In The Slow Drip Lower, a Flash Alert issued on June 8, I predicted a summer rally for global stock and commodity markets. It appears that move is now underway.

The panic was palpable in late May and early June, and emotional extremes typically occur near market bottoms. Another short-term positive is that traders have been buying “bad” news, a sign that the selling pressure is running out of steam.

In this issue I update my outlook for the markets and energy stocks, share my latest take on developments related to the oil spill and discuss two of my favorite safe-haven plays for the summer: tanker companies and energy-focused master limited partnerships.

In This Issue

The Stories

All indications suggest that the threats to a summer rally in the stock markets are contained. See The Summer Rally.

A recent legal decision suggests that the ban on deepwater drilling in the Gulf of Mexico may not last as long as many analysts had expected. Nevertheless, uncertainty rules the day. See BP and Macondo.

Fundamentals are firming up for tanking operators, a volatile sector that can offer explosive growth and high yields. Here are my top picks. See Tankers.

Every master limited partnership (MLP) is a combination of two companies, a limited partner (LP) and a general partner (GP). The specifics of this relationship can distinguish the losers from the winners in the MLP space. See The General Partner’s Take.

The Stocks

Seadrill (NYSE: SDRL)–Buy @ 29
Schlumberger (NYSE: SLB)–Buy @ 85
Baker Hughes (NYSE: BHI)–Buy @ 55
Weatherford International (NYSE: WFT)–Buy @ 26
Knightsbridge Tankers (NasdaqGS: VLCCF)–Buy @ 22
Nordic American Tanker Shipping (NYSE: NAT)–Buy @ 32

The Summer Rally

How stocks and commodities react to important news events is a great short- to intermediate-term indicator. Although this publication focuses primarily on long-term returns, that doesn’t mean investors can ignore the short-term trends completely; at the very least, shorter-term swings offer long-term investors an opportunity to buy stocks on dips or sell into rallies.

Whenever an important piece of economic or company-specific news is released, pay close attention to how the market reacts to that news. If the earnings or economic data is weak or below expectations and the market closes on its lows, it’s a strong signal that the bad news wasn’t priced in and the bears remain in control.

Sometimes, however, the opposite happens. The market may dip in response to bad news but then rallies and closes higher, or at least off its intraday lows. That’s a strong sign that the news was already expected, and traders were looking to buy the market on dips.

The latter phenomenon has occurred a few times of late. Last week, for example, the US crude oil inventory report was bearish for oil prices. Analysts had expected inventories to decline, but the Energy Information Administration (EIA) reported that crude stockpiles increased by 1.7 million barrels.

Oil prices dipped in response at 10:30 am ET but rallied and closed higher for the day; traders chose to ignore the news and buy the dip. Much the same can be said for the S&P 500’s benign reaction to weaker-than-expected retail sales and disappointing news from the Federal Reserve Bank of Philadelphia.

In addition, European credit crisis appears to be abating–at least temporarily.

Longtime readers are intimately familiar with the TED spread, one of my favorite indicators of health in the interbank credit markets. The TED spread is calculated by subtracting the yield on three-month US government bonds from the three-month London Interbank Offered Rate (LIBOR), the interest rate that banks charge to lend money to one another. LIBOR spikes when banks grow cautious and the financial system is stressed. Here’s a graph of the TED spread.

Source: Bloomberg

There are two points worth noting about this graph.

First, the TED spread did spike in May amid all the negative headlines about the fiscal challenges facing Greece, Portugal and other European nations. But the TED Spread never approached the elevated levels reached in 2008 and early 2009; despite all the sensationalist headlines about a global credit freeze, actual conditions in the interbank market stopped far short of catastrophic.

Second, the TED spread started to head lower; LIBOR rates have remained held steady since late May, but the yield on US three-month bonds has increased slightly. The latter point is important because US bonds are a traditional safe haven in panicked markets. Rising yields on US Treasuries suggest some of that money is shifting back into stocks, commodities and other risky classes.

It’s also notable that LIBOR didn’t move appreciably higher when attention turned to Spain early in June.

I’m writing this week’s issue as I travel through southern Greece and Italy. The mood in the EU is rather less dour than one might imagine. Despite the headlines about fiscal austerity, I’ve yet to witness rioting or strikes in Athens, and my US Airways flight 758 from Philadelphia to Athens was fully booked with American tourists looking to take advantage of a weakened euro.

We are seeing similar signs of calm in the hard data on credit. I’ve written extensively about credit troubles in Greece and other nations in southern Europe. Alone, Greece’s deficit sovereign debt problems are the issue; Greece’s economy accounts for roughly 0.5 percent of global gross domestic product (GDP). However, investors are concerned that the contagion could spread through Europe and contaminate global credit markets.

Greece’s fiscal austerity hurts the local population but has little or no impact on the EU economy as a whole because Europe’s GDP growth–or lack thereof–is driven by bigger countries such as Germany, France, Italy and the UK.  

The best and simplest indicator of contagion is the spread between the yield on a European country’s bonds and the yield on German bunds of equivalent duration. The market is well aware of Germany’s fiscal prudence, and the nation has always favored a strong currency; if yields on Italian or Spanish government bonds rise relative to bunds, traders are nervous about sovereign credit quality.

And when panicked traders flock to bunds, the price of German bonds goes higher and yields tumble. German bonds, like US Treasuries, are what European institutions buy when they’re afraid to buy anything else.

As you can see, the yield on Greek 10-year government bond yields continues to rise relative to bunds.

Source: Bloomberg

Yields on Greek bond have headed higher because of lingering concerns that the nation will need to restructure its debt–most likely by agreeing to pay back only part of the principal. The country will continue to function over the next two years or so because it will be able to borrow directly from bailout funds established by the EU in April and May.

But check out this graph of yields on Italian and Spanish sovereign credits relative to bunds.

Source: Bloomberg

Italy and Spain are the two largest EU countries that are considered riskier sovereign credits. A major credit crunch for these two countries would be a problem for Europe as a whole.

Investors had feared that Greek credit troubles would spread to the likes of Italy and Spain–yields on both countries’ bonds spiked in May relative to bunds. But spreads have moderated, suggesting that traders are moving away from a bet on Europe-wide contagion.

Note that these spreads are narrowing because the yield on bunds is rising and the yield on Italian and Spanish government debt is falling. Money appears to be shifting from the safety of German bunds to riskier assets; European stock markets have rallied recently, as have bonds issued by eurozone countries with shakier credit profiles.

Investors also were concerned that weakness in EU sovereign credits would spread to the US corporate bond market. During the 2008-09 portion of the most recent recession, even companies with rock-solid credit histories were unable to sell bonds or take on new lines of credit. That credit crunch emanated from US residential mortgages, but there was a legitimate risk that the EU credit crisis would ultimately prompt a similar credit freeze in 2010.

A year ago, US corporations issued a lot of new debt; they’d been locked out of the bond market for much of late 2008 and early 2009.

Bond issuance remained firm throughout late 2009 and in the first four months of 2010. The decline in May, just as the crisis in EU unfolded, was dramatic: Total US corporate issuance contracted to about $35 billion, roughly a third of the monthly average in the first four months of the year.

But data for the current month (through June 18) US corporations have issued nearly $40 billion in bonds–more than they issued in the entire month of May. Albeit hardly a blockbuster month for bond issuance, these numbers are a marked improvement.

Conditions in the US corporate bond market suggest that May was a one-off event. US corporations held off on new bond offerings in May because rates on corporate debt ticked higher and firms were in no hurry to raise capital. With those spreads narrowing once again, corporations are returning to the market. The US corporate bond market continues to function, and the current environment bears little resemblance to late 2008.

None of this means that global stock and credit markets are in the clear; several risks loom large, including the potential for a double-dip recession. Recent improvement in EU credit markets reflects, in part, the fact that traders now assign a lower probability to this scenario.

As I outlined at some length in the past two issues, I don’t anticipate a double-dip recession. Bears call for a double dip in every economic cycle, but such swoons are exceedingly rare: Only one such cycle has occurred in the past 90 years.

The only modern double-dip recession occurred in 1982, prompted by Federal Reserve Chairman Paul Volcker’s efforts to stamp out inflation by hiking interest rates to unprecedented levels in the early stages of an economic recovery. That’s not happening in this cycle. Thanks to safe-haven buying, US rates remain near record lows, and the Fed has signaled it’s in no hurry to reverse course.

Economic data is always noisy. The May jobs report disappointed, but few recoveries progress smoothly. And one of my favorite basic indicators of US economic health–the Conference Board’s US Leading Economic Index (LEI)–expanded a healthy 0.4 percent in May despite the negative news from the EU. Gains in LEI have slowed, but that’s normal one year into an economic recovery.

There’s a risk that economic data will continue to deteriorate, increasing the odds of a double-dip recession, but none of the indicators point in that direction. This is a weak recovery, and US unemployment likely will remain elevated for longer than usual. That being said, the risk of an outright recession appears minimal.

However, I won’t be surprised to see some negative economic data points from time to time in coming months. The still jittery market could seize on any of these releases as an excuse to sell off once again.

And the market tends to be nervous around major US elections. This year is a midterm election year, and the current odds favor a significant change in the make-up of Congress. The Republican Party stands a good chance of retaking the House of Representatives and, at the very least, whittling down the Democrat’s majority in both the House and Senate. Such an outcome would make it more difficult for the Obama administration to pass new legislation.

Regardless of your political stripes, this would be a favorable outcome.  Midterm election years typically feature significant corrections in the S&P 500. For example, in 2006 the S&P 500 corrected roughly 8 percent from its May highs to its summer lows, though it run to new highs after the election. In 2002 the S&P 500 was still mired in a bear market that began with the collapse of the tech bubble in 2000. But in 1998 and 1994, years with key midterm elections, the market corrected significantly during the year but didn’t break into a new downtrend.

And for all the talk about the benefits of bipartisanship, the market tends to prefer divided government. Under a divided government it’s tough to pass major reforms, eliminating a key source of uncertainty–one thing markets truly abhor.

Bottom line: The likelihood of a global double-dip recession remains low, and I regard the pullback in global markets as a correction rather than the beginning of a new bear market. With credit market conditions calming, the summer rally has the scope to continue in the near term, though another correction could occur come election time.

In the previous issue, I highlighted a number of safe-haven sectors that should continue to perform well amid volatile market conditions. That list includes energy-focused master limited partnerships (MLPs), as well as companies focused on onshore gas production and oil-levered firms that have limited exposure to the Gulf of Mexico.

The specific sectors and stocks I outlined in that issue have continued to outperform and remain my top picks. I am also adding another income-oriented group to my list of favorite sectors in this issue: oil tanker firms.

I will also add some hedges as this summer rally progresses to insulate the model Portfolio from any downside in the broader markets this autumn.

BP and Macondo

I’ve written extensively about the oil spill in the Gulf of Mexico, covering the latest news in every issue since late April. I suspect this will continue for some time as the spill–and the government’s response–will remain major drivers for energy stocks.

My general take on Macondo debacle and the resulting winners and losers hasn’t changed.

Two major events have transpired since the last issue: BP (NYSE: BP) agreed to set up a $20 billion fund to handle claims in the Gulf, and a federal judge struck down the Obama administration’s six-month drilling moratorium in water deeper than 500 feet.

By agreeing to the $20 billion fund and to eliminate its dividend, BP bought itself a bit of goodwill, which may calm some of the political vitriol aimed at the company. Broadly speaking, however, this move doesn’t change my outlook for BP–the company will be a political football for years to come. Ultimately, I think BP is likely to survive, though it could require support from the British government or be acquired by another firm.

Nonetheless, I won’t add BP to the model Portfolios anytime soon because of ongoing headline risks and out-of-control volatility.

BP’s partner Anadarko Petroleum Corp (NYSE: APC) is more interesting from a growth perspective. The company has an outstanding position in the deepwater Golden Triangle, particularly in a series of exciting plays offshore West Africa.

According to the operating agreement between Anadarko and BP, the company would be responsible for 25 percent of the clean-up bill because it owns 25 percent of the well. But BP could get stuck with the entire bill if Anadarko can prove that the blowout stemmed from gross negligence on the part of the operator.

Anadarko is a survivor and boasts outstanding assets. The stock was, for a long time, one of the best-performing exploration and production firms in the model Portfolios. That being said, I’m not adding it back to the portfolio; the legal and headline uncertainties are too great.

I suggest that investors stick with the companies I outlined in the last issue whose stocks have sold off despite having little exposure to the Gulf of Mexico. This list includes high-yielding contract driller Seadrill (NYSE: SDRL), June’s Energy Stock of the Month. Buy Seadrill under 29.

Shares of services firms Schlumberger (NYSE: SLB), Baker Hughes (NYSE: BHI) and Weatherford International (NYSE: WFT) have also pulled back and represent attractive buys at current levels.

The lifting of the six-month moratorium on drilling in the Gulf has important implications for investors in energy-related stocks. As I explained in the last issue and in the Flash Alert Politics and the Gulf of Mexico, the main problem with the strict ban on drilling is that companies with assets in the Gulf–rigs, equipment and personnel–would ultimately need to relocate those assets. And once these pieces leave an area, it’s far from a simple matter for them to return; any assets moved abroad would be signed under long-term deals.

Schlumberger would suffer in the short term because it would lose profits from the lucrative deepwater Gulf and face the costs associated with shifting its business elsewhere. And an extended ban could damage the US energy supplies over the long term; the Gulf accounts for about a third of domestic production and is the only region where production has grown meaningfully. That adds up to much higher energy prices.

On June 22, US District Court Judge Martin Feldman halted the moratorium and prohibited the government from enforcing the ban. Feldman ruled that the moratorium was too strict and broad given the findings of the government’s investigation into the spill. The judge also noted that the ban could do irreparable harm to the Gulf Coast economy and employment in the region.

Not surprisingly, the government is digging in its heels and has appealed the decision. The case will move to a higher court, raising questions about whether the ban will be enforced. Interior Secretary Kenneth Salazar also stated that he will issue new rules on deepwater drilling that will reflect the need for a moratorium and affirm the government’s authority to impose such a ban.

Until these legal uncertainties are resolved, companies are unlikely to resume drilling in the Gulf.

Prior to Feldman’s ruling, there was a real risk that the moratorium on deepwater drilling could extend for 18 months or more while the government investigates the spill and formulates new regulations. Most analysts felt that, at a minimum, the Obama administration would extend the ban well beyond the six months originally outlined.

This ruling appears to make a prolonged ban less likely–an incremental positive for all of the producers, services and drilling firms with exposure to the Gulf. The reaction was muted and short-lived because of the ongoing legal uncertainties and broader market conditions, but this decision has the potential to become a major upside catalyst as these issues are resolved.

Tankers

In addition to the sectors I discussed in the last issue, investors should consider adding exposure to the oil tanker industry. This business is notoriously volatile, as tanker rates fluctuate with demand for oil and the availability of ships.

Nonetheless, with global oil demand recovering, I expect the back half of the year to be a solid environment for tanker companies. Moreover, many stocks in the group offer substantial dividend yields–a great source of returns amid volatile and uncertain market conditions.

The important point to note is that tanker companies don’t make money from rising oil prices. Tanker rates have no direct relationship whatsoever to energy prices; rates depend on demand for oil transport. Demand for oil transport can rise for a number of reasons, but the two most important single factors to watch are OPEC oil output and global oil demand.

Let’s start with a brief look at demand. In recent issues I’ve highlighted the improvement in US oil demand over the past six months. As most investors are well aware, US oil demand collapsed during the 2008-09 recession. But weekly data from the EIA indicates that this trend has reversed.

Source: Energy Information Administration

This graph is based on the four-week moving average of US oil demand as reported by the EIA. The data includes consumption of oil and all sorts of oil-related products. By using the four-week moving average, the data filters out some of the week-to-week noise in the series.

As you can see, US oil demand is on the rise, up 6 to 8 percent in recent weeks on a year-over-year basis. Of course, these demand statistics represent an easy comparison because US oil demand was unusually depressed a year ago because of the credit crunch and recession. But on a pure percentage basis, US oil demand growth is growing at the fastest pace in a decade.

Meanwhile, despite all the talk of a slowdown for the Chinese economy, oil demand in the Middle Kingdom remains robust.

Source: Bloomberg

Chinese oil imports have trended steadily higher after a brief dip at the height of the 2008-09 credit crunch and global recession.

Some subscribers ask if Chinese data on oil imports is reliable. Whether or not you believe Chinese data is reliable, these statistics are backed up by data on tanker fixings; a lot of tankers headed from the Persian Gulf to the Far East. According to the most recent data, about 70 percent of all tankers chartered to transport oil from the Middle East are headed to the Far East–a staggeringly large percentage.

And tankers chartered in West Africa or South America traditionally head to the US because the distance is shorter. But tankers booked in these markets increasingly head east, a sign that growth in global oil demand is originating from that region.

Because major oil consumers such as the US and China are also big importers, strengthening global oil demand spells rising rates for tanker shipping services.

The other key factor to watch is OPEC oil production. Much of the oil produced by large, non-OPEC oil producers such as the US and Russia is shipped by pipeline rather than by ship.  In contrast, roughly 90 percent of all oil produced in OPEC is shipped on tankers; an uptick in OPEC oil production means a lot more for tanker demand than rising non-OPEC output.

When OPEC increases its output quotas, tanker companies reap the benefits. OPEC sets output limits for all of its members in an effort to control global oil supply and stabilize profits. Accordingly, OPEC nations hold spare capacity–idled oil wells and fields that can return to production within a month and sustain output for a lengthy period.

Readers often ask why crude oil prices tend to rise when OPEC increases output and fall when these nations cut their quotas. After all, logic would seem to dictate that rising OPEC output would spell higher oil supplies and, therefore, weaker prices.

But oftentimes the oil market focuses on the level of spare capacity rather than actual production. When OPEC boosts quotas, member states are effectively reducing their spare production capacity in an effort to supply more oil to global markets.

Spare capacity is a sort of cushion for global oil demand–it represents an overhang of oil supply than can be used to balance global oil markets as needed. Falling spare capacity, therefore, means less of a cushion and higher prices.

Rising OPEC quotas and output is also bullish for tankers. Producers in the region tend to use the largest class of tanker ship–very large crude carriers (VLCC)–to transport oil to markets in the Far East or to the US. When OPEC’s output is on the rise, demand for tankers increases. 

There’s also a distinction between official OPEC quotas and actual oil production. That is, many OPEC producers cheat by producing and selling more oil. According to the most recent data, OPEC countries are producing slightly less than 27 million barrels of oil per day–around 2 million barrels of oil over the official quota. Average compliance stands at 55 percent, well off compliance levels of 70 to 80 percent that prevailed in the first half of 2009.

Although the organization undoubtedly would prefer that its member states adhere to the quota, noncompliance was somewhat of a given in the current environment. In early 2009 crude oil prices dipped into USD30 range, a level at which many nations simply can’t produce oil profitably. In short, fear made member countries more likely to follow through with the major output reductions OPEC announced when oil prices collapsed in the latter half of 2008 and early 2009.

But crude oil prices stand in the USD70 range and almost reached USD90 earlier this year; it’s tempting for countries to produce a bit more and realize extra profit from export sales.

The bottom line: While OPEC hasn’t raised its official quota, the cartel’s de facto output has increased by roughly 2 million barrels per day–good news for tanker companies.

I expect OPEC to make this de facto hike in output official at some point. Given the increase in global oil demand, such a move could occur toward the end of 2010 or early in 2011. This would be a major upside catalyst for tanker rates and related stocks.

Here’s a look at the Baltic Dirty Index, a good indicator for tracking average spot rates for a wide range of tanker sizes that travel an array of routes.

Source: Bloomberg

As you can see, tanker rates evince a clear seasonal pattern: Rates tend to rise in the winter and slump in summer. But tanker rates were at depressed levels for much of 2009 and have increased counter-seasonally in recent weeks–a sign of underlying strength.

Part of this unseasonal strength stems from Chinese oil consumption and rising OPEC output, but strong demand for VLCC tankers for oil storage has also bolstered rates. Given these supports, tanker rates could enjoy significant upside later in the year.

Two of my favorite tanker plays are Knightsbridge Tankers (NasdaqGS: VLCCF) and Nordic American Tanker Shipping (NYSE: NAT), both of which yield over 8 percent at current prices.

Nordic American owns a fleet of 16 Suezmax class tankers–the largest vessels capable of navigating the Suez Canal. The average size of Nordic’s ships is between 150,000 and 160,000 deadweight tons. In addition to its 16 existing tankers, Nordic has four tanker ships on order: One will be delivered this month, another in autumn 2010 and two more in the latter half of 2011.

Nordic American is known for its concentrated exposure to the spot market where ships are contracted for immediate use. There are advantages and disadvantages to both spot-market contracts and time charters; spot contracts offer more upside in strong tanker markets and more downside when rates are weak.

Time charters provide for more predictable average rates over time but don’t give firms as much upside leverage to improving tanker rates. Currently 14 of Nordic American’s 16 ships are on spot contracts, and the remaining two ships will convert to spot rates this year. Given the bullish outlook for tanker rates, exposure to spot market rates is desirable.

In the case of Nordic American and many other tanker operators, ships contracted at spot rates aren’t managed directly by the owner. Rather, these ships are managed as part of a cooperative with other major tanker operators. This arrangement offers superior economies of scale for many of the costs associated with marketing tankers. Nordic American’s tankers are in cooperatives along with ships owned by other major operators including Teekay Corp (NYSE: TK) and Frontline (NYSE: FRO).

Nordic American has a clear-cut dividend policy: Each quarter the company distributes all of its cash flows as dividends to shareholders, though management can withhold a certain reserve of cash to handle corporate expenses such as maintenance or payments on new-build vessels.

The direct tie between dividends and cash flows means that Nordic American’s payout rises and falls from one quarter to the next based on spot market tanker conditions. For example, in the strong tanker market of 2005, Nordic paid out $5.85 per share in dividends; amid depressed spot conditions in 2009, the operator paid out just $2.35.

On June 1, 2010, Nordic paid a dividend of $0.60–much better than the $0.10 it paid in the fourth quarter of 2009 and the $0.25 it disbursed in March. Assuming that the firm manages to pay out roughly the same amount it paid in 2009 this year, the dividend yield would be around 8.2 percent at current share prices. And if oil demand and tanker rates continue to firm up, it’s not hard to make a case that Nordic could ultimately boost its payout to $3 to $4 per share on an annualized basis.

And the company has no debt and more than $100 million in cash. Nordic does have a credit line it can tap if management sees a compelling opportunity.

I’m adding Nordic American Tanker Shipping to the Wildcatters Portfolio as a buy under 32. Normally, a stock like Nordic American with a yield in excess of 8 percent would be considered more appropriate for the income-oriented Proven Reserves Portfolio. But given the group’s inherent volatility, I’m adding it to my Growth-focused Wildcatters Portfolio.

Knightsbridge is a smaller and more volatile company that’s leveraged to the VLCC tanker market. VLCCs are larger tankers used almost exclusively on long-haul routes; the ships are more leveraged to a hike in OPEC’s output quotas than the Suezmax ships owned by Nordic American.

Knightsbridge owns four VLCC tankers. One ship operates on the spot market and is managed by a cooperative. The other three VLCCs are on time-charter deals: One expires in June 2011, one in May 2012 and the final in August 2012.

In addition to VLCCs, Knightsbridge also owns two smaller dry-bulk carriers, ships designed to transport dry commodities such as coal, grains and metals. These two ships, both built and put into service last year, aren’t due to come off their time charters until 2014.

Because Knightsbridge’s fleet is small, the single spot VLCC provides some leverage to an improvement in spot rates. And as the VLCC patch accounts for much of the strength in the overall tanker market, spot exposure to the segment is attractive. Meanwhile, the time-chartered ships offer a bit of income stability.

On the dry bulk side of the business, Knightsbridge’s new fleet is a benefit. A quarter of the world’s dry bulk ships are over 20 years old, and new ships tend to earn higher rates and cost less to maintain.

Knightsbridge didn’t pay a dividend amid weak market conditions in 2009 but dispensed $0.30 per share in March and $0.40 on June 7. If we simply annualize that $0.40, Knightsbridge yields nearly 9 percent. And I expect the operator to boost its payout toward the end of 2010.

A riskier plan than Nordic American Tankers Shipping, I’m adding Knightsbridge Tankers to the aggressive Gushers Portfolio as a buy under 22.

The General Partner’s Take

Every master limited partnership (MLP) is a combination of two companies, a limited partner (LP) and a general partner (GP). When you purchase an MLP, you’re typically buying a stake in the LP, and as an LP unitholder, you’re entitled to a share of the cash flows generated by the MLP.

The GP is best thought of as part manager and part parent. The GP performs the day-to-day management of the assets and makes major business decisions such as acquisitions or the construction of new pipeline projects.

The best GPs also take steps to foster the growth of the MLP. In some cases this involves asset drop-downs, deals where the ultimate parent of the GP sells assets into the MLP. Typically drop-down transactions are priced so that they’re immediately accretive to cash flows and allow the LP to increase its distributions. GPs can also help with the financing of acquisitions, direct financial support during periods of market weakness or simply by providing management-level expertise.

As you might imagine, the GP doesn’t perform these functions out of the goodness of its heart. The exact relationship between GP and LP is governed by the partnership agreement–the basic document drawn up when the MLP is formed–which also sets out the fees the LP pays to the GP in exchange for its services.

The most typical structure for these fees is what’s known as incentive distribution rights (IDR) paid every quarter by the LP to the owners of the GP. Remember that IDRs are based on the size of the quarterly distribution made to LP unitholders. IDRs are tiered such that the GP gets a larger percentage cut of cash flows when the LP distribution increases; the GP only gets paid when the public unitholders benefit in the form of higher quarterly distributions.

As you might imagine, the GP/LP relationship is among the most important fundamental considerations when investing in an MLP. One of the most common questions we receive from subscribers is to explain exactly how much the GP is charging LP unitholders to manage the business. To answer this question, it’s important to understand how a tier-structured IDR system works.

The best way to explain is with an example. Let’s use Wildcatters Portfolio holding Sunoco Logistics Partners LP (NYSE: SXL), a refined-products pipeline MLP, as an example. The company has a four-tiered structure for calculating IDRs based on the distributions paid to LP holders:

• Tier 1: 98 percent to SXL holders and 2 percent to the GP up to a quarterly distribution of $0.50 per unit;
• Tier 2: 85 percent to SXL holders and 15 percent to the GP up to a quarterly distribution of $0.575;
• Tier 3: 63 percent to SXL holders and 37 percent to the GP up to a quarterly distribution of $1.5825; and
• Tier 4: 50 percent to SXL holders and 50 percent to the GP for all quarterly distributions above $1.5825

In mid-May, Sunoco Logistics paid a quarterly distribution of $1.115 to unitholders. Thus, Sunoco Logistics Partners is in the third tier of the distribution structure outlined above. Once the MLP exceeds a quarterly payout of $1.5825 it will be in the highest tier of IDRs–in industry parlance this is the high splits.

This structure causes significant confusion. Let’s alleviate these concerns.

Most important, just because Sunoco Logistics is in the third tier of its IDR structure does not mean that it’s paying out 37 percent of cash flows to the GP as an IDR fee. Second, the high splits concept is widely misunderstood. You cannot accurately gauge the GP’s fees by looking solely at the maximum high-splits percentage in the IDR tier structure. 

The only way to gauge the true IDR fees is to calculate what the GP received in the most recent quarter. Here’s how the calculation works for Sunoco Logistics:

• Tier 1: The first 50 cents paid to the LP unitholder represents 98 percent of the actual total distribution. That means that the total Tier 1 payout is 51.02 cents (50 divided by 0.98). This consists of 50 cents for ETP holders and a little over 1 cent for Sunoco Logistics GP.
• Tier 2: The next 7.5 cents (57.5 cents minus 50 cents) paid to the LP is 85 percent of the total distribution. That means the total payout is 8.82 cents (7.5 divided by 0.85). That’s 7.5 cents to the LP holders and about 1.32 cents to the GP.
• Tier 3: The next $1.0075 ($1.5825 minus 57.5 cents) paid to the LP is 63 percent of the total distribution. However, in the case of Sunoco Logistics, the distribution of $1.115 is below the maximum for this tier. Therefore, 54 cents ($1.115 minus 57.5 cents) is paid out. That means the total payout is 85.714 cents (54 divided by 0.63)–54 cents to the LP and 31.714 cents to the GP.
• Tier 4: The final tier only comes into play when Sunoco Logistic’s distribution is above $1.5825. So, in this case there is no payout under the high splits.

Summing all of these figures shows that Sunoco Logistics’ unitholders received $1.115 per unit in mid-May and the partnership’s GP received about $0.3405 per unit. Sunoco Logistics paid out a total of $1.4556, and the GP took a fee equal to around 23.4 percent of that total payout ($0.3405 divided by $1.4556). If you look at the maximum high split, it does not provide a meaningful measure of the GP’s take; you must look carefully inside the IDR structure.

The structure of IDRs is the key to determining distribution growth potential and sustainability. In the case of Sunoco Logistics, imagine a situation where the MLP is able to grow its distributable cash flow by $0.50 per unit, and the GP decides to pay out $0.40 as additional distributions and hold back $0.10 as a reserve cushion.

Given the structure of Sunoco Logistics’ IDRs, a $0.40 increase in total distributions does not mean a $0.40 increase in the payout to unitholders. Rather, the MLP could boost its payout to LP holders by about $0.25 from the current $1.115 per unit to $1.365. The remainder of roughly 15 cents would go to the GP as an additional IDR.

In other words, as an MLP moves through its tier structure it becomes more difficult for the partnership to generate growth in LP distributions. A larger percentage of each dollar of distributable cash flow would go to the GP.

Some GPs have taken steps to change their IDR structure to facilitate growth. Proven Reserves bellwether Enterprise Products Partners LP (NYSE: EPD) was among the first to take that step when it cut its top “high splits” rate from 50 percent to 25 percent and then revised the parameters of its tier structure.

On Jan. 26, 2010, Sunoco Logistics Partners also revised its tier structure; the calculations I detailed above are for the new, revised system. Sunoco Logistics increased the thresholds for the IDR tiers but changed the 25-percent IDR tier to a 37-percent tier. Despite that higher threshold, the impact of the changes was a drop in the GP’s take on IDRs. In fact, if Sunoco Logistics had maintained its older IDR structure, the GP would have taken more than 30 percent of the current total distribution rather than 23 percent. 

Other MLPs have taken these reforms to a different level by abolishing IDR tier structure outright. For example, Magellan Midstream Partners LP (NYSE: MMP) recently purchased its GP by issuing additional units. Although the new unit issue was dilutive, it allowed the MLP to eliminate IDRs and boost the cash flow available for distribution. The net impact was positive.

In addition, investors should remember that GPs and managers can be compensated in other ways. In Magellan’s case, the former GP received shares of the LP when it was acquired; the former GP holders will benefit directly from rising LP distributions. In other cases, GP holders get subordinated units in the MLP that convert to actual units when certain distribution targets are achieved.

The structure of IDRs is important for LP unitholders. Generally speaking, the IDR structure provides an attractive incentive that aligns the incentives of the GP and LP.

Without further ado, here’s a table showing the current percent IDR take for every MLP recommended in the TES Portfolios.

Source: Bloomberg

In addition to the GP’s take the table illustrates the total distribution paid to the LP and the total amount paid out to both the LP and GP.

The final column shows the impact of a 10 percent jump in distributions to LP unitholders. For example, as we calculated earlier, the GP gets around 23 percent of the total distribution paid to GP and LP holders each quarter at the current distribution rate of $1.115. If we increase Sunoco Logistics’ distribution to LP holders by 10 percent to $1.2265, the GP’s take increases to just less than 25 percent.

Generally speaking, the higher the figure in the “Percent GP Take” column, the higher the fees paid to the GP, and the tougher it is for the MLP to generate distribution growth. It’s also useful to compare the final two columns.  If there’s a major jump in the GP’s take due to a 10 percent increase in LP distributions, this is a huge incentive for the GP. Under such a scenario, one would expect the GP to be firmly focused on distribution growth, so that it can move through the tiers.

This table also provides a useful framework for evaluating changes to the IDR structure. If a company reshuffles its IDRs, a drop in the GP’s take should be considered an investor-friendly move.

That being said, it’s always dangerous to rely too heavily on any single number–there’s no golden quantitative standard for evaluating an MLP. It’s important to consider both qualitative factors and quantitative factor when evaluating the group.

Here’s a brief list of other factors to consider when reading this table.

The risk level of the underlying MLP: The MLPs that have the lowest IDR takes tend to be relatively newly listed partnerships. When MLPs are first listed, the partnership agreement is typically structured so that the IDR fees to the GP are low, allowing the MLP to generate solid distribution growth and attract investors’ attention.

But sometimes these newly minted MLPs are in businesses that bear commodity price risk–for example, gathering and processing. In that case, a low IDR take may attract investors to an MLP in a shakier sector. Alternatively, an MLP with a relatively large IDR take may be a large well-capitalized partnership in a defensive sub-sector. Such a partnership can still attract investors with a higher GP fee.

Quality of management: A valid analogy is that the IDRs are a way for investors to pay managers. If you want better, proven managers, you have to pay higher salaries and offer te potential for better compensation.

Classic examples are Portfolio recommendations Enterprise Products Partners LP (NYSE: EPD) and Kinder Morgan Energy Partners (NYSE: KMP). The former was run by one of my personal heroes, Dan Duncan, until he passed away earlier this year.

Since then his hand-picked management team has followed in his footsteps. The GP has a 15 percent IDR take, but the partnership’s experienced management team is worth it and then some. The company’s extraordinary asset base, easy access to capital and history of consistent defensive distribution growth warrants that fee.

Kinder has the highest IDR take of any MLP on the list, and one could argue that the company might benefit from a shift in the IDR structure. But the man in charge of the GP and LP is Richard Kinder, one of the most experienced midstream operators in the business.

When funding was tight in late 2008, Kinder stepped up and said that the GP (a private company) could provide funding to help the LP grow if that were needed and credit markets remained closed. That statement shored up the stock, which outperformed in the toughest market in a generation. That sort of support when it counts most warrants a higher pay. 

The nature of the GP: Some GPs are publicly traded companies like Energy Transfer Equity (NYSE: ETE), the GP of Energy Transfer Partners (NYSE: ETP).

Other GPs are private firms controlled by private equity interests. And some are controlled by publicly traded energy companies like ConocoPhillips (NYSE: COP), Williams (NYSE: WMB) or Chesapeake Energy Corp (NYSE: CHK).

Refining giant Sunoco (NYSE: SUN) controls the GP of Sunoco Logistics (NYSE: SXL). This has helped SXL’s growth because the parent has assets it can drop down into the MLP to facilitate growth. This warrants a higher IDR than a private-equity GP that might try to sell out of the deal for a quick profit when market conditions warrant.

And remember that the IDR structure offers a useful incentive. LP unitholders want high yields and growing distributions–those are the two major factors that drive MLP performance.

Under an IDR structure, GPs want exactly the same thing as LP holders; they get paid more when LP holders receive higher distributions. And since their percentage take of each incremental dollar rises with the distribution, this heavily incentivizes the GP to boost the distribution.

Generally, the IDR structure aligns the interests of the GP and LP but, investors need to examine this relationship closely. The GP might try to grow the distribution too quickly in an effort to run up higher fees. This is why we always evaluate the underlying business with an eye toward the sustainable cash flows and distribution payments

Don’t be blinded by huge yields or massive distribution growth; chasing unsustainable yields puts you on the fast track to trouble.