3 High-Yield MLPs to Buy Now, and 3 to Avoid No Matter What Oil Prices Do

Source: Holly Energy Partners

Long-term investors know that market timing doesn't work  The same applies to cyclical industries such as energy, where theoretically buying when oil prices are at the bottom could result in stupendous profits. 

EPD Total Return Price data by YCharts

Not surprisingly since the oil crash began in mid 2014 most midstream MLPs have under performed the broader market, even after accounting for dividends. However, notice how Holly Energy Partners (NYSE: HEP), Magellan Midstream Partners (NYSE: MMP), and Enterprise Products Partners (NYSE: EPD), have done so much better than both MLPs in general. This is especially true of competitors such as Williams Partners (NYSE: WPZ), Energy Transfer Partners (NYSE: ETP), and Plains All American Pipeline (NYSE: PAA).

Let's look at three important reasons why Holly Energy Partners, Magellan Midstream, and Enterprise Products Partners have held up so well during this industry downturn. More importantly, learn why these quality midstream MLPs are likely to prove far superior long-term income investments than their beaten down competitors; no matter what energy prices do in the short-term.

Superior distribution profiles are just the first part

Sources: Yahoo Finance, Fastgraphs, earnings presentations, management guidance

Midstream MLPs are mainly owned by dividend investors seeking generous income. However reaching for yield can be dangerous as extremely high payouts can be a warning sign that the distribution is either unsustainable and at risk of being cut, or unlikely to grow much in the future, or both. 

Thus midstream MLP investors need to look at all three aspects of a payout profile: yield, distribution sustainability (as measured by the distribution coverage ratio, or DCR), and realistic distribution growth potential. 

From the table you can see that Holly Energy Partners, Magellan Midstream Partners, and Enterprise Products Partners all had extremely strong coverage ratios in 2015, and management at all three MLPs is guiding for ongoing payout growth in the short to medium-term. 

While rosy forecasts must always be approached skeptically, based on the impressive track record that these MLPs have of raising payouts even during trying economic or industry conditions, investors can have reasonable confidence of growing income from the likes of Holly Energy Partners, Enterprise, and Magellan. 

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In contrast Williams Partners, Energy Transfer Partners, and Plains All American Pipeline struggled to cover their payouts with 2015 cash flow and their sky-high yields indicate that they represent significant risks for distribution cuts. 

What is the key difference between these two types of MLPs? Why are Holly, Enterprise, and Magellan solid long-term investments, while Plains, Energy Transfer, and Williams Partners represent value traps to be avoided? The answer lies mainly with the quality of their respective management. 

Conservative balance sheets are key 

Sources: Morningstar, Gurufocus

Midstream MLPs hoping to maintain secure and growing payouts over time require lots of capital to invest in new projects. There are just three sources of that capital: retained cash flow, debt, and equity. 

Retained cash flows are a big competitive advantage

We've already seen that Holly Energy Partners, Enterprise Products Partners, and Magellan Midstream Partners have much higher DCRs than Williams, Energy Transfer, and Plains All American, however the importance of that metric goes beyond just sustainable the distribution is; it also represents how much cash flow management chooses to retain to invest in future growth. 

The more retained cash flow available the less dependent on outside sources of capital an MLP is, meaning less leveraged balance sheets and easier debt servicing. More importantly, during times of industry turmoil, a healthy balance sheet is key to maintaining good credit ratings (rating agencies like to see leverage ratios of 4.5 or less), low interest rates for new borrowing, and thus low costs of capital that mean larger and more profitable growth opportunities available to management. 

Holly, Magellan and Enterprise, thanks their long-term focus and conservative, "slow but steady" approach to growth, have been able to continue to reward investors with smaller short-term losses, as well as continued payout growth, thanks in large part to their smaller dependence on fickle equity markets. 

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Williams Partners,  Energy Transfer Partners, and Plains All American Pipeline, thanks to their eagerness to please short-term focused dividend growth investors, chose to retain no cash flow and thus were entirely dependent on debt and equity markets for their continued growth. 

As the last few years have proven, having an MLP's payout security and growth plans at the mercy of fickle investors and creditors can be a great way for investors to lose a lot of money, very fast.   

Bottom line

Holly Energy Partners, Enterprise Products Partners, and Magellan Midstream Partners are perfect examples of why longer-term focused, more conservative management is the key to successful investing in the midstream MLP industry. 

In contrast, Williams Partners, Plains All American Pipeline, and Energy Transfer Partners illustrate the dangers of relying exclusively on external capital markets for continued distribution sustainability and growth. Since no one can predict what energy prices will do over the next few years, and how debt and equity markets will react, the best selections for a diversified dividend portfolio remain those MLPs that have the least dependence on external capital funding sources.