This section is designed for people that are brand new to the MLP space or those that simply want a refresher. Master Limited Partnerships, or MLPs, are companies engaged in the transportation, storage, processing, and production of natural resources. When most investors think about MLPs, they focus on midstream energy MLPs—those companies involved in transportation, storage, and processing. These toll-road business models benefit from benign federal regulation and generate consistent cash flows. An investment in midstream MLPs is an investment in the build-out of North American energy infrastructure over the next several decades.
The Very Basics
MLP stands for Master Limited Partnership. Most people think of MLPs as energy pipeline companies with an advantageous tax structure, which is an extreme simplification, but not untrue. All partnerships in the US, including MLPs, pay no income tax at the partnership (or company) level. Unlike most partnerships, MLPs are public companies, trading on the major stock exchanges and filing documents such as 10-Ks, 10-Qs, and reports of material changes with the Securities and Exchange Commission (SEC).
The Four Basic MLP Businesses
Just like it sounds, transportation MLPs move energy commodities like oil and natural gas from one place to another. Most North American energy travels through a pipeline, but it can also move via truck, railcar, or ship. Transportation MLPs are the cornerstone of the asset class.
Processing encompasses any business that transforms the raw product into a useable form. It could involve removing impurities like water and dirt, as well as separating raw energy into pipeline-quality natural gas and natural gas liquids (NGLs), which are used as heating fuels and industrial feedstocks.
There are tanks, wells, and other storage facilities both above and below ground. They provide flexibility to the energy economy, so there is propane available for winter heating, gasoline for summer driving, and jet fuel for the holidays.
- Exploration and Production
Commonly referred to as E&P, it’s really two businesses in one, but they are so closely linked in the energy industry that it’s worth considering them at the same time. Exploration is searching for energy underground in its various raw forms: crude oil, raw natural gas, and coal beds. Production involves bringing it to the surface.
How is an MLP different than a traditional corporation?
Most notably, by limiting themselves to handling natural resources and minerals, MLPs do not pay income taxes to federal, state, or local governments at the entity level. This means that they are able to pay out more of their earnings to investors. Corporations, on the other hand, pay federal income taxes of up to 35% as well as any applicable state and local taxes.
MLPs are also governed differently from regular corporations. Companies such as Exxon, Apple, and Ford are 100% owned by shareholders. Founders may own significant amounts of stock, but decisions are made by management teams as well as by shareholders at an annual meeting where major issues are decided by voting. A shareholder has one vote per share owned, and either a majority or a plurality of votes may be required for particular decisions. Most MLPs, on the other hand, are governed by their general partner.
MLPs generally have two classes of owners, the general partner (GP) and the limited partner (LP). The general partner interest of an MLP is typically owned by a major energy company, an investment fund, or the direct management of the MLP. The GP controls the operations and management of the MLP and typically owns a small portion of the LP. Limited partners (aka people who own units) own the remainder of the partnership but have a limited role in its operations and management. Legally, the general partner has no fiduciary duty to make decisions that will benefit LP unitholders; although what benefits the GP typically benefits the LP.
How MLPs Make Money
MLPs typically operate toll road or fee-based business models. Just as the company that owns the toll-road makes a set fee per mile driven, regardless of the cost of the car, MLPs earn a set fee for each barrel of oil, cubic foot of natural gas, or ton of coal that is processed, transported, or stored, regardless of the cost of the hydrocarbon. (At Alerian, we call this the Honda Civic/Aston Martin example, named for the cars driven by two of our founders.) This is because MLPs typically do not own the oil or gas, just as the toll road does not own any cars. MLPs generally sign long-term contracts (5 to 50 years in length) with their customers, which makes for a very stable business.
Extending this example, the MLP revenue equation is fairly simple. It’s just price multiplied by volume. On the price side, a federal agency sets the fee charged by interstate liquids pipelines, and the fee increases with inflation. On the volume side, energy demand growth in the US is expected to increase by 0.3% through 2040.
A small number of MLPs are E&P companies. Typically, these MLPs will buy older, more mature oil and gas wells that are still producing energy. Profits depend on how much energy they produce and the prices for which it can be sold, exposing them to fluctuations in commodity prices. Frequently, E&P MLPs use financial tools called options or hedges to lock in specific prices for a certain amount of time.
How Investors Make Money With MLPs
If you own a stock, there are two ways to make money.
- The price of the stock increases and you can sell it for more than you bought it. Formally, this is known as price appreciation.
- The stock pays you dividends. MLP dividends are called distributions because of the partnership structure, and the amount of distributions relative to the share price is known as yield.
The historical average yield of MLPs over the past 10 years has been 6.8%, which means that if you invested $100, on average, you would be paid $6.80 each year. As a comparison, Utilities and Real Estate Investment Trusts (REITs), which are asset classes known for their income potential, have about a 4% yield. The S&P 500 has around a 2% yield.
Source: Alerian as of January 30, 2015
It is worth noting that MLP distributions are not guaranteed and vary depending on the MLP. Unlike REITs, which must distribute a certain percentage of their cash flow each quarter, the partnership agreements of individual MLPs determine the level of distributions. Traditionally, MLPs pay out between 80%-100% of their cash flow.
History of MLPs
In 1981, Apache Corporation created the first MLP, Apache Petroleum Company (APC). By combining the interests of 33 oil and gas programs into one and having Apache Corporation acting as a grand boss, APC was able to combine the disparate interests and operate them more efficiently. As APC was traded on both the New York Stock Exchange and the Midwest Exchange, investors were easily able to buy and sell these interests just like shares of stock, rather than waiting for the sale of the whole business to realize their profits.
Other oil and gas MLPs soon followed. As did real estate MLPs. And throughout the 1980s, more and more businesses became involved until there were cable TV MLPs, hotel MLPs, amusement park MLPs, and even the Boston Celtics became an MLP. Soon, the government began to notice (after all, it was losing out on taxes!), and Congress worried that every corporation, especially Exxon, would become an MLP.
Congress passed the Tax Reform Act of 1986, and President Ronald Reagan signed it on the South Lawn of the White House. In addition to eliminating a number of other tax shelters, it defined the structure of the modern MLP. Section 7704 of the Revenue Act of 1987 limited which businesses could be MLPs, delineating that an MLP must earn at least 90% of its gross income from qualifying sources, which were strictly defined as the transportation, processing, storage, and production of natural resources and minerals.
Any MLPs that had other kinds of income were allowed to remain MLPs, but in the past 30 years, most have gone private or converted to other structures. By the mid-1990s, many of the original oil and gas MLPs were unable to maintain their distributions and stopped trading, while most real estate MLPs converted to REITs.1
With the turn of the millennium, MLPs began to own ships for the seaborne transportation of energy resources as well as the storage tanks and bobtail trucks necessary for propane distribution. Several coal companies also became MLPs, and in 2006, after a long hiatus, the E&P MLP returned. In 2012 and 2013, more non-traditional MLPs came to market. Now, there are refining and marketing, fertilizer, and frac sand MLPs.
The Pipeline Business, Explained
The modern pipeline network in the United States had its roots in the outbreak of World War II. Before the war, the East Coast was the largest consumer of energy in the country. Refined products (such as gasoline, diesel, and jet fuel) were delivered from the Gulf Coast refineries via tankers, as was raw crude oil from the Middle East. However, once the US became involved in the war, German submarines began sinking these tankers. Together, the government and the petroleum industry invented and built pipelines that were able to cover long distances and transport large amounts of oil. This network subsequently fueled the economic boom that followed the war, and many of those original pipelines are still in service today.1
There are both large diameter trunklines that function like interstates (instead of being four lanes wide, they are often 42” in diameter, or large enough for a child to stand inside), as well as smaller delivery lines which connect the large pipelines to each small town. Product traveling through trunklines is considered to be fungible—the customer will receive product on the other end that is the same quality as that which was sent, but they won’t be the exact same molecules. It is as if someone sent $100 to a college student through a bank. That student will not get the exact same $100 bill as his or her benefactor sent, but the student doesn’t care because $100 is $100. Money is fungible. However, smaller delivery lines operate on a batch system, where the exact same molecules are delivered as were shipped. In this case, our lucky college student gets a couple dozen cookies, and the ones delivered are the exact same cookies his or her parents baked, not cookies that some other people made.
Throughout history, technological advances have completely changed people, countries, and humankind. In the past five years, smartphones have dramatically changed the personal lives of financial professionals. Similarly, fire, steel, gunpowder, manufacturing, steam engines, and electricity have shifted the course of industry. The technological advances impacting North American energy aren’t quite on that level, but they are close.
The new technologies this time are horizontal drilling and hydraulic fracturing. Vertical drilling, which was used for decades, is essentially drilling straight into the ground, capturing a limited amount of resources. Horizontal drilling means that instead of drilling many vertical wells, only one vertical well is drilled and the drill bit makes a 90 degree turn and continues drilling horizontally, creating something similar to the letter L. Hydraulic fracturing takes place after the well is drilled and lined with protective casing. A mixture of water, sand, and a few chemicals is pumped into the well at very high pressure to break up delicate rock. (Think of a butterfinger candy bar, but instead of candy and air, there is rock and hydrocarbons. The mixture lets a driller open all those tiny pockets.) The water is removed, but the sand props open the cavities, allowing the hydrocarbons to continue to flow to the surface.
The US and Canada have large reserves of shale rock with natural gas, crude, and NGLs trapped in between layers; such reserves were previously deemed unrecoverable, but a combination of horizontal drilling and hydraulic fracturing has made production profitable. Horizontal drilling was developed in the first half of the 20th century, and the first commercial applications of hydraulic fracturing took place in 1949. The natural gas industry began large scale application of these technologies in the early 2000s. After seeing such success, oil producers began applying the same technologies to oil wells in the late 2000s and have seen similar results.
Since 2011, tight oil production has more than tripled and is expected to gradually increase through 2021. Total natural gas production is expected to increase 55% from 2014 to 2040, with the bulk of the growth coming from shale gas production, which is expected to increase by 106% during the same time period.
The term “energy renaissance” refers to the overwhelming production growth in energy resources that has occurred and is expected to continue, with the potential for the US to be net energy independent by the 2020 to 2030 timeframe (estimates vary).
Energy Demand Growth
While the sharp increase in US natural gas supply may eventually lead to significant exports, many industries have already taken advantage of lower natural gas prices domestically. The trend of switching from coal to natural gas for power generation has already achieved considerable momentum. While coal is currently the largest source of power generation in the US, natural gas power plants are more economical to build, maintain, and operate. Additionally, President Obama’s announced climate change strategy includes utilizing the Environmental Protection Agency (EPA) to establish and enforce carbon pollution standards for coal power plants, further increasing the cost of operation and raising the likelihood of coal plant retirements.
Industrial demand for natural gas has also grown considerably, with multinational corporations moving their petrochemical operations to the United States to take advantage of cheap natural gas. A potential and developing trend is the construction of gas-to-liquid (GTL) plants that convert natural gas into gasoline or diesel fuel. Typically, such products are refined from crude oil and not natural gas, but the abundance of cheap natural gas in the US could make such plants in the US a reality.
Another consideration for both natural gas and petroleum products is the impact of international demand. The US is in the process of exporting natural gas for the first time in history, and US exports of liquefied petroleum gas (LPGs) are at a record high.
What This Means for MLPs
MLPs are not the companies engaging in horizontal drilling or hydraulic fracturing. They’re not the industrial firms taking advantage of inexpensive natural gas, or the exporters who will directly benefit from international demand. MLPs are not the companies chasing the gold rush and taking risks to strike gold and get wealthy. Instead, MLPs are selling blue jeans, canned beans, and shovels. There may be hundreds and hundreds of new wells being drilled in North Dakota and not every operator will strike it rich, but the MLP that provides transportation, processing, and storage facilities for a large portion of the operators has reduced the concentration of risk and benefits broadly from US energy production.
The 2014 Interstate Natural Gas Association of America (INGAA) study quantified just how much infrastructure would be needed in North America through 2035. That number is $641 billion: on average, over $30 billion per year. For an asset class that is currently $500 billion, that’s significant growth.
Alerian expects the broader MLP space to return 10%-12% annually over the long term. This return assumes no meaningful movements in valuation from current levels, and is comprised of a 6% yield and distribution growth of 4%-6% per year. This growth number is based on incremental building of more assets to support the energy renaissance in the United States and does not include large acquisitions from corporate entities or major changes to the industry.
Every company who has ever hired a lawyer and published anything has been told that they have to have a list of risks, warnings, and disclaimers 87 pages long. Even if you don’t like reading fine print, PLEASE still read this. We’ve worked extra hard to make it interesting, it isn’t even close to 87 pages, and part of understanding MLPs is understanding what could go wrong. While some of these risks may be unlikely to occur, they could impact the 10%-12% annual total return that Alerian predicts for the asset class.
Legislative Risk – It’s hard to predict the government’s actions, but MLP investors have heightened concerns that the beneficial MLP tax structure could be abolished, given the history of governmental treatment of pass-through structures. Canadian income trusts used to have a similar tax structure, but in October 2006, the government announced that all income trusts would be subject to corporate tax. Overnight, income trust equity prices plummeted. Over the years, such trusts were eventually converted into corporations and those surviving and paying dividends now yield between 3% and 4%. In the early 1980s, the US saw the same overuse of the structure that led to the dissolution of the Canadian income trusts. In 1987, the US Congress strictly limited which sorts of income would qualify for MLP status, rather than abolishing the entire structure. Most MLP industry analysts, together with Alerian, view a change in the MLP tax status as unlikely, given this restriction. While the partnership structure does mean that the government forgoes tax revenue, the $1.4 billion annually (a number provided by Congress itself) is a drop in the bucket compared to the deficit.
On another note, a great deal of political rhetoric has been focused around the potential for US net energy independence. Given the critical infrastructure role MLPs would play in such a development, logically, members of Congress are unlikely to pass legislation that would hurt MLPs and slow the process. However, political strategy is complicated and people (even members of Congress) do not always act rationally.
Commodity Price Sensitivity – Generally, the movement of energy stocks such as E&P or refining companies depends on the price of commodities. Changes in supply or demand as well as geopolitical risks dictate where commodities will theoretically trade. Unpredictable changes in these factors can lead to pricing volatility, which can translate into cash flow volatility for investors. Since MLPs typically do not own the oil and gas they transport, the business performance of MLPs is not directly connected with the price of oil or gas. However, there are indirect connections between the price of energy and the performance of MLPs. If commodity prices are very high, consumers will use less, creating less demand for oil and gas to be transported. Additionally, investor psychology may connect MLPs with the broader energy sector and commodity prices beyond what the underlying business models would otherwise indicate.
Interest Rate Risk – Because many investors have historically owned MLPs for yield, they have been perceived to trade similar to yield instruments such as bonds or yield asset classes like Utilities and REITs. The yield spread represents the difference in yield between a government note (typically the 10-Year Treasury) and the yield of a stock or asset class, like MLPs. Since a promise from the US government is considered (relatively) risk-free, the spread represents the additional risk that an investor is willing to take in exchange for a higher return (or yield). If interest rates increase, it means the yield on government notes has increased. If the same spread were added to the now-higher government note, then an MLP would have a higher yield, which also means the MLP equity price would fall, assuming the same distribution paid. This reflects the inverse relationship between price and yield. Over the past three decades, MLPs have benefited from a trend of declining interest rates and have shown no day-to-day correlation with rates. Historically, MLP stock prices initially tend to respond unfavorably to the announcement of increases in interest rates, as when that happens, nearly everything that pays dividends falls in price. Over the long term, inflation-adjusted tariffs and dividend growth has largely mitigated this effect.
Environmental Risk – Some pipelines in major transportation corridors were constructed in the 1950s and 1960s. An aging pipeline system as well as high-profile oil spills and gas leaks have increased investor concerns regarding transportation safety. Pipelines are by far the safest form of transportation for oil and natural gas. They are 34 times safer than road transportation when compared on the basis of incidents and serious incidents per billion ton miles per year. The number of spills per 1,000 miles has dropped by 60% in the past ten years, and the number of barrels released has dropped 42%.2 These improved metrics are due to increased maintenance and new technology enabling more frequent and accurate monitoring of pipelines.
Hydraulic Fracturing – The safety of this technique has garnered national media attention. Specifically, there are claims that hydraulic fracturing contaminates fresh ground water or has caused more tectonic stress and more earthquakes. The energy industry claims that the method itself is safe. Many studies have been conducted and drawn conflicting conclusions. The Departments of Energy and Interior and the Environmental Protection Agency (EPA) have agreed to collaborate on safety research. The EPA is currently conducting a study on the effects of fracturing on drinking water resources, which is expected to be completed in 2016. However, New York State currently prohibits hydraulic fracturing. Should other states or the federal government also ban the process, as has been done in some parts of Europe, the future growth of MLPs could be curtailed.