Master Limited Partnerships are enjoying a strong performance year to date and after peaking in mid-May, they are now consolidating near the yearly highs.

At this juncture it is important to look at valuations and also, given the interest rate environment, to see how MLPs have performed in other periods of rising rates.

We continue to see fairly significant range of returns between different subsectors and within each subsector.  This element emphasizes stock picking over passive exposure.  MLPs focused in crude oil and refined products along with General Partners continue to show up at the top of the list while Coal and Upstream are the laggards.  The upstream sector has also suffered from the exogenous event related to accounting questions related to LINN ENERGY. While the company refuted quite comprehensively the attacks brought out by the shorts, the SEC is now trying to clarify these accounting issues once and for all. What is at stake at the moment is the completion of the Berry deal which is highly accretive and will allow Linn to increase distributions.  The deal is a stock for stock merger and therefore Linn’s stock price is a huge variable. The deal is also scrutinized by the SEC as the first of his kind: an MLP buying a C-Corp which allows for large tax savings.  I was on conference call with Swank Capital and they confirmed their due diligence on Linn and do not foresee unpleasant discoveries from the SEC.  However, all this noise hit not only Linn but other names in the upstream sector as well.

Overall, MLPs are not too expensive but they are not a bargain either. The price to trailing twelve month cash-flow is at 11.3x, which is at the plus one standard deviation barrier from the historical average of just below 10x.  Tops in 2007 and 2011 saw the metric above 12. 

The spread of MLP yields over the 10 year US Treasury yield is just below 300 basis points (depending on what MLP index you choose, this number can be slightly different). This level is in a normal range; best forward twelve month total return performance, however, usually follows spreads over 400 basis points.

In regards to MLPs correlations to interest rates; the evidence of the past 10 years is relatively random. In the slightly rising rates environment of 2005-2006, the sector was flat to higher.  In the decreasing rate environment of 2008, the sector was significantly weaker as the credit crisis hit pretty much all financial assets with the exception of US Treasuries.  Slightly rising rates in 2009 did nothing to slow down the violent recovery of MLPs from the lows of 2008.  In the end, rates will have a more negative impact in combination with high valuations.  If MLPs become more expensive, a subsequent rise in rates will have a stronger knock down effect.

Some trends to watch:

-          The compression of the WTI-Brent spread has made rail transportation a lot less economical ; as a result pipes are back

-          Not only LNG is being looked at as an export commodity but refined products and butane as well

-          Ethane rejection remains a problem; weak pricing is pushing estimates for ethane rejection higher.  This is impacting a few names like EEP, LINE.