Publicly traded partnerships, or PTPs, (commonly referred to as Master Limited Partnerships or MLPs) include both limited partnerships and limited liability companies traded on a securities exchange.
The most general term is PTP (publicly traded partnership). MLP is somewhat more structurally specific than PTP, but the expression MLP and PTP are commonly used interchangeably, which we also use interchangeably in this article.
Ownership is issued in "units" which are the functional equivalent of "stocks". Instead of calling cash paid to investors "dividends", the payments are called "distributions".
Investors own "units" in the MLPs, which are taxed as partnerships, for which they are provided K-1 reports each year. Part of the distribution is treated as currently taxable income, and part is treated as return of capital which reduces the investor's basis in the position.
Typically, in each case, the sponsor of the partnership holds a management interest for which they are paid some sort of fee or share of revenues or profits, and may receive some element of expense reimbursement. Sponsors may also own some of the units.
How Similar Are They to Royalty Trusts and REITs?
Royalty trusts and REITS are also income pass-through entities, and are viewed as yield oriented investments. Royalty trusts and REITs, howeer, have statutory distribution minimums, whereas MLPs do not.
What Do They Do?
Most MLPs are engaged in the energy or natural resources business, but there are others engaged in financial businesses, real estate and some other miscellaneous industries.
This article focuses on those in the energy and natural resources industries, which account for about 2/3 of the total market capitalization of the entire MLP arena.
The majority of MLP assets are in the "pipelines" business, which broadly includes gathering, transportation and storage of oil, gas and refined oil or gas products (such as heating oil, and propane), but to also to some degree ammonia (for fertilizer manufacture) and carbon dioxide (in part for use in pressurized oil recovery in older wells).
A secondary, but significant industry for MLPs is energy exploration and production for oil, gas and coal.
Marine transportation of oil and gas is also represented within the MLP industry.
Broadly speaking, MLPs in the energy or natural resources industry (as opposed to those in other industries such as AB, which is a publicly traded investment manager), are classified into one of three main categories: "Upstream" for exploration and production, "Midstream" for gathering, transportation and storage, or "Downstream" for refining and marketing.
Why Are They Attractive?
The category is attractive generally due to typically high yields and current tax shelter. Midstream MLPs, in particular, are attractive due to their infrastructual nature. Midstream MLPs tend to have comparatively stable cash flows, that are based on volumes passing through their hands, not on the fluctuations price of the commodities they gather, transport or store. They are sometimes referred to as "toll road" businesses, because they are the highway by which so much energy related product gets from source to bulk use.
There are high barriers to entry for the Midstream segment due to the very high capital investment requirements, as well as the rights of way required to build pipelines.
The pipeline arena is one that is expected to continue to grow as consumption demands increase with population, making it attractive to thematically oriented investors, and those interested in demographically driven growth.
There are asset class correlation arguments, but with so much general convergence, that may not be a continuing advantage, and in a crisis market correlations among ownership assets tend to go down together over the short-term.
Energy and natural resources MLPs tend to be defensive in nature and are becoming better known and more accepted by investors.
How Do They Come About?
Typically, an operating company contributes or sells assets (e.g. a pipeline or a well or mine) to an entity organized by them as a limited partnership or LLC, and then does an IPO of that entity. Some of the IPO money goes to the operator, to pay for purchased assets or for some other reason. The remaining IPO money is then available to make acquisitions or enhancements of the owned assets of the entity.
The organizer probably decided to do all that because they believe they have a higher return potential with cash from the sale of assets to the partnership entity than continuing to hold the assets. For example (and this is true also of royalty trusts), an oil and gas exploration company might drill a well, transfer the well to a partnership at its appreciated value over the cost of drilling it, retain a partial interest in the form of management fees, and redeploy the cash proceeds from sale of the asset to the partnership, or sale of acquired partnership units into the public market, into the exploration and development of additional wells.
How Do the Sponsors Benefit?
The sponsor typically manages the partnership or its assets through a general partnership interest, managing member interest or a separate management company. They may be reimbursed for certain costs. They may receive some sort of administrative or management fee. They typically also participate on an incentive basis in the revenue and/or the profits of the partnership.
Who Buys Them?
Because of certain tax issues, tax qualified accounts (IRAs, pensions, foundational and endowments) can't or don't buy them. As a result the marketplace for MLPs is much smaller than for stocks of regular corporations.
Since 2004, mutual funds can allocate up to 25% of their assets to MLPs (formerly up to 10%), but pensions, endowments, and foundations effectively cannot own MLPs, because the income is treated as unrelated business income and taxed.
The result has been that a much larger share of MLPs are owned by individuals than is the case with typical stocks issued by corporations.
What About Liability?
General partnerships units expose all partners to financial and operational liabilities of the partnership. Stock ownership in public companies limits the risk of the stockholder to the value of the stock held if the business fails or is held liable for any reason. Publicly traded partnership units also limit the liability of the investor to the value of the units, except it is reported in numerous reports that in theory the unit holder can be held responsible for liabilities to creditors for distributions that were made inappropriately with respect to the right of creditors. That risk would continue, even if the unit holder sold the units before the creditors claims were asserted.
It is our understanding that no such creditor / unit holder problem has arisen with PTPs, but in theory it could happen. We are not legal experts and accept the representation of this risk at face value, but have not verified it.
MLPs have various operational risks associated with their particular industry (such as pipeline leakage into the environment, terrorism, and reduced demand in a slowed economy). Like other yield oriented investments, they have interest rate risk. However, higher yielding investments probably have lower interest rate risks than low yielding investments; and unlike bonds which do not pay more when rates rise, MLPs may experience improving business conditions during a rising rate period that may allow continued distribution growth.
How Much Do They Distribute?
MLPs pay cash distributions out of operating cash flow. There is no statutory minimum distribution percentage. They hold back what is necessary, according to management, to perpetuate or grow the enterprise, then distribute the rest.
Because MLPs are income oriented investments for investors, there are market forces that effectively prevent the manager from holding back too much for too long. The market price of the MLP would suffer if a reasonable balance between cash retention and cash distribution is not maintained, unlike many corporations that do not pay any dividends, and take the position that cash in their hands is better for investors than cash in the investors' hands.
Because MLPs pay distributions out of cash flow, and because of above average non-cash depreciation and depletion expense opportunities in many MLPs, the traditional "payout ratio" (dividends divided by net income) can be a confusing number. Available cash for operations before distributions is a better measure than net income.
This table shows the 5-year cumulative payout ratio (distribution divided by earnings) for the 20 most liquid MLPs (by average dollar trading volume) compared to the 5-year cumulative ratio of the sum of distributions to cash flow per unit plus distributions. [Note that cash flow is a post-distribution figure, requiring distributions to be added back to make the ratio meaningful).
How Do They Become Eligible for Partnership Taxation?
There are certain criteria that must be met for an entity to be treated as an MLP for US tax purposes, instead of being classified and taxed as a corporation.
MLPs must generate at least 90% of their revenue from qualifying income sources.
The detailed rules are complex on qualifying as an MLP with respect to revenue sources. We are not tax experts in any way and don't purport to know those rules in depth, but there are some high level points that are worth mentioning.
It is our understanding that tax code defining qualifying income for publicly traded partnerships is quite complex -- so much so that many private letter rulings have been sought and issued as a result of those sponsoring MLPs seeking to be qualified and compliant. However, those are internal issues for the MLPs. For investors the issues are less complex. We'll take a look at tax issues from the investor perspective in a subsequent article in this series on MLPs.
However, to understand what MLPs may and may not do to remain eligible for the partnership status, let's look at what the international accounting firm KMPG said about the related tax rules.
KPMG published a lengthy article for public partnership sponsors, highlighting key elements of the tax code sections defining qualifying income in the December 2009 issue of "Taxes -- the Tax Magazine" in the article titled "Triangles in a World or Squares: A Primer on Significant U.S. Federal Income Tax Issues for Natural Resource Publicly Traded Partnerships (Part I)". The technical specifics that follow in this article are from that publication.
They first pointed out that the legislation enabling public partnerships required certain "passive-type income" or certain income types that had been historically "commonly and typically" in partnership form. They go on to discuss what is eligible and ineligible income.
You can expect to find MLPs generating income from qualifying sources, and in some cases and to some degree to be provided current tax shelter through "depletion allowances". There is a wide range of business pursuits for entities to set themselves up as eligible to be publicly traded partnerships, if they are willing to operate within the broad parameters identified in the language. Income outside of that, or whatever future range Congress defines, is "unrelated business income" and that has certain issues for investors owning MLPs in tax qualified plans, such as IRAs.
Beginning with text from the code section that defines eligible income for public energy and natural resources partnerships, we see this broad eligible income range:
"[for those with]... income and gains derived from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or products thereof), or the marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber), industrial source carbon dioxide, or the transportation or storage of any fuel described in subsection (b), (c), (d) or (e) of section 6426, or any alcohol fuel defined in section 6426(b)(4)(NYSE:A) or any biodiesel fuel as defined in section 40A(d)(1)."
KPMG goes on to quote code and to explain that "minerals and natural resources" that are eligible for depletion include such things as:
- iron ore
- gravel and other products extracted from mines
- oil and gas wells
- fertilizer (including sulfur, potash and nitrogen)
- phosphate based livestock feed
- geothermal energy
- naturally occurring carbon dioxide from wells
- industrially produced carbon dioxide
Also included as eligible income for PTPs are oil and gas products from refining or field activities, such as:
- number 2 fuel oil
- refined lubricating oils
- diesel fuel
Oil and gas products from secondary processing, such as plastics are not included in the list of eligible income sources.
Also excluded from the eligible energy, minerals or natural resources qualified income definition are:
- farming, ranching or fishing products
- hydro-electric power
- nuclear power
- solar power
- wind power
- minerals from seawater, air or other "inexhaustible resources"
Entities engaged primarily in some forms of transportation or marketing are not eligible. While pipelines exclusively devoted to transporting refined products are eligible, those exclusively transporting by truck, or those marketing of refined products at the retail level (e.g. gasoline stations) are not eligible.
To further complicate the world, however, the rules make transportation of oil, gas or oil/gas products to bulk distribution centers, such as a refinery or a terminal, or to a utility for fuel, to be eligible whether transported by pipeline, truck, barge or rail. And then, pipelines that transport to a retail distribution point are not eligible. Further, bulk (1 ton or more) transport of fertilizer to farmers, is not "retail", and is eligible. And, the IRS allows truck transport of propane to retail customers to be treated as eligible income.
Other important eligible pipeline transportation is for:
- alcohol fuel mixtures
- biodiesel fuels
- liquefied petroleum gas
- compressed or liquefied natural gas
- liquefied hydrogen
- certain liquid fuels from coal or peat moss
- compressed, liquefied or liquid fuels from biomass
- methanol fuel
- ethanol fuel
Other forms of qualifying "passive-type" income are:
- real property rents
- gain from sale of real estate
- gain from sale of capital assets
- buy / selling of futures, options or forwards on commodities if the primary business purpose
See our Part I of this series to see how 79 MLPs are classified for the dominant business purpose.
MLPs are more structurally and tax complex than corporation stocks, but they more closely resemble the private business model of the ownership deriving all of the cash not required to operate, grow and perpetuate the business. They have a place to be considered in an equity income oriented portfolio.
Disclaimer: Opinions expressed in this material and our disclosed positions are as of August 20, 2010. Our opinions and positions may change as subsequent conditions vary. We are a fee-only investment advisor, and are compensated only by our clients. We do not sell securities, and do not receive any form of revenue or incentive from any source other than directly from clients. We are not affiliated with any securities dealer, any fund, any fund sponsor or any company issuer of any security. All of our published material is for informational purposes only, and is not personal investment advice to any specific person for any particular purpose. We utilize information sources that we believe to be reliable, but do not warrant the accuracy of those sources or our analysis. Past performance is no guarantee of future performance, and there is no guarantee that any forecast will come to pass. Do not rely solely on this material when making an investment decision. Other factors may be important too. Investment involves risks of loss of capital. Consider seeking professional advice before implementing your portfolio ideas.