Despite some moderation from a 40-year high level, inflation in the United States is proving to be much more stubborn than expected. According to the last released Consumer Price Index (CPI) numbers for August, the figure stood at 8.3% — high enough for the Fed to raise its core interest rate by another 0.75% and taking its year-to-date increase to 3%. In fact, inflation fears have roiled the market this year, with the S&P 500 losing more than 24% so far. Worse, experts believe that there will be continued upward pressure on most prices in the near-to-medium term.

As the above scenario pans out with upside inflation surprises, investing in high-quality energy infrastructure stocks like MPLX LP (MPLX Quick QuoteMPLX - Free Report) , DCP Midstream LP and Delek Logistics Partners (DKL Quick QuoteDKL - Free Report) might help you earn a decent return.

Inflation & Portfolio Returns: A Negative Correlation

In the United States, several measures of inflation are currently hovering near 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 intermittent resurgence of coronavirus in China.

While the 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?

Contracts with Inflation Protection: A salient feature of these entities is that the bulk of their cash flows is 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.

Exposure to Physical 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. This is because the economy is healthier and demand for real assets rises.

Attractive Payouts: 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, which often ranges in double digits, can also help investors to offset some of the impacts of high inflation.

3 Pipeline Choices

We bring here three energy pipeline firms with high yields that could be used as an inflation hedge.

MPLX LP: MPLX owns and operates gathering and processing assets along with crude transportation and logistics infrastructure. The partnership, which is valued at around $31.5 billion, carries a Zacks Rank #1 (Strong Buy). MPLX has edged up 1.4% in a year.

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

The energy infrastructure provider has an expected earnings growth rate of 14.7% for the current year. MPLX pays out 70.50 cents quarterly distribution ($2.82 per unit annually), which gives it a 9.2% yield at the current unit price.

DCP Midstream LP: 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.

This Zacks Rank #3 (Hold) partnership has an expected earnings growth rate of 128.3% for the current year. DCP pays out a 43-cent quarterly distribution ($1.72 per unit annually), which gives it a 4.6% yield at the current unit price. DCP units have gained 21% in a year.

Delek Logistics Partners, LP: 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 98.50 cents quarterly distribution ($3.94 per unit annually), which gives it a 7.6% yield at the current unit price. Delek Logistics has an expected earnings growth rate of 10.6% for the current year. Valued at around $2.3 billion, DKL, a #3 Ranked stock, has gained 6.5% in a year.