Oil, natural gas and other refined products are constantly moving through the 2.5 million miles of pipelines that traverse the nation. While these pipelines are frequently owned by the oil and gas corporations that operate them, individual investors can also acquire ownership via master limited partnerships (MLPs). Similar to real estate investment trusts (REITs), MLPs are pass-through entities that trade on exchanges. MLPs combine the liquidity of publicly-traded securities, with the tax benefits of limited partnerships. But in order to enjoy the latter, MLPs must earn 90% or more of their revenue from processing, mining, refining, storage, transportation and other qualified natural resource businesses.
MLP investors, or unit holders, pay taxes at rates specific to their cash distributions, which are identified as capital returns, instead of profits, due to non-cash expenses such as amortization and depreciation — both of which reduce taxable income. (For more, see: Discover Master Limited Partnerships.)
Energy MLP Growth
With more than 122 energy MLPs currently in existence, the number of these vehicles has more then doubled over the last 10 years. There are two primary drivers behind this growth. Firstly, particularly low interest rates increase the attraction of yields, which are frequently north of 5%. But also, a shale revolution coupled with an oil and gas production surge in U.S, have heightened the need for pipelines and other energy infrastructure. Distributions investors receive are similar to bond coupons, but ones that keep growing. And success in the MLP space has opened the doors for other companies using this model — from coal mining and drilling, to exploration and production. (For more, see: How Does a Master Limited Partnership (MLP) Differ from other Business Structures?)
Although MLPs have yielded steady income streams and rich capital gains over the past decade, crude oil’s drop to under $65 dollars a barrel in December, from a high of $107 in June, has triggered worries that U.S. oil and gas production will decline and ultimately hamper pipeline activity. This worry has caused a recent double-digit drop in MLP values. But experts underline that this isn’t due to weakened fundamentals, but rather, due to fear-based sell-offs. Consider that even natural gas pipelines have been dropped by skittish investors, even thought natural gas itself hasn’t experienced the same sell-off that oil has. (For more, see: What Determines Oil Prices?)
This has created some bargain opportunities in the energy MLP space. Advisors suggest investing in MLPs with long track records of increasing distributions, cash-flow supported payouts, investment-grade credit ratings, and robust balance sheets. These are all elements crucial to maintaining a competitive advantage — especially during inhospitable markets, when flexibility can help such vehicles weather tough times.
Two MLPs that fit these criteria are Enterprise Products Partners (EPD) and Magellan Midstream (MMP). And Sunoco Logistics (SXL) is projected to grow its revenues by 15%, to over $22 billion in 2015, with earnings before interest, taxes, depreciation and amortization (EBITDA) surging 20%. Its distributions this year are expected to climb 18%. SXL also boasts an investment-grade credit rating, as does Magellan, which also enjoys the distinction of claiming the longest U.S. refined petroleum products pipeline. (For more, see: Enterprise Buys $2.1 Billion in Low-Hanging Fruit.)
Prudent investors should cast a leery eye towards unusually high yields of 8% or greater instead focusing on growth and distribution coverage — characteristics of MLPs such as Energy Transfer Partners (ETP), Western Gas (WES) and Spectra Energy (SEP). (For more, see: Breaking Down Energy Transfer's Corporate Anatomy.)
The Bottom Line
Oil and gas MLPs are here to stay and their numbers have been on the steady climb for quite some time. Although drops in crude have momentarily depressed values, they still represent strong potential for long-term sustainable growth for investors with long-term horizons. (For more, see: Should I Purchase a MLP in My Retirement Account?)