-term value proposition-oriented investors should ride out any correction that hits the sector,” says the report. “We expect positive funds flow and valuation metrics to limit a potential correction to within 10%.”

The outlook is not, however, one of merely cruising along the wide-open MLP highways. Where the Barclays report strikes a cautionary note is in encouraging investors to keep a watchful eye out for an eventual mean reversion in oil—something not anticipated near term, but that should not be ignored, akin to the oil light that may be blinking even as your car logs mile after mile.

“Don’t entirely ignore that nagging light on your portfolio dashboard,” says Gross. “Check your oil, the light’s blinking.”

Is mean reversion in oil a likely a 2013 event?

“No way,” says Gross. “The shift in fundamental momentum is not a 2013 event,” writes Barclays, “so a wholesale shift in orientation is not warranted, in our view.” Even with the valuation disparity between oil and gasoriented MLPs widening to an “extreme” level, oil fundamentals “remain vastly superior” to those of natural gas. “At this juncture, a wholesale thematic shift is likely to result in underperformance, as there is no clear catalyst to slow oil growth.”

The report does, however, hold out the possibility of some recovery in the natural gas rig count during 2013, even if competition with coal limits the upside for natural gas. With an eye to mean reversion in sector fundamentals over time, Barclays proposes that a portfolio positioning predominantly weighted to oil be retained through large-cap names. Small-cap oil exposure can be dialed back and substituted with MLPs that offer visible growth that is more skewed to natural gas.

Spending peak possible

With regard to infrastructure spending—the chief driver of MLP distribution growth—Barclays says its studies haven’t been so rigorous that it can pinpoint the potential peak in spending for the current cycle. However, it thinks the cycle will likely peak in the next two to three years—probably in 2016—and will mark the culmination of three successive waves of investment: first in natural gas, then in NGLs and finally in oil. The repercussions will be initially modest and then become more important.

Barclays says a peak in spending doesn’t necessarily translate into an immediate peak in distributions. This is because utilization often lags new capacity being installed, and lower unit costs can help offset a slower—but still incremental— pace of capital that is being deployed. However, the growth rate of MLP distributions will at some point go from expansion to contraction and organic growth as the driver of spending will switch to mergers and acquisitions by the larger investment grade MLPs.

So how sustainable is the outlook for growth? And what innings are we in now?

Barclays offer more than a single answer. First, it does not foresee a boom-bust capital cycle, as the resource base exploitation should sustain spending for a long time. In terms of the current cycle—from the start of shale gas drilling in 2005 through to the projected peak in aggregate spending in 2016—the sector is about 72% to its peak. Using the baseball analogy, this would put the industry in a 7th inning stretch.

But what about the resource base itself?

The outlook for the MLP sector is dependent more on energy demand, rather than supply, notes Barclays. Resources in the Lower 48 states continue to expand “at a pace well in excess of demand,” with productivity in drilling rising, costs falling and new plays emerging. However, weakness in natural gas and NGL prices, plus a growing surplus of condensate, show that demand is constrained.

“The resource base is not going to be the issue. It’s going to be conjuring up the demand to handle the opportunity set,” observes Gross. “We’re going to have to find export markets to balance our supply and to sustain capex at levels higher than we otherwise would if we overwhelm the existing market.”

What is needed—in addition to a faster growing domestic economy—are new markets for an array of energy products: natural gas, ethylene (derived from ethane), liquefied petroleum gas, condensate (for use as diluent) and refined products for export (butane, light crudes). If developed, growing markets for these products would accommodate rising supplies and sustain robust infrastructure capital programs.

And what inning are we in related to developing our resource base supply? “We’re closer to the 2nd or 3rd innings,” says Barclays.

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