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MLPs or Upstream Companies: Where Should You Invest?

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MLPs are less volatile compared to upstream companies

In addition to the attractive yields discussed previously, MLPs offer other benefits. The average beta of all Alerian MLP Index companies is 1.2. In comparison, the average beta of all the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) companies is 1.45. The average is 1.55 for all of XOP’s exploration and production companies. So, MLPs are less volatile compared to upstream companies. Currently, both of the sectors are more volatile than the broader market.

Historically, MLPs’ beta had been less than one. This indicates less volatility compared to the market.

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Valuation

Currently, MLPs are trading at an average forward EV-to-EBITDA (enterprise value to earnings before interest, tax, depreciation, and amortization) ratio of nearly 10.6x. MLPs usually distribute most of the available cash. So, the EV-to-EBITDA multiple is a more commonly used metric for valuing MLPs.

In comparison, the upstream sector’s mean forward EV-to-EBITDA ratio currently stands near 14x. With negative earnings, the exploration and production sector’s price-to-earnings numbers have become meaningless.

The above graph compares the forward EV-to-EBITDA ratio relative to the expected EBITDA growth of select MLPs and upstream companies. As the graph shows, while midstream companies are expected to have positive compound EBITDA growth over the next two years, the expected growth for the selected upstream companies is mostly negative.

ONEOK Partners (OKS) and Plains All American Pipeline (PAA) have the lowest EV-to-EBITDA ratio among the selected MLP peers after Williams Partners (WPZ) and Energy Transfer Partners (ETP). Williams Partners and Energy Transfer Partners’ respective parent companies are in a merger mess—this led to uncertainty around these MLPs.

MLPs or upstream companies?

In addition to attractive yields, expected distribution growth, relatively lower correlation with commodity prices, relatively lower volatility, and attractive valuation, MLPs offer tax benefits that aren’t available to C corporation investors. Considering their higher correlation with commodity prices, upstream companies might stage a faster recovery if commodity prices continue to recover. This makes them attractive for investors mainly looking for capital gains.

In comparison, MLPs seem to offer a better long-term risk-return proposition. Due to their relatively lower correlation with commodity prices, MLPs seem to be placed better than oil and gas exploration and production companies in the uncertain commodity price environment.

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