Back in 1986, Halley's Comet streaked through the sky, Bill
Buckner broke the hearts of Red Sox fans in the World Series, and
the U.S. government passed a landmark tax reform act.
You may not remember that last event, but more than two decades
later it still has a profound impact on millions of investors. That
particular piece of legislation set up a special tax loophole for a
select group of companies known as master limited partnerships
(MLPs).
To spur the development of vital energy infrastructure assets,
Congress essentially granted these businesses an exemption from
federal income taxes. But favorable tax treatment is only one
reason why income investors have flocked to this group.
The attraction lies in the highly stable business model of MLPs,
their double-digit yields, and their ability to hike distributions
every year.
The vast majority of MLPs operate in the energy business. These
companies own and operate networks ranging from pipelines to
liquefied natural gas (
LNG
) terminals -- which transport, process and store crude oil,
natural gas and petrochemicals.
In short, these critical "midstream" functions serve as a vital
link in the chain enabling oil and gas producers to get their
products from the ground to the market. And this business has some
highly attractive features:
- Aside from routine maintenance, pipelines and other
facilities don't require much in the way of ongoing capital
expenditures and can stay in service for decades.
- Most companies have staked out different territories, and
since overlapping pipelines are rare, competition tends to be
minimal in many regions.
- Unlike other sectors, disruptive new technologies and product
obsolescence aren't much of a threat -- pipelines aren't going
out of style anytime soon.
- In general, MLP income is largely based on the volume of oil
and gas flowing through the system, not the prices of the
underlying commodities.
- Pipelines that cross state lines are often regulated at the
federal level, with rates tied to the Producer Price Index, so
tariffs ratchet higher over time to match inflation.
Because MLPs aren't involved in the actual production and sale
of commodities, many pipeline owners care little about commodity
prices. As long as oil and gas are flowing through the system, the
company responsible is well-compensated for its services.
Very few industries can count on inelastic demand, natural
barriers to entry, strong operating leverage, and partial
insulation against fluctuating prices. So it's not surprising that
MLPs are famous for their ability to generate highly stable and
predictable cash flows in both good times and bad.
And just like utilities, these mature companies usually
distribute their profits to shareholders (technically known as
"unitholders" in partnership lingo) as fast as they take them in.
In fact, MLPs typically distribute about 90% of their cash flows
each quarter -- and in this case, Uncle Sam doesn't take a cut of
the proceeds.
Commodity prices can fluctuate wildly from day to day -- but
demand for crude and natural gas is fairly level and increases at a
steady pace each year. Most experts agree that world oil
consumption (which now stands at 85 million barrels per day) will
continue to increase at a +1.25% annual clip during the next 20
years.
That might not sound like much, but consider that most MLPs are
busy making acquisitions. By expanding pipeline systems, firms can
rake in more cash even if product volume remains flat.
More cash in the company's coffers means dividend distributions
could continue to increase. During the past decade, MLPs have
parlayed gradually rising demand, built-in inflation adjustments
and billions in expansion projects into dependable more than +7%
average annual distribution increases.
As you can see from these widely held MLPs (which are commonly
found in nearly all MLP funds), those steady increases can really
add up over time.
Company (Ticker)
2006 Dist.
2007 Dist.
Current Dist.
5-Yr. Div. Growth Rate (
CAGR
)
Current Yield
Energy Transfer (
ETP
)$2.01$3.19$3.58+19.6%8.1%Enterprise Products (
EPD
)$1.80$1.92$2.21+7.4%7.6%Magellan Midstream (
MMP
)$2.29$2.49$2.84+10.5%7.3%Plains All-American (
PAA
)$2.87$3.28$3.68+9.5%6.6%I would be remiss if I didn't mention that
for all their benefits, MLPs can create some headaches at tax time.
Distributions are usually a mixture of net income and a return of
capital (an allowance for depreciating assets). For more
information, this primer might help.
Fortunately, those who invest in this sector through a fund rather
than individual stocks can bypass most of these complications.
Still, you may want to consult your tax advisor before
investing.
In any case, it's easy to see why MLPs are prized for their
unique mix of stability, income and growth. There has arguably
never been a better time to invest in this attractive sector.
a:link {color:#125AD3; } a:visited {color:#125AD3;}
Nathan Slaughter
Editor:
Market Advisor
Half-Priced Stocks
The ETF Authority
P.S. -- MLPs are one way to beat the market, but I see three
other reliable ways to make money in today's market. Using this
triple-pronged attack, I'm making money from 24 out of my 27 picks.
If you're ready to stake your claim in this profit patch, go here
now.
Disclosure: Nathan Slaughter does not own shares of any security
mentioned in this article.