Investors typically invest in large integrated exploration and production names from the energy sector, as well as utility companies for additional income, and often overlook the midstream sector, says Michael Underhill, chief investment officer at Capital Innovations in Wisconsin.
Many MLPs, or master limited partnerships, are energy pipeline companies, while others transport, process or store crude oil, natural gas and natural gas liquids, says Stacey Morris, director of research at Alerian, a Dallas-based financial information services company for asset managers and investment professionals.
“Stable cash flows and the fact that MLPs do not pay federal taxes allow MLPs to offer attractive yields to investors through dividends, which are called distributions for MLPs,” she says. “In other words, the investor does not pay taxes on that portion of the distribution until the MLP units are sold.”
Advantages of Investing in MLPs
MLPs provide exposure to the cash flows of North American energy infrastructure companies in a tax-advantaged structure, says Loren Asmus, vice president of investment research at Canterbury Consulting, a Newport Beach, California-based investment advisory firm.
They have generated elevated yields compared with other income-generating securities in recent years, but this has also produced significant volatility.
The current yield on the Alerian MLP Index is more than 10%, and the income is often tax-deferred. Investors can receive a cash distribution that is “treated as return of capital for tax purposes yet be allocated little or no taxable income from the partnership,” says Rob Thummel, a portfolio manager at Tortoise Capital in Kansas.
“This typically happens when the partnership is constructing new projects, so the partnership generates a lot of depreciation expense that shields the partnership’s operating income,” he says.
MLPs operate energy infrastructure assets that are critical for the economy to function and grow, so cash flows can be steady.
The revenues from MLPs are mostly based on fees from pipelines, processing plants or storage facilities and tend to generate stable cash flows, which support attractive distributions.
MLPs vary, and investors must analyze the underlying assets operated by an MLP, Thummel says. Some operate pipelines that are typically fee-based revenue models based on volume transported over the pipeline, while other MLPs operate assets in which revenues fluctuate with commodity prices.
MLPs have been beneficial for investors because they are liquid like stocks but also provide income like bonds. One issue is that the sector has been out of favor since the energy downturn from 2014 to 2016 as MLPs were negatively affected by declining oil prices, Asmus says.
“Declining equity values and large debt burdens made it difficult for MLPs to maintain their distributions and/or reinvest in capital-intensive projects,” he says. The industry has transformed significantly with many MLPs that simplified their general partner/limited partner structures, merged with one another or converted into traditional C corporation business structures.
“However, the new MLP model encourages lower leverage, lower cost of capital, higher distribution coverage targets and lower operating costs,” he says.
Disadvantages of MLPs
MLPs have undergone higher volatility and demonstrated high correlation to oil and the broad energy sector in recent years, Asmus says. MLPs also correlate with the broader economic cycle and tend to perform poorly in a recession.
One inconvenience of investing in MLPs is that investors have to file the Schedule K-1 form even if they did not sell the MLP, Underhill says.
Investors can avoid filing a K-1 by buying exchange-traded funds that provide a 1099 instead.
How to Invest in MLPs
There are several MLP ETFs that provide additional diversification for investors who want exposure in this sector. MLP ETFs were impacted when crude oil prices crashed in March. The InfraCap MLP ETF has more than doubled its price from its low on March 18 of $7.20 and is now trading at about $16, which is a large decline from its high of $57.90 on July 12, 2019. The Alerian MLP ETF is trading at about $23, which is an improvement from a low of $12.05 from March 18, but down from its high of $50.85 on July 15.
Investors should allocate 5% of their portfolio to MLPs, Underhill says. Some MLPs include the following:
— Williams Cos. (WMB), a Tulsa, Oklahoma-based company that includes an interstate natural gas pipeline, natural gas gathering and processing and crude oil production handling and transportation and operates through the Atlantic-Gulf region, Northeast and West segments. The company owns and operates 30,000 miles of pipelines, 28 processing facilities, seven fractionation facilities and approximately 23 million barrels of liquefied natural gas storage capacity. Underhill’s company, Capital Innovations, has a target price of $30 a share, and WMB is trading at about $18.35.
— Cheniere Energy (LNG), a Houston-based company, focuses on the liquefied natural gas, orLNG, businesses in Louisiana and Texas. The company owns terminals and pipelines. Cheniere trades at about $48.65, and Underhill has a target price of $65 a share.
— TC PipeLines (TCP) is a Houston-based company that has interests in eight natural gas interstate pipeline systems that transport 10.9 billion cubic feet per day to markets in the western, midwestern and eastern U.S. It serves large utilities, local distribution companies, natural gas marketers, producing companies and other interstate pipelines. TCP is trading at about $30, and Underhill has a target price of $50 a share.
Other companies that investors could consider include Houston-based Enterprise Products Partners ( EPD), which owns and operates a critical set of energy infrastructure assets and generates a dividend yield of more than 10%. The management team owns a significant amount of the units, and investors should be concerned about the company’s ability to generate free cash flow given the continuous project backlog, Thummel says.
Tulsa-based Magellan Midstream Partners ( MMP) operates refined products such as gasoline, diesel and jet fuel along with crude oil pipelines. The company’s dividend yield is about 10%, and Thummel says it has a disciplined management team along with relatively low debt levels. Magellan’s potential for long-term growth is limited and depends on the demand for refined products and crude oil.
Retirees like MLPs since they tend to provide higher yields than other income-oriented investments like bonds, real estate investment trusts or utilities, Morris says.
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