Shale oil boom sends investors back to risky MLPs for high income in time of low yields

Key Points
  • ExxonMobil and Chevron are projecting huge increases in Permian Basin oil and gas production in the next few years.
  • Pipeline projects are planned to meet that increased oil supply and handle as much as 3 million barrels per day.
  • ETFs and mutual funds that invest in MLPs are benefiting and offer high annual yields in a low-income world, but like the energy industry, they experience boom-and-bust cycles.
A worker walks through an oil production facility owned by Parsley Energy in the Permian Basin near Midland, Texas, August 23, 2018. 
Nick Oxford | Reuters 

The Permian Basin in West Texas is experiencing an oil and gas boom with consequences for the global oil supply-demand balance, but a key underpinning of the story is the pipelines needed to move hydrocarbons to market. There are not enough of them.

ExxonMobil forecasts an increase of as much as 80 percent, to 1 million barrels per day, over the next five years from its Permian finds. Chevron plans to double its Permian production to just under 1 million barrels daily by the end of 2023 and 600,000 barrels by the end of next year.

Permian Basin production already is topping 4 million barrels per day, one-third of total U.S. output. But producers can't afford to push production too far, because pipelines to carry the oil and gas from the field to refineries and export terminals are still in short supply. That is going to change.

Three major pipelines transporting more than 2 million barrels per day from the Permian Basin to the Gulf Coast are slated to open over the next 18 months. They include the 900,000 bpd EPIC pipeline, the 670,000 bpd Cactus II pipeline and the 800,000 bpd Grey Oak pipeline. Pipeline expansion projects also are occurring between the Permian and Cushing, Oklahoma oil hub.

According to S&P Global Market Intelligence, a further 1 million barrels per day are on the drawing board but lacking a timeline.

Permian pipeline expansion plans

Companies Pipeline Capacity (bbl/d) In-service date
Plains All American PipelineSunrise expansion200,000Q4 2018
Plains All American Pipeline, Magellan Midstream Partners, OMERS InfrastructureBridgeTex expansion40,000Q4 2018
Enterprise Products PartnersNGL-to-oil Seminole pipeline conversion200,000Q2 2019
Epic Midstream Holdings, Noble Midstream Partners, Alts Midstream, Rattler MidstreamEpic590,000Second half of 2019
Plains All American Pipeline, Western Gas Equity PartnersCactus II525,000Q3 2019
Phillips 66 Partners, Marathon Petroleum, EnbridgeGray Oak900,000Q4 2019
Energy Transfer, MPLX, Magellan Midstream Partners, Delek US HoldingsPermian to Gulf Coast600,0002021
Plains All American Pipeline, Exxon Mobil, Lotus MidstreamWink to Webstermore than 1 millionFirst half of 2019

Source: S&P Global Market Intelligence, company filings (data as of March 7, 2019)

Investments are increasing in the region to capitalize on the boom.

Exploration and production company Noble Energy announced it will invest roughly $500 million in two Permian Basin-to-Corpus Christi, Texas, projects that are being developed by San Antonio pipeline operator EPIC Midstream Holdings, projects also being funded by private-equity giant Ares Capital Management.

The Permian pipeline story has led to renewed interest in one of the most volatile areas for energy investment: master limited partnerships focused on the pipeline companies. Over the past year, the only energy sector ETFs to see new interest from investors equaling flows of $100 million or more have been MLP-focused funds. The Global X MLP & Energy Infrastructure ETF (MLPX) has taken in more than $360 million in 2019; the Alerian MLP ETF (AMLP) has seen near-$230 million in new investor dollars; and the Tortoise North American Pipeline Fund (TPYP) has seen $184 million in new money. One reason for interest is recent performance: the Tortoise MLP ETF's 13 percent return, among the best runs in the energy sector.

The big MLP ETFs have most of the companies involved in the Permian pipeline expansion plans among their top 10 holdings, including Plains All American Pipeline, Energy Transfer, Enterprise Products Partners and Phillips 66 Partners, as well as other major pipeline players, like Kinder Morgan.

A world of low yields keeps interest up in MLPs

Another reason: Income-oriented investors weary of stingy yields on bonds, money markets and bank saving, especially at a time when the Fed has paused its plans to raise rates more, are looking for investments that offer higher yields, and these oil and gas facilities pay income of 6 percent, 7 percent or 8 percent — and sometimes even more.

But master limited partnerships, the funds that own energy infrastructure, and royalty trusts, which pay income from oil and gas fields, are not to be confused with safer holdings, like U.S. Treasury bonds. The energy industry is volatile, and the siren song of high yields comes with big risks.

Even as the oil majors like ExxonMobil pour money into Permian drilling, there are concerns that production forecasts from many oil and gas companies are overly bullish. Recent experience drilling in the fields with a technique that has been promoted as a big advance have so far been disappointing, and that could disrupt the production growth best-case scenario.

"I'd stay away from MLPs," said Holmes Osborne of Osborne Global Investors in Kansas City, Missouri. He warns that many MLPs are burdened by debt and driven to issue new shares to raise money, diluting the existing shares. RTs can be even riskier.

Alerian MLP, the ETF that tracks the Alerian MLP Infrastructure Index of two dozen MLPs, has a generous yield of roughly 8 percent but has seen wide performance swings that, over time, can lead to longer-term losses that negate any short-term boom periods. Annual returns have averaged negative 4 percent for the past five years, according to Morningstar data. And for every Tortoise MLP, there is a loser: Over the past year, three of the 10 worst energy ETFs were MLP investments, according to XTF.com data.

Alerian has roared back this year, and the prospect of big price gains on top of generous dividends has some investors salivating.

MLP funds

ETF YTD return 1-year return 12-month yield Assets
Tortoise North American Pipeline Fund18%13.50%3.90%$333 million
Alerian MLP ETF (AMLP)13.50%2.90%8.30%$9 billion
Van Eck Vectors High Income Infrastructure MLP ETF (YMLI)10%3.20%7.30%$18 million
Global X MLP & Energy Infrastructure ETF (MLPX)18.00%8%5.30%$780 million

Source: Morningstar (data as of 3/05/2018)

Simon Lack, managing partner at SL Advisors, a Westfield, New Jersey, manager of energy infrastructure investments, such as the $186 million Catalyst MLP & Infrastructure Fund (MLXIX) — which has returned 18 percent this year and 13 percent over the past three-year period, according to Morningstar, which put it No. 1 in its category — thinks a recent MLP downturn is over.

"Four years of distribution cuts are ending, and 2019 should see rising payouts," he said. "This in turn should motivate investors to return to the energy infrastructure sector once again."

Expect more ups and downs

The world's growing energy needs should make energy assets "a constant source of income" for investors who can stomach sharp ups and downs, said Daniel Milan, managing partner of Cornerstone Financial Services in Birmingham, Michigan.

"The ideal investor in both of these types of funds typically are those looking to generate income, most often for retirement," Milan said. "While that is a significant benefit, investors with a very conservative risk profile should stay away from these types of funds, as they are much more volatile than other traditionally safer income-producing investments.

MLPs earn fees by moving oil and gas through pipelines, refineries and storage facilities. As limited partnerships rather than corporations, they are not taxed at the company level if at least 90 percent of their income comes from these types of "qualified sources." That makes them similar to real estate investment trusts.

Even better, MLP earnings are not taxed like ordinary dividends but are subtracted from the investor's cost basis. That increases the capital gains tax paid after shares, or "units," are sold but lets the investor postpone tax until then. (Experts warn the favorable tax treatment is not allowed if the units are held in an IRA or similar account.)

Because MLPs rely on fees, which go up with volumes, earnings are protected to some degree from the gyrations of energy prices. In fact, fee income can rise when price drops spur energy use and volumes increase.

Deck hands on a natural gas drilling rig in eastern New Mexico.
Robert Nickelsberg | Getty Images

Royalty trusts (RTs), which include coal and mining as well as oil and gas, are rights to share income from reserves, making them highly sensitive to prices, the mine or field's productivity and remaining resources, which can be uncertain. RTs are financing vehicles and don't actually own the resources they are connected to. The rights last for a given period and gradually lose value as production winds down.

"If an investor had to choose between MLPs and Royalty Trusts, it might make sense to lean toward MLPs, as they historically are less volatile," Milan said. "Royalty Trusts can have huge swings in value and income streams based on commodity prices and output."

Investors drawn in by fat RT yields can be disappointed, said Janet Briaud, founder and chief investment officer of Briaud Financial Advisors in College Station, Texas.

"When I looked at a fund recently, it stated the yield was more than 11 percent," she said. "However, the five-year return was zero. ... These kinds of investments typically have tremendous volatility, but they can be a good investment if you catch them at the right price." Occasionally, dividends are cut to make debt payments, especially if declining energy prices cut into revenues, she added.

One of the largest RTs is San Juan Basin Royalty Trust (SJT), with rights to gas fields in the San Juan Basin of New Mexico. Yield is about 8 percent, and the trust is up 11 percent this year, but it lost over 35 percent in the past one-year period, according to Morningstar data.

"Because these kinds of investments tend to be much more volatile than what an ordinary investor is comfortable with, the ideal person is a sophisticated investor who understands when to buy it and when to sell it," Briaud said.

Unlike RTs tied to a single production source, MLPs tend to hold multiple assets, making them more diversified and a better bet for ordinary investors, she said.

MLPs and exchange-traded funds that own them are traded like stocks, allowing investors to make trading decisions quickly.

The issue today: How well will prices and yields hold up in coming years? Advisors say MLPs are ideal for investors who can wait out downturns and who expect high demand for oil and gas to continue, ensuring high volumes and fee income from pipelines, refineries and storage facilities.

"We believe that MLPs are a safer and better bet [than RTs] for a diversified portfolio, both due to the oil and natural gas industries' current status and the forward-looking expectations," Milan said, citing likely growth in energy infrastructure.

SL Advisors' Lack said ordinary investors should plan on staying in an MLP for at least three to five years and predicts healthy dividend growth as more oil and gas flows through MLP facilities. "Production continues to surprise to the upside."