A Risk Worth Pursuing

Know Your Risk Tolerance

Given the ongoing correction in the oil and gas markets, I want to use this week's column to reflect on investment philosophy and risk. In recent weeks some master limited partnerships (MLPs) have experienced sharp corrections, a reminder of the downside risks especially inherent in high-flyers and some of the higher yielders.

I think it's critically important to understand what type of an investor you are, and the extent of your risk tolerance. This is why I usually qualify investment recommendations with descriptors such as "short-term," "long-term," "aggressive," "moderate" or "conservative." My own investment style is long-term and moderate. For me, that means I am generally making an investment that I know could take three years or longer to pay out.

My "moderate" threshold means that I am willing to withstand up to about a 20% downside on the investment either during a market correction, or if there is bad short-term news that doesn't really affect the longer-term prospects. To me, conservative investors should be prepared to accept a potential 10% downside risk on an investment, while those making aggressive investments must understand that downside risks can easily exceed 20%.  

A Recent Reminder

Consider Phillips 66 Partners (NYSE: PSXP), which owns some of the midstream logistics assets of its sponsor, the refiner Phillips 66 (NYSE: PSX). Ordinarily we might consider such a midstream MLP to be a fairly conservative investment, but PSXP exploded out of the gate after its IPO and has continued to be one of the most lucrative MLPs since its IPO. In just the first half of this year, the unit price rose 110%. As the unit price rose and the yield continued to shrink, price targets were raised again and again by brokerage houses.

We have urged caution as we felt the valuation of PSXP was reaching unsustainable levels. Last m! onth in Full Hearts, Thin Yields, I warned that investors "have very aggressive expectations of  how the partnership [PSXP] will grow its distribution" and that "anything that falls short of those aggressive expectations could result in a sharp pullback in the unit price." PSXP units are down over 16% since I wrote those words three weeks ago, and down nearly 20% over the past month.

I am not telling that story to impress you. If you held PSXP since its IPO, or even since the beginning of this year, you are still very happy with your investment. But this is a reminder that even a midstream MLP can be an aggressive investment, and anyone investing in PSXP a month ago needed to be mentally prepared for such a correction, or at least have stop-loss protections in place.   

Admittedly, midstream MLPs are not where you will tend to find the most risk. They are generally less volatile than the variable distribution MLPs such as refiners and fertilizer producers, as well as the upstream MLPs, which I expect to benefit from the continued growth of domestic oil and gas production. If you are a conservative or moderate investor, these investments are not for you in most cases. For aggressive short-term traders these investments can prove lucrative — but timing is everything.

And just as a yield depressed by a big runup in the unit price can signal trouble ahead, so can a higher yield implying higher risk. We dropped Eagle Rock Energy Partners (NASDAQ: EROC) from The Energy Strategist and MLP Profits portfolios last year shortly before declines turned it into a double-digit yielder, and haven't regretted those decisions for a second.

At this point, the trailing 13.7% yield reflects a distribution that was discontinued last quarter amid a business slump. It is no consolation to investors who have seen the unit price drop 24% year-to-date, and 35% over the past 12 months. Might EROC have an impressive showing over the next 12 months? It's possible, but you have to be pre! pared for! further downside. EROC units are trading at $4.37, and we know people who thought they were getting a bargain at $10, $8, and $6 (as it fell from its 2011 high above $12).

Don't Forget to Get Paid

Obviously, investments with higher downside risk must offer commensurately greater upside. I look for those that are out of favor but still have a bright long-term outlook. The natural gas sector fits that bill right now. I see upward pressure on prices over the next five years (despite the recent downward pressure on natural gas prices, which I view as short-term), for two primary reasons.

Liquefied natural gas (LNG) export terminals will begin operation as early as late 2015, when Cheniere Energy Partners (NYSE: CQP) completes its Sabine Pass LNG export terminal. Sempra Energy (NYSE: SRE) has also received approval for an LNG facility on the Gulf Coast in Louisiana, and there are 13 more proposals awaiting approval. As more of these terminals come online, some of the excess natural gas will find its way to more lucrative markets.

Natural gas should get another long-term boost from a US Environmental Protection Agency (EPA) rule that would cap carbon emissions on new power plants. Coal-fired power would be unable to economically meet the new emission standards, but current gas-fired power plants already do so.

However, short-term fluctuations like uncharacteristic weather can override the longer term trends, so this is a riskier bet for a short-term investor. This past winter was uncharacteristically cold, and pushed gas prices to highs that haven't been seen in years. Now an uncharacteristically cool summer is underway, and that has reduced demand and resulted in a steep drop from the highs seen in the spring.

But longer term, I believe higher gas prices are in the cards and natural gas producers should benefit. This will benefit upstream MLPs as well as midstream MLPs racing to transport new gas production to market. Over the past four years direct capital invest! ment in U! S oil and gas infrastructure has increased by 60%, reaching $90 billion in 2013. Over the next 10 years, the US is projected to spend $1 trillion on new oil and gas infrastructure.

This is a positive long-term story and there will be numerous winners. Patient investors — even patient aggressive investors — should see ample rewards. But we all need to understand our short-term risk tolerance, as short-term corrections can be steep.

Conclusions

The energy sector has been one of the top performing sectors of the year, but over the past month a correction has been underway. The Alerian MLP Index declined by more than 5% in just the past week, while some typically steady MLPs have shed even more. Given this year's gains, it may be worthwhile to reflect on the makeup of your portfolio and make sure that it still matches your time horizon and risk tolerance.    

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)