Where the Grass Is Greener

Investing Daily Article of the Week

by Robert Rapier, Investing Daily

Last week we held the monthly joint web chat for subscribers of The Energy Strategist and MLP Profits. The chat is conducted by Igor Greenwald, managing editor for TES and chief investment strategist for MLP Profits, and myself.

There was a large spike in interest in the latest chat, and we received a larger than normal number of questions. We place a priority on answering questions about portfolio holdings and recommendations during the chat, but are often asked about other companies in the energy sector. Sometimes we may get questions that require an extended answer, or there may just be so many questions we can’t get to them all. I will address four remaining MLP questions from the chat below. (For answers to some remaining chat questions on energy companies outside the MLP space, see this week’s Energy Letter.)

Q: Would you put KYE in an IRA?

We got several questions about Kayne Anderson Energy Total Return Fund (NYSE: KYE) during the chat. The main advantage of closed-end MLP funds is the diversification they provide, along with the convenience of a 1099 miscellaneous income tax form instead of having to deal with K-1 forms from each individual MLP. This makes a closed-end MLP fund a more attractive option for an IRA.

MLPs have hit a bit of a rough patch lately, and as a result closed-end funds like KYE find themselves trading at a discount to the underlying assets held by the fund. After the close on Dec. 12, the net asset value for KYE was $27.66, but the share price was $25.70 — a discount of 7.1 percent. This represents the largest discount for the fund in more than two years. As recently as October of this year the fund actually traded at a premium to the underlying assets, and that premium had reached double digits two years ago. Thus, the timing looks historically attractive.

The biggest problem with the fund is that while it yields an attractive 7.5 percent annually based on the most recent quarterly distribution, the total expense ratio is presently an astronomical 4.4 percent. This is bound to be a drag on performance over the long run (although it still potentially offers an attractive short-term play). As a result, my preference for a long term investment in and IRA would be to own an exchange-traded note (ETN) based on one of the Alerian indices that I reviewed recently in Navigating the Universe of MLPs. There are several to choose from, including the JPMorgan Alerian MLP Index ETN (NYSE: AMJ), which presently yields 5 percent and has an expense ratio of 0.85 percent.

Q: Any insights/thoughts as to why MLPs have been underperforming the general market this year and especially the recent weakness?

Over the past 10-, 5-, and 3-year periods the MLP sector has outperformed both the Dow and the S&P 500. Over the past year, MLPs still outperformed the Dow, while falling slightly short of the S&P 500’s performance (through Q3).

Select sector returns through Q3 2013. Source: Alerian
Click to enlarge

The fourth quarter hasn’t been as kind to the sector. As of this writing, both the S&P 500 (+ 4.7 percent) and the Dow (+3.7 percent) are up slightly, while Alerian MLP Index has dropped 2.7 percent.

There are several factors behind the recent decline. One is that cold weather affected operations for some MLPs. Weakening prices for West Texas Intermediate (WTI) took a toll on upstream-focused MLPs. Poor Q3 results for the downstream MLPs caused many in that sector to take a dip following earnings announcements.

None of these factors are expected to have a big long-term effect The weather is still cold, but the WTI and refining margins have both rebounded. This should have the fortunes of the sector turning back up soon.

It’s important to keep a long-term perspective, especially when investing in MLPs. Not only have MLPs outperformed the major indices over the past decade, but they have consistently been at or near the top of all performers on a wide spectrum of sectors year after year.

Select sector comparison through Q3 2013. Source: Alerian
Click to enlarge

Thus, a long-term investor shouldn’t worry too much about the short-term performance. The sector has proven to be resilient over time.

Q: Are other upstream MLPs such as BBEP and VNR worthy of consideration?

In our September chat, I was asked about Memorial Production Partners (NASDAQ: MEMP), another upstream MLP like BreitBurn Energy Partners (NASDAQ: BBEP). I addressed this question in the September article Upstream Turbulence Yields Bargains, writing that Breitburn looked attractive as a cheaper alternative to MEMP. Since that time, MEMP is down 0.6 percent and BBEP is up 6.4 percent. So the discount has narrowed somewhat since September.

However, Breitburn has been growing its oil production, WTI prices have bounced up over the past couple of months, and Breitburn has maintained one of the best (if not the best) distribution coverage ratios in the upstream MLP space. Breitburn also has one of the highest yields in the space, so it’s hard to make a case against it unless one believes that we are facing a sharp drop in oil prices (and I don’t think that’s likely).

Vanguard Natural Resources (NASDAQ: VNR) isn’t technically an MLP, but the differences will be transparent to most MLP investors. It is certainly worth considering, and one we have recommended. However, my preference would be to pick this one up at a slight discount from the current unit price of $28.48.

Q: Your thoughts on LRE and QRE?

LRR Energy (NYSE: LRE) was another name I covered in the article Upstream Turbulence Yields Bargains. LRE is an upstream MLP focused on acquiring and developing oil and natural gas properties in the Permian Basin, the Mid-Continent region, and the Gulf Coast region in Texas. Total proved reserves at the end of 2012 were 31.7 million barrels of oil equivalent (BOE), of which 50 percent were liquids. The partnership is ~85 percent hedged through 2017 at average prices of $92.73/barrel for oil, $37.04/bbl for NGLs, and $5.06 per MMBtu for natural gas.

In the September article I wrote that LRE looks undervalued. The unit price rallied by 13 percent in the month following that article, but has since corrected back down to almost the same price as when I wrote that September article. Since the initial article, a $0.49/unit distribution was made to unit holders, the partnership raised the low end of prior full year 2013 production guidance, and of course WTI prices have rallied back from declines in October and November. However, the partnership also missed consensus earnings estimates by a penny, and its distribution coverage ratio fell to 0.96.

While I still think LRE units are undervalued, BreitBurn Energy Partners probably presents a more compelling case at present.

QR Energy (NYSE: QRE) reported a solid third quarter, with earnings before interest, taxation, depreciation and amortization (EBITDA) up 13 percent to $69 million. Production was up 5 percent despite a disruption at some of it operations.

Distributable cash flow for the quarter was up 26 percent to $35 million, or $0.54 per unit, adequately covering its current distribution of $0.4875. (The partnership will convert to monthly distributions in 2014.) Based on Friday’s close, this translates into an annualized yield of 11.8 percent. Given that QRE’s solid performance came despite temporary production issues, it looks like a decent bet in the upstream MLP space for 2014.

Next week I will address the remaining three or four MLP-related questions.