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MLPs: Winning Streak Broken, Growth Story Intact

April 9th, 2013

by Sponsored Content from Legg Mason ClearBridge<br> by Chris Eades, Portfolio Manager

Chris Eades

What are you anticipating for MLPs in 2013?

2012 was the first year in thirteen years in which MLPs underperformed the S&P 500. But while MLPs’ winning streak relative to the S&P 500 may have been broken, the growth story for this sector was far from broken.

Crude oil production was up 15% in 2012, well beyond expectations going into the year. Natural gas liquids production was up 12%. Natural gas production was up 6%.

With those growing production volumes, the infrastructure build-out that we’ve long expected began to play out and should continue to play out going forward.

Why do you foresee continued expansion in this sector?

Consider the underlying oil and gas companies that have been driving increased production volumes of oil, natural gas liquids, and natural gas. At their current level of drilling activity, it’s estimated that they have over 20 years of prospective inventory remaining to drill.

So this is not a one-year story or a ten-year story. It’s a multi-decade story. As such, I feel comfortable asserting that we’re in the early innings of growth as it pertains to infrastructure and the MLPs that are helping to build out this infrastructure.

What held back MLP performance in 2012?

My feeling is that a major factor was uncertainty about policies in Washington in the fourth quarter of the year, particularly uncertainty as to what would happen with the capital gains tax rate. The expectation was that it would go up, as in fact it did, and as a result there were selling pressure on MLP stocks among some investors to potentially lock in a lower capital gains tax rate ahead of a future increase.

There were also some misconceptions out there about what an increase in the dividend tax rate might mean for MLPs. Of course, MLPs do not pay dividends; they pay distributions, which are subject to different tax treatment. Even so, this may have been a contributing factor.

How have MLPs fared so far this year?

The Alerian MLP index entered 2013 at roughly the same level that it entered 2012.1 However, distributions were 7% higher entering 2013 than they were in 2012. Balance sheets were in better shape, and distribution coverage ratios stronger than they were a year ago. Given that, I don’t think it’s all that surprising that in the early days of 2013, MLPs have performed very well relative to the S&P 500.2

TheS&P 500 Indexis an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S. An investor cannot invest directly in an index.

The Alerian MLP Index is a composite of the 50 most prominent energy Master Limited Partnerships (MLPs) and is calculated using a float-adjusted, capitalization-weighted methodology.

Investments in energy related Master Limited Partnerships (MLP) securities are subject to unique risks, including the risks of declines in energy and commodity prices, decreases in energy demand, adverse weather conditions, natural or other disasters, changes in government regulation, and changes in tax laws. MLP cash distributions are generally tax deferred. Non-cash expenses, such as depreciation or depletion, usually offset income derived from an MLP’s operations. To the extent that these expenses exceed income, cash distributions are considered return of capital under current tax law. As such, they are not taxed when received. Instead, the distribution, in the form of return of capital, reduces a unit holder’s cost basis. This adjusted cost basis, in turn, results in a higher capital gain or lower capital loss when the units are sold. Of course, there can be no assurances that distributions from an MLP will be tax deferred.

All investments involve risk, including possible loss of principal. Past performance is no guarantee of future results.

Asset allocation and diversification do not assure a profit or protect against a loss.

Please note an investor cannot invest directly in an index.

Dividends and yields represent past performance, and there is no assurance they will continue to be paid in the future.

Legg Mason and affiliates do not provide tax or legal advice. Consult your tax and or legal advisor for such guidance.

The views expressed are those of the portfolio manager as of February 6, 2013 and are subject to change based on market and other conditions. These views may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice.

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1. The Alerian MLP Index opened on 1/3/12 at 389.93, and on 1/2/13 at 385.09. Source: Bloomberg.

2. Total return for the Alerian MLP Index for the period 12/31/12 through 3/21/13 was 16.5%% vs. 8.9% for the S&P 500.

The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S. An investor cannot invest directly in an index.

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