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 —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 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
- Transportation 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 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.
- Storage 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.
- Production and Mining This encompasses both exploration (searching for energy underground in its various raw forms) and production (bringing it to the surface). This includes crude oil, natural gas, coal, and frac sand.
How is an MLP different than a traditional corporation?
Most notably, by limiting themselves to handling natural resources and minerals, MLPs do not pay federal income tax at the entity level. This means that they can pay out more of their earnings to investors. Corporations, on the other hand, do pay federal income tax.
MLPs are also governed differently from regular corporations. Companies such as Exxon, Apple, and Ford are primarily 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 in the US is fairly inelastic and only expected to increase by 5% from 2016 through 2040. Translated to an annual basis, this growth is relatively flat.
A small number of MLPs are Production and Mining companies. Typically, these MLPs own either coal mines or 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.
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 around 7%, which means that if you invested $100, on average, you would be paid $7 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 December 31, 2016
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 could 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 noticed (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 several 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 could remain MLPs, but in the past 30 years, most have gone private or converted to other structures.
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 upstream MLP returned (only to decline during the 2014-2015 commodity downturn). In 2012 and 2013, more non-traditional MLPs came to market. Now, there are refining, marketing, and frac sand MLPs. For a complete list of all energy MLPs, please see Alerian’s MLP Screener.
Source: Alerian as of December 31, 2016
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. Tankers also carried 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 could 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
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 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 decade, 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. The combination makes it possible to profitably produce the large reserves of crude oil, natural gas, and NGLs trapped between layers of North American shale rock. 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.
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).
In the early 2000s, much of the energy industry was focused on peak oil and the ways the industry and our society would have to shift in response. While producers knew that oil still existed, accessing it in a cost-effective way was still difficult. Experts forecasted that expensive and complex recovery methods would be needed to continue to produce even a modest number of barrels. By the mid-2000s, the natural gas shale revolution began as drilling technologies and methods had improved, making recovery cheaper. Such methods were then applied to oil wells several years later, and by 2012, lack of supply soon became surplus supply. As supply rose, prices fell and politicians then spoke of the US becoming energy independent and a net energy exporter.
The sharp increase in US natural gas supply has led many companies to build liquefaction plants where the natural gas can be cooled and pressurized to a liquid form. This liquefied natural gas (LNG) can then be loaded onto ships for export.
The trend of switching from coal to natural gas for power generation has achieved considerable momentum. While coal has historically been the largest source of power generation in the US, natural gas power plants are now more economical to build, maintain, and operate.
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.
Midstream MLPs are building the infrastructure to connect new areas of supply and new areas of demand. They build the pipelines to LNG plants, natural-gas-fired power plants, and necessary storage facilities.
What This Means for MLPs
Traditionally, MLPs are not the companies engaging in horizontal drilling or hydraulic fracturing. They are not (generally) the industrial firms taking advantage of inexpensive natural gas, or the exporters who will directly benefit from international demand. Only very rarely are MLPs the companies chasing the gold rush and taking risks to strike gold and get wealthy. Instead, MLPs are typically selling blue jeans, canned beans, and shovels. There may be hundreds and hundreds of new wells being drilled 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.
A 2017 American Petroleum Institute study quantified just how much energy infrastructure would be needed in the US from 2017 through 2035. In the study’s base case, $742 billion would be required for oil and gas infrastructure investment, which equates to approximately $40 billion per year. For the MLP asset class, which had a total market capitalization of just under $400 billion at the end of 2017, that’s significant growth.
Every company who has ever hired a lawyer and published anything has been told that they must have a list of risks, warnings, and disclaimers 87 pages long. Even if you don’t like reading fine print, PLEASE still read this. While some of these risks may be unlikely to occur, they could impact your expected total return.
Commodity Price Sensitivity – 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 low, upstream companies will drill less and demand will fall for gathering and other pipelines and facilities. 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 unit 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 for MLPs has largely mitigated this effect.
For further explanation, please see Alerian’s white paper on How MLPs Respond in a Rising Interest Rate Environment.
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. 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 billion annually (a number provided by Congress itself) is a drop in the bucket compared to the deficit.
A reduction in the federal corporate tax rate would not directly impact MLPs as they do not pay federal income taxes. However, such a reduction could impact the number of new MLPs as the comparative benefit of the structure diminishes.
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.
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%. These improved metrics are due to increased maintenance and new technology enabling more frequent and accurate monitoring of pipelines.
Renewable Energy – The potential for renewable forms of energy (solar, wind, hydraulic) to replace hydrocarbon-based energy is both the largest and least immediate risk to energy infrastructure MLPs. Such a technological breakthrough is likely many years away, and it will also take many years to fully implement. However, if the next form of energy is transported in a gaseous or liquid form, it is highly likely that existing steel pipelines and storage facilities can be converted. For instance, liquid hydrogen could easily be moved by our current infrastructure.
Permitting Risks – The permitting process for a new pipeline involves federal and state government approvals and permits, as well as environmental impact studies and potentially eminent domain complications. Each state has its own regulations, and pipelines often pass through many states. Should an approval not be granted (or conditionally granted), a pipeline may need to be rerouted, which is an expensive and time-consuming necessity. It is at this stage that community and environmental protesters often delay the timeline. Any delays or cost overruns in the permitting process may make the project less profitable, as well as potentially preventing the pipeline from being built, resulting in lost sunk costs for the company.