MLPs have several advantages that make them appealing investments.  One key advantage is the absence of double taxation when it comes to paying dividends to investors.  Common stockholders, for example, are essentially taxed twice on company earnings: once at the corporate level (the company itself has to pay taxes to the US government on earnings) and again when they receive dividend payments.

MLP unitholders, however, only pay taxes when they receive a dividend payment (called a “distribution”).  Further, MLPs can defer paying taxes on the majority of the distribution until the units are actually sold.  Not bad, eh?

Always Know the Downside

Don’t forget to do your research.  In some cases, MLP unitholders may have to pay taxes in each state where the partnership operates.  I strongly encourage everyone to consult a tax advisor before attempting to invest in these vehicles.  They can be great investments only if you do the research and follow the rules.

Many investors assume, incorrectly, that fluctuations in oil & gas prices can significantly impact MLP unit prices.  However, the truth is that revenue from MLP assets (the majority of which are pipelines) is generated from a “toll road” model.  That is, it doesn’t matter how expensive the commodity shipped is – it only matters how much of it gets shipped.  Of course, high (or low) prices can impact the amount shipped – but energy demand has been growing fairly consistently over time.

A good analogy is, unsurprisingly, an actual toll road.  It doesn’t matter if 100 Honda Civics use the road or 100 Aston Martins – the same toll is collected and, consequently, the same amount of revenue.

It’s been a rough year for the markets,  as major equity indexes suffered significant losses in the wake of subprime lending, rising inflation, and slowing economic growth.  So it’s no surprise that publicly traded MLPs have also had their share of bad luck lately.  However, as with any investment, there is risk involved.  SemGroup Energy Partners is a good example of why investors should always understand the potential downside involved when investing in MLPs.
continue reading "Learning from SemGroup Energy Partners"

MLPs and the Market

The media focus on a US recession and a declining stock market continues to escalate. However, one thing is clear: demand for midstream services and MLPs is here to stay. The logic is easy to follow. Regardless of commodity prices, oil and natural gas will always need to get shipped from one place to another via pipelines. Further, other midstream services such as fractionation and storage are essential to making this entire process work.

Sleeping Giants

The master limited partnership (MLP) is the most efficient corporate tax structure for midstream assets. Not only does it eliminate the pitfalls of double taxation of dividends, but it often allows for a built in hedge against inflation. As large institutional investors start to understand how MLPs work, they will realize that the benefits far outweigh any of the potential risks.

The Value Proposition

Currently, because institutional investment remains low, the price variability of LP units is higher than most US large cap stocks. However, for the long term investor who is comfortable with near term risk and is willing to do more work at tax time, the value proposition remains clear: Per the Alerian MLP Index, MLPs have returned an average of 19% annually over the last 5 years, and 16% over the last 10 years.

Despite the recent volatility in the markets and media focus on a possible US recession, investors should remain focused on the long term potential of MLPs. There is a good chance that the major market indices will continue to fluctuate and lose value (including the benchmark Alerian MLP Index). Even so, midstream transport and services will continue to be in demand regardless of commodity prices and market conditions. Further, the fact remains that MLP distribution yields remain competitive and continue to grow. Over the long term, MLPs as measured by the Alerian index have outperformed the S&P and the Dow, and I believe they will continue to do so for the foreseeable future.

The US Energy Information Administration (EIA) estimates natural gas consumption grew approximately 6% in 2007 vs. 2006. Forecasts call for continued growth of approximately 0.6% in 2008 and 1% growth in 2009 due to expected normal weather conditions.

Financial publication The Economist recently released its annual World in 2008 edition, in which it predicts natural gas to grow a healthy 3.4% in 2008. Further, per the article, the International Energy Agency expects natural gas to become the 2nd largest primary energy source worldwide by the year 2015.

The National Association of Publicly Traded Partnerships will host the 2008 MLP Investor Conference in New York on May 21st and 22nd.  The event will be held at the Crowne Plaza Hotel in Times Square, and will include sponsors such as Raymond James & Associates.  Additional information can be found at the NAPTP website here.

What makes high net-worth investors even richer?

2 things:  Information that only a small number of privileged individuals have access to and a mindset which goes beyond the scope of “typical” investments.

These are some of the key reasons why the Master Limited Partnership (MLP) is a high performing security that remains a secret on Wall Street.

Enter the MLP

Typically, financial institutions usually only inform high net-worth clients about MLPs. Why? Because, while they are unconventional and the tax benefits must be fully understood, they are a great way to boost investment returns for these individuals. That is, they have to differentiate their services from those offered to the average Joe in order to keep them as customers (otherwise, they’ll take that $20 million and park it at another bank).

Outperforming the Market

Like a dividend paying stock, MLPs make a quarterly distribution of income to investors. However, that distribution generally is much higher than dividend stocks (which boosts overall returns). For example, the year to date dividend yield is about 1.87% for the S&P 500 and around 2.84% for the Dow Jones utility index.

However, the Alerian Select MLP Index has a YTD yield of over 6%! Plus, just like with a dividend stock, your total return includes both appreciation in share price as well as the return from dividends. In terms of overall return, the Alerian Select Index is up about 10% YTD, while the S&P 500 is up only about 3%. The difference in return is even more pronounced over time:

Looking for the “Catch”

Why can the yield be this high? The answer: pass-through taxation. One of the biggest problems with stocks is that investors are double taxed on earnings. As we all know, a public company must pay tax on money it earns in a given year. With what is left over, they pay dividends. Unfortunately, when you as an investor receive those dividends you are then taxed again!

However, because MLPs are engaged primarily in developing energy resources and infrastructure in the US, the government does not require them to pay taxes at the corporate level. So, they can pass the savings along to investors.

What About Risk?

MLPs are unique because most are engaged in what are called “midstream” energy services. That is, all the stuff involved with getting a commodity such as oil or natural gas from the source (i.e., the well) to its destination (customers). This includes pipelines (which make money by charging essentially a “toll” to ship commodities) as well as services (separating natural gas into components that can be used such as propane, ethane, etc.).

As a result, they reduce their exposure to fluctuations in the price of oil and gas because they are just the shipper. It doesn’t matter how expensive a given commodity is, it still needs to get from point A to point B. While prices can cause the amount shipped to vary, the impact is mitigated since the MLP doesn’t have direct price exposure.

However, it is important to note that MLP units may vary in price more than stocks in the near term. This is because large institutions have been slow to invest in these securities. Therefore, big trades by larger investors can cause price volatility over the short run. This doesn’t impact the underlying value though – as most MLPs have steady, dependable income and tangible, fixed assets (i.e., pipelines). Long term, the potential is clear: we will still need oil & gas, and we will still need to ship oil & gas from point A to point B.

Additional Benefits

Deferral of Taxes

Liquidity

Related Links:

An Overview of MLPs

MLPs & Energy

We recently posted an entry outlining the importance and calculation of distributable cash flow (DCF) when evaluating MLPs.  In a nutshell, DCF represents what the MLP could have paid out in cash to unitholders had it chosen to do so.  However, while investors want to see cash distributions grow over time, they also want to see the MLP managing cash responsibly as well.  That is, they want to feel confident that the firm is maintaining reasonable levels of cash “coverage” so it can continue to grow the business moving forward.  The “coverage ratio” is the de facto standard for measuring this and is calculated by:

Typically, investors want to see a coverage ratio of anywhere from 1.2 to 1.5 in addition to growing quarterly distribution payments.