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By Josh Peters, CFA and Jeremy Glaser | 08-26-2015 02:00 PM

The 3 Best MLPs to Ride Out the Energy Downturn

The overhyped virtues of these firms didn't pan out for investors, but after selling off, a small handful of the stronger ones now look attractive, says Morningstar's Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

The midstream energy sector has been under a lot of pressure recently. I am here with Josh Peters, editor of Morningstar's DividendInvestor newsletter and also our director of equity income strategy, to see if this has opened up any opportunities for dividend investors.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's talk about some of these industry pressures and why the share prices have been falling. What are some of the issues that are facing midstream energy? Weren't these supposed to be "toll booth" businesses and that the price of oil wasn't going to have such a big impact?

Peters: I think the midstream MLPs can be very good businesses, but they have developed a tendency over the last couple of years for the virtues to be oversold to investors. Certainly the promoters of the industry on Wall Street had a vested interest in describing these as toll roads that were going to throw off lots cash flow and pay these big distributions no matter what happens to energy prices. That really was never true, because the simplest way to think about it is that the midstream energy companies--pipelines, storage, gathering and processing, these kinds of activities--their clients effectively are the producers of oil and gas as well as the consumers.

Well, the producers and the consumers at each end of the pipeline are affected by the price of the commodities flowing through it. So how can you expect the literally middle-of-the-stream midstream businesses not to be affected too? Even as the S&P energy sector has been under a tremendous amount of pressure since the end of the summer of 2014 on the lower oil price environment, midstream MLPs, using the Alerian MLP Index, is down by roughly the same amount--depending on the day, it may be down even a little bit more. I think that shocked a lot of people, but it's got something to do with the group just having been oversold and perhaps partnerships getting access to capital that ought not to have happened under a more sane environment for the industry.

Glaser: We've had this pullback. Has that created a wealth of opportunities? Are there a lot of options if you wanted to buy midstream today?

Peters: I think it is not too early to be very selectively greedy. As we've moved into this period I only owned two names in midstream energy. And it was a smaller piece of my portfolio than it had been since inception back in 2005. I'd owned more even until early 2014, and I looked at these businesses and I said, there is just not the margin of safety here for any kind of downturn if they are paying out 100 cents on the dollar of their distributable cash flow, which in a lot of cases is sort of an enhanced interpretation of long-term earnings, to put it mildly.

So I sold my exposure down to where I held only Magellan Midstream and Spectra Energy Partners, which are very strong businesses from an operational and cash-flow standpoint and also providing the requisite levels of financial strength to see to it that they can continue to pay and, in fact, raise their distributions even through a downturn.

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