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Paul Jansen: Pros and Cons of Master Limited Partnerships and Royalty Trusts

Q & A with Paul F. Jansen, Managing Director, Houston

Question: Generally, who do you see as the ideal investor for these funds, and who should stay away, and why? Where in the portfolio do they belong — competing with stocks in the risky end, or with bonds in the safer, income-producing end? Over time, how well have these performed?

Paul Jansen: The motivation for creating this type of investment product was to provide investors with very stable, predictable cash flows that provide yields similar to traditional bonds. The long term midstream contracts fit this model very well and contributed to the popularity of midstream MLPs.

The risk profile has shifted over the past couple years for midstream MLP’s. Midstream MLP’s are more comparable to bonds due to their predictable cash flows and perceived lower risk profile. The risk profile was believed to be lower as a result of low volatility and variability in cash flows. Revenues were predictable for a long time as midstream MLPs benefited from take-or-pay contracts that included fixed prices and minimum volumes. These contracts provided downside protection for MLPs and significantly reduced risk. However, following the decrease in oil prices and associated bankruptcies of E&P companies, these contracts were rejected or renegotiated. The new contracts don’t have the same protection and guarantees as the old contracts resulting in an increased risk profile and a shift from more bond-like returns to more of an equity risk and return profile.

Midstream MLPs have performed well throughout the unconventional boom and associated North American infrastructure buildout. However, the need to continue to grow MLPs in order to increase investor returns and increasing interest rates have made it more difficult for midstream MLPs more recently. To expand on investor returns, MLPs continuously need to raise capital in order to grow as they are contractually required to distribute profits instead of reinvesting them. This is easier in a higher commodity price environment.

Question: Next, how do you see the appeal of these funds in today’s conditions? Are they a better bet now that the oil industry in doing well? Would you recommend one type — MLP vs RTs – over the other, and why? What kind of income and return should an investor expect in a long-term plan? Or do you see this as a short-term bet? What are the biggest dangers in these markets today? Are certain types of MLPs and RTs especially appealing today, or especially hazardous?

Paul Jansen: Both MLP and Royalty Trusts provide benefits. MLPs offer the more flexibility in terms of growth opportunities while Royalty Trusts allow for a more targeted investment. Both products provide benefits to an investor. You should select the investment vehicle that fits in an investor’s personal portfolio, risk profile and has the best asset quality to maximize the risk adjusted returns.

As I mentioned before, rising interest rates could make these positive yield instruments less attractive on a relative basis and could push down valuations on the asset class as a whole. Additionally, midstream MLPs are dependent on the E&P companies’ growth plans to increase their volumes. Understanding the E&P counterparties, and their associated growth plans, is very important for valuing an MLP’s future growth prospects and performance.

Question: Do you recommend investing directly or through a mutual fund or ETF?

Paul Jansen: I personally think that ETF’s are a cost efficient way to invest with lower fees and often higher liquidity.

Paul F. Jansen is a managing director in Conway MacKenzie’s energy practice. He performs strategic, financial and operational analyses to unlock value in challenging situations. He has extensive experience serving as executive management to both publicly traded and privately held energy companies. Jansen is accredited in business valuation, a certified insolvency and restructuring advisor, a certified public accountant, and a chartered accountant in the Netherlands. He has published several articles in the Oil & Gas Investor and the Oil & Gas Financial Journal, and has been quoted on TheStreet.com and US News & World Report.