Pipeline master limited partnerships are standout income alternatives. These pass-through vehicles often yield around 5% or 6%, though they can present tax-reporting headaches and are far from risk free.
That was brought home earlier this year when Boardwalk Pipeline Partners (BWP) slashed its distribution by about 80%. The price of partnership units tumbled.
'DIVERSIFICATION IS YOUR FRIEND'
Brian Kazanchy, a managing partner at Morristown, N.J.-based Regent Atlantic Capital, says that such a stumble can happen in any industry. To guard against it, he uses investment products that track MLPs as a group. “Diversification is your friend,” he says.
There are several ways to expose clients to a diversified selection of MLPs, including traditional mutual funds, closed end funds and exchange traded notes (ETNs). The latter don’t own the investments directly. They are debt instruments issued by a bank that promises to pay the returns of an MLP index. When dealing with an ETN, part of the advisor’s due diligence is to check the creditworthiness of the issuer.
Brian Kazanchy uses the ETNs in tax-deferred accounts. “You want to vet the counterparty very carefully,” he says, adding that he recommends not having more than 3% of any portfolio with any single counterparty to limit that risk. Overall, Kazanchy says exposure to MLPs constitutes about 6% of the equity portion of client portfolios, vs. the roughly 1% of global market cap the pipeline operations represent. He notes that in addition to good yields, the group also offers growth potential.
ENERGY PRICE FLUCTUATIONS
Oil and gas producers have to pay the pipeline companies to move their products. To a large extent, that insulates the MLPs from energy price fluctuations.
Oil is a global commodity. Although spot prices differ in the U.S. and overseas, the benchmarks are closely tied. “I think that’s going to continue to be the case for a while,” says Richard Hoe, founder of Richard Hoe Investments in Tulsa. But with the U.S. awash in oil, things may change in a few years.
“I think that at some point, we’re going to have so much oil, we’re going to stop using the global spot price,” says Hoe, who has long watched MLPs from his base in the oil patch. “And when that happens, the oil and gas producers will attempt to negotiate the fees they pay [to pipeline companies].”
As producers see their profits squeezed, they may try to share the pain with pipeline companies, pressuring MLP returns and distributions.