MLP yields increased in July but equity capital is more expensive

Market Realist

Master limited partnerships rely heavily on external financing to fund growth

Master limited partnerships or MLPs are specially structured entities that must pay out most of the cash they generate to unitholders. So MLPs especially rely on external funding sources (as opposed to internally generated cash) to execute growth projects and acquisitions because they’re prevented from keeping much cash on hand. Because of this dependence, the state of the capital markets (generally referring to the equity and bond or loan markets) is an important factor in determining whether an MLP can find the money to participate in growth-oriented activities.

(Read more: Why MLPs provide excellent risk-reward for investors)

MLP equities traded down slightly during July, a slight negative for the cost of equity capital

The cost of equity capital across most of the MLP spectrum was up for many MLP names over the month of July. When the cost of equity capital increases, it’s negative in the sense that it’s more expensive for MLPs to fund growth and makes less growth projects and acquisitions attractive. The upside of this is that more expensive equity capital inherently comes from higher MLP yields as a result of stock price depreciation, providing a potentially attractive entry point.

Using the Alerian MLP ETF as a proxy for the MLP universe, the current dividend yield (as of July 31) is 5.92%, compared to roughly 5.92% on June 28. This was unchanged, but looking at the universe of individual MLP names, most had experienced slight depreciation (increases in yield) over July.

For Enterprise Products Partners (EPD, $56.5 billion market cap), one of the largest MLPs by market cap, the dividend yield was 4.31% on June 28, compared to 4.39% on July 31. Another large-cap MLP, Kinder Morgan Energy Partners (KMP, $31.4 billion market cap), had a dividend yield of 6.09% on June 28, compared to 6.40% on July 31.

The dividend yields on small- and mid-cap MLPs also generally increased. For example, Targa Resources Partners (NGLS, $5.3 billion market cap) had a dividend yield of 5.53% on June 28 compared to 5.74% on July 31. Genesis Energy (GEL, $4.4 billion market cap) had a dividend yield of 3.84% on June 28, compared to 4.09% on July 31.

MLP yields are also down significantly since the financial crisis

Though recently, MLP yields have increased somewhat, from a longer-term perspective, MLP yields have compressed dramatically since the financial crisis of 2008. So raising funds by issuing equity had become a more and more attractive option over the past few years, as the cost of equity has continued to reduce. During the financial crisis, yields on these MLP stocks spiked up to levels from ~10% (KMP) to over 30% (NGLS) compared to levels of ~4% to 7% now on the same names.

Cheaper equity capital means more growth projects may be attractive

Again, the long-term yield compression on MLP stocks has been a positive for growth because generally speaking, the lower the cost of funds, the more projects a company may find attractive. For example, if a company has identified a project that has returns of 15% and the company’s cost of funds is 10%, it may pursue the project. If the cost of funds increases, for example to 20%, the same project may no longer be viable to the company. Usually, the more attractive projects a company is able to pursue and fund, the greater the likelihood for an increase in a company’s assets and cash flow.

(Read more: An in-depth look at the mechanics of fractionation spreads and how they affect MLPs)

Generally positive outlook

Currently, despite the slight increase in yields over July, equity capital remains relatively cheap for MLPs. This helps fund MLPs’ growth, which is positive for the companies, though the stock price appreciation may make the MLP sector less attractive to investors. The equity financing environment is an important factor for the majority of MLP names such as KMP, EPD, NGLS, and GEL.

(Read more: Oil and gas industry overview: Midstream (Part 2))

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