Master Limited Partnerships

Master Limited partnerships (MLP’s) have been around since the late 1980s, when Congress created their tax-deferred structure to encourage investment in the U.S. energy infrastructure….but it was an Enron employee (named Rich Kinder) that really put MLPs “on the map” as a dynamic investment vehicle.  Kinder resigned from Enron in 1996 after been overlooked for the position of CEO….by his college buddy Ken Lay, who reportedly was more interested the exciting new field of energy trading instead of the ‘boring’ old business of oil pipelines (which was Rich’s speciality).

Around the same time Bill Morgan, college buddy of Rich, had bought some pipelines system and coal terminal from Enron, which were lying unused with them. However, Bill needed some one to run the business. Bill approached Kinder with the proposal which materialized into Kinder Morgan Inc.

Within span of 7 months by optimizing efficiency and shipping more volumes through the pipelines, Kinder doubled company’s market capitalization to half a billion dollars. As of today Kinder Morgan Partners (NYSE: KMP) operated 35,000 miles of pipelines running across the length and breadth of US with market capitalization of $23 billion. From a couple of MLP’s in 1990’s today there are dozens of actively traded MLP’s. What cause significant increase in the number of MLP’s?

Let’s understand MLP’s in details to unearth the cause of their popularity.

MLP’s are publicly traded companies, in which shares of ownerships are referred to as ‘units’ rather then shares. MLP’s are aggregates of its partners units rather then a separate entity. Majority of the MLP’s are in the business of operating pipelines that carry oil and natural gas. The most unique distinguishing dual feature with MLP’s is that they allow for ‘pass-through income’ and at the same time are as liquid as the stock market.

MLP’s by law do not have to pay corporate income tax. It leaves a lot of cash to be distributed amongst the partners, which they are required to do. This is one reason income investors are drawn towards MLP’s.  MLP’s have not let the investors down either. On average their dividends have grown by 8-9% during last 10yrs.  This explains why some of the best dividend paying stocks are actually MLP’s.

Most distributions from MLPs are tax deferred.  This happens because the cost-basis of the partnership units (the price you paid) gets adjusted for distributions, income and passed-through tax items.  Each year, the MLP sends out a K-1 to notify investors what portion of the distributions is shielded from ordinary income taxes.  That portion, that is not taxable, must be subtracted from your original purchase price to calculate your new cost basis.  When you ultimately sell your units, some of the gain will be taxed at the lower capital gains rate but the portion that was the result of deductions (such as depreciation which lowered your basis downwards) will be taxed at your ordinary income rate.

Despite the volatility present in commodity markets MLP’s have successfully clocked double digit gains. The Alerian MLP index has returned 19% on average annually since 2009.

On an average MLP’s yield about 7%, which is three times more then the puny yield offered by the S&P 500. However, it is not the high yields that make the MLP’s sought after but rather the rare combination of risk and growth makes it a necessary asset class in Portfolio.

Energy is in our genes. We live with it and we die with it. MLP’s, mostly deal in transportation of energy. Commodity prices do not affect MLP’s cash flow as they deal in volume of the commodities moved. Even during the crisis and during last oil shock the energy consumption was affected by a very small number. As a result MLP’s have very stable cash flow. Furthermore, the rates that the MLP’s charge for Interstate pipe lines is depended on the location rather then the commodity prices, thus securing very stable government revenue.

However as MLP’s are required to distribute to the shareholders, so what is driving their growth? MLP’s achieve growth by ramping up their capacity so that they can transport more volume and in turn secure more cash flows. This they do by buying and building infrastructure, whether it is tanks, barges, pipelines or royalty interests, MLP’s get it.

With the energy demand projected to grow at 1% for the next 20 years MLP’s will keep on eliciting income investors for the foreseeable future.

How to increase the Yields?

MLP’s constitute 80% of capital return and 20% net income. Ordinary tax rates apply to Income portion. MLP’s are ideal for long term investors as capital gain is not taxed until the security is sold.

For example if an MLP share is priced at $50 and at the end of the year $5 is the capital distribution, then the cost basis of share declines to $45. If next year shares are priced at $55 and you sell it you will be taxed on $10, capital gains at ordinary tax rate.

However, there is a caveat. MLP’s are not good for retirement accounts or deferred tax account. MLP’s gain are classified as “unrelated business taxable income” (UTBI) and you will be taxed if your retirement account earns more then $1,000.

Closed end funds that invest in MLP’s such as Kayne Anderson Energy total return fund (NYSE: KYE) bypass these issues as they don’t generate UTBI and are also apt at handling the other requirements. The funds come with the added advantage of diversification, where you can hold multiple MLP’s.

Management expenses are the bane of MLP funds, however due to their tax and diversification benefits, MLP’s will keep on enticing investors for the foreseeable future with their higher yield.