Entering text into the input field will update the search result below

The Renaissance Of Pipelines



  • Pipelines are undergoing a renaissance of cash generation today. The pandemic and low commodity prices increased uncertainty in the industry, and pipeline companies stopped investing in new projects and have thus been generating enormous cash flows.
  • This trend did not start in 2020, but a few years back, as their shareholder base changed from retail to institutional investors. They generate cash flows and then decide what is the best use for the cash (after they pay a reasonable dividend).
  • Two companies stood out when we analyzed pipelines in January 2020: Magellan Midstream and Enterprise Products Partners. However, at the time we decided to do nothing - they were not cheap enough. Ten months later, they were.

This is the final excerpt from IMA’s winter letter.

Pipelines are undergoing a renaissance today, but it's not the one you think. The previous renaissance of shale oil and natural gas development was anything but a good outcome for this industry. Capital-intensive industries, contrary to common opinion, don't benefit from increased demand for their product. Increased demand attracts competition. In a capital-intensive business, it is very difficult to increase your capacity just a little. These industries don't work that way, and here is why: Larger investments bring lower costs on a per-unit basis. But when everyone does this, it also brings lower prices (revenues) per unit.

To make things more complicated, the pipeline industry is structured as master limited partnerships (MLPs). MLPs are mostly owned by retail investors who hold them to get one shiny object - yield. These companies generate enormous cash flows, while maintenance capital expenditures - basically, the expenses of maintaining their pipelines - are relatively small (10-20% or so of their cash flows).

To grow cash flows, once a company has an established pipeline network, it can do any number of things: It can raise prices for transporting products in its pipelines. It can make small investments to improve the interconnectivity of its pipelines, thus increasing the value of the pipelines to its customers, which also brings higher prices. It can send more products through its pipelines (of course, they are limited by capacity). There are probably a few other small things it can do, and we are sure these companies did them. A company can also do big things - build new pipelines, for instance. Improvements in oil and natural gas extraction technologies brought an enormous amount of petrochemicals to the surface, and they need to be transported.

Here is the problem. Since their investors were

This article was written by

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley).    His books were translated into eight languages. Forbes Magazine called him "The new Benjamin Graham". To receive Vitaliy’s future articles by email or read his articles click here.

Recommended For You

Comments (24)

gman1253 profile picture
There is OKE which is a corp... no K-1.
elliot_mllr profile picture
@gman1253 :
I explicitly referred to EPD, which is a partnership.
Elliot Miller
elliot_mllr profile picture
That's a good analysis of EPD, except for one thing. The article discusses stock and dividends. As a partnership EPD's equity is in partnership units not in stock, and it pays partnership distributions and not dividends. The different tax consequences between owning units in a partnership, which is a pass through entity and where allocated partnership earnings and profits are subject to the 20% deduction under Code section 199A, and stock in a corporation, are material. The difference between receiving partnership distributions, which are tax deferred, basis reducing, returns of capital, and corporate dividends, are very material.
Elliot Miller
OffSiteLocation profile picture
Solid analysis. Only thing keeping me from buying more is diversification.
fhbecker profile picture
If you don't like the extra tax work or IRA complications, just own the MLP's through a CEF.
Vitaliy, what are your thoughts on SHLX and BPMP? These MLP's have a unique twist to the issues you raised. A level of assured revenues due to affiliations with the Shell and BP for one.
Very interesting, thanks for the insightful article and I guess I agree, as EPD is now my largest holding and MMP is number three. That is surprising to me at least as I would not have predicted that 3 years ago ...but its hard to look at 43 and 45 cent dollars and turn them down.
I am continually amazed when authors do not highlight then pipelines are in an MLP structure. This has significant considerations for anyone purchasing these units within an IRA or other trust-based account, as well as a particular set of tax benefits for regular, non tax-deferred accounts. This makes one wonder what else the author missed, because that is fundamental item #1.
metal27 profile picture
@Wake up to Reality I am amazed that so many make such a fuss over what is little more than a legal and accounting structure, not an economic or business condition affecting the entity's performance. Any investor who does even the tiniest bit of due diligence soon learns the difference. I wonder if those who decry that difference should not be limiting themselves to savings accounts or similar plain-vanilla investment vehicles.
that "legal and accounting structure" that you are looking to trivialize can have a HUGE effect on an investment's performance, especially the AFTER TAX performance (which is what counts!). I've owned many C corps and MLPs for decades and have the scars to prove it. How long have you been an investor in MLPs? Have you gone through any of the "roll-ups" and gotten tax bills for "recapture"?
The C Corp structure and the MLP structure have their own pros and cons. MLPs are highly complex instruments and are not for everyone.
Wait till you get a K-1 that requires you to file non resident state tax returns in half a dozen states!
The bigger landmine with MLP's is when they are placed within an IRA and expose the holder to Unrelated Business Income Tax (UBIT). Each holder is allowed $1000/year of UBIT across retirement accounts until relatively punitive trust tax rates kick in. This UBIT also applies to the recapture income when the MLP is sold, even if the MLP had ordinary losses every year, thus with no annual income to report, and there was no gain on sale. Those annual depreciation amounts (which feeds the recapture) add up over time.

This tax situation has been very well documented in innumerable articles and posts. It shocks me that an article on MLP's doesn't carry a warning label for their use in IRA's or in most forms of a Trust. Especially one written by a CFA.
this article does a disservice to investors by neglecting to mention that EPD and MMP are, as Derf points out below, MLPs or Master Limited Partnerships.
They trade in units, not shares, they pay distributions, not dividends and they report to their unitholders (there are no shareholders) with a K-1 form rather than a 1099 form. Prospective investors should educate themselves about MLPs and their tax issues before investing in them.
Long EPD for a long time and it's been a good investment. However, this year my K-1 indicates that I will have to file a state tax return in Louisiana even though I've never set foot in that state. Just do your homework!
Chancer profile picture

Good example, and why I stick to corporate pipelines- not LPs. I do not want to file more state tax returns, or even track this to determine if I have non-resident state tax liability. Certainly, other investors may disagree with me.
@ahimsaka - I may be in the same boat as you with EPD. I sent you a private email message.
Aren't both MMP and EPD K-1 master limited partnerships? The market currently seems to demand higher returns on a price/distribution basis from such. And M&A is an alternative popular with some MLP's vs increasing distro's.

Last not least, some pipelines are FERC and state regulated -- raising carriage rates is not a given and politically fraught.
TraderJoeZ profile picture
"He's right, you know"
Here's another idea to research. DTE is spinning off its pipeline business. Its a moderate size player. Big enough to stand on its own. Small enough to be acquisition bait. Its not clear yet what the various pricing metrics look like but spinoffs are often interesting because legacy holders - utility oriented - may not want the new stand alone pipes business.
Disagree with this article? Submit your own. To report a factual error in this article, . Your feedback matters to us!
To ensure this doesn’t happen in the future, please enable Javascript and cookies in your browser.
Is this happening to you frequently? Please report it on our feedback forum.
If you have an ad-blocker enabled you may be blocked from proceeding. Please disable your ad-blocker and refresh.