The Perfect Time to Add These Income Vehicles to Your Portfolio
In Saturday’s article, I explained the structure of master limited partnerships and what makes them different from regular companies.
Today, we’ll go over the different types of businesses MLPs engage in. I’ll also discuss how and when it makes sense to invest in MLPs.
The first step is to determine where MLPs’ assets are located in the value chain.
MLPs in exploration and production are referred to as upstream MLPs.
Midstream MLPs transport the commodity between producers and distributors. They usually have long-term, fee-based contracts with their customers.
Downstream MLPs engage in activities related to end user distribution. Refineries and storage terminals are examples of downstream MLPs.
One of the most important considerations when selecting an MLP is determining the exposure to the commodity it handles. Upstream and downstream MLPs tend to have exposure to the underlying commodity.
That’s why I like midstream MLPs. They are like toll roads.
A midstream MLP gets paid based on the volume of the commodity it handles, irrespective of its price.
A Key Measurement
Let’s take a look at some more of the important criteria I use when selecting an MLP for investment. Distributable cash flow (DCF) is the money available for distribution to unit holders.
The distribution growth of an MLP is the rate at which quarterly and annual distributions are growing.
It’s a key measurement for the effectiveness of management and asset utility.
The distribution coverage ratio is another criterion I look at. It’s a quarterly or annual measure of DCF divided by the actual cash distributed to all unit holders.
I want the MLPs I invest in to always have extra cash on hand. In the event of a down quarter, the partnership will be able to maintain its distribution.
That’s why I look for the coverage ratio to always be greater than 1.0. If it is, it indicates the MLP’s DCF is equal to or greater than the distribution for the period in question.
If it’s less than 1.0, it means the MLP distributed more cash than it had available. This may (or may not) be an indication of weak revenues or some other issue.
Every company or partnership, especially in the energy business, has a bad quarter now and then, and its coverage ratio may slip below 1.0. As long as it’s a single quarter, that’s generally not a red flag.
Some general partners have incentive distribution rights (IDRs).
This is a good thing to look for when reviewing MLPs because IDRs incentivize general partners to increase distributions to unit holders.
Time to Buy
I recommend the direct purchase of individual MLP units. Most of my recommendations in Oxford Resource Explorer and Advanced Energy Strategist are individual MLPs.
The alternative is to purchase shares of one of the MLP funds that are available. The disadvantage is that you will likely receive a lower return than you would if you directly invested in individual MLPs.
That’s because MLP funds can have only 25% of their investable assets in MLP units. The rest has to be invested in general partner units or other stocks.
The best part is there’s never a bad time to buy MLPs.
Why? Because regardless of the outlook for the sector in general, MLPs always have the tax-advantaged “hook” that regular dividend-paying companies don’t.
However, now is a particularly good time to invest in MLPs because most have sold off (15% or more) along with other oil stocks.
More good news: The outlook for midstream pipeline and processing continues to accelerate. E&P companies continue to need more pipelines, processing facilities, storage tanks and export terminals.
Right now, interest rates have never been cheaper when it comes to borrowing money. That’s good news for MLPs, since building pipelines and processing plants is capital-intensive. So the returns on pipeline and processing plant construction far exceed the capital cost of building them.
The best MLPs receive 90% to 100% of their income via fee-based contracts. When I’m evaluating MLPs, I look for this first.
Take-or-pay contracts are even better. They stipulate that the customers must pay for the commodity even if they can’t take it at the specified delivery time.
Well that about does it. You should now have a basic understanding of MLPs and how to evaluate one that has captured your interest. You can also find more information on MLPs at MLPdata.com.
If you have any questions about MLPs that weren’t addressed here or in my previous article, please email me at firstname.lastname@example.org.