Why Buy MLPs?

Master Limited Partnerships (MLPs) are a new type of investment with an excellent record of high rates of stable growth & mostly tax-free (until the ultimate sale) high yields. Despite this performance, they are still little appreciated & understood partially due to poor investor relations by the companies.

Emerging Asset Class

Their business typically involves building pipelines & terminals for transporting oil & gas. Capital additions are their form of addiction. They have to keep investing in more assets to build more pipelines & terminals, a national priority. Spectacular growth for MLPs is forecasted to grow many fold going forward because of a growing demand for energy needing more infrastructure investment.

MLPs emerged from a small industry with only a handful of participants in the middle 1990s to a large industry with over 50 companies today. Below is market capitalization of publicly traded MLP's value calculated by Standard & Poor's:

Market Capitalization ($B)

1995: 6

1996: 8

1997: 9

1998: 11

1999: 11

2000: 16

2001: 26

2002: 27

2003: 42

2004: 53

2005: 64

2006: 102

2007: 127

2008: 115

(All values are year end except for 2008 taken on August 7)

December 31, 1995, was the beginning of the Alerian MLP Index [AMZ] at 100. The index has risen to 273 with only modest swings around the trend line, including the extremely volatile period in the early 2000s. A recent measure of the beta for MLP is only 0.35. They have a second index, AMZX, which includes reinvested income. That index at 648 yields a compounded annual growth rate over 16%, double the comparable rate earned by the S&P 500. In recent years, MLPs gained attention & fans with this growth record.

AMZ; AMZX; Yield

12/31/96; 108; 117 (8.7%)

12/31/97; 127; 147 (7.9%)

12/31/98; 115; 143 (9.0%)

12/31/99; 99; 132 (10.9%)

12/31/00; 131; 192 (8.8%)

12/31/01; 176; 276 (7.1%)

12/31/02; 159; 266 (8.2%)

12/31/03; 214; 385 (6.5%)

12/31/04; 235; 449 (6.3%)

12/31/05; 237; 478 (7.0%)

12/31/06; 283; 602 (6.4%)

12/31/07; 301; 679 (6.4%)

08/29/08; 273; 648 (7.7%)

MLPs typically offer high yields, maybe because of their association with utilities. For most companies, 80-90% of the income is not taxable in the current year. However, tax advantages brings tax hassle. These companies are limited partnerships which pay distributions, not dividends. Instead of sending 1099s, companies issue K-1 tax statements around March 15. The portion not taxed is used to reduce cost basis. After cost basis is reduced to zero, years in the future, distributions will be taxable. In addition, these businesses compete in many states which may require dealing with various state taxes. However, these tax numbers can be handled by popular tax packages.

Valuation

One way to value MLPs is based on the spread of their yield over the 10 year Treasury bond. The yield on the MLP index is expected to be 200 basis point above the yield on the Treasury bond. This relationship has gone through a lot of trials in the last year. In mid 2007, Treasuries fell in price sending their yields to 5¼% while the MLP index was marching to a record level of 342, driving down its yield so the two yields came within a few basis points of being equal (the spread was essentially zero). As it turns out, that would have been an excellent time to buy Treasuries & sell the MLP index component companies. With the increase in Treasury bond prices & fall of the MLP index, the yield spread has widen to 390 basis points currently, 7.7% for MLP index vs 3.8% on Treasuries. Years from now, people will look back on this time with fond memories about this unusually wide spread, remembering the good old days when these high yields on were available on MLPs .

Correlations with Commodity Prices

Commodity prices do not correlate with MLPs. For example, oil prices doubled in the last year while MLPs have been sliding. Changes in oil prices are similar to changes for other fuel commodities and they also do not correlate with the MLP index. In addition, MLPs have a very low beta, unlike the high volatility for fuel prices. However, especially this year, changes in the MLP index have followed or at least took cues from changes in oil & other fuel prices.

Complications

Limited partnerships take a little getting used to because they are complicated. Generally they are composed of limited partners & general partners. The limited partners supply 98% of the capital expecting to get a return on their passive investment. The general partners supply 2% of the total capital. They are the active managers who are rewarded when profits achieve goals. They get a low percentage on first earnings earned. As income rises, they receive a higher percentages of profits for achieving goals. Income is divided into tiers, income in the higher tiers brings bigger rewards to general partners. At some companies, general partners receive 50% of profits in the highest tier. Profit sharing agreements vary from one firm to the next. Each investor will have to decide what is reasonable on splitting profits. An alternative is not to worry about the profit splits, instead accept the arrangement as satisfactory if they have a good track record.

Two companies, Kinder Morgan (KMR) and Enbridge Energy (EEP), also have I-unit shares. Each share of I stock is backed by one unit from the partnership. Distributions paid to unit holders are paid as stock dividends to shareholders of the class I stock, similar to a company dividend reinvestment plans. These stocks do not issue K-1 or 1099 statements, making them friendly for individual shareholders and retirement accounts (such as IRAs).

Distributable Cash Flow

Distributions paid to unit holders come from distributable cash flow, a measure which is not consistently defined. Real estate trusts (REITs) pay dividends from an alternative earnings metric, "Funds From Operations or FFO." FFO has an industry definition used by all REITs for determining how much cash earnings are available for dividends. Some MLPs talk about distributable cash flow.

Even when there is a definition, there is no accounting standard to supply a number consistent from one company to the next. Lacking an accounting standard makes it difficult to evaluate a company's ability to pay & raise distributions. Companies have a constant need to sell more units for more capital to build more pipelines.

Thus, management has an incentive to increase distributions frequently (i.e. 2, 3 or even 4 times a year). An investor will have to calculate alone that $3 of earnings plus depreciation & other non cash items accruing to all units holders justifies a distribution of $4.80. If that distribution is increased to $4.88, it is difficult to understand the rationale for the increase (especially when earnings decline). The industry needs a standard, similar to FFO in real estate, to be used by investors for better understanding discipline used to determine distributions.

For those interested in learning more, some investment firms have written primer reports on MLPs with more information about the industry. These free reports are available on the web.

MLP securities

Below are listed 7 MLPs:

Prices are closing prices on 8/29/08.

MLPs have excellent track records with relatively mild price fluctuations around their growth trend line, high yields (largely tax free) with excellent prospects for rapid growth going forward from strong demand for more oil & gas pipelines. These prospects have attracted many investors and this investment should gain popularity in the future.

Disclosure: none (currently)

Comments

[The Planes:]

I enjoyed reading your blog, and I agree with everything you say…

2008 Sep 05 03:06 AM

[Riga:]

I fully agree that, as of this writing, it is a great time to purchase these energy MLPs. They are broadly cheap as a group. They are under-owned by institutional investors and their need to regularly access the capital markets to fund expansion, somewhat like business development companies (e.g. ACAS, ALD, GLAD) is depressing their share prices to the extent that their cost of capital has risen. The Sem Group bankruptcy in Oklahoma has also hurt perceptions. These issues will, however, dissipate over time as the reliable "toll-taker" nature of the business shines through.

The author also usefully mentions KMR as a nice alternative to dealing with the K-1s and as an option for those investors who would like energy infrastructure MLPs in their IRA accounts. In that regard, I would also like to highlight a second option, corporations, acting somewhat akin to closed-end mutual funds, that specialize in holding pipeline MLPs. These include symbols TYG and KYN. They both have good yields, are diversified among MLPs moving crude, refined products, and natural gas. Above all, they are themselves structured as corporations, not limited partnerships, so you get a normal 1099-DIV, not a K-1. That means less complicated tax filing AND qualified dividends. Yet, it gets better. Because of the underlying tax deferral qualities of the MLP structure, and since these two corporations own exclusively MLPs, your 1099-DIV will still characterize a substantial amount of your quarterly dividends as return of capital, which lowers your tax obligation. Of TYG and KYN, my personal favorite is the former. The URL is www.tortoiseadvisors.c.... Thanks for the MLP write-up.

2008 Sep 05 03:35 AM

[sharksm:]

A very good article . I have held MLP's for several years, including KMP, EEP, TPP, MWE, OKS and a coal MLP, NRP. All have regularly raised the distributions and I really consider these as Income vehicles in lieu of bonds. The yield is superior to bond yields, distributions increase on a regular basis and some capital gain potential exists. Let's face it, $10,000 in Bonds that mature in ten years will pay 4 1/2% for ten years and then pay the holder the $10,000 as the bond matures. $10,000 in KMP (I own 6500 shares) has more than doubled in value in ten years and the distributions have also more than doubled. It is obvious which is a better investment.

2008 Sep 05 08:57 AM

[CT Programmer:]

What exactly do you mean by "making them friendly for ... retirement accounts"? I added both EEP and OKS in my IRA (a SIMPLE plan) last year. I did receive the K-1 come tax time, but since its in my retirement account there wouldn't be any taxes due anyway. Will there be issues down the road, maybe when I start withdrawing from it when I retire? I bought them at the time because they were good investments with a good dividend, even if I'm maybe not getting all the tax benefits.

2008 Sep 05 09:51 AM

[searcher:]

My understanding is that many LPs and MLP’s should not be held in IRAs because they generate unrelated business taxable income (UBTI) which can't be tax-deferred or sheltered. Whenever Uncle Sam hands out a tax break, there are strings attached.

Because of a weird technicality in the law, called Unrelated Business Taxable Income, you shouldn't hold MLPs inside a tax-sheltered retirement account. The IRS will sock you for taxes on any MLP income earned inside a retirement account above $1,000 a year.

I urge you to have your tax preparer look into your situation immediately. Please reread the last sentence of the first paragraph.

2008 Sep 05 10:54 AM

[OldNavySailor:]

MLP's as part of your IRA have one negative aspect: the evil UBTI (Urealized Business Taxable Income) tax!

If the sum total of UBTI for all your MLP's held in an IRA exceeds $1,000 annually, you will have to pay tax; even though the account is an IRA. Most of the MLP's I hold in my IRA have a negative UBTI so I never have had to pay any tax. But if you do, you will have to get a separate tax ID to file.

Look at your K-1's for the past year at line item 20: OTHER INFORMATION. Usually UBTI is coded using the letter "V".
If it is negative, you're okay. It the income is positive, it can be offset with other MLP UBTI that is negative. If you exceed the threshold of $1,000. you owe the tax. So, watch out!

2008 Sep 05 11:02 AM

[Dividend Gr...:]

Very nice and thorough analysis. If analyzed TPP and KMP on my blog several months ago and concluded that they are both fine investments.

dividendgrowth.blogspo...

and

dividendgrowth.blogspo...

2008 Sep 05 11:15 AM

[BIG-T:]

I've held MLP's (Pipelines and Propane Distributors) in my IRA account since 2002 and have never seen a positive UBTI on any K-1. They've all been negative. Doesn't mean there will never be a positive but if you spread it around 4 or 5 MLPs its unlikely the combined amounts would net out to a positive number. Also, if you're going back to check prior years K-1 forms you will find the UBTI in box 20-P. Only the IRS knows why they changed it to 20-V. I have no background with REIT's. They may be a differant story.

2008 Sep 05 01:51 PM

[rdp1:]

I have a question: I, too, have held KMP and other MLP's for years and am happy, indeed.
My KMP cost basis will be zero in 2009.
However, i did not know that when the cost basis falls below zero that i would have to begin paying for dividend income at that time.
Are you certain of this provision?

2008 Sep 05 01:53 PM

[Mmarrkk:]

rdp1: I'm pretty sure that's right. check with someone who knows taxes but I believe you will owe taxes on the "return of capital" portion of the dividend payment, not the whole thing.

2008 Sep 05 03:36 PM

[Mmarrkk:]

rdp1: here's an idea to eliminate that nasty little problem when your cost basis goes to zero:

donate the shares you currently own to a charitable organization certified by the IRS. You will get to claim a tax deduction for the entire amount. Then, turn around and buy the same number of shares in your account. That will "reset" your cost basis to whatever you pay for the new shares. All of this assumes you donate money of that quantity to charity anyway. I do this every year. Instead of donating $15,000 to my church, I donate $15,000 worth of stocks that have very low cost basis/very high taxable gains. Then I buy the shares on the market. Its a win-win for everyone...except the tax man who gets way too much of my money anyway!!

2008 Sep 05 03:40 PM

[AJ30:]

I am puzzeled why many others were left off the list ie APL?

2008 Sep 05 04:11 PM

[CT Programmer:]

Thanks for the info everyone. My line 20 of my K-1 is zero, but I had only held it for a month in 2007 (originally bought in Dec 2007) and hadn't received any dividends yet. Does the UBTI accumulate over the years, or is there a $1,000 limit per year for all your MLP's combined? Also, about how many years does it usually take before your cost basis falls to zero? And, if I'm reading all this correctly it sounds like if your cost basis goes to zero (even if in an IRA), when you actually sell you're on the hook for taxes on the full price when you sell, correct?

2008 Sep 05 04:20 PM

[rdp1:]

Thanks Mmarrkk,
I will call my CPA next week.
To: CT Programme....the only way out of paying taxes I am told, is to die. Then the cost basis goes to stock price as of date of death or 6 months later.

2008 Sep 05 04:26 PM

[Mmarrkk:]

I know some guys that tried that death approach...IRS still got their pound of flesh!! If you can time your death just right and hit it when the death tax is low, you'll be okay but its pretty tricky!!! Good way to end a week! Beer Thirty!

2008 Sep 05 05:10 PM

[passandshoot:]

ERRORS/ASSUMPTIONS/ETC... in this article include:

"Master Limited Partnerships (MLPs) are a new type of investment"
- MLPs have been around for decades, although the 1986 tax law changes dramatically altered their structure and availability.

"they are still little appreciated & understood partially due to poor investor relations by the companies"
- What empirical evidence exists to back this statement up?

"Capital additions are their form of addiction. They have to keep investing in more assets to build more pipelines & terminals, a national priority."
- This is a business choice, not a requirement. There is nothing that says an MLP has to keep investing in more assets. They invest in more assets to grow (which usually leads to higher valuation multiples).

"MLPs typically offer high yields, maybe because of their association with utilities."
- MLPs offer high(er) yields because of their capital structure and tax situation. Not all MLPs are associated with 'utilities'.

"Years from now, people will look back on this time with fond memories about this unusually wide spread, remembering the good old days when these high yields on were available on MLPs:
- Credit spreads for all types of yield instruments have widened in the last year. While it is true that MLPs are at historically high levels of yield compared to the 10 year, it is not true that MLP yields are high compared to investment grade or junk corporate debt.

"Commodity prices do not correlate with MLPs."
- This blatantly false. Different MLPs are impacted in different ways by commodity prices. Many hedge to limit their exposure to commodity prices. MLPs that are in the exploration & production business can be highly correlated to oil prices. Some MLPs that are in the natural gas gathering and processing business are highly correlated to either natural gas prices or fractionation spreads. Furthermore, depressed oil and gas pricing environments generally lead to lower interest in the MLP sector. I challenge the author to provide R-squared metrics to back up his assertion.

"The limited partners supply 98% of the capital expecting to get a return on their passive investment. The general partners supply 2% of the total capital."
- This is misleading. The definition of capital usually includes debt in the capital structure. Many MLPs carry debt, and thus limited partners would only provide 98% of the 'partners' capital', not the total capital. Also, it is not uncommon for the general partner to also be a limited partner (and thus provide more than 2% through a mix of GP and LP units).

"An alternative is not to worry about the profit splits, instead accept the arrangement as satisfactory if they have a good track record."
- An investor should note that the higher the profit split, the higher the equity and weighted average cost of capital is. This impacts the MLPs ability to make accretive acquisitions or fund organic growth projects profitably. To not worry about profit splits is ignorant.

"Companies have a constant need to sell more units for more capital to build more pipelines."
- Once again, this is patently false (see above). Companies may choose to sell more units, but do not have a constant need.

"MLPs have excellent track records with relatively mild price fluctuations around their growth trend line, high yields (largely tax free) with excellent prospects for rapid growth going forward from strong demand for more oil & gas pipelines"
- Not all yield is largely tax free. It is TAX DEFERRED. This is a BIG difference. Also, not all MLPs have oil & gas pipelines.

2008 Sep 06 07:11 AM

[Steven Ward:]

On the natural resource MLP's, you may want to wait after the election and if Obama wins beware of US Congressman Markey, (D. Mass.), who is a dedicated Marxist/Lenninist striving to destro capital accumulation by rich man and poor man alike.

He has introduced leggislation to cancel the US tax credit given to US investors on their Canroy dividends from the Canadian witholding.

His next attempt will be to knock down tax benefits for the MLP share holders.
This election is the 600 pound gorilla in the room no one is talking about.
Wait and see, you'll be better off.

2008 Sep 06 03:34 PM

[GD:]

AVI, your statement of EEP as a div payer w/ 1099 is confusing. I visited the EEP site and found------

"Where is my 1099?

A: 1099's are used to report items such as interest and corporate stock dividends. Your investment in Enbridge Partners is an investment in a partnership which requires a K-1 tax form instead of a 1099."
Can you clarify your statement?
GD

2008 Sep 07 01:17 PM

[sf123:]

EEQ should be the one with 1099. It is a LLC.

2008 Sep 09 02:11 AM

[Avi Morris:]

After being an investor all of my adult life, I only began following MLPs since last year, prior to the 342 peak for the Alerian MLP index. I was attracted by their high yields and tax efficiency. Partially because of tax hassle on distributions, I held back investing. But I've learned a lot about the business.

Buying MLPs for IRA's is tricky. Congress passed an exception which can be haunting, such investment income has to be under $1000 per year. If it goes over, tax problems are a very big pain. As a result, my broker, and suspect many others, do not permit buying limited partnerships in IRAs. However, stock equivalents or closed end funds are permitted because they are just stocks.

I am not an accountant, only an amateur with street knowledge. All personal tax issues should be taken up with a professional accountant.

My blog:

verysmartinvesting.blo.../

generally gives at least a mention for MLPs daily, today (Sep 9) much more. More readers are always welcome.

2008 Sep 09 11:23 AM

[Avi Morris:]

I'm new to comments, but the comment above is from me. Today at my blog:
verysmartinvesting.blo.../
there is commentary on the Alerian MLP index falling to a 2 year low!

2008 Sep 09 03:27 PM

[User 165363:]

I too was troubled about having significant positions in pipeline MLPs in my IRA, related to UBIT (unrealized business income). The UBIT is shown on line 20 of the MLPs K-1. It is designated as "V".
If that line is above $1000, then anything above the $1000 is subject to the tax even if the MLP is in a tax deferred account. If you have several MLPs, as I do, you can add all the V Line 20 and the net UBIT is used. Many UBIT are negative numbers (i.e. EPD and many others, as well). I checked my K-1s online and out of 6 MLPs I had only one with a positive UBIT, and it was only $43. I checked with my CPA and verified how the tax is calculated. It has nothing to do with the amount of income you receive as distributions. It is important to check your K-1s, add the numbers in line 20 V and if the net exceeds $1000, then you have a tav liability. jmt houston


On Sep 09 11:23 AM User 258492 wrote:

> After being an investor all of my adult life, I only began following
> MLPs since last year, prior to the 342 peak for the Alerian MLP index.
> I was attracted by their high yields and tax efficiency. Partially
> because of tax hassle on distributions, I held back investing. But
> I've learned a lot about the business.
>
> Buying MLPs for IRA's is tricky. Congress passed an exception which
> can be haunting, such investment income has to be under $1000 per
> year. If it goes over, tax problems are a very big pain. As a result,
> my broker, and suspect many others, do not permit buying limited
> partnerships in IRAs. However, stock equivalents or closed end funds
> are permitted because they are just stocks.
>
> I am not an accountant, only an amateur with street knowledge. All
> personal tax issues should be taken up with a professional accountant.
>
>
> My blog:
>
> verysmartinvesting.blo.../
>
> generally gives at least a mention for MLPs daily, today (Sep 9)
> much more. More readers are always welcome.

2008 Sep 10 07:24 PM

[31October:]

The tax issue is so heinous that I would completely avoid these wonderful ivestments. I have royalty trusts, RIETs, and MLPs. A single MLP causes delayed filing. If you think you are done with 2006 taxes, you will be opening that pack and searching old records through 2009. Then the IRS field office will have more questions. And since the agents are totally confused, the approval from the 2007 audit will be reversed. Trust me, MLPs are nice and profitable, but your CPA will get the profits. I sold because I don't have time for the IRS. But if you sell at a fat profit, there is another issue regarding basis.

2008 Sep 18 11:45 AM

[Simpleman:]

Questions. KMP pays a dividend so no K-1s no tax problems? Other than the regular tax treatment when distributed right? Ultimately you want to accumulate as much as possible for the dividend income, not the sale of the stock down the road; you will always have that though? What's up with the cost basis going to zero, donating it to charity etc.? This tax consequence seems to be the only major downside is this accurate?

2008 Sep 18 10:29 PM

[webwayne:]

When you are talking about IRA's are you meaning tax deferred IRA's?
If MLP are held in a Roth IRA would that solve the tax problems?

anyone reply

2008 Oct 31 11:51 PM

[Arch:]

I have a ROTH IRA which I put money into, after taxes. So when I retire and get the money out I will not be taxed on that money. If I hold a regular dividend paying stock (e.g. KO) I won't have to pay any taxes on that. So I will be investing in the MLPs in this account the same way. By buying stock of the MLPs. So do I need to pay taxes even if I hold the MLPs in this account?

May 12 05:50 PM

[The Kansan:]

I've been looking for this info. Thanks.


On 2008 Sep 05 11:02 AM OldNavySailor wrote:

> MLP's as part of your IRA have one negative aspect: the evil UBTI
> (Urealized Business Taxable Income) tax!
>
> If the sum total of UBTI for all your MLP's held in an IRA exceeds
> $1,000 annually, you will have to pay tax; even though the account
> is an IRA. Most of the MLP's I hold in my IRA have a negative UBTI
> so I never have had to pay any tax. But if you do, you will have
> to get a separate tax ID to file.
>
> Look at your K-1's for the past year at line item 20: OTHER INFORMATION.
> Usually UBTI is coded using the letter "V".
> If it is negative, you're okay. It the income is positive, it can
> be offset with other MLP UBTI that is negative. If you exceed the
> threshold of $1,000. you owe the tax. So, watch out!

Jul 07 06:47 PM