This week in MLP Investing Insider I answered a reader’s question about my thoughts on Energy Transfer Partners (NYSE: ETP). It was a timely question for me, as I am about to move some cash back into the market, and I have been strongly considering a midstream master limited partnership (MLP). As a result, I have been taking a close look at a number of partnerships that fit my criteria, and I will share some of my research with readers.

Just about anyone who invests in the energy sector should consider an MLP. There are MLPs that are focused on oil and gas production (upstream), there are those that are focused on oil and gas transportation (midstream), and there are those that deal with refining and fuel distribution (downstream). There are also MLPs that fit numerous niches.

Why should you consider a partnership over a corporation? Because as explained below there are significant tax advantages, and all other things being equal, an MLP should deliver more money in your pockets over time than a comparable corporation. But because of this MLPs also generally trade at a premium to comparable corporations, so it’s important to find MLPs that are good values.

A Review of MLP Investing

Most readers know the basics of MLP investing, but for those who don’t here is a brief overview. For those who are familiar with MLP investing, please skip to the next section.

In 1987 Congress legislated the rules for publicly traded partnerships in Internal Revenue Code Section 7704. The rules state that at least 90% of an MLP’s income must come from qualified sources, such as real estate or natural resources. Section 613 of the tax code requires qualifying energy sources to be depletable resources or their derivatives, such as crude oil, petroleum products, natural gas and coal — although recent case-by-case Internal Revenue Service rulings have expanded the range of activities qualifying for MLP treatment.

An MLP issues units rather than shares, but the key advantage is that MLPs aren’t taxed at the corporate level. MLPs pass profits directly to unitholders, also known as limited partners, in the form of quarterly distributions. This arrangement avoids the double taxation of corporate dividends affecting traditional corporations and their shareholders.

In addition, the bulk of the distributions is typically not immediately taxable. Because of the depreciation allowance, 80% to 90% of the distribution is termed a “return of capital” and thus not taxable when received. Instead, returns of capital reduce the cost basis of an investment in the MLP.

The rest of the distribution — typically 10% to 20% — is taxed as ordinary income. But being able to defer the rest of the tax until the investment is sold is an advantage, since the income can be reinvested to generate compound returns that could more than pay for the eventual tax bill.

When you ultimately sell the units the portion of the capital gain attributable to the rise in the unit price is taxed at the special long-term capital gains tax rate, and the remainder as ordinary income,

MLPs issue Schedule K-1 forms instead of the 1099 forms you may receive from a corporation, and the K-1 will reflect your share of the taxable income. Partnerships are not required to file their K-1’s for the prior year until April 15 just like individuals. Most K-1s are issued between late February and early April, which could delay your tax return.

When might you not want to own an MLP? You get maximum advantage from an MLP by holding it for a long period of time. If you don’t intend to do so, you may still experience gains from price appreciation, but you won’t gain much from the tax benefits. Likewise, if you are investing primarily in tax-deferred retirement funds, you lose out on some tax benefits, while possibly exposing that tax-deferred account to taxation on the partnership distributions.

One other potential downside is that the taxes for MLP investors are more complex. The K-1 package will include a state schedule that details the MLP’s share of income or loss attributed to each state in which it operates. For example, a pipeline may cut across 5 states and have reportable income in each state. You may be required to file state tax returns for each of these states, which means your tax reporting may be more complex and costlier, though most individual investors fall well under the threshold for having to do so.

A Focus on the Midstreams

As I have noted on a number of occasions, I am a relatively conservative investor. I expect that I still have a number of years until retirement, but the closer that time comes, the more conservative I become. When I do retire, I, like many other retired investors, will primarily utilize my investments to provide a steady and fairly reliable income stream. This is where the midstream MLPs excel.

Midstream MLPs generally operate as toll collectors who are paid to move oil and gas from the field to the market. They may be involved in some oil and gas processing, as well as storage. Their contracts are largely fee-based, with a large fraction of income guaranteed whether an oil or gas producer utilizes their services or not. Therefore, the midstreams are more insulated from commodity price fluctuations than are their upstream and downstream counterparts.

That doesn’t mean they can’t lose value. One component of an MLP’s value rests on the expectation that it will be able to grow distributions by adding new infrastructure. If oil and natural gas prices remain depressed, the infrastructure buildout will slow, dampening distribution growth. Thus, the prices of midstream MLP units have dropped along with the price of oil — but their decline has been relatively mild in comparison with drillers’ shares.

The Alerian MLP Infrastructure Index is a composite of energy infrastructure MLPs. The 25 constituents of the index earn the majority of their cash flow from the transportation, storage, and processing of energy commodities. Over the past six months the total return of that index is about -8%, but this is during a time that oil prices fell by nearly 60%. In comparison, the Energy Select Sector SPDR (NYSE: XLE), which is composed primarily of major oil and gas companies and oilfield service companies, was down 25% over that time span.

Since its introduction in late 1995, the Alerian MLP Infrastructure Index has increased steadily, with very few significant corrections, while yielding an average of 7.5%. The yield has only been below 5% during one year — the second half of 2014 — and it has ranged as high as 14.2% (during the oil price collapse of 2008).


Above: the total return of the Alerian MLP Infrastructure Index since inception

Thus, history suggests that midstream MLPs are a relatively safe haven for income-seeking investors, and they offer yields that are difficult to find elsewhere.

In the next issue of The Energy Strategist I am going discuss specific midstream MLP recommendations, but if you don’t want to wait for that you can find several that are currently recommended in our Conservative Portfolio. I will close this article by listing the 10 largest components of the Alerian MLP Infrastructure Index, and highlighting some of the important parameters to note when evaluating an MLP:

^{Price/DCF = Market capitalization divided by the last year’s distributable cash flow
TTM Coverage = the amount of cash distributions divided by the amount that was available to be paid out over the past 12 months
Market Cap = Market capitalization in billion dollars
Yield = Annualized yield per unit}

Note that from this table, EPD and ETP are rated as Buys in our Conservative Portfolio, while MWE and SXL are currently Holds. 

In the next issue, I will focus on some of our specific recommendations and discuss in more detail some of the key parameters to consider when evaluating an MLP for your portfolio.

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