The hedge fund manager is all over this energy MLP theme.

By Alex M., Founder of Macro Ops:

Range-bound markets over the past year have made it difficult to earn good returns. Most investors haven’t made any money at all. And this reality has forced them to pile into high-yield products to make up the difference.

One popular area to reach for yield has been the energy space. The general belief is that crude has hit a bottom and that energy companies are now a safe bet. Especially with the dividends some of them are offering.

Billionaire hedge fund manager David Tepper is all over this theme. His interests lie specifically in Energy Transfer Partners (ETP) and Williams Partners (WPZ). Both these companies are master limited partnerships (MLPs) and both operate in midstream energy assets such as storage and pipelines.

For those unfamiliar with the energy space, the industry can be broken up into 3 segments:

• Upstream: These are the exploration and production (E&P) companies that include drillers. They find and extract energy products.
• Midstream: These are transportation companies that move raw product through their pipelines. It’s in this segment that we find our MLPs.
• Downstream: The transportation companies move raw product to downstream companies that act as the processors and distributors of the final product. Refineries are in this segment.

If you take a look at Tepper’s latest 13F filing, his top buys are ETP and WPZ. Both these companies are also part of his most concentrated holdings. Tepper is betting big on the MLP theme.

Energy Transfer Partners (ETP) is an MLP that started with natural gas pipelines, but later expanded into natural gas liquids (NGLs), refined products, and also crude oil. It currently has a dividend yield of 11.49% — exactly the type of yield investors would love to earn.

Williams Partners (WPZ) is another MLP that’s focused on dry gas pipeline transport. It’s dividend yield is 10.82%, also pretty juicy.

With dividend yields like that, this play may seem like a no brainer, but there are actually significant risks. Both these MLP’s have credit ratings one level above junk status. The reason is because both are leveraged and have debt servicing costs to take care of. They’re exposed to energy prices. If prices drop too low, these companies will have a difficult time servicing their debt.

And being so close to junk status, another downgrade would have significant effects on their current cost of borrowing. A further increase in debt servicing costs would put pressure on their dividend, which would likely be first on the chopping block to pay off debt costs.

Tepper knows this. But the reason he’s still interested is that WPZ and ETP are currently in the middle of a merger. This merger would increase the odds that the combined company could maintain their dividend regardless of volatile energy prices.

The probability of the merger going through has recently increased in the eyes of merger arbitrate specialists: The spread between the share price of WPZ’s parent company and the price of the deal has fallen by half, from over $8 in May to $4 more recently. A higher spread indicates that investors are less confident in a successful merger, while a lower spread suggests that the market is more confident in the merger’s success.

This is all well and good, and a merger may make sense, but now is still not the right time to enter this trade.

A big part of this MLP thesis rests on the idea that energy prices have bottomed. But we don’t believe this is true. The bullish US dollar trend is still intact. And because commodities are priced in dollars, a stronger dollar means lower commodity prices.

Just looking at the relationship between oil and the dollar, dollar strength has historically accounted for 30-50% of oil’s price movement. Take a look at the graph below. It isolates an estimate of the price of oil based only on demand. It then compares it to the real price of oil in the market. The gap you see between actual prices and demand exist because of the impact of USD strength.

As the dollar strengthens, commodities in general (including energy) will take another trip back to prior lows. The pain in the energy space is not over. The “blood in the streets” moment has yet to occur. There were not enough defaults and there are still too many companies hanging on by a thread. There needs to be another washout once energy prices drop again.

Some may argue that these MLPs should be protected because most of their exposure is in natural gas instead of oil and their position as midstream operators is not directly affected by energy prices. These points may be valid, but they don’t matter. This reasoning didn’t save MLPs in the recent energy downturn, and it won’t save them in the next one either.

Regardless of these MLP’s position, they tend to fall victim to the classic case of the baby being thrown out with the bathwater. When energy prices drop again, investors will bail on anything energy related. All the selling creates liquidity issues that force funds invested in these MLPs to exit their holdings. Their margin level restrictions trigger and they have to sell. MLPs end up getting dumped along with every other energy play.

MLPs may make a great investment down the line, but not right now. The dollar trend has to play itself out and there needs to be a bigger washout of energy companies. At that point we’ll be interested in jumping into MLPs for the long-term. By Alex M., Macro Ops.

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