Profiting from MLPs as Inflation Rises

Even as Federal Reserve policymakers seemed unsure of the immediate direction of the global economy, debating whether disinflation could be an issue in the short term at their meeting March 18-19, most of them expected inflation would return to 2 percent in the next few years, according to minutes of the gathering released April 9.

But just when within the next two years inflation would start rising has been a point of debate, and the fact that producer prices exceeded economist expectations this week reinforced the idea that policymakers, for all their good intentions, may not time interest rates correctly to contain runaway inflation, as historically has been the case.

And this situation also clearly calls for the need to have investments that can simultaneously enhance earnings and protect against inflation, which can appear more suddenly than policymakers have forecasted. Energy infrastructure or midstream Master Limited Partnerships (MLPs) can deliver this investment flexibility, offering investors exposure to the shale boom or commodity price rises, tax benefits, and most MLPs’ contracts are protected against the producer price increases we saw this month.

The prices businesses receive for their goods and services rose in March, defying a long stretch of subdued inflation across the U.S. economy, according to the Wall Street Journal. The producer price index for final demand, which measures changes in prices for everything from food and machinery to warehousing and transportation services, rose a seasonally adjusted 0.5% from February, the Labor Department reported on April 11. The index rose 0.6%, excluding the volatile categories of food and energy.

Economists surveyed by the Wall Street Journal had expected the index to rise a more modest 0.1%, and predicted a 0.2% increase excluding food and energy. The index fell 0.1% in February, unchanged from the Labor Department’s i! nitial estimate. The PPI for final demand was up 1.4% in March from a year earlier, the biggest year-over-year increase since last August.

The PPI measures the prices businesses receive from buyers such as governments, consumers and other businesses. The Labor Department overhauled the report this year to measure a much broader swath of the U.S. economy.

The Case for MLPs as an Inflation Hedge

Focusing on the energy infrastructure segment of the MLP market can provide a high level of cash flow stability while preserving inflation-hedging and diversification benefits. There is an explicit hedge against inflation in certain MLP contracts—for example, interstate crude oil pipeline companies, are allowed to increase their prices explicitly.

The Federal Energy Regulatory Commission (FERC) regulates pipelines and has established tariff rates that are adjusted on an annual basis to the PPI for finished goods plus 2.65%. MLPs also own real assets that provide value over replacement costs that generally increase during inflationary periods. Additionally, some MLPs considered to be "midstream" also have diversified business lines with commodity exposure through upstream operations and experience increased revenues during periods of inflation due to higher commodity prices.

As Morgan Stanley explains in a report, looking at the fixed income side, many MLPs have a "toll-road" business model, resulting in cash flow stability. These MLPs receive a fee, or "toll," for handling a customer's product on their infrastructure system.

The MLP does not own the commodity, virtually eliminating commodity price exposure and smoothing out its cash flows. For example, natural gas pipelines receive stable income (essentially rental fees) from pipeline capacity reservations, independent of actual throughput, largely via "ship-or-pay" contracts.

Other product pipeline revenues typically depend on throughput, as noted above, but are protected by inflation escalators t! hat act a! s a hedge. Finally other midstream assets have similar fee-based contracts that vary in risk depending on their position in the energy value chain. That’s why a potential MLP investor that wants to hedge against inflation will have to find the right combination of exposure to the commodity and its “toll-road” earnings.

And MLP price performance is not as sensitive to interest rate movements and/or inflation as commonly perceived. While sudden spikes in interest rates have caused declines in MLP price performance, there has only been a 0.29 correlation between MLP price performance and ten year treasury over the last 5 years, according to an analysis by Wells Fargo.

In our sister publication, MLP Profits, two Best Buy MLP recommendations are Enterprise Products (NYSE: EPD) and Magellan Midstream (NYSE: MMP). Offering a balance between its toll-road and commodity business, Magellan's profits are driven by two factors: (1) throughput volume, and (2) the tariffs it can charge on that volume. With regard to throughput volume, Magellan's enormous pipeline and storage network provides it with a great deal of flexibility, ensuring that it can keep its throughput volume moving along when particular refineries are down for maintenance. MMP is a Buy up to 77.

Enterprise Products has grown significantly since its IPO in July 1998, increasing its asset base from $715 million to over $38 billion as of March 2013.  It is the largest publicly traded master limited partnership (MLP) in the US, boasts a diversified business mix that includes natural gas pipelines, offshore production platforms, oil pipelines and even tank barges.

Roughly 70 percent of the firm's revenue comes from pipelines and other assets that generate fees regardless of whether they operate at full capacity. These fee-based businesses limit sensitivity to commodity prices and broader economic conditions and prevent massive earnings volatility. The company has a very low cost of capital because of i! ts asset ! base and cash flows and can use its stable cash flows and low borrowing costs to add more accretive fee-based assets. EPD is a Buy up to 75.