Mid-Stream Oil and Gas MLPs; One of the Best Investment Opportunities Available Since 2013

Since the overall stock market skyrocketed 32 percent higher in 2013, genuinely ‘cheap' assets have been very hard to find. Almost every asset class with the exception of commodities has gone up significantly over the past 3 ½ years. This increase in prices has been great for all those already invested but has caused a scarcity of truly cheap assets for those still looking to put money to work. Almost all asset classes (bonds, stocks, real estate, etc.) look expensive using traditional valuation metrics and thusly offer below average future returns with higher risk. Over the past 1 ½ years, however, the commodity and oil price plunge has caused some assets to once again cross over into ‘true bargain' territory. What exactly does a ‘true bargain' mean? Currently if we find an investment with a relatively conservative balance sheet, a consistent free cash flow stream, and a valuation that provides a 10% or greater future annual return, we have found a ‘bargain'. There is one group of companies that appear to meet all the above criteria. In aggregate the ‘mid-stream' oil and gas MLPs (master limited partnerships) appear to be worthy of a ‘bargain' investment. To start, what are ‘mid-stream' MLPs? Simply put, this is a relatively small group of companies which are in the business of transporting and storing natural gas, oil, and other hydrocarbons. The companies are not involved in the exploration and production of resources, so they are less sensitive to commodity prices. They simply care about the volume of product transported or stored through their pipelines and tanks. Because of their business model, as long as you purchase MLPs with manageable debt, a systemically important infrastructure, and a fee based business model, cash flows tend to be very stable regardless of the commodity price/energy cycle. We will look at two specific periods of extreme stock market and commodity stress over the past 10 years to illustrate the point above. Between 2007 and 2009 while most corporations were reeling and free cash flow all but disappeared, the MLP space experienced stable or slightly higher revenues and earnings! In addition they actually were able to grow their dividends (also called distributions) during the period. This was in stark contrast to the price behavior of MLPs, which along with the rest of the market dropped more than 50% from top to bottom. This huge difference between company fundamentals and stock price created an immense opportunity. If you would have bought the index in 2009, not only did you grab a dividend yield of around 10%, but substantial capital appreciation and dividend growth awaited you in the years ahead. The total return for the MLP index was 300% from Jan 1 2009 through the recent top in mid 2014! Now we seem to be going through another one of these divergences between industry fundamentals and stock prices. From 2014 through today we have seen product volumes, revenues, free cash flow, and dividends growing moderately while the prices of MLPs have cratered. The index (including dividends) from July 2014 through today is down a staggering 45%! It seems the market is providing yet another opportunity to purchase a group of companies that have stable or growing free cash flows and currently yields around 9%! In addition, we think the total return potential could be in the 12-14% per year range. These numbers would be attractive at any time, but with the 10 year Treasury yielding 1.85% and cash returning nothing, this potential is all the more tempting. So what could go wrong? Below is a summary of the major risks in the space over the next year or two: 1- Oil stays at ~ $30 or less per barrel for several years due to a significant global recession. This would most likely be enough to lower transport volumes of oil and gas and thusly impact cash flow and dividends. Currently we do not see oil at that depressed level for an extended period of time, but if the globe slows significantly it is possible. 2- The regulatory landscape changes in regards to fees charged. Many of these companies are regulated under the ‘Federal Energy Regulatory Commission' or ‘FERC'. Historically they have set rates in accordance with a ~ 12-14% return on equity and with yearly adjustments for inflation. Currently the yearly fee reset rate is 1.1% + PPI (broad inflation measure). 3- The biggest threat in our opinion is investor fear that continues to depress MLP stock/bond prices and makes raising additional capital very costly. These companies distribute a very large amount of their free cash flow (typically 70% to 100%) to investors in the form of dividends. Because of this, if they want to grow and invest in capital projects they must raise additional capital by issuing debt or stock. Currently with stock prices depressed and debt costs high, many companies would be forced to cut dividends or future growth projects. In terms of valuations we look at several factors: • Current Yield: The current ~ 9% dividend/distribution yield on the MLP index is high and well above the longer term average of around 7%. • Current Yield vs. 10 Yr. Treasury (Spread): The 10 year Treasury yields about 1.8% and the MLP index is around 9%. This 7.2% ‘spread' is extremely wide and the only other time it reached current levels was during the financial crisis. The average spread is around a 3%. • DFCF Analysis: This is a method used to value MLPs by taking sustainable free cash flow, assuming either no growth or low growth, and discounting these income streams into the future. With this method we are getting projected total returns (dividends plus growth) of around 12% per year for the index. Given all the above, we believe the MLP space to be about 2 standard deviations below normal in terms of valuation. In other words the valuation levels we are seeing now, has historically been available only 5% of the time. This is all the more impressive when compared to bonds, cash, and other risk asset return prospects. Before investing in the space, extensive diligence should be taken in researching what specific MLPs

or MLP funds

TORTX) to purchase. More than most other asset classes, tax complication and realized tax rates are huge factors to navigate. Eric Mancini, CFP is the director of investment research at Traphagen Financial Group, an independent investment advisory firm located in northern New Jersey (www.tfgllc.com). For more information about MLPs please listen to our recent podcast on the subject found here (http://www.tfgllc.com/traphagen-wealth-radio)