Master Limited Partnerships (MLPs) offer another opportunity for investors to obtain attractive yields in the equity sector. Because MLPs are partnerships, the tax treatment that an investor is subject to is a bit unique and requires special attention. However, MLPs offer opportunities for both solid dividend yield and considerable appreciation in value over time.
As partnerships, MLPs are generally not taxed at the institutional level. Like other pass-through entities, they must distribute a relatively high percentage of income. Investors receive a tax form called a K-1 each year which must be used as part of the investor's tax preparation. The investor's taxable income from the MLP may bear only a limited relation to the distributions that taxpayer receives from the MLP. In many cases, the distributions are higher than the taxable income due primarily to depreciation. The amount of the distributions not taxed as income is treated as a reduction in basis.
The taxpayer is required to reduce the tax basis of the stock below the actual purchase price paid. This, in turn, increases the capital gain upon sale of the stock as well as the tax paid on that gain (capital gains taxes are generally assessed on the difference between the amount realized on sale of an asset and the tax basis of the asset).
MLPS are generally not recommended for IRAs and tax advantaged accounts because of the potential for Unrelated Business Income which would (if it exceeds a certain threshold) be taxable to the IRA and would add a layer of complexity to the tax preparation process. I have read a number of investors' comments to the effect that they have not experienced much unrelated business income with their MLP investments in the past. The best solution is to call the investor relations department of any MLP you are considering before putting such an investment in an IRA.
Most MLPs invest in capital intensive projects like oil and gas pipelines and terminals. They usually generate considerable depreciation and it is likely that the depreciation exceeds any actual decline in the value of the assets held by the MLPs. This, in turn, provides the MLP with cash flow and permits some reinvestment of free cash flow in additional facilities.
Many MLPs have experienced considerable share appreciation over the years. In this respect, MLPs, like equity REITs, may be a more attractive long term investment than entities which hold debt instruments (most BDCs and mortgage REITs) because the entities which hold debt instruments distribute almost all of their cash flow and are unlikely to see much asset appreciation beyond the face value of the debt instruments they hold (although such stocks appreciated enormously from the depressed values of early 2009 when they were trading way below book value).
MLPs that invest in pipelines and other throughput assets are not affected materially by the prices of oil and gas because they are generally paid per unit of throughput regardless of the price of the energy traversing their system. The United States has an extensive and expanding system of oil and natural pipelines, distribution facilities and storage facilities. This is really the infrastructure backbone of the oil and gas industry. It is in extensive use and is absolutely essential to the functioning of the economy.
In a recession, there may be some decline in throughput volume but there is much less potential for a steep decline in profits than there is with a company whose income depends on the price of oil or gas. As a general matter, MLPs held up relatively well during the Panic of 2008 and are certainly doing well now.
It is beyond the scope of this article to list all of the MLPs traded on public markets. I will list a representative sample. After each name, I will list the symbol, Friday's closing price and the current yield. Several of the entities on the list are not actually MLPs; I will explain below why I have included them.
1. Kinder Morgan Energy (KMP): ($72.90), (5.5%)
2. Enterprise Product (EPD): ($43.33), (5.5%)
3. Enbridge (EEP): ($30.14), (6.8%)
4. Boardwalk Pipeline (BWP): ($28.88), (7.2%)
5. Teekay LNG (TGP): ($37.34), (6.7%)
6. Cedar Fair (FUN): ($20.66), (1.9%)
7. Energy Income & Growth (FEN): ($29.23), (6.27%)
8. ClearBridge Energy (CEM): ($22.30), (6.5%)
FEN and CEM are closed end funds which invest primarily in MLPs and are an interesting way to get exposed to a diverse group of stocks in the sector. FUN is a Public Traded Partnership (PTP), and like MLPs is subject to the K-1 tax drill. It owns a number of amusement parks in the United States and Canada.
I think it will resume higher dividends at some point in the reasonable future. I like it because I consider these amusement parks to be one of the ultimate "wide moat" assets in the market. Although a deep recession will be bad for FUN, any moderate downturn is a double-edged sword. In our area, many parents will drive their kids to King's Dominion rather than booking a week in Orlando.
TGP owns LNG facilities and this sector has generally been viewed as having a bright future, although the emergence of shale fracking may reduce the need for LNG imports. EPD owns natural gas processing and transportation facilities. BWP owns some of the largest natural gas pipeline facilities in the country. EEP owns oil pipeline and storage facilities, as well as natural gas gathering, processing and transmission facilities; a good deal of the oil (and virtually all of the natural gas) in the United States is transported around the country by pipeline and stored in terminals and storage facilities adjacent to these pipelines. KMP is one of the largest entities in the sector and owns a broad variety of oil and gas gathering, processing, storage and transportation facilities. It owns a large system for transporting carbon dioxide by pipeline to oil fields. The diversity of its assets arguably reduces investor risk.
I generally like this sector for investors willing to put up with the K-1 tax return hassle. The companies have valuable assets that are probably appreciating in value (in some cases, the rights of way are probably irreplaceable) and yet are not subject to much reduction in income if oil or gas prices decline. An investor in this sector is not really hedging against a Peak Oil related explosion in oil prices but the sector seems to do well under a variety of circumstances. As with the other sectors, an investor should perform due diligence on any individual MLP he or she considers investing in.