The Case for Investing in MLPs

Investors should take advantage of the ongoing correction in the stock market to pick up units of our favorite master limited partnerships–particularly those that operate in the upstream space–at favorable valuations.

Since the end of 2007, the Alerian MLP Index has generated a total return of 66.6 percent, about 32 percent of which came from price appreciation. The S&P 500, on the other hand, lost 1.55 percent over the same period.

This outperformance reflects strong fundamentals, particularly for master limited partnerships (MLP) that own and operate midstream infrastructure for processing and transporting oil, natural gas and natural gas liquids (NGL).

For one, midstream operators stand to benefit over the next several years from rising demand for takeaway capacity in the nation’s prolific shale oil and gas plays.

Surging activity in the Bakken Shale in North Dakota, the Eagle Ford Shale in South Texas and other plays has enabled the US to grow it annual oil output for the first time in decades. Even more impressive, this increase in overall oil volumes has occurred despite a sharp decline in production offshore Alaska and in the Gulf of Mexico.

Meanwhile, frenzied drilling in the nation’s shale plays enabled the US to surpass Russia as the world’s leading producer of natural gas and has dramatically depressed gas prices in the closed North American market. Despite gas prices that continue to hover near record lows, US output has continued to grow. Exploration and production firms have shifted their emphasis from dry-gas fields to fields such as the Marcellus Shale and Eagle Ford Shale that also produce large amounts of higher-value NGLs that improve wellhead economics.

This upsurge in onshore oil and gas output has occurred in many regions that lack legacy takeaway and processing capacity, while even the Permian Basin in west Texas–an area that’s produced oil since the 1920s–requires additional infrastructure to handle growing volumes.

In a comprehensive report on this subject, the Interstate Natural Gas Association of America (INGAA) estimates that the US and Canada will need to spend $83.8 billion to build and expand enough midstream infrastructure to support the surge in onshore production. Although a trade organization that represents pipeline owners produced this report, many of the pricing and production assumptions underlying the INGAA’s estimates appear reasonable.

Demand for these midstream assets will be met by MLPs, setting the stage for the best-positioned names to grow their cash flow and quarterly distributions to unitholders. Rising cash flow and quarterly payouts inevitably add up to rising stock prices.

In addition to rising demand for midstream infrastructure, MLPs continue to reap the rewards from an extraordinarily low cost of capital. Because MLPs are pass-through entities that disburse the majority of their cash flow to their investors, publicly traded partnerships rely on the debt and equity markets to fund acquisitions or organic growth projects.

With many of our favorite MLPs raising inexpensive debt and equity capital to fund growth projects in the nation’s burgeoning shale plays, we expect the coming distribution growth to fuel additional price appreciation.

Moreover, the current market environment should combine with investor psychology and demographics to increase investment in the group.

For one, despite the Alerian MLP Index’s recent rally, the group still offers superior yields to an overbought bond market and traditional income-oriented securities such as real estate investment trusts.

Many income-seeking investors also remain scarred by the stock market implosion that accompanied the global credit crunch and Great Recession, a period that reminded investors of the risk involved in investing in higher-yielding fare. Few will forget the panic that ensued when corporate titans such as General Electric (NYSE: GE) and Bank of America Corp (NYSE: BAC) were forced to slash their dividends after the credit bubble burst.

In contrast, many energy-related MLPs managed to maintain their distributions throughout this turbulent period, overcoming frozen capital markets and plummeting oil and gas prices. MLPs that own midstream assets such as pipelines proved the most resilient; these names tend to garner much of their cash flow from fees and are relatively insulated from fluctuations in commodity prices.

At the same time, uncertainty surrounding the EU sovereign-debt crisis and global economic growth should ensure that volatility once again rules the stock market through at least 2012. With shell-shocked investors seeking reliable income and growing dividends to offset losses incurred by panicked selling and a flat stock market, expect inflows to the MLP sector to continue apace.

Besides investor psychology, demographic trends also bode well for energy-related MLPs. The US Census Bureau estimates that the number of elderly American will increase by 36 percent in 2020 and 79 percent in 2030. To meet the needs of this wave of retiring baby boomers, financial planners continue to shift their focus from the best strategies for accruing assets to turning accumulated savings into a lifelong income stream. Not surprisingly, the sustainable yields offered by MLPs hold a great deal of appeal for investors whose bodies are becoming less reliability.

Retirees will also gravitate toward the tax advantages offered by MLPs. The Tax Reform Act of 1986 sought to encourage investment in energy infrastructure by exempting the MLP structure from corporate taxes. Similar to real estate investment trusts, MLPs are pass-through entities that transfer any profit or losses to individual unitholders who pay taxes at their ordinary income rate.

Because of depreciation allowances, 80 to 90 percent of the distribution you receive from a typical MLP is considered a return of capital by the Internal Revenue Service. You don’t pay taxes immediately on this portion of the distribution.

Instead, return of capital payments serve to reduce your cost basis in the MLP. You’re not taxed on the return of capital until you sell the units.

In other words, 80 to 90 percent of the distribution you receive from the MLP is tax-deferred. The remaining piece of each distribution is taxed at normal income tax rates, not the special dividend tax rate. But the piece taxed at full income tax rates is only 10 to 20 percent of the total distribution; there’s still a huge deferred tax shield for unitholders.

An example can provide a useful illustration. Assume you own an MLP purchased for $50 and receive $5 in annual distribution payments, $4.50 of which is considered a return of capital. After one year, your cost basis on the MLP would drop to $45.50 ($50 minus $4.50); no income tax is paid on that $4.50. You’d pay normal income tax rates on the remaining 50 cents.

When you finally sell the units or the cost basis drops to zero dollars, a portion of the capital gains are taxed at the special long-term capital gains tax rate. The remainder is taxed at your full income tax rate. But in most cases, MLPs should be held for long periods to get the full benefit of distributions. You’re likely to be deferring 80 to 90 percent of your taxes for several years or perhaps indefinitely–a tremendous benefit, especially for older investors.

Older investors can also rest easy that when their MLP holdings pass on to their heirs. The cost basis of an MLP is reset to the initial cost basis (purchase price) when an investor dies. MLPs can be a valuable component of your estate plan, allowing you to pass along an income-paying asset without owing tax on shielded income.

Not surprisingly, financial institutions have been quick to capitalize on rising demand for MLPs, rolling out 41 funds that provide one-stop exposure to the group.

Not only does this trend raise investors’ awareness of the benefits of MLPs, but the added liquidity should also boost unit prices within the sector and increase the correlation between this security class and the S&P 500.

Investors will eke out better returns over the long run by purchasing units of individual MLPs. The funds pushed by the various investment houses eliminate some of the headaches with figuring out tax liabilities on individual MLPs, but many of these funds expose investors to the double taxation that individual holdings avoid. Also, these funds’ portfolios often include a number of marginal names in addition to the sector’s top performers.