- Natural gas production is soaring.
- In the U.S., nat-gas can only be shipped via pipelines.
- General partners produce higher returns than MLPs.
- Stick with GPs, which are taxable as corporations.
General Partners Beat MLPs
About a year ago, in August 2013, I described MLP General Partners, a category of stock that you had probably not heard of before. Hopefully, you paid attention. As of August 25, 2014, the four stocks that I mentioned in the column had averaged a 65% total return (dividends plus price appreciation). Now that I have your attention, here's some background.
Natural Gas Production Soaring
Thanks to new extraction techniques, natural gas production has increased dramatically over the past few years. Using May 2014 data, the latest available figures, production had increased 24% over the past five years, and almost 5% since my August 2013 column. Driven by the higher production totals, supply temporarily exceeded demand, causing natural gas prices to fall more than 60% since peaking in 2006. Those lower prices motivated users to switch from coal and crude oil to natural gas, which in turn, hiked demand.
Only Transported by Pipelines
Of course, all of that natural gas must be transported from the wells to end users, and currently, that can only be done via pipelines. Unlike crude oil and gasoline, you can't ship natural gas via trains or trucks. Consequently, soaring natural gas production must be matched by similar growth in natural gas pipeline capacity.
Most natural gas pipelines are owned and operated by Master Limited Partnerships (MLPs), which do not pay federal income taxes. Consequently, most MLPs pay relatively high dividends, typically in the 5% to 7% range, which makes them attractive to income investors.
GPs For Higher Returns
However, there's a better way to invest in natural gas pipelines. As the name implies, MLPs are partnerships, not corporations. Typically, a general partner (GP) runs the business, and individual shareholders (technically unitholders) are limited partners.
Here's why you should consider buying the GPs instead of their MLPs. The general partner usually takes a percentage off the top of its MLP's cash flow, and then distributes the balance to the limited partners. The GP's percentage typically increases as the MLP's cash flow grows. For instance, the GP's cut might start at 2%, but then eventually ramp up to 50%.
Here's how that math works. Say that three years ago, an MLP generated cash flow of $200 million and its GP took 10%. So, the GP collected $20 million, and the limited partners received $180 million. Now, assume that this year the MLP generates $400 million from its pipeline business, but now the GP takes 25%. In this case, the GP takes $100 million, leaving $300 million for the limited partners. Thus, over the three years, the GP's take grew fivefold (400%) compared to 67% for the limited partners.
GPs pay lower dividend yields (2% to 4%) than their MLPs. However, your total return is dividends plus share price appreciation, and GP's faster dividend growth translates to faster share price growth.
Stick With Corporations
General partners may be organized as corporations or as MLPs themselves. I recommend sticking with corporate GPs. Corporations require simpler tax returns than MLPs and their dividends are subject to a maximum 15%/20% federal tax rate. Here are four worth considering.
Four GPs to Consider
ONEOK (NYSE:OKE): Originally a natural gas utility, ONEOK spun-off its utility business earlier this year, and is now a pure-play general partner. Its MLP, Oneok Partners (NYSE:OKS), operates natural gas pipelines.
Plains GP Holdings (NYSE:PAGP): Following an October 2013 IPO, Plains owns 21% of the general partner that controls crude oil pipeline MLP, Plains All American Pipeline (NYSE:PAA). Although organized as an MLP, Plains GP Holdings has elected to be treated as a corporation for tax purposes.
Williams (NYSE:WMB): Formerly Williams Companies, a natural gas producer and natural gas pipeline operator, Williams spun-off its exploration and production operations in 2012 and is now primarily the general partner of natural gas pipeline MLP, Williams Partners (NYSE:WPZ).
These are my ideas. As always, do your own due diligence. The more you know about your stocks, the better your results.