Are MLPs Going Down the Tubes?

A version of this article was published in the August 2015 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.

The first half of 2015 was rough for holders of exchange-traded products devoted to energy-oriented master limited partnerships, which have been battered by lower commodity prices and some tough quarter-over-quarter comparisons. Most recently, investors have been spooked further both by currency concerns and by interest-rate jitters. Rising interest rates, investors fear, could result in a greater cost of capital for MLPs and potentially lower distributions.

And while MLP ETPs long have been viewed as being more insulated than energy funds when it comes to energy-price volatility, the past year has shown that MLP ETPs are certainly not immune to such volatility. Now, with continued uncertainty in energy prices, concerns about growth in emerging markets, still-growing U.S. energy production, and interest-rate increases on the horizon, MLP ETP investors who have enjoyed solid returns over the past few years--including valuable income in an environment where interest rates have hovered near zero--may find themselves at a crossroads. Looking ahead, while some dynamics--interest-rate movements and commodity prices--will always be difficult to forecast over the longer term, MLP ETP investors should be well prepared for the impact from such dynamics on the funds they hold.

This article will provide an overview of several broad themes affecting the MLP space and then explore several strong ETP options for investors interested in MLPs.

U.S. Energy Production Up...And Likely to Stay Up Energy-oriented MLPs own and operate liquid and gas pipelines along with the storage facilities and processing plants that bring product to market. As such, MLPs depend on the volume of oil and gas that travels through their pipelines and plants. And in recent years, MLPs have had much to be thankful for. United States energy output has continued to grow, and, despite a popular belief that lower energy prices will prompt producers to shut down some production, what's actually happening is that energy producers have been curtailing their poorest-performing facilities.

As a result, Morningstar's equity analysts continue to forecast rising U.S. energy production at least through 2020. For oil, unconventional drilling is expected to continue to fuel supply growth, making the U.S. a critical source of incremental supply for global oil markets. In natural gas markets, a reduction in oil-directed drilling might slow U.S. gas production in the near term, but our analysts anticipate long-term growth in production due to the prevalence of low-cost inventory in areas like the Marcellus Shale.

Greater U.S. energy production can be good for some MLPs because it means a greater need for new infrastructure. Because most MLPs collect fees for volumes, greater volumes typically result in greater cash flows for MLPs. And for some fee-based MLPs with low break-even costs--because, for example, they're close to Gulf Coast refineries and their gathering systems are close to wellheads--higher production is a plus. However, not all MLPs benefit equally from greater energy production. To cite a different example, higher energy supply might hurt an MLP with a higher break-even price, because more supply equals lower prices.

Lower Commodity Prices: A Double-Edged Sword While MLPs are less affected by commodity price volatility than, say, exploration and production firms, that's not to say that there's no impact. Roughly one fourth of industry cash flows are commodity-sensitive. So as oil prices decline relative to natural gas prices, gas processing margins contract, weighing heavily on cash flows for MLPs with non-fee-based gas processing businesses.

Over the longer term, however, commodity price volatility shouldn't have an impact on MLPs. Prolonged lower prices for crude oil and natural gas should stimulate demand, which ultimately should be good for MLPs. In addition, while lower energy prices may slow project development and may limit energy MLPs' ability to keep their project backlogs full, the vast majority of MLPs' cash flows are linked to long-term, fee-based contracts, supporting relatively stable cash flows despite market tumult. Because midstream firms create value by building new assets, as long as lower oil prices don't hinder project development, MLPs' growth prospects should not be affected.

The Latest Blow: Rate Jitters For quite some time, the timing of an interest-rate hike has felt like something of a moving target. Certainly, however, the U.S. Federal Reserve Board--at least until the recent deterioration in the Greek debt situation--had been resolute that an interest-rate hike would happen sometime in 2015. And no matter when an interest-rate increase comes, it generally would be bad for MLPs, as higher rates mean a higher cost of capital and potentially lower distributions--which would be a major disappointment to the many investors who hold MLPs and MLP ETPs for income.

In recent weeks, investors have shown increased concerns over an interest-rate hike. That has continued to pressure the MLP space. Investors interested in MLP ETPs should continue to closely monitor investor sentiment regarding interest-rate activity.

Consolidation in the MLP Space

Somewhat overshadowed by recent commodity-price movements and interest-rate jitters have been some recent consolidations in the MLP space that have removed some players from MLP indexes altogether. The consolidations began in November, when, in a $44 billion deal,

Will the Kinder Morgan deal change underlying industry dynamics? Our equity analysts don't think so, given that its affiliates long have had deep existing connections to the Kinder Morgan parent. However, we did expect that the consolidation could spark other similar corporate reorganizations for similar reasons. Indeed, in May, natural gas pipeline firm

Investor Options ETP investors have a wealth of MLP options, with fully 26 exchange-traded funds and exchange-traded notes available. Below is a look at the four largest MLP ETPs, all covered by Morningstar and all of which have at least $530 million in in assets. As a result, each of these ETPs has sufficient trading volumes.

Far and away the largest MLP ETP is

The next-largest MLP ETP,

Another option is another MLP ETN,

Still another MLP ETN worth considering is

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