Why—in the context of high demand for new energy infrastructure, stagnation in the broader economy and a dearth of yield-oriented investments—have master limited partnerships (MLPs) consistently underperformed the broader equity markets this year?

One important benchmark, the Alerian MLP Infrastructure Index, had produced a total return of 6% for 2012 as of August 31, which was less than half of the S&P 500's 13.5% return for the same period. As of the end of August, the 10-year U.S. Treasury bond yielded only 1.55%, yet August was the sixth month of the year that MLPs lagged stocks.

Many of the MLP second-quarter earnings reports, which were released over the summer months, fell short of analysts' estimates and nearly 10 partnerships lowered guidance for the remainder of the year. The earnings reports revealed adverse impacts from the declines in natural gas liquids (NGLs) prices with results from commodity-sensitive propane, upstream and gathering and processing (G&Ps) MLPs being the weakest.

"As for supply, MLP midstream management teams have not seen slowdowns in NGL drilling despite the plummeting prices."

MLPs with the highest NGL leverage via percent-of-proceeds and keep-whole contracts underperformed those that operate under volume and fee-based processing contracts, which helped to limit their exposure to commodity price fluctuations.

MLPs with G&P assets were also hurt by lower volume and high basis differentials due to constraints to NGL pipeline takeaway capacity. Insufficient infrastructure led to ethane rejection from the natural gas processing stream in the Midcontinent, Rockies and Permian and, accordingly, lighter liquids volumes for the MLPs that operate in those regions. Although new pipelines are being built, they are not expected to come online until 2013, and so these logistical issues are expected to continue for the next six to 12 months.

NGL pricing

NGL pricing is probably the single biggest factor that will impact MLP performance going into the home stretch of the year. While prices are down 30% year-to-date, the summer saw an approximate 20% rebound from late June lows.

The ascent was driven by an uptick in ethane demand as steam crackers returned to service from maintenance turnarounds. However, ethane prices cannot sustain their improvement without an increase in propane prices. Propane supply-demand dynamics will be helped as Enterprise Products Partners and Targa Resources increase export capacity by 170,000 barrels (bbl.) per day in late 2012 and 2013.

Additionally, a sufficiently cold winter would help to drawdown the above-average amounts of propane in storage. However, whether these factors—in the context of broader economic weakness—will support NGL demand sufficiently enough to raise prices is uncertain.

As for supply, MLP midstream management teams have not seen slowdowns in NGL drilling despite the plummeting prices.

Another factor that weighed on MLPs in August was unit-price dilution from the more than $2 billion that was raised in seven primary and secondary equity offerings—all of which were executed within the first 16 days of the month. This compares to the only $665 million raised in August 2011, and $547 million raised in July 2012, according to Wells Fargo. With such a high concentration of equity issued in a narrow time period, the entire sector experienced pressure—not just those issuing the equity. Investors are wary that the sector's heavy equity issuance will continue through year-end given the large capital requirements for midstream projects and the robust spate of MLPs in the pre-initial public offering (IPO) stage.

"The proliferation of MLPs highlights both the vast expansion in the nation's energy infrastructure as well as the financial market's appetite for yield."

There are 13 MLP S-1s (pre-IPO documents) that are already on file with the Securities and Exchange Commission, which should generate more than $2.3 billion in new sector capital, according to Wells Fargo. Moreover, as the MLP asset class garners additional interest from institutional investors, more C-corp management teams are willing to consider divesting some of their assets into separate, publicly traded limited partnerships.

MLP expansion

As a result, we have seen the energy MLP group expand beyond midstream businesses to include assets that are not typically associated with limited partnerships. For example, Northern Tier Energy LP, a downstream partnership, and Hi-Crush Partners, a frac sands producer, recently effected successful IPOs as MLP entities.

Several other refiners, shippers and oilfield service companies have already said that they are considering forming MLPs with some of their assets in order to take advantage of the cheaper cost of capital that MLPs have relative to C-corp.

The proliferation of MLPs highlights both the vast expansion in the nation's energy infrastructure as well as the financial market's appetite for yield. However, as additional MLP supply is generated and absorbed, we can expect more near-term volatility in the sector's performance. In other words, the very factors that have supported MLP outperformance relative to other asset classes up until this year—fractionation margins for NGLs, high growth and steep distributions—may prove to be headwinds for the asset class, at least for the next six to 12 months.

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