Picking and Choosing MLPs

 | Sep 01, 2011 | 1:00 PM EDT
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You know how much I like the energy master limited partnerships (MLPs). They're a great part of every energy-allocated portfolio for reduced risk, and they offer terrific distributions, some of them delivering 6.5%, 7%, sometimes even 8% and more.

But it's not easy figuring out how to structure a portfolio of MLPs. I was discussing this with a trader friend of mine who admitted that he's done very well with them basically by throwing darts at the sector and picking a mostly random swath of the offerings.

It's true -- each one of the MLPs, while they share almost universally the same model, are individually very, very different, dealing with unique challenges in growth, commodity exposure, weather, balance sheets and executive expertise, just to start.

I want you very much to choose your own MLPs and avoid both the fund managers and ETFs such as the new Alerian MLP ETF (AMLP), because fees really cut into this sector more deeply when you're basically scrounging for yield in the first place. But let me center on one MLP and quickly analyze it to show how unique each investment is and what kind of work you should expect while selecting the five or six of these that I believe should compose an MLP portfolio.

Let's look at Energy Transfer Partners (ETP). With a big Texas pipeline that backbones this company, ETP has paid consistent dividends to shareholders since 2008, a steady $3.58 a year. But revenues from that pipeline have been falling, and Energy Transfer Partners has fallen into a big MLP trap of delivering a more than 100% payout ratio in order to continue to please shareholders. Of course, this is unsustainable in the long run, and ETP knows it -- in short, ETP is eating itself.

ETP made a bold move earlier this year in inking a preliminary buy of Southern Union (SUG), a deal that would have increased ETP's debt but also would have ensured the dropdown asset growth that most well-run MLPs need to continue to maintain steady distributions. But almost immediately, Williams (WMB) saw too much value in the deal and upped the ante with a rival bid. ETP made another raised bid offer, which was again immediately trumped by Williams, and since then the deal terms have run out the clock at Southern Union, making Williams the only available merger, if it happens.

With this loss of fresh growth, ETP shares have slowly but inexorably drooped, now trading 10% lower from the start of the year.

Executives at ETP are very vocal about their continued desire to find a new deal for fresh assets, but until they do, their continued steady distribution means continued erosion in their balance sheet position.

As an aside, this is why premiums are often paid for MLPs that are "sisters" of established integrated energy companies: Continued dropdown assets and long-term growth are practically guaranteed for these MLPs. Chesapeake Midstream (CHKM) and SandRidge Mississippian Trust (SDT) come immediately to mind.

But back to ETP: The sweetener on this MLP right now is its share drop since the beginning of the year, which has hyped the distribution to just over a very tasty 8%, making this one look almost too good to be true.

It may be. I own this one, believing that ETP's leadership understands and is looking to meet its challenges, and also believing (maybe wrongly) that I'll have time to bail on this one before all the seams come out of this baseball, certainly years away.

Either way, it is only one of the MLPs I own as part of my portfolio, and therefore it accounts for only a small part of the risks.

And that's a very quick analysis of just one of these -- but a worthy one. The point is that this is the kind of look you need to do before selecting any of a half-dozen worthy MLPs. There is no free lunch when scouring for yield, but I believe that MLPs can be invested in relatively safely and are a necessary part of everyone's energy portfolio. 



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