U.S. inflation still runs hot. You need an investment class that can simultaneously enhance income and hedge against inflation.

Energy infrastructure in the form of midstream master limited partnerships (MLPs) can deliver this investment flexibility, offering investors exposure to rising energy prices and tax benefits. What’s more, most MLPs’ contracts are protected against inflation.

And you certainly need that protection. On Wednesday, the U.S. Bureau of Labor Statistics released the producer price index (PPI) for September. Here’s a handy snapshot, for month-over-month and year-over-year (“core” strips out food and energy):

MoM: Actual 0.4% (Forecast 0.2%, Previous -0.1%)

YoY: Actual 8.5% (Forecast 8.4%, Previous 8.7%)

Core MoM: Actual 0.3% (Forecast 0.3%, Previous 0.4%)

Core YoY: Actual 7.2% (Forecast 7.3%, Previous 7.3%)

Because the PPI measures wholesale price changes before they reach consumers, many analysts view the PPI as an earlier predictor of inflation than the more popularly followed consumer price index (CPI).

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.

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 that act as 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.

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The best performing sector so far this year has been energy. The decision by OPEC+ last week to dramatically slash crude oil production should keep energy prices elevated, despite the global economic slowdown.

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, historically over the long haul there has been only a slight correlation between MLP price performance and U.S. 10-year Treasury yields.

Two Great MLP Buys Now

In terms of MLPs, I’m particularly keen right now on Enterprise Products Partners (NYSE: EPD) and Magellan Midstream (NYSE: MMP).

Enterprise Products has grown significantly since its initial public offering (IPO) in July 1998, to reach a market cap of $54 billion as of this writing.

EPD is one of North America’s largest midstream MLPs, with about 50,000 miles of natural gas, natural gas liquids (NGL), crude oil, refined products, and petrochemical pipelines. This MLP boasts a diversified business mix that includes offshore production platforms and even tank barges.

Roughly 70% 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.

EPD has a very low cost of capital because of its asset base and cash flows. The company can use its stable cash flows and low borrowing costs to add more accretive fee-based assets. EPD’s dividend yield is a robust 7.66%.

Magellan (market cap: $10 billion) offers a balance between its toll-road and commodity business, with profits that 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’s dividend yield is 8.67%.

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John Persinos is the editorial director of Investing Daily.

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