If the economy begins to heat up this year, we will probably see interest rates creep higher. On the positive side for MLP investors, this should generate plenty of demand for new energy infrastructure, which should provide some opportunities. But there are some potential threats.  

Investors in master limited partnerships (MLPs) tend to keep a close eye on interest rates, and for good reason. Yield-seeking investors are generally looking to minimize their risk to capital, and as interest rates rise other options may present themselves for generating yield at a lower risk. The cost of doing business may also rise for an MLP when interest rates are rising, cutting into the distributable cash flow (DCF). Thus, a low-yielding MLP may find itself especially vulnerable to a decline in price if interest rates rise.

One example I sometimes use to highlight the risk in a rising interest rate environment is the low-yielding MLP Phillips 66 Partners (NYSE: PSXP), which was one of the most highly-anticipated initial public offerings of 2013. PSXP owns some of the midstream logistics assets of its sponsor, the refiner Phillips 66 (NYSE: PSX). The IPO was initially intended to be 15 million shares at an indicated range of $19 to $21. According to the IPO prospectus the minimum yield was to be $0.85 per unit on an annualized basis, which translates into a 4.25 percent annual yield at the initial midrange IPO price. This yield is pretty typical for a midstream MLP.

Demand for PSXP units proved to be very strong, so the deal was upsized to 16.4 million shares and the price increased to $23 a unit. But demand outstripped even the expanded offering, and units opened on July 23, 2013 at nearly $29, and traded as high as $36 in subsequent days before finally settling down in a range of $30 to $31. Then in the fourth quarter PSXP units raced forward, exceeding $38 at one point and presently trading at $37.16.

Thus, an investment made on the first day of trading could have gained 28 percent thus far, but this has pushed the yield down to a very low level. Investors buying in at the current price are getting a minimum annualized yield of only 2.3 percent.

Two things PSXP has going for it are that it has no debt, and is likely to be able to grow future distributions. But there are other midstream MLPs that have little or no debt and are also in position to grow distributions, but with a higher yield than PSXP. Marathon Petroleum’s (NYSE: MPC) midstream affiliate MPLX (NYSE: MPLX) also has essentially no debt, but a slightly higher yield of 2.9 percent.

Once you start to consider MLPs that carry more debt, you can find lots of offerings with yields in the 4-6 percent range. As mentioned, the downside to MLPs with higher debt is that the cost of business will probably increase if interest rates rise, but investors may prove less likely to flee a 6 percent yielding MLP for a 3 percent interest-bearing account that has less downside risk than an MLP.

PSXP at 2.3 percent, on the other hand, won’t stack up as well. The MLPs with the lowest yields will be especially susceptible to threats from rising interest rates. Thus, if you are looking for yield and minimum downside risk, I recommend that investors avoid those whose yield has been depressed due to significant capital appreciation. They are at risk of a significant haircut if interest rates begin to rise.    

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Update

Enterprise Turns to Oiltanking

Sometimes you have to shop all over the place to appreciate something that’s been under your nose all along. Three months after announcing plans to build a second export terminal for propane and butane along the Gulf Coast, Enterprise Products Partners (NYSE: EPD) now says it will instead expand its current terminal on the Oiltanking Partners’ (NYSE: OILT) turf in the Houston Ship Channel to end up with even more export capacity at a “nominally” lower cost.

The expanded capacity is due to come online by the end of 2015, and is backed by long-term purchase contracts as well as a 50-year service agreement between Enterprise and Oiltanking. Enterprise said it continues to negotiate with customers about a separate ethane export terminal.

While the announcement was taken in stride by investors in both of these Conservative portfolio holdings, it underscores the continued buildout of liquefied petroleum capacity export along the Gulf Coast, and gives us confidence in further gains for natural gas liquids. Continue buying EPD below $66 and OILT in the unlikely event of a pullback below $50. 

— Igor Greenwald

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