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Are MLPs Too Good to Be True? PM Darren Schuringa Crunches the Numbers

Source: George S. Mack of The Energy Report  (9/11/12)

Darren Schuringa Master limited partnerships (MLPs) have outperformed the markets for 11 of the past 12 years. With more investors catching on to these low-risk, high-income vehicles, can the outstanding returns continue? Manager Darren Schuringa of Yorkville Capital Management says yes. But as Schuringa explains in this exclusive interview with The Energy Report, MLPs are a different animal, and investors in this space will need some specialized metrics in their toolkits. Read on for due diligence tips and some names that pass muster.

The Energy Report: Darren, many investors have considered real estate investment trusts (REITs) as high-yielding alternative investments. Are energy MLPs a natural place for investors in that space to migrate?

Darren Schuringa: Absolutely, for the following reasons: First of all, MLPs pay out greater income than REITs. As of the end of August, MLPs across the universe were yielding 6.3%, versus 3.3% for REITs. That difference amounts to approximately 300 basis points of additional income, nearly 100% more than REITs. Secondly, MLP performance is more consistent, as a study we did demonstrated. Consistency is very important for investors, especially for those who are looking for alternatives to fixed-income instruments.

TER: Since the year 2000, MLPs have beaten the S&P 500 in 11 of 12 years, and they have done this by a remarkable average margin of 19.5%. But is this just too good to go on?

DS: An institutional investor actually said something similar to me recently. He said, "Wouldn't that level of outperformance generally point to an asset class that has had its run?" His was essentially a question of valuation. What we need to address is the valuation of MLPs and how are they priced on an absolute basis. One of the primary valuation absolute basis metrics that we look at is the spread relative to the 10-year Treasury, which is currently 460 basis points. That spread did get as low as 0.5% or 50 basis points in 2007. Looking back at that 12-year period you've just described, the average spread over Treasuries has been 327 basis points or 3.27%, and so MLPs are currently trading a bit above their historical average spread. When the spread's been near 500 basis points or 5%, MLPs have had tremendous outperformance relative to the market and tremendous absolute performance in the following 12 months, according to a study done by Credit Suisse. So, based on spreads, MLPs do not look expensive.

Also, if you look at total return of MLPs, 50% of it comes from your current income, which is about 6.3% right now. The other half of your total return is the result of distribution growth. Through the first half of the year, we've been seeing distribution growth rates of about 6.5% for MLPs. So, if you add a 6.3% current yield to a 6.5% distribution growth rate, you're really looking at a 13% total return picture in the current environment.

Therefore, in regard to whether MLPs are overvalued right now, I'd say no. I'm not sure what the S&P 500 is going to do, but given their fundamentals, MLPs have the ability to continue to grow their distributions in the mid-single-digit numbers.

TER: Could MLP outperformance be a low interest rate phenomenon?

DS: It's not even that, and that's a really interesting point because if you look at it the last time the Fed was in a tightening cycle, 2004 through 2006, MLPs returned 40%. So, it's almost too good to be true because if you're looking at them in any environment, in a tightening environment, in a recessionary environment, in the bull markets we've experienced over the past 12 years, the MLPs have consistently outperformed the broader market.

TER: What do you look for in an individual MLP?

DS: It comes down to high-quality yield. If you invest in an MLP that cuts its distribution by even a modest amount, you will witness a huge decline in the stock price of the partnership. That's a tremendous loss of capital. We need to know that the distributions that an MLP is paying are safe; that's our top priority. Secondly, we're looking for partnerships that have catalysts. We're looking for distribution growth. Remember, the total return picture of MLPs is that you get half from your current income and the other half of your return from capital appreciation. We want to make sure that we have good current income, a high yield and growth to enrich the value of our portfolios.

TER: What specific situations do you avoid?

DS: We try to avoid any MLP that has even the slightest probability of cutting its distribution. That is front and center. No need to make it any more complicated than that.

TER: If an investor is chasing high yields in MLPs, does that necessarily mean that he's assuming higher risk, as an investor does in high-yield bonds?

DS: Not necessarily. A bond is expected to pay fixed distributions. An MLP, however, is an operating business, and you're picking up both high current income and growth in distributions over time. This is a very different animal.

I'm going to surprise you because you're on to something here. Our team has been investing in the MLP asset class now since the early nineties, and I tell investors right from the get-go that one of the things that always surprised me is that MLPs have more volatility than you would expect from an income-producing instrument. Generally speaking, high distributions reduce the volatility of the asset. But MLPs really have a risk profile that's in line with equities, and where you really saw that was in 2008, the one year out of 12 that MLPs underperformed the market. MLPs underperformed by 2.6% that year, which saw the meltdown of the equity markets. MLPs declined pretty much in line with the S&P 500 at that point, but the big difference is that most partnerships didn't cut distributions. In fact, many increased distributions over that period of time. So, when you had the market dropping by 40%, MLP yields went from mid-single digits to mid-teen levels across the asset class because they maintained their distributions.

So, when investors started to realize this and saw this type of income and consistency of income that the MLPs were producing in the heart of a crisis, you saw MLPs bounce back to their high-water mark within 12 months. We've only seen the S&P 500 recently flirt with its previous highs, and we're four years post-crisis. So, again, you do have volatility in the asset class similar to equities, but you don't have volatility with distributions, even in turbulent markets, as we experienced in 2008. Warren Buffett said that's the worst market he's ever seen in his entire investing career.

TER: Let's talk about some individual MLPs.

DS: I will. I'm going to start with Linn Energy LLC (LINE:NASDAQ), a commodity MLP. It's in the exploration and production (E&P) segment under the Yorkville Capital classification. I like Linn because it has hedged 100% of its future oil production through 2017. This means investors have visibility into its future cash flow on its oil properties for the next five years, and the average price is in the high nineties per barrel. So, we can now look with a high degree of confidence into what Linn's future distribution growth will be. Linn has also completely hedged its natural gas production through 2015 in the low $4 per thousand cubic feet range, and it is going to be rolling out hedges for the next two years. This is helpful to investors, who need to take a very macro view when they're looking at portfolio allocation in order to preserve the purchasing power of assets.

TER: Tell me a little about your ETF. By the way, that's a tremendous yield considering that the fund is trading at either NAV or at a slight premium.

DS: Absolutely. Yorkville High-Income MLP ETF (YMLP:NYSE) has no leverage, and pays dividends that are going to be close to a 100% return of capital. From an after-tax perspective, it's an even more efficient way of producing current income in your portfolio than even owning an underlying partnership directly. A partnership is 80% tax-deferred, and when you sell the partnership there's a recapture at the end of that income. I'm not going to get too deeply into the tax advantage/liability of MLPs, but because the majority of Yorkville High-Income MLP ETF's income, if not all, will be return of capital, that lowers your tax basis. So, if you're getting 8.5% in a year, that is a 100% return of capital, and your after-tax yield is actually greater than 8.5% with no recapture upon sale. You would just pay the capital-gains rate when you decided to sell the fund. Additionally, investors in Yorkville High-Income MLP ETF don't need to deal with the complexities of a K-1 tax form. Instead, the fund pays 1099 income, making it much easier come tax time.

From a holdings standpoint, Yorkville High-Income MLP ETF invests in a diversified portfolio of MLPs from various sectors including exploration and production, marine transportation, fertilizers and more. The fund utilizes a proprietary ranking methodology in order to select what we consider to be the best partnerships to invest in from a distribution standpoint, both in terms of current levels and future growth.

Given the fundamentals of MLPs and the boom that we're experiencing here in the U.S. right now with the unconventional shale plays, the forecasts are that we're going to need another $250 billion (B) of infrastructure to connect these unconventional shale plays. This infrastructure has to hook these new energy-producing areas into the energy backbone of the United States. That will double the size of the MLP asset class, which will result in future growth of distributions.

TER: What other MLPs are looking strong?

DS: Investors should look at Atlas Energy L.P. (ATLS:NYSE). What you find here is an example of an MLP that falls on the infrastructure side. It has reinstated its distribution. It is experiencing multiples of distribution growth, and the company is performing very well for us. It's a little bit different in the fact that it's not as high yielding as some, but in this case we gave up yield for distribution growth, because it is the general partner for two other MLPs, Atlas Pipeline Partners L.P. (APL:NYSE) and Atlas Resource Partners (ARP:NYSE).

TER: I see that Atlas Energy L.P. has been a stellar performer. It's up 63% over the past 12 months, which is triple and even quadruple some of the runners up. The yield is 2.93% currently, but you certainly got great capital appreciation. Is there another one you could talk about?

DS: Yes, I've got another one— Terra Nitrogen Co. L.P. (TNH:NYSE). The fertilizer plays were really hurt at the beginning of this year when the U.S. Department of Agriculture forecast bumper yields per acre for 2012. Unfortunately, yields are down significantly this summer with the drought. And, in fact, some farmers that we've spoken to have actually already plowed their fields under, and they did this back in July. They threw in the towel, and corn prices have taken off.

Now, farmers are going to have to be planting more acreage because of lack of a harvest this year. That bodes very well for fertilizer stocks. Fertilizer plays are a way to use the MLP asset class in a non-traditional way to gain long-term commodity exposure. Water, food and energy are all global themes you can play. Terra Nitrogen highlights the diversity of the MLP universe.

TER: Darren, can you address Energy Transfer Equity L.P. (ETE:NYSE) and Energy Transfer Partners L.P. (ETP:NYSE)?

DS: Energy Transfer Partners is the general partner. Energy Transfer Equity is the limited partner, and it's also the general partner of Regency Energy Partners L.P. (RGNC:NASDAQ). The general partner is responsible for the management of the business, and then the limited partner owns the underlying assets of the business. Because of two major acquisitions, Energy Transfer Equity's purchase of Southern Union Co. and Energy Transfer Partners' buyout of Sunoco Inc. (SUN:NYSE) (expected to be finalized before year-end), we anticipate that Energy Transfer Partners will begin to increase its distribution in the near future. This will redound to the benefit of Energy Transfer Equity, which serves as a leveraged way to play both Energy Transfer Partners and Regency via its general partner interests.

TER: Darren, thank you very much.

DS: Absolutely, thank you for having me.

Darren Schuringa was previously a partner and senior portfolio manager with Estabrook Capital Management, where he managed over $1B of fund, institutional and individual assets. At Estabrook, Schuringa oversaw separately managed accounts. In addition, he served as co-manager of the Bank of NY Hamilton Large-Cap Value Fund, a Morningstar five-star rated fund, and co-manager of an institutional collective trust from the date of each fund's inception. Schuringa received a Bachelor of Arts in finance from the University of Western Ontario in Ontario, Canada, and a Master of Business Administration in finance from the Crummer School at Rollins College in Winter Park, FL. He is also a Chartered Financial Analyst (CFA).

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DISCLOSURE:
1) George S. Mack of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Energy Transfer Equity L.P. and Energy Transfer Partners L.P. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Darren Schuringa: I personally and/or my family own shares in the following companies mentioned in this interview: Yorkville High-Income MLP ETF and Atlas Energy L.P. I personally, and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.

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