Savvy income investors know that any bout of volatility on Wall Street is an opportunity in disguise, and the recent sell-off in the oil market is no exception. However, market veterans also know that every opportunity has a unique risk/reward profile, and in the case of energy-related securities, not every beaten down prospect is a worthwhile bargain.
More specifically, we’re referring to Master Limited Partnerships, or MLPs, that operate in the oil & gas industry. Recently, I discussed in a CNBC article the importance of having a “stomach for risk” and maintaining a long-term horizon if you’re thinking about scaling into beaten down MLPs. For anyone eager to take advantage of discounted prices in the space, it’s worth taking a step back and making sure you understand the various types, or “breeds,” of MLPs before making an allocation.
Different Types of MLPs
For the sake of simplicity, the following explanation will focus around energy-related MLPs, as opposed to MLPs whose operations revolve around other natural resources like coal or timber. Basically, most MLPs fall into one of these two categories:
- Upstream: This refers to companies that are more involved in the exploration and production of oil and natural gas from the wellhead. This breed of MLPs owns and operates assets related to the actual production of energy resources, and therefore their profitability is closely linked to the prevailing market price of the goods they produce; some examples of upstream MLPs are Linn Energy LLC (LINE ) and EV Energy Partners L.P. (EVEP ).
- Midstream: This refers to companies that are more involved in the transportation and storage of oil and natural gas. Midstream MLPs are essentially energy infrastructure companies that connect energy producers—the “upstream” firms—to consumers like refineries, which are referred to as “downstream” companies. Because midstream MLPs are primarily involved in the transport of energy assets, their profitability is closely linked to the sheer volume of goods they move and store, rather than the prevailing market price of those resources; some examples of midstream MLPs are Energy Transfer Partners L.P (ETP ) and Kinder Morgan Inc. (KMI ).
To learn more, be sure to read our guide: Everything Dividend Investors Need to Know About MLPs.
The Bottom Line
As you can see, not all beaten down energy MLPs boast the same lucrative risk/return profile at this point in time. MLPs that fall under the “upstream” umbrella may endure a more prolonged downturn as their profitability is more closely linked to the price of oil, which remains extremely volatile at the moment. On the other hand, MLPs that fall under the “midstream” umbrella are arguably more lucrative at this time given their more defensive nature; that is to say, because these firms generate revenues based on the volume of goods they transport, their profitability is less influenced by the wild swings seen in the energy futures market.
As always, be sure to closely look under the hood of any security before making an allocation; buying into an upstream MLP versus a midstream one is an important decision, and certainly not one that you should make without taking the time to properly educate yourself on the nuances associated with each type of security.
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