According to the recently released Consumer Price Index (CPI) numbers for March, U.S. inflation soared at its fastest pace in more than 40 years. At 8.5%, it’s a level not seen since 1981. In fact, inflation fears have roiled the market this year, with the S&P 500 losing around 6’5% so far.

Inflation: A Threat to Portfolio Returns

In the United States, several measures of inflation are currently at 40-year high levels. The outbreak of coronavirus has significantly devastated the global supply-chain system in the last two years. Input costs have soared for businesses. At the same time, strong pent-up demand, supported by massive personal savings in the last two years, has resulted in soaring prices.

Market participants are highly concerned that inflation will remain elevated in the near term due to the prolonged war between Russia and Ukraine and the recent resurgence of coronavirus in China.

While cost of going to the supermarket or ordering meals from restaurants has clearly spiked for consumers, another worrying side effect of inflation is that it eats into the returns generated by financial instruments such as equities and bonds by eroding their value. 

Mitigating the Risk

A particular asset class that possesses attributes to combat the value destruction from inflation is energy midstream. These entities typically operate transportation services, storage facilities and refined products' terminals. They are often structured as Master limited partnerships (or MLPs), which differ from regular stocks since interests in them are referred to as units, and unitholders (not shareholders) are partners in the business. Importantly, these low-risk hybrid entities bring together the tax benefits of a limited partnership with the liquidity of publicly traded securities that earn a stable income.  

Let’s check out the underlying rationale for owning midstream companies during periods of rising consumer prices

Why Midstream?

Inflation Indexation: A salient feature of these entities is that bulk of their cash flows are under long-term, fee-based contracts, which are indexed to inflation. In other words, midstream operators fix tariff rates in accordance with FERC regulations tied to the Producer Price Index - a measure of changes in prices covering a host of goods and services. Consequently, pipelines can pass on at least a portion of the higher costs to customers.

Real Assets: The properties that these entities own are mostly pipelines and storage facilities, or, infrastructure systems that help in moving oil and natural gas. Unlike stocks and bonds, midstream firms own real (physical) assets that do not derive their value from a contractual right. Their intrinsic worth has been historically proven to outperform traditional stock and bond instruments in years when inflation is high. That is because the economy is healthier and demand for real assets rise.

Distribution Growth: Apart from defensive characteristics, investors are typically attracted to MLPs for their reliable distributions. Adjusting costs with the prevailing business activity, the partnerships have focused on the generation of free cash flow (post distribution payment) to lower debt and strengthen their financial position. The growing free cash flows could be used to boost investor returns through buybacks and distribution hikes. Finally, the distribution growth can also help investors to offset some of the impacts of high inflation.

5 Pipeline Choices

To guide investors to the right picks, we highlight four pipeline firms that carry a Zacks Rank of #1 (Strong Buy) or 2 (Buy). The Zacks Rank is a reliable tool that helps you to trade with confidence regardless of your trading style and risk tolerance. To learn more about how you can use this proven system for market-beating gains, visit Zacks Rank Education.

You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Sunoco LP (SUN Quick QuoteSUN - Free Report) : Sunoco participates in the transportation and supply phase of the U.S. petroleum market across a number of states. It also focuses on motor fuel distribution to convenience stores, independent dealers and commercial customers.

SUN pays out 82.55 cents quarterly distribution ($3.302 per unit annually), which gives it a 7.7% yield at the current unit price. Sunoco beat the Zacks Consensus Estimate for earnings twice in the trailing four quarters, the average being 44.4%. Valued at around $4.3 billion, Zacks Rank #1 SUN has gained some 41.6% in a year.

DCP Midstream Partners : This leading energy infrastructure firm has a diversified portfolio of gathering, logistics, marketing, and processing assets. DCP Midstream has a foothold in the major shale plays of the United States, including the Permian Basin, Eagle Ford, DJ Basin and SCOOP.

The Zacks #1 Ranked partnership has an expected earnings growth rate of 139% for the current year. DCP pays out a 39-cent quarterly distribution ($1.56 per unit annually), which gives it a 4.3% yield at the current unit price. DCP units have gained around 66.3% in a year.

Delek Logistics Partners, LP (DKL Quick QuoteDKL - Free Report) : The firm is engaged in the gathering, transportation, storage and distribution of crude oil, intermediate products, feedstocks and refined products, and is also into wholesale marketing.

DKL pays out 97.50 cents quarterly distribution ($3.90 per unit annually), which gives it an 8% yield at the current unit price. Delek Logistics beat the Zacks Consensus Estimate for earnings twice in the trailing four quarters, the average being 2.7%. Valued at around $2.2 billion, #2 Ranked DKL has gained some 42% in a year.

MPLX LP (MPLX Quick QuoteMPLX - Free Report) : MPLX owns and operates gathering and processing assets along with crude transportation and logistics infrastructure. The partnership, which is valued at around $34.9 billion, carries a Zacks Rank of 2. MPLX has increased some 46.3% in a year.

The energy infrastructure provider has an expected earnings growth rate of 9.8% for the current year. MPLX pays out 70.50 cents quarterly distribution ($2.82 per unit annually), which gives it an 8.2% yield at the current unit price.

Targa Resources (TRGP Quick QuoteTRGP - Free Report) : A leading provider of integrated midstream services in North America, Targa Resources’ fractionation ownership position in Mont Belvieu is among the company’s best midstream assets.

The 2022 Zacks Consensus Estimate for this Houston, TX-based firm indicates 74.1% year-over-year earnings per share growth. Targa Resources beat the Zacks Consensus Estimate for earnings in two of the last four quarters. The Zacks Rank #2 stock has a trailing four-quarter earnings surprise of roughly 61.1%, on average. TRGP shares have surged around 140.6% in a year.