The Nine Best Natural Gas, Oil Pipelines for Income and Capital Gains

This concludes my trilogy of articles discussing why natural gas & why now, which exploration firms I think offer the best opportunity, and, below, the pipeline, gathering, storage, and processing firms I believe are poised to profit most.

Most natural gas pipeline companies are organized as MLPs – Master Limited Partnerships. MLPs are a little like REITs -- Real Estate Investment Trusts -- since they don’t pay income taxes directly. Instead, income is allocated among all partners (that would be you and me as shareholders) in proportion to the number of shares we own. Typically, there will be a general partner, whose responsibility it is to actually run the business, and we shareholders are the limited partners.

To qualify for the tax advantage, the IRS demands that 90% of an MLP’s income come from real estate, commodities, or natural resources -- mining, timber or energy. MLPs typically provide a tax advantage because much of their distribution is classified as a return of investment instead of income and is thus tax-deferred. Some people shy away from MLPs because they are a pain in the neck at tax time.

Personally, I’d rather put up with that pain in the neck once a year and sleep soundly the other 364 nights, but your mileage may vary. The MLP’s general partner will mail individualized “K-1” tax forms to each shareholder (technically, since you are a partner, “unit-holder”) in March of each year that specifies the tax treatment of the prior year's payouts.

The fraction of distributions that is not taxable gives you a tax break each year but must be subtracted from your original purchase price to compute your cost basis. When you finally sell, some of your gain will be taxed at the lower capital gains rate, but the portion of the gain that results from deductions such as depreciation and depletion will be taxed as ordinary income. I’m OK with that – better to pay my taxes in ever-less-valuable dollars 10 or 20 years from now than losing the value of compounding those distributions in today’s dollars.

A lot of people will tell you that MLPs aren’t appropriate for IRAs and other tax-sheltered accounts. If you have hundreds of thousands of dollars in MLPs, that may be true. But the advice actually stems from a relatively remote possibility for most of us. That segment of the distributions designated as ordinary income will be considered Unrelated Business Taxable Income (UBTI) by the IRS, and subject to tax. But UBTI is typically such a small percentage of total distributions (and it won’t be taxed as long as the amount of UBTI from all holdings doesn’t exceed $1,000 annually) that it is seldom a consideration for many investors.

Balance that advice with this: if you buy MLPs when they are cheap and expect a fine capital gain, better to pay a little tax as UBTI but shelter your gains for as many years as possible. Particularly in my clients’ Roth accounts, where both dividends and share price gains accrue and compound tax-free, I have no problem purchasing MLPs.

The MLPs I like best are the ones that transport natural gas, because I see natural gas as America’s immediate, available today, cheap and abundant energy salvation. I’ll let others hold high the banner of quintupling solar from its current 12/100 of 1% market share to 6/10 of 1%. I’ll watch and shake my head sadly as the administration subsidizes, cajoles and spreads pork and spin for “clean” electric cars which are in fact fueled mostly by coal, since it provides the electricity.

You won’t always find a pure natural gas carrier so when I speak of the pipeline MLPs I’m talking about those that transport natural gas, oil, gasoline, and other petroleum by-products through their pipelines. These MLPs enjoy a stable and profitable business (though not necessarily a stable stock price given the alternating cycles of investor despair and euphoria.) Since pipelines almost never overlap, they have no competition on the routes they serve.

It’s important to note, before you buy a pipeline MLP, that you can’t evaluate an MLP the same way you evaluate most common stocks. Because these MLPs own assets that provide big depreciation charges, you might view their reported earnings and conclude they are basket cases. But those reported earnings aren’t the most important factor in assessing a pipeline MLP – it is cash flow that powers distributions and provides the best likelihood of continued steady distributions, and provides cash for capital expenditures and for acquisitions.

One final caveat. Among pipeline MLPs, there are two primary subsets: oil & refined products (like gasoline or heating oils) pipelines and natural gas pipelines. The oil pipeline operators tend to have a more stable business environment, since their fees are regulated and are based on the volume of product transported, not by the price of oil. Natural gas pipeline firms, on the other hand, often operate gas-gathering systems, which connect individual wells to public pipelines, which then connect to processing plants. This makes natural gas pipeline MLPs more exposed to changes in the price of the underlying commodity. However, most operators use hedging strategies to reduce their susceptibility to price swings and guarantee a steadier market at a steadier price.

With all this as a solid foundation, here are some pipeline companies I follow. I’ll give you the basics so you can research them at your leisure and see if you agree with my choices. Those in bold are owned by officers and clients of Stanford Wealth Management LLC; those in bold and in red I still consider attractive for purchase even after the run-up of the past 6 months. [click to enlarge]

There are a couple anomalies in this list you may have noticed. Of the 13 companies we own, I only recommend 9 at their current prices and 2 of those are only for the most speculative accounts. Even those remaining 7 – BWP, OKS, WPZ, MMP, MGG, PVR and WMB -- are at the high end of their range for the trailing few months. You may wish to establish some percentage of your position now and add to it if it declines into the center of the range I’ve suggested.

The special situation above is that I’ve listed both MMP and MGG. If you buy only MGG, as we have done recently, it reduces the field to just 6 currently recommended. MMP is taking over the general partner’s share and will be self-managed. Since no deal is final until the ink is dry, MGG trades at a slight discount to the actual “takeover” price, giving us a small (less than a dollar) arbitrage opportunity here I prefer MGG because I believe it is in all shareholders’ interest to approve the deal. I see it as highly likely to take place. If it doesn’t, I’m still pleased to own MGG. (TPP, not currently recommended – but owned by us – also has a slight arbitrage value as EPD has extended an offer almost certain to go through…)

That leaves the two speculative (!) MLPs, APL and SGLP.

I selected APL, even though it currently pays no dividend (a decision will be made in 2010 as to future distributions) based upon their partnership with WMB and the increased price I expect for natural gas. I think APL's JV with Williams gives them new-found credibility and a solid partner.

As for SGLP, it may or may not continue as a going concern. It was spun off from a private company desperate for cash. (It has now declared bankruptcy.) SGLP is having to make its way in an unforgiving market environment. Worse, business has suffered as customers confuse them with the bankrupt former parent, which shared the same base name. (If management is on the ball, expect to see a name change in the near future. Even Enron Oil & Gas is prospering as EOG Resources (EOG)!) The company has less than $3 million cash on hand and an unused credit availability under its revolving credit facility of just $27 million. They are skimming the surface of violating their bank covenants.

So why even talk about it? Sometimes an underdog like this, dealt a bad hand, has assets that may yet be realized. And I believe its price already reflects the current situation. They have, since the spinoff, reached a settlement with their former parent to clarify the division of asphalt processing and delivery assets; signed asphalt contracts with 13 new customers (resulting in 45 of SGLP's 46 asphalt facilities being under contract, with the majority of these agreements extending through 2011); negotiated an amendment to its credit facility, effective through June 2011; and signed new crude oil storage contracts at its Cushing, OK facility, increasing the total to 6.2 million barrels of shell capacity.

I wouldn’t bet the farm, but as an adjunct to a solid portfolio like the others recommended above, for those with a speculative bent I believe it may be worth a shot. Long live the underdog…

Full Disclosure: We are long the 13 issues in bold in the chart above.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Also, past performance is no guarantee of future results, rather an obvious statement if you review the records of many alleged gurus, but important nonetheless – especially so you are not over-impressed by the fact that our Investors Edge ® Growth and Value Portfolio has beaten the S&P 500 for 10 years running. What if this is the year we under-perform it?

It should not be assumed that investing in any securities we are investing in will always be profitable. We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

Comments

[Steven Ward:]

I have purchased only one MLP, the old Buckeye Partners that owned an oil pipeline from Canada that serviced Midwest Refineries.
My whole problem is with management taking such a huge cut in the cash flow with nio correspondiing upfront equity stake.
Congress enacted tax benefits for pipeline companies that permitted the MLP structure,however, think of the return the investor would receive if the MLP structure contained a regularly compensated management with the GP comming from board members who were unit holders themselves that had purchased shares in the open market.
Somebody should do that. you don;t need a rocket scientist to run a pipeline company. In fact they are deliberatly designed to be dull with a day out and day in routine. Only issues are rates, FERC and EPA.

Sep 16 11:55 AM

[bbowen7:]

I agree. This is the most comprehensive discussion of the implications of MLPs that I have seen - particularly the tax treatment. I hold KMP, and don't see enough on the differentiation to change that. The article does, however, tilt me over the edge to getting a good tax preparer.

Sep 16 01:57 PM

[TJ Schoenlein:]

Excellent overview without the "long story."
Having seen my banks, shipping dividends slip into the abyss.. the MLP's payouts have been my bread & butter during this recession. Being retired, the money is there on a quarterly basis.

Sep 16 03:05 PM

[LKofEnglish:]

Still don't see the growth potential. in other words what happens once the pipeline is built? and then of course there is the government which not only build their own pipelines but have their own utilities that consumer the gas. in other words its you the taxpayer that has put forth the upfront cost and therefore you the investor that gets the return. in other words isn't the answer the natural gas utilitity since they are the government?

Sep 16 03:30 PM

[wg:]

"PMBIF. This company transports about 1/2 the oil produced in the western Canadian sedimentary basin, offers a current distribution yield of approximately 10%, and pays monthly. "

all of the financial stats sites I visit say PMBIF pays no dividend/yield. What's up?

Sep 16 06:19 PM

[d_teller:]

I most strongly disagree with the premise that it is safe or desirable to hold MLP's or other securities that issue K-1's in tax-sheltered accounts:

The problem of UBTI (Unrelated Business...Taxable Income) that has accumulated to a single taxpayer's I.D. across all the taxpayer's shelters - is really very simple:

if it exceeds $1000.00/tax year, it has to have the Fiduciary of one of the shelters file a Tax Identification Number request and pay any UBIT (tax) from the shelter to the IRS. This isn't the income from the MLP's or pipelines...it's only the profits directly passed through to the limited partners...the taxpayer... that represents the income that is "unrelated to the limited partnership registration". An example, last year, a lot of MLP's had negative UBTI or losses, due to the swoon of commodity pricing.
The previous year, many had a lot of UBTI from selling a portion of their assets or raising debt. This varies from year to year.

Fiduciaries need the copies of the K-1's, and charge fees to get a TIN (920t) for the sheltered account. This is After the tax season closes, so interest and penalties accrue. The tax payer (beneficial owner) of the shelter may NOT pay the UBI tax directly, because it is:
a. After the year of the record
b.Considered an excess contribution.

With regard to Roth's, this can disqualify the Tax-Exempt status, and has other ramifications.

In any case, all of the return of capital, losses carried forward, and other allowed depreciation from the original price of purchase are totally wasted in a tax-sheltered account...those that aren't Roth's will pay tax at marginal rates...there's no Capital Gains advantage when e.g., Enterprise' ROC or Tax-loss carry-forwards ( which reduce the capital basis of the securities in a taxable account) can't be used to offset withdrawals.

The beneficial owner has to notify the fiduciary of the sheltered account that will be used to pay the tax, because the fiduciary (Brokerage) probably doesn't "know" what's on the K-1...they don't get copies. Only the Registration agent of the MLP (the accountants) and the IRS and the tax-payer get these forms.

In addition, it hasn't yet come to pass, but it probably will, that ETF's and Holdrs and other issuers of K-1's that take delivery and hold in storage >90 days...are considered COMMODITY HOLDERS: the IRC has an explicit prohibition vs holding commodities in a tax shelter, unless one has a "self-directed" IRA, with a fiduciary (not just a brokerage or advisor) who will file the TIN and 990 Tax forms...and these charge a percentage of assets or fees from $200-2500/year.

In summary:

UBTI across all sheltered accounts with a single Taxpayers's I.D > $1000, requires a fiduciary to file and pay tax.

The various schema to reduce "basis' or defer income, are wasted in a tax sheltered account.

The costs for setting up a "self-directed" IRA can exceed $2500/year.

Sep 16 09:10 PM

[losbronces:]

They just announced their October distribution. This is the website, which is a good place to start:
www.pembina.com/webcms...

I recommend that you have your broker buy the stock (if you decide to go that way) on the TSX, as I have done with my holdings in Peyto and Arc. The volume will be better there and I personnally don't like trading the pinksheets. I have found in the past that sometimes my limit orders didn't get filled even when the price crossed, so I just don't do it anymore.

The TD Waterhouse website will provide you with a quote for this stock and additional financial information. You don't have to have an account there to access the information. Also, the SEDAR website will have all the pertinent filings for the company (e.g., reserve reports and financial reports).

On Sep 16 06:19 PM wg wrote:

> "PMBIF. This company transports about 1/2 the oil produced in the
> western Canadian sedimentary basin, offers a current distribution
> yield of approximately 10%, and pays monthly. "
>
> all of the financial stats sites I visit say PMBIF pays no dividend/yield.
> What's up?

Sep 16 09:23 PM

[d_teller:]

PMBIF is the "pink sheet" listing for Pembina, which pays dividends at ca. 10%/yr on a monthly basis. The Canadian Income trust withholds 15% for Cdn Tax...and in a sheltered accout, this can't be claimed as a tax credit...but it can be in a US taxable account.

You can find the info at the NASDAQ site under the "pink sheets" listings, (OTCBB) and also at www.QuantumOnline.com

which has quite a number of the Cdn Income trusts listed with their TMX(TSX) and OTC equivalent listings.


On Sep 16 06:19 PM wg wrote:

> "PMBIF. This company transports about 1/2 the oil produced in the
> western Canadian sedimentary basin, offers a current distribution
> yield of approximately 10%, and pays monthly. "
>
> all of the financial stats sites I visit say PMBIF pays no dividend/yield.
> What's up?

Sep 16 09:24 PM

[d_teller:]

It's not the total income, but the accumulation of UBTI...the author of the review above carefully notes that the sum of UBTI limit is what's important. Unfortunately, one can't know this before the K-1's come.


On Sep 16 11:53 AM GimliJan wrote:

> One of the best articles I have read on MLP's and how they work.
> I appreciated the information about holding them in a Roth IRA as
> that is what I am doing. I had read on the forums that due to the
> tax consequences on the UBTI if you made over a $1000 a year you
> could lose the Roth IRA status and have to pay taxes on your whole
> account! I don't a large account and the $1000 a year is way more
> than I will realize in profits from the MLP portion of my portfolio.
>
> I also would like some more information on the reasons you picked
> the companies you hold and also about the "arbitrage". I bought TPP
> at $17 and have thoroughly enjoyed the run up and the merger with
> EPD. I plan on adding Pembrian and maybe WPZ.
> Thanks for a great article!

Sep 16 09:33 PM

[MexCom:]

My self directed IRA cost nothing to set and it pays no income taxes. I own REITs and a gas partnership that spins off great distributions in excess of $1,000/yr and never had to pay any tax. The broker does all the work - I am now taking income distributions from the account and have regular income tax withholding.


On Sep 16 09:10 PM d_teller wrote:

> I most strongly disagree with the premise that it is safe or desirable
> to hold MLP's or other securities that issue K-1's in tax-sheltered
> accounts:
>
> The problem of UBTI (Unrelated Business...Taxable Income) that has
> accumulated to a single taxpayer's I.D. across all the taxpayer's
> shelters - is really very simple:
>
> if it exceeds $1000.00/tax year, it has to have the Fiduciary of
> one of the shelters file a Tax Identification Number request and
> pay any UBIT (tax) from the shelter to the IRS. This isn't the income
> from the MLP's or pipelines...it's only the profits directly passed
> through to the limited partners...the taxpayer... that represents
> the income that is "unrelated to the limited partnership registration".
> An example, last year, a lot of MLP's had negative UBTI or losses,
> due to the swoon of commodity pricing.
> The previous year, many had a lot of UBTI from selling a portion
> of their assets or raising debt. This varies from year to year.
>
>
> Fiduciaries need the copies of the K-1's, and charge fees to get
> a TIN (920t) for the sheltered account. This is After the tax season
> closes, so interest and penalties accrue. The tax payer (beneficial
> owner) of the shelter may NOT pay the UBI tax directly, because it
> is:
> a. After the year of the record
> b.Considered an excess contribution.
>
> With regard to Roth's, this can disqualify the Tax-Exempt status,
> and has other ramifications.
>
> In any case, all of the return of capital, losses carried forward,
> and other allowed depreciation from the original price of purchase
> are totally wasted in a tax-sheltered account...those that aren't
> Roth's will pay tax at marginal rates...there's no Capital Gains
> advantage when e.g., Enterprise' ROC or Tax-loss carry-forwards (
> which reduce the capital basis of the securities in a taxable account)
> can't be used to offset withdrawals.
>
> The beneficial owner has to notify the fiduciary of the sheltered
> account that will be used to pay the tax, because the fiduciary (Brokerage)
> probably doesn't "know" what's on the K-1...they don't get copies.
> Only the Registration agent of the MLP (the accountants) and the
> IRS and the tax-payer get these forms.
>
> In addition, it hasn't yet come to pass, but it probably will, that
> ETF's and Holdrs and other issuers of K-1's that take delivery and
> hold in storage >90 days...are considered COMMODITY HOLDERS: the
> IRC has an explicit prohibition vs holding commodities in a tax
> shelter, unless one has a "self-directed" IRA, with a fiduciary (not
> just a brokerage or advisor) who will file the TIN and 990 Tax forms...and
> these charge a percentage of assets or fees from $200-2500/year.
>
>
> In summary:
>
> UBTI across all sheltered accounts with a single Taxpayers's I.D
> > $1000, requires a fiduciary to file and pay tax.
>
> The various schema to reduce "basis' or defer income, are wasted
> in a tax sheltered account.
>
> The costs for setting up a "self-directed" IRA can exceed $2500/year.
>

Sep 17 06:53 AM

[MexCom:]

The big profit from Nat. Gas will be from companies that develop technology to use the stuff. T-Bone Pickins seems to have failed to get the government to gear up a program to use it as an automotive fuel. With deep water exploration for oil discovering reserves in excess of Saudi - there is too much oil to compete with that prospect. Cheap oil can make a gas pipline worthless. I see a future where most Nat. Gas production will not be used at all - only to be flared off as a bi-product of oil production as much of it is disposed of now where it is too expensive to build storage and pipelines.
An investment in a gas pipeline could result in a complete loss.

Sep 17 06:59 AM

[Shale Gas:]

How levered are these stocks on the list?

Sep 17 07:31 AM

[Dances with...:]

very interesting

Sep 17 08:30 AM

[Benny D.:]

Any comments on using closed end funds? KED KYE TYG TYN TTO

Sep 17 12:32 PM

[Chancer:]

I like KMR because you receive the dividend in shares.

No K-1. No tax until you sell, and that will be capital gain.

Every time you receive the stock dividend, your average cost (tax basis) goes down.

Sep 17 03:28 PM

[capitainecr...:]

The author recommends KMP, I prefer KMR - it is the same as KMP
but it pays the same dividend in shares instead of cash. So it does not have any UBTI or K1 issues (i.e. safe for an IRA) and it is also cheaper to buy than KMP and gives you a higher ROI to boot.

Sep 17 04:59 PM

[Uncle Pie:]

visit the company's website for the most accurate info.


On Sep 16 06:19 PM wg wrote:

> "PMBIF. This company transports about 1/2 the oil produced in the
> western Canadian sedimentary basin, offers a current distribution
> yield of approximately 10%, and pays monthly. "
>
> all of the financial stats sites I visit say PMBIF pays no dividend/yield.
> What's up?

Sep 19 02:51 PM

[strovej1:]

It's unfortunate that such a bedrock US investment is so little understood. Perhaps it's because it is primarily a retail product, so you don't hear much about these companies on CNBC, etc. However, their positive investment qualities dramatically overcome any accounting considerations, in my opinion.

Regarding the growth comment: MLPs grow both organically as well as through acquisitions. There is a need for energy infrastructure in our country. MLPs fill that need by extending pipe to new finds, building new processing/fractionation plants/storage, etc. to handle new capacity. Since 1995 they have, as a group, a compound annual return of over 14%... that would make most "growth" companies hide their faces in shame. Indeed, even if they shared the growth profile of utilities (with whom they are not correlated) most people either don't realize, or disregard the fact that utilities as a group have outperformed the NASDAQ by about 70bps/year since it's inception in 1971.

I believe it has to do with our fascination with capital gains, ignoring the fact that real wealth is built through compounding.


On Sep 16 03:30 PM LKofEnglish wrote:

> Still don't see the growth potential. in other words what happens
> once the pipeline is built? and then of course there is the government
> which not only build their own pipelines but have their own utilities
> that consumer the gas. in other words its you the taxpayer that
> has put forth the upfront cost and therefore you the investor that
> gets the return. in other words isn't the answer the natural gas
> utilitity since they are the government?

Sep 19 08:48 PM

[genetuck:]

UBTI is often a negative figure. One reason is that depreciation offsets UBTI. However, the longer you hold the MLP the more you "use up" your eligibility for depreciation, and I was shocked to see UBTI of $750 for just 600 shares of OKS in an IRA. This was because it was bought 13-years ago. I had been accustomed to negative UBTI or very small positive figures. The lesson to me was that you may need to swap out your MLPs in IRAs every ten years or so, or get out of individual issues for a while when UBTI starts building up in them. You can get back in to start again with full eligibility for depreciation benefits. The risk of MLPs in an IRA is that you might be libel to having to pay 35% taxes on UBTI in excess of $1,000, and the broker may charge a hefty fee for filing the report and deducting the tax. But exceeding the limit very rarely happens. Another point is that negative UBTI from one MLP offsets positive UBTI from another MLP in the same IRA.

Sep 20 10:50 PM

[drbob66:]

Buy AHD now, and hold it for a while..it will be $20.90 within 3 years (current price $3.94).

And don't forget...you heard it here first.

You're welcome.

Oct 08 04:29 PM