Frequently asked questions about Master Limited Partnerships (MLPs)

 In Insights

I. Structure

What are Master Limited Partnerships (MLPs)?

MLPs are operating companies that invest primarily in U.S. energy infrastructure. In addition to offering all the benefits of investing in infrastructure including uncorrelated returns and higher yields, they provide the added benefit of generating regular liquidity.

MLPs are structured as partnerships versus corporations for U.S. tax purposes.

What types of companies qualify as MLPs?

In 1986 an act of Congress created MLPs as a way to encourage private investment in U.S. energy infrastructure. In order for an entity to qualify for MLP status, 90% of its revenues must come from energy related activities.

How are MLPs structured?

MLPs are structured as partnerships. Partnerships do not pay federal corporate income taxes, which currently are 21%. Instead, profits and losses of MLPs pass directly to the underlying partners. This pass-through structure status is similar to REITs and gives MLPs an important advantage over corporations: a lower cost of capital.

It’s important to note, all private or public partnerships have the same pass-through structure and capital advantage.

 

II. Growth Drivers

What drives MLP growth?

Unconventional plays in shale production in the form of new technologies have successful unlocked vast new energy reserves in the U.S. This is driving the growth in MLPs, which is anticipated to continue for the foreseeable future.

What’s more, the U.S. is the fastest growing energy producing nation in the world and is rapidly becoming the new Middle East based on reserves. Industry groups forecast energy independence for the United States by as early as 2020.

How will MLPs benefit from unconventional shale plays?

MLPs provide the essential infrastructure (i.e. pipelines) required to transport oil and natural gas from the wellhead to the end user. The industry sources predict between $250 – $300 billion dollars will be invested in energy infrastructure in order to develop the U.S.’s unconventional shale reserves. These infrastructure investments will become the fundamental driver of MLP distributions for the next 10-20 years.

What do lower energy costs mean for the United States?

Low energy costs are a key driver of U.S. GDP growth. This energy advantage is the primary reason the U.S. is experiencing a manufacturing renaissance. A $30 billion investment blitz is underway in the U.S. petrochemical industry. This investment has dual benefits:

  • Original capital investment in property, plant and equipment; and
  • high-paying manufacturing jobs for a long period of time.

 

III. Investment Case for MLP’s

What are the benefits of investing in MLPs?

MLPs are an alternative asset class that’s uncorrelated to equities, commodities, or fixed income. The underlying assets of the public partnerships are primarily U.S. energy infrastructure. MLPs are a hybrid between higher yielding fixed income and equities, which offer capital appreciation. MPS are viewed as an inflation hedge because of its ability to grow distributions.

How have MLPs historically performed?

Over the long term, MLPs have consistently outperformed broader equity markets. This outperformance is consistent across economic, interest rate, and commodity price cycles.

How are MLPs correlated to other asset classes?

MLPs increase portfolio diversification, lower risk, and enhance returns. Relative to other asset classes, MLPs have a very low correlation. Consider the following:

  • MLPs have an average correlation of 0.5 to equities, 0.4 to REITs, and 0.5 to global infrastructure.
  • Their correlation to commodities is even lower dropping to 0.1 to natural gas and 0.3 to oil.
  • Depending on the fixed income category, MLP correlation to bonds is typically flat, slightly negative, or slightly positive.

How stable are the cash flows from MLPs?

MLPs generate stable income streams with limited exposure to commodity prices. Pipeline operators generally enter into long-term contracts that charge rental fees based on leased capacity (“ship-or-pay”). These contracts are typically access based and not volume based. Furthermore, long-term contracts usually have some type of step-up in pricing providing a hedge against inflation.

 

IV. Risks

What will happen to MLPs if interest rates rise?

MLPs are not correlated to interest rate movements. Their ability to grow distributions offer a hedge against inflation and interest rate increases. MLPs had total returns of over 40% during the last Federal Reserve tightening cycle between 2004 and 2006.

What would happen to MLPs if U.S. tax rates increase?

MLPs will benefit from an increase in tax rates. Approximately 80% of MLP income is tax deferred. This tax deferral shields income from tax increases. Consider the following example:

$1 million of dividend income is taxed at the federal level at 15%, leaving an investor with $850,000 after taxes. If the tax rate on dividends increases to 40%, then this after-tax income decreases to $600,000.

$1 million of MLP income 80% is tax deferred, of which $200,000 of taxable income leaving investors with $930,000 after taxes. If federal income taxes rise to 40%, after-tax income only decreases to $920,000.

MLPs provide an excellent way for U.S. investors to shield income from the pending fiscal cliff. In fact, the prospect of rising taxes may increase investment demand for MLPs.

What is the risk of competition driving down pricing?

There is an economic disincentive for other firms to build competing pipelines in a region. This is primarily because incumbent pipeline operators have long-term contracts with the energy companies producing in the area. Another reason is because pipeline operators need to tap the capital markets to obtain financing for new projects. In these instances, only projects with contracts in place are typically financed.

 

V. Evaluating MLP’s

What drives MLP fundamentals?

Strong and consistent distribution growth is the cornerstone of the MLP investment thesis. Price returns are tied to strong fundamentals across market and economic cycles. Future distribution growth will be fueled by the $250 – $300 billion of infrastructure investment needed to develop unconventional shale reserves. This distribution growth will be the driver of further capital appreciation.

 

 

 

 

 

 

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