The Pros And Cons Of Master Limited Partnerships: An Investor View

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 |  Includes: EPD, KMP, LINEQ
by: Reel Ken

Those that have followed my articles know that I mostly write on various option strategies. Every strategy that I propose, I have used at one time or another. They are all borne from personal experience and I put them forth as an aid to the reader.

Recently, a reader asked me about using options to hedge Master Limited Partnerships (MLPs). I don’t think options are an effective hedging tool with MLPs and really couldn’t describe why without going into detail on my views of MLPs. So I will take this opportunity to diverge from my standard practice of discussing options and instead discuss MLPs.

As with my option strategies, I will relay what I have learned from experience. I have owned Enterprise Partners (NYSE:EPD) for over 15 years and Linn Energy (LINE) for about 5 years. I have “dabbled” in various others from time to time. So, instead of pounding you with charts, P/E’s, yields and the usual “stuff” you can read on SA, I will bring a slightly different viewpoint, that of an investor not an analyst.

First, let me deal with some issues:

1) MLPs are not well suited for IRAs. There are some tax-accounting issues that indirectly tax the distributions generated from the MLP. The amount of the tax may not be so great, but it creates a paperwork burden and a visibility you may not want to engage in.

There are several MLPs such as Kinder Morgan (NYSE:KMP) that have a traditional corporate “surrogate” (NYSE:KMR) that can be used in an IRA. These are perfectly fine and provide good alternatives.

Also some ETNs such as AMJ have been designed to “convert” the distributions to avoid the tax issues. The idea is good, but the execution fails.The ETN effectively pays the tax and the returns suffer. SA has had many articles on these MLP ETNs in the past and you may want to do some research before diving in.

But I must really warn against ETNs in general. I know I will get some flak for this view, but I just can’t see investing in an ETN. An ETN (unlike an ETF) is only financialy as strong as the sponsor. You not only undergo the risk of the ETN's underlying securities but the solvency of the sponsor. If you had bought an ETN sponsored by Bear-Stearns, Lehman or most recently MF Global, how would you feel? Of course JP Morgan, UBS, Credit Suisse, etc. are all strong and could never “go under”...or could they? If the current financial crisis has taught me anything, it is that unnecessary risk is just that, unnecessary and risky.

2) Let me deal with the tax issues of an MLP. MLPs typically make distributions quarterly.These distributions are often referred to in articles as “dividends”, “distributions”, “tax free dividends/distributions”, etc. The fact is the distributions are RETURN OF CAPITAL. They are tax free simply because you are just getting some of your initial investment returned to you. It’s like buying 100 shares of any stock and then selling 4 shares at cost. There is no tax.

The difference is that in an MLP, your number of units doesn’t reduce. Instead, your cost basis in the units is reduced. As a result, when you ultimately sell your units you pay capital gains on the proceeds after adjusting the cost basis downward.

For instance, if you invested $10,000 and received $4,000 in tax free distributions over the years your cost basis is now $6,000. If you sell the remaining units for $8,000 (what you perceive as a loss), you will actually incur a capital gains tax on $2,000.

Ahhh, I wish it was just that simple. The MLP is able to make capital distributions because it has earned income to sustain them (if not, the MLP is on its way to ZERO). Normally this earned income would be fully taxable to the unit-holder. However, the MLP has various tax offsets such as depreciation, depletion allowances, etc. that reduce or eliminate current income taxation.

Unfortunately, when you ultimately sell your units you “recapture” many of these offsets and pay Ordinary Income tax on this, now phantom, income. This is in addition to any capital gains tax.

You have a tax-deferred “double-whammy”.

3) Tax Preparation. Many people have warned against the added complexity of filing K-1s with your income tax return. I think this is totally overblown. The annual K-1 may be new to some but they contain relatively easy to follow instructions that detail where to enter all the information on your tax return. Most tax-prep software easily accommodates this. I find them easier to navigate than a stock analyst’s opinion or a balance sheet. If this level of complexity is too much than perhaps the stock market should be completely avoided.

So, where does this all lead?

A good MLP with a proven track record and solid fundamentals is a CASH-COW.

They can pay excellent returns and increase them regularly. (I’m not talking about the high-flyers with 12% distributions, but the 5%-7% variety). They are ideal as income investments. Over the years I have more than fully recovered my initial cost for EPD and the current price of almost three times what I paid is all profit. And this is a conservative investment !

When interest rates are high, the unit prices seem to suffer a bit. As alternate investments match or exceed MLP distribution rates they appear relatively less attractive. This comparison is unfair as MLPs have distinctly different characteristics. But it is better to understand and accept this than argue its unfairness.

When interest rates are low, the unit price tends to climb as their relative appeal increases. We are seeing this now. It is reasonable to expect less price appreciation in a few years if interest rates go up.

MLPs like EPD and Kinder Morgan are in the energy sector and tend to fluctuate with the price of oil or natural gas. They really shouldn’t because their business is predominately leasing pipelines (midstream energy). In theory, as long as usage is constant, income should be constant. But, once again, acceptance is better than fighting. So I tend to discount fluctuations because of the fluctuation in commodities, as they really aren't too relevant.

Overall, fluctuations in unit price really don’t matter so much to me. It’s all about income and return on investment. The potential tax liability on disposition is tantamount to being “locked in” to these positions. Of course I could get out, but the tax, after all these years, would be burdensome. If I compare the current distribution rate to the amount I would realize net after taxes, there is just no alternative.

As a result MLPs are the perfect buy and hold investment. In fact, when the market crashed in 2008, EPD dropped from $35 to $17. Stocks drop because people sell them. Not me, the tax would be too great. I was forced to hold and have seen it climb back up from $17 to $46 in three years. It’s nice to look like a genius when you have no other choice.

Don’t get me wrong. I always monitor EPD, just in case. If the outlook starts to deteriorate, I’ll sell. It’s just that as long as the outlook is good I don’t concern myself with the unit price. This is the real strength of a good MLP.

I look at an MLP as very similar to investing in a rental apartment. As long as the tenant pays rent and I get annual rent increases, the price fluctuations aren’t that great a concern. It is the net income that matters. I also enjoy some tax benefits for the time being, though my tax return becomes more complicated. I have to keep an eye out that the neighborhood doesn’t deteriorate. But as long as everything is in order I’m in no hurry to dispose of it. After all, once sold, I just have to find another rental opportunity to replace the lost income.

For a “thirty-something” I would not recommend MLPs as strongly. The tax benefits are all but reversed on a sale and you may just accumulate a tax monster by the time you retire. Granted you received a lot of "conditionally tax free" money, but taxes you didn't pay in past years are seldom quite as meaningful as taxes due today.

For a person near or in retirement, however, they are ideal investments. Consider them conservative and make sure you pick a good stable MLP. There are plenty of articles that can help you. The ability of the MLP to grow income and increase distributions is more important than the current distribution rate.

Also be very wary if the current earnings of the MLP are not sufficient to maintain the distribution or the distribution seems disproportionately high. Some of the smaller, less popular MLPs use high distribution rates as “eye candy”.

Disclosure: I am long EPD, LINE.