The world of master limited partnerships (MLPs) has brought great reward to investors in recent years. 24/7 Wall St. wants to know if the enthusiasm can stay in this sector this summer now that so many new secondary offerings have come in the recent weeks and months. The payouts are great, but there are many things to consider under a risk-reward analysis here, even after most MLPs really have come off of their highs.

At a time when Treasury yields have been nonexistent, MLP investors have been able to get high payouts that are viewed as quasi-dividends, due to some payouts representing income and some representing return of capital. The question to ask now is whether the risk-reward is there for new investors at the current prices. The unit prices of many key MLPs have been hit hard along with stocks in the past few weeks, and we wanted to take a risk-reward look for summer 2012. This sector could get a recovery, or it could face additional pressure like we saw in 2011.

If investors have been involved in the MLP sector since before, during or right after the great panic selling of 2008 and 2009, they are up huge if they held on. In many cases they have doubled their money or more. And as far as they are concerned they have been getting 5% to 8% in payouts each year (again, some income and some return of capital). The problem is that the prices here have become choppy and the MLP structures often have had secondary offerings on top of secondary offerings. Those secondary offerings have provided growth and acquisition capital, but some investors have started to worry that these secondary offerings may be the biggest contribution to the never-ending payout increases that have been seen in this sector.

MLPs in the energy space often attract the same sort of investors who would buy utility shares and preferred shares of banks, but they also overlap with REIT investors who look for above-market yields. This sector has enjoyed large price gains in the unit (share) prices, and investors are looking for any safe investments that have high payouts, compared to the world of no-returns in CDs and Treasuries. A wave of secondary offerings from many MLPs came before and during the recent market sell-off.

24/7 Wall St. has evaluated some of the top MLP investments to see how much implied upside remains in this sector. We have taken price performance as far as the sell-off from recent highs, as well as issues like the payout ratios (implied yield-equivalent) and the consensus price targets from Thomson Reuters. We have evaluated the following MLPs: Enterprise Products Partners LP (NYSE: EPD), Kinder Morgan Energy Partners LP (NYSE: KMP), Plains All American Pipeline LP (NYSE: PAA), ONEOK Partners LP (NYSE: OKS), Energy Transfer Partners LP (NYSE: ETP) and Enbridge Energy Partners LP (NYSE: EEP). These MLPs mentioned and covered here are some of the ones we track and keep on our watch list in the sector. These have market caps above $8 billion, they have a history of increased payouts each quarter, for the most part, and generally speaking these MLPs are all believed to have good management teams.

Investors have made a bundle here in this sector. MLPs are not really all that correlated to the price of oil because these are the partnerships (general and limited) for pipelines, terminals, and other facilities involved in the oil and gas sector in America. MLPs must derive 90% of their income from real estate, natural resources and commodities. The issuing of K-1 statements can make the structure more complicated, but the payouts often make that worth it for many investors seeking higher streams of cash flow.

We also have evaluated some of the key ETFs and closed-end funds in this sector. Be advise that just the three vehicles we have tracked in funds and ETFs have a combined market value of more than $11 billion.

Enterprise Products Partners LP (NYSE: EPD) traded around $49.85, and it has a 52-week range of $36.36 to $52.95 and market value of $44.1 billion. Thomson Reuters has a consensus target price of $56.39. That implies upside of about 13%, along with a payout yield-equivalent of just over 5%.

Kinder Morgan Energy Partners LP (NYSE: KMP) traded around $80.50, and it has a 52-week range of $63.42 to $90.60 and a market value of $27.3 billion. Thomson Reuters has a consensus target price of $86.00, which implies upside of just under 7%, along with a payout yield-equivalent of just over 5.95%.

Plains All American Pipeline LP (NYSE: PAA) traded around $79.35, and its 52-week range is $54.90 to $84.48 and its market value is $12.8 billion. Thomson Reuters has a consensus target price of $87.03. That implies upside of about 9.7%, along with a payout yield-equivalent of bit more than 5.25%.

ONEOK Partners LP (NYSE: OKS) traded around $56.00. It has a 52-week range of $43.05 to $61.58 and a market value of $12.3 billion. Thomson Reuters has a consensus target price of $61.42, which implies upside of about 9.6%, along with a payout yield-equivalent of just over 4.5%.

Energy Transfer Partners LP (NYSE: ETP) has a higher payout than its sister Energy Transfer. It recently traded around $45.90, and the 52-week range is$38.08 to $51.00 and its market value is $10.5 billion. The Thomson Reuters consensus target price is $50.00. That implies upside of about 8.7%, but this one has a payout yield-equivalent of just almost 7.8%, based on its last payout.

Enbridge Energy Partners LP (NYSE: EEP) traded around $30.35, and it has a 52-week range of $24.66 to $33.85 and a market value of $8.65 billion. Thomson Reuters has a consensus target price of $33.92. That implies upside of about 11.7%, but this one has a payout yield-equivalent of about 7%, based on its last payout.

If these were normal stocks we would be too scared to expect upside. Analysts do not generally cover MLPs anticipating massive upside in price. The MLP sector has been built around the promise and hope of high payouts. The capital gains that have been seen so far may have only been a secondary benefit that outpaced the primary objectives. The same can happen in the REIT and other high payout sectors. You rarely see analysts targeting massive upside in REITs and utilities. So this prevents us from panicking from a lack of analyst enthusiasm.

So, there is a problem with the world of MLPs from a simple risk-reward analysis. If you watched MLPs fall last summer, you know that these can fall out of bed and go out of favor very easily. Investors will lock in gains. Another concern from investors is that there is an unknown about just how the tax treatment will be after 2012 as dividend taxes are set to go higher and politicos keep attacking “tax breaks for oil companies” in public speeches. That being said, at a minimum there is the fear of political risk in the sector.

There are two key exchange traded funds that investors flock to here. JPMorgan Alerian MLP Index ETN (AMEX: AMJ) has a market value of $4 billion and, at $38.01, its 52-week range is $31.52 to $41.68. ALPS Alerian MLP ETF (AMEX: AMLP) has a market value of $3.1 billion and, at $15.98, it has a 52-week range of $13.10 to $17.19. Kayne Anderson MLP Investment Company (NYSE: KYN) is a closed-end mutual fund and it has some leverage to it with investments of more than $4 billion at the end of April.

There are many other ETFs and closed-end funds out there, but these two ETFs have a $7 billion-plus market value combined, and there is another $4 billion in investments from this one MLP closed-end fund. Yahoo! Finance has some large overlaps in share classes but it has some 53 “mutual funds” from fund families like Kayne Anderson, Tortoise, Salient, ProFunds, SteelPath, Cushing and others. We have been concerned about the raw size of this sector, as far as how much more size can be absorbed by the public. Will all of those secondary offerings of late signal a peak for the time being? What if investors decide to exit the funds and exchange-traded products that back MLPs?

What is keeping investors interested here are the high distributions. The payout level risk also could be hard to maintain ultimately, if these entities keep issuing new units (shares) as we have seen and as we have discussed here. Capital raised from new shares allows for a larger capital base to make distributions from, but it also keeps raising the bar, making it harder and harder to keep increasing those distributions each and every quarter as so many of these MLPs have done. What happens if or when those distributions cannot be raised any further? Or worse, when the distributions have to be cut?

Another risk is Treasury yields only having one way to go. The high payouts are a huge incentive for wealthy investors to sit there and keep receiving payments. Treasuries pay nothing now. But what happens the day that the 10-year Treasury note yield rises 100 basis points? Or what about a 200 basis point rise?

Perhaps the greatest risks today pertain to a risk-on versus safety mentality. MLPs should physically have no European exposure to speak of, except that anything tied to the energy markets comes with geopolitical risks and comes with the problem that investors can just choose to walk away.

Investors used to worry about the MLP sector being closely tied to the total returns of the 10-Year Treasury as far as correlation. The newer logic seems to be that the MLP sector may have more correlation to the S&P 500 Index. As long as the stock market does not melt down in the summer heat as you saw in each of the past two years, then MLPs should not melt down either. Still, that is far from a promise, and we have never gone entirely away from the opinion that there is still a tie to Treasury yields here.

As you can see, there is no free lunch, and many investors have a hard time deciding on the true correlation in MLPs. This sector can be very rewarding. It also can be quite painful when your timing is off. Many investors have a hard time understanding exactly what these investment vehicles are, and throwing in the tax structure can really complicate the issues.

JON C. OGG

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