Master Limited Partnerships: An Island of Stability for Dividend Investors

Master Limited Partnerships are limited by US Code to only apply to enterprises that engage in certain businesses, mostly pertaining to the use of natural resources, such as petroleum and natural gas extraction and transportation. They combine the tax advantages of a partnership and higher dividend yields with the day to day tradability of common stocks.

MLPs consist of a general partner who manages the operations and limited partners who own the rest of the units for the partnership. Unlike corporations MLPs are not subject to double taxation.

Their stocks are called units, while their dividends are called distributions. The units are very easy to buy and sell, as they trade just like any other stock on NYSE, Nasdaq and AMEX.

MLPs mail individualized K-1 tax forms to each unitholder in late February or early March of each year that specifies the tax treatment of the prior year's payouts. A portion of their payouts can be tax-deferred, and it is subtracted from ones cost basis. When you sell your units, some of the gain that comes from certain deductions such as depreciation expense will be taxed as ordinary income. Because of MLPs specific legal structure, investors should consult with their tax advisor before investing in them.

The majority of Master Limited Partnerships engage in the transportation and storage of natural resources such as refined petroleum products and natural gas.

Thus MLPs typically enjoy toll-road business models. Thus:

• They do not take title to the commodities transported
• Are mostly indifferent to fluctuations in commodity prices because they are paid to transport not produce commodities
• They do not have significant credit risk as commodity prices balloon.
• MLP’s receive a fixed fee for moving a product over a certain distance through their pipelines

Other qualities that enable these stable enterprises to keep increasing their dividends over time include:

• Long Useful Lives of their assets
• Fees are indexed to inflation, which provides an inflation hedge
• Most MLPs have a near monopoly in their area
• There is a high cost of entry and thus there is virtually no competition

There are different types risks to investing in MLPs as well, including Regulatory Risks, Interest Rate Risks and Liability Risks.

MLPs are subject to Regulatory Risks. Currently most partnerships enjoy a pass through taxation of their income to partners, which avoid double taxation of earnings. If the government were to change MLP business structure, unitholders will not be able to enjoy the high yields in the sector for long. In addition to that since the fees that MLP charge for transportation of oil and gas products through their pipelines are regulated by the governments, this could affect the revenue stream negatively.

MLPs also carry some interest rate risks. During increases in the interest rates by the FED in 1994, 1999 and 2004 the partnerships didn’t produce decent returns to shareholders. Because of the ability to grow their cash flow base, MLPs could relatively outperform in a rising interest rate environment.

Liability risk -Unitholders typically have no liability, similar to a corporation's shareholders. Creditors however have the right to seek the return of distributions made to unitholders if the liability in question arose before the distribution was paid. This liability stays attached to the unitholder even after he or she sells the units.

The benchmark for Master Limited Partnerships, the Alerian MLP Index, has enjoyed above average annual total returns of 11.90% from 1995 to 2008. Part of the strong performance could be attributed to the above average distribution yields that most MLPs enjoy, coupled with strong growth in distributions. Master limited partnerships generate predictable and growing cash flows, which are somewhat immune to commodities price volatility and overall economic conditions. Despite the fact that the Alerian MLP Index lost 36.90% in 2008, the index is virtually unchanged so far in 2009.

The five MLPs with highest weights in the index include:

Kinder Morgan Energy Partners (KMP) owns and operates natural gas, gasoline, and other petroleum product pipelines. Also operates coal and other dry-bulk materials terminals and provides CO2 for enhanced oil recovery projects. KMP has managed to increase annual distributions by 13.90% on average since 1993. The partnership’s units currently yield 9.10%. Check out my analysis of Kinder Morgan, which is one of my best high yield stocks to own in 2009.

Enterprise Products Partners (EPD) owns onshore and offshore natural gas, natural gas liquids, crude oil and petrochemical pipelines and associated facilities. EPD has managed to increase annual distributions by 9.60% on average since 1999. The partnership’s units currently yield 9.80%.

Plains All American Pipeline (PAA) owns crude oil and refined products pipelines and associated facilities, primarily in Texas, California, Oklahoma, Louisiana and the Canadian Provinces of Alberta and Saskatchewan. Also involved in the marketing and storage of liquefied petroleum gas. PAA has managed to increase annual distributions by 7.40% on average since 1999. The partnership’s units currently yield 9.30%.

Energy Transfer Partners (ETP) owns natural gas pipelines and associated facilities. ETP also markets propane to retail customers in 40 states. ETP has managed to increase annual distributions by 13.50% on average since 1998. The partnership’s units currently yield 9.90%.

Oneok Partners (OKS) owns natural gas pipelines, processing plants and associated facilities, mostly in the Mid-Continent region. OKS has managed to increase annual distributions by 4.70% on average since 1994. The partnership’s units currently yield 10.20%.

As usual these MLPs are just a starting point for research and should not be taken as recommendations. Because of their unique structure, consult with a tax professional before investing in them.

Disclosure: Author is long KMR

Comments

[saluki65:]

They have been a great income investment for me throughout the last fews years.

Mar 18 11:51 AM

[sf123:]

The most conservative (stable payout in the future) is probably SEP. EPB is the other one. However, the payout is a lot lower than that of the ones mentioned in the article.

Mar 18 12:14 PM

[Living ON D...:]

I have debated buying into MLPs for nearly a year. I have been procrastinating because of my doubts. Perhaps some of you could help educate me:
1.) I thank Dividend Growth Investor for shedding light into the business model. Yet, MLPs seem so complicated still. I don't want to invest in things that I don't understand. Are there other resources/sites that I can go to to learn more ?
2.) If MLPs are such a good deal, then why are the yields so high ? Why have they plummetted ?
3.) I tend to quasi follow EMH. Isn't MLP really a tiny niche market. What is the total market cap of all the MLPs ?
4.) One of MLP (or was it an LP?) got into BIG trouble and went bankrupt buying futures betting that the price of it's commodity would rise. How can I avoid this when investing ?
5.) What is the leverage / debt level of these MLPs ?
6.) Obviously diversification is the safest way to get into MLPs. Putting all ones eggs in one MLP could be disastrous. Alerian's product has two problems: 1) High expense ratio 2) It is an ETN not an ETF - Therefore you have counterparty risk. No thank you. So Alerian is OUT. So I have to buy 5 or so of the MLPs. IS there anyway to get data on things like debt levels and risky forays into futures ?

Mar 18 07:20 PM

[THofler:]

Living,

On part 2). Some of the drop in MLPs is because of interest rate sensitivity. An investor that timed some of the market panics well over the last 6 months have gotten some amazing yields on AA to BBB bonds and preferred stocks. The other part of the decline is because these securities have been heavily owned by hedge funds that have gotten hit (repeatedly?) by margin calls and forced selling.

I have a medium sized holding of ETP and a small holding of EPD. I am a little concerned about the collapsing spot price of nat. gas in spite of the author's assurances.

ETP claims "midstream services" are a significant part of its business. My understanding is that this mostly nat. gas processing, and that these fees are correlated to the price of nat. gas. Also, EPD said they just opened a new gas processing facility.

So I'm concerned that the distributions could decline a bit until gas prices come up again. On the other hand, I'm heartened that ETP seems to be growing their pipeline transport fees rapidly.

Mar 18 09:29 PM

[DuffBeer:]

D-I-G
Thanks for all your post that show it is possible to make a few bucks
to buy my beer. Alot of commenters are strying to put together a monthly income stream and I am certain they appreciate you sharing
your knownledge in this area. I have tried the highflyer ,fast climber and so called rocket stocks but it always seems my turtle paying
divie issues are right along side me just churning along.
To all of you hope you reach your goals of critical mass.
I'll toast to that !!!
Cheers, DuffBeer

Mar 19 10:11 AM

[L S:]

Hey Living, Look at some of the Kayne Anderson funds, like KYN, KYE. They offer diversification, with holdings in a variety of MLP's. This should reduce your risk. Also, the tax implications are easier to manage as they issue a regular 1099 versus a K-1. I'm sure there are other options out there like this.

Mar 19 11:44 AM

[OldNavySailor:]

Beware fellow investors!

If you hold MLP's or LP's in a tax deferred account such as an IRA, you may be liable for paying the evil UBTI tax (Unrealized Business Taxable Income). If the sum total of UBTI across your MLP/LP investments exceeds $1,000.00, you will have to pay tax even though you did not sell the stock. You will have to apply for a tax id and the process is not simple to comply with the tax code.

Look at section "V" (usually) on your K-1. Many companies show a negative value, but some are positive. For details see page 2 of IRS publication 598, "Tax on Unrelated Business Income of Tax Exempt Organizations".

Mar 19 06:45 PM

[Living ON D...:]

Thank you THofler for your Comments

MLPs sound tempting - I am still confused by them. To me, the different types of income investments are: common equities. Preferreds. Bonds. Convertibles. & REITs. I understand what CDOs are what CDSes are.
I just cant seem to get my mind around these MLPs. I guess they are closest to a REIT.

Mar 20 06:38 PM

[Universal H...:]

Living:

As far as I know, the Bear Stearns Alerian MLP Select ETN (BSR) is the only fund tracking the Alerian MLP Index (AMZS), however, you are correct in stating that an ETN is a debt instrument and not an equity instrument and therefore subject to both market risk and issuer risk. In these troubled times, that makes many investors nervous about ETNs.

"LS" mentioned the Kayne Anderson funds (KYN) and KYE). These are both Closed-End Funds. The Kayne Anderson MLP Investment Co. (KYN) invests roughly 80% of its resources into midstream energy MLPs. The Kayne Anderson Energy Total Return Fund (KYE) was 57% MLPs last time I checked, and the rest in a mixed bag of production, development, transportation and storage. Kayne Anderson also has another CEF, The Kayne Anderson Energy Development Co. (KED), which was 56% invested in private energy companies and the rest in micro-cap MLPs.

You might also look at the Tortoise CEFs which parallel the Kayne Anderson funds: (TYG) Tortoise Energy Infrastructure Corp. (mostly midstream MLPs), (TYY) Tortoise Energy Capital Corp. (MLPs and other select upstream and downstream companies), and (TTO) Tortoise Capital Resources Corp. (mostly private and micro-cap energy infrastructure). Both Kayne Anderson and Tortoise boast a number of experts and insiders from the energy MLP sector, and the impression I get is that these guys know their, uh, stuff.

There are also a few other CEFs you might want to consider: (FEN) First Trust Advisors Energy Income and Growth Fund, 5.36% expenses, all top-ten holdings are midstream gas & oil MLPs. (FMO) Fiduciary/Claymore MLP Opportunity Fund, about 80% MLPs mostly from midstream energy. And (MTP) MLP & Strategic Equity Fund, 1.3% expenses.

Looking at any of these nine funds is an easy way to invest while automatically diversifying and simultaneously avoiding the K-1 and UBTI tax issues.

Mar 20 07:30 PM

[F=ma:]

Thank you for taking the time to explain MLPs. I now understand them better thanks to all the posters, but I realize that I still have quite a bit to learn. I had never heard of the tax liability within an IRA, or perhaps a 401-k. What is the downside of holding an MLP within a 401-k vehicle ?

The domestic pipelines seem to be the brightest examples for stability in comparision to the "toll road" analogy. Are the foreign MLP's involving shipping, such as TKY or TNK more suspect compared to the more readily quantifiable "near monopolies" and "toll roads" ? Some of the shipping MLPs appear to be taking on debit to pay the dividends. The regulations for billing may be less but they don't really have a long-term monopoly. Should non-domestic MLPs be avoided in favor of domestic MLPs regulated by the US Government ?

Thank you for any instruction or clarification that you provide. I am not seeking an actionable tip. I am solidly on the sidelines for now, with the exception of some well-battered domestic and international mutual funds.

Thanks again !

Mar 20 10:19 PM

[Oray:]

Can you provide more details. I have printed and read Pub 598. I acquired MLP units in a Roth IRA after my CPA said that withdrawals from Roth are not taxed. How likely is it that ETP or KMP, for example, would generate unrelated business taxable income anyway.


On Mar 19 06:45 PM OldNavySailor wrote:

> Beware fellow investors!
>
> If you hold MLP's or LP's in a tax deferred account such as an IRA,
> you may be liable for paying the evil UBTI tax (Unrealized Business
> Taxable Income). If the sum total of UBTI across your MLP/LP investments
> exceeds $1,000.00, you will have to pay tax even though you did not
> sell the stock. You will have to apply for a tax id and the process
> is not simple to comply with the tax code.
>
> Look at section "V" (usually) on your K-1. Many companies show a
> negative value, but some are positive. For details see page 2 of
> IRS publication 598, "Tax on Unrelated Business Income of Tax Exempt
> Organizations".

Mar 23 06:34 PM

[thinking ahead:]

A tip for fellow MLP holders: once cashflows reach certain thresholds, amounts diverted to the GP increase. These are called incentive distribution rights (IRD's), and they usually top out at tier 3 - 50%, after 15% and 25% steps. Most of the more established MLP's have already reached the top 50% IDR level (e.g. KMP, ETP, OKS). EPD is an example of a MLP that has a lower IDR threshold - 25% maximum.

Once MLP's reach tier 3, the distribution growth typically slows - not stops, just slows - because more of the growth is being sent to the GP. It's all a way to incentivize the GP to do a good job for the MLP unit holders.

One way to take advantage of this is to buy the GP's. But there are far fewer available, because these are the most profitable parts of the partnership structure and the smart guys like Kinder and Dan Duncan and Lowes like to keep the GP slot for themselves. But there are some available. One that has reached the 50% IDR limelight is ETE. ETE is the GP for well known ETP. If ETE follows the past pattern it should start to boost dividends significantly, while ETP grows somewhat slower that in the past. I've left some detail out to keep this post short, so do your reading. Disclosure: I own both ETP and ETE, along with KMP,BWP and EPD.

Apr 07 03:28 PM

[weiwentg:]

For GPs, my favorite is probably Enterprise GP Holdings (EPE). They hold GP stakes in EPD, ETE and TPP.


On Apr 07 03:28 PM thinking ahead wrote:

> A tip for fellow MLP holders: once cashflows reach certain thresholds,
> amounts diverted to the GP increase. These are called incentive distribution
> rights (IRD's), and they usually top out at tier 3 - 50%, after 15%
> and 25% steps. Most of the more established MLP's have already reached
> the top 50% IDR level (e.g. KMP, ETP, OKS). EPD is an example of
> a MLP that has a lower IDR threshold - 25% maximum.
>
> Once MLP's reach tier 3, the distribution growth typically slows
> - not stops, just slows - because more of the growth is being sent
> to the GP. It's all a way to incentivize the GP to do a good job
> for the MLP unit holders.
>
> One way to take advantage of this is to buy the GP's. But there are
> far fewer available, because these are the most profitable parts
> of the partnership structure and the smart guys like Kinder and Dan
> Duncan and Lowes like to keep the GP slot for themselves. But there
> are some available. One that has reached the 50% IDR limelight is
> ETE. ETE is the GP for well known ETP. If ETE follows the past pattern
> it should start to boost dividends significantly, while ETP grows
> somewhat slower that in the past. I've left some detail out to keep
> this post short, so do your reading. Disclosure: I own both ETP and
> ETE, along with KMP,BWP and EPD.
>

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