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Navigating Choppy Waters in the MLP Space

By Elliott H. Gue, on Mar. 27, 2015

Over the past several years, the stock market has rewarded investors who bought the dips in the energy sector.

These fond memories and perceived low valuations have prompted many bargain-seeking investors to allocate capital to upstream names and oil-field services stocks in the hopes of finding a bottom.

There will come a time to buy these names selectively, but smart investors should remain on the sideline for now. Regard any near-term rebounds as a sucker’s rally—another opportunity to exit riskier positions.

Energy analysts remain almost universally bullish on midstream master limited partnerships (MLP), citing their fee-based contracts and resilience when commodity prices cratered in late 2008 and early 2009.

But investors shouldn’t assume that the entire MLP universe will be immune to the downdraft in commodity prices.

Extended weakness in energy prices will reduce drilling and completion activity, slowing demand growth for new midstream infrastructure and expansions of existing systems.

And as the competition for market share and funding within upstream operators’ portfolios heats up, throughput volumes on systems serving higher-cost or otherwise out-of-favor areas could come under pressure over time.

Rumblings in the energy patch likewise suggest that marginal producers have started to exert pressure on midstream companies to cut them breaks on contracts signed under much different market conditions.

Crestwood Midstream Partners LP (NYSE: CMLP), for example, modified its gathering contract with Quicksilver Resources (OTC: KWKA) to give the customer a break on fees in exchange for running another rig in the Barnett Shale.

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At the same time, plummeting NGL prices have made processing gas a money-losing venture for midstream operators that operate under keep-whole or percent-of-proceeds contracts that entail significant commodity risk. In this environment, fee-based and cost-of-service agreements are the safest.

MLPs often tout their long-term, fee-based contracts—a claim that far too many investors take at face value. What constitutes long term varies dramatically in different parts of the energy patch.

Whereas an offshore contract driller might consider a three-year fixture a long-term deal, an interstate oil pipeline might operate under 10-year capacity-reservation agreements. Be on the lookout for near-term re-contracting risk.

Counterparty risk also continues to rise. American Midstream Partners LP’s (NYSE: AMID) general partner, for example, recently had to scale back its planned expansion to a gathering system in the Eagle Ford Shale after its customer, the former Forest Oil Corp, decided to scale back its drilling activity.

In this challenging environment, investors should focus on the names in the MLP Portfolio’s conservative sleeve—our top picks in the current market and the partnerships that are best-positioned to weather the storm and emerge stronger on the other side.

Investors seeking higher yields should buy the names in the MLP Portfolio’s aggressive segment selectively; we discussed all our favorites at length in Under the Microscope: Conservative MLP Portfolio and Under the Microscope: Aggressive MLP Portfolio. Be sure to consult these articles to understand the risks and opportunities offered by each stock.

Also consider staggering your purchase to scale into these stocks and take advantage of the inevitable selloffs that will occur in coming months, especially if the market panics when marginal MLPs slash their payouts or scale back their growth outlook.

With roughly two dozen MLPs (excluding upstream names) offering yields of more than 8 percent, the frequency with which readers asks us about these stocks has increased.

In High-Yield MLPs: The Good, the Bad and the Ugly, we dig into about half these names—we’ll cover the rest in the second February issue—highlighting the ones worth buying and the ones you should sell. Note that a Hold rating means that investors shouldn’t allocate new capital to the name in question. We will continue to monitor Hold-rated names for signs of further deterioration.


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