Master Limited Partnerships Deserve a Closer Look

Master Limited Partnerships (MLPs) offer attractive yields in today’s low-rate environment. Many of my clients have inquired about higher-yielding investments with a relatively stable asset base, and we believe MLPs are an attractive option that we see expanding in 2012.

An MLP is an investment vehicle that allows an investor to participate in different stages of mineral and nature resource value chains. They are primarily oil pipelines, oil transportation, and storage. The structure offers the features of a partnership and the full liquidity of an exchange-traded security. They must distribute 90% of their income and therefore generate a high cash flow.

They provide high income, inflation protection, and they are “cash cows” with a yield of 5 percent to eight percent on the average. Their total return is driven by income and growth. In 2011, they had an average 6.2-percent yield. Industry estimates indicate that approximately $100 billion of infrastructure investment will be required over the next decade in both natural gas and crude oil. Additionally, there are currently more than $200 billion in U.S. midstream assets that are being “dropped down” into MLP structures at a rate of $5 billion per year. Over the past 5 years, MLPs have invested more than $70 billion in essential infrastructure projects in the U.S.

These vehicles allow investors to participate in monopoly-type assets with relatively inelastic demand, such as oil and gas pipeline storage facilities. They typically do not own the underlying commodities that their pipeline infrastructure transports. Rather, their business is fee-based, which means their shippers reserve pipeline capacity and pay regardless of usage. Therefore, in general, they have limited risk to the underlying commodity and their prices are not correlated with commodity price movements.

MLPs offer two distinct tax advantages: 1) as pass-through entities, there are no corporate-level taxes, so they avoid double taxation of distributions; and 2) a significant portion of distributions are tax-deferred, with 80% to 90% the rule of thumb. This deferral occurs because the partnership’s income is offset by operating costs, deductions, and depreciation. Upon sale, the investor must pay taxes on the accrued depreciation at the ordinary income rate and on any appreciation at the capital-gain rate. This unique structure allows MLPs to generate more free cash flow than a corporation with the same operating income.

The Alerian MLP Index1 (AMZ) was developed to track the performance of MLPs in 1996. Since then, it has produced a gain of 917% compared with 181 percent on the S&P 500 over the same time period.2

For tax-exempt vehicles, such as pensions and IRAs, direct investment in MLPs may not be suitable because they generate Unrelated Business Taxable Income (UBTI) which could become a tax liability if it exceeds $1,000 per year. However, there are other investment options, such as closed-end funds and Exchange Traded Notes (ETNs), which offer investors general exposure to MLPs and do not generate UBTI. For example, JP Morgan’s Alerian MLP Index ETN (AMJ) which tracks MLPs pays a quarterly coupon linked to MLP cash distributions.

Risks and concerns associated with MLPs is their inherent reliance on capital markets to finance new growth opportunities. They were not immune to the credit crisis and inherent lack of capital in 2008 and early 2009. MLPs may also be exposed to steel prices as a main input in pipeline construction, but factors such as the shake-up in the auto industry, however, have left excess near-term supply. Another risk lies in the fact that pipeline infrastructure operators may be responsible for fires, spills, and other accidents. Finally, MLPs rely on continued favorable treatment from the Federal Energy Regulatory Commission (FERC) in regard to pipeline tariff increases and tax advantaged status from the IRS.

In conclusion, we believe midstream MLPs can be a good way for some of our clients to invest in the country’s growing energy infrastructure and potentially receive relatively stable high current income. If you would like to discuss this topic in more detail and whether it should be included in your portfolio, please call us at 601-264-0946 or e-mail us.


1
Index of 50 enrgy MLPs with a market cap of approximately 84 billion, as of 9/20/2011.

2Midstream Energy Infrastructure from Q1 1996-Q3 2009.

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