Should I Be Investing In Master Limited Partnerships?

I need to admit I made a mistake.  At first glance, master limited partnerships ( ‘MLP’ for short) always seemed like the kind of investment I would automatically dislike — With flat share prices, large debt levels and high dividend yields.  They ticked a lot of my “don’t invest” boxes pretty quickly.

It should come as no surprise, that I’ve essentially ignored MLP’s for years.  But I was wrong.  I blithely passed over such investments with nary a read through the annual report.  This was a big mistake.

The world is an ever changing place, and I’ve recently come to realize that what I knew about MLP’s is no longer relevant today.  I missed out on a lot of potentially very good returns.

But I’m getting ahead of myself here — I need to start this story at the beginning…

What is a MLP?

A Master Limited Partnership is a form of business structure (technically a partnership) that is publicly traded.  Like your standard C-corp type stock, small investors can buy into these ventures as a ‘limited partner’ and enjoy income and capital appreciation as well as liquidity similar to any other stock.

What’s different, is the significant tax advantages MLP’s enjoy over your standard stock.

You see unlike a C-corp, MLP earnings are pass-through.  Meaning, the partnership itself typically doesn’t pay taxes on the cash the business makes.  Instead, these funds are “passed though” to the partners, and then the partners get to pay the taxes at their individual taxation rates.

In stark contrast, a typical C-corp stock pays taxes at the corporate level, and then the individual pays taxes again on any dividends they receive.  Essentially, the government double-dips on taxation from C-corps, but MLP’s escape this little double taxation problem.

On top of all that, income from MLP’s now qualify for the 20% qualified business income tax deduction.  Meaning, for any taxable income you receive from a MLP, you don’t pay taxes on 20% of that.

This is a pretty sweet deal, because almost all MLPs have earnings in the form of taxable distribution, and a significant portion which is called “return of capital”.  Return of capital is not taxed, but instead regularly reduces your cost basis.

All this adds up to a corporate structure where almost all the cash generated by the MLP is distributed to the partners without much in the way of taxes.  Some of that distribution is going be taxable income, but a good portion of it isn’t taxable.

Reportedly, 80% or more could be tax free (until you sell and realize a capital gain).

Oil & Gas Only?

MLPs usually operate in the energy industry.  You typically find MLP’s that pump oil and gas out of the ground, operate pipelines, or perform other support logistics for energy companies.

This is one of the big things I missed by ignoring MLP’s in recent years — MLP’s also operate in other industries besides oil and gas.  Take for example Brookfield Renewable Energy Partners (Symbol: BEP).  They operate hydro, solar and wind renewable power generation assets.  Essentially the green energy industry — which is a huge growth industry that earns higher returns on capital than your traditional coal-fired power plant.

Yep, I missed that one.

There’s also infrastructure MLP’s like Brookfield Infrastructure Partners (Symbol: BIP), that do so many different things I have trouble even classifying it.

You also have MLPs like Cedar Fair (Symbol: FUN) operating amusement parks.  Or, there’s cemetery and funeral home operators like StoneMor Partners (Symbol: STON).

You can also have lumber companies like Pope Resources (Symbol: POPE), and fertilizer companies like CVR Partners (Symbol: UAN), as well as management partnerships like Icahn Enterprises (Symbol: IEP).

Clearly, the MLP world has become much more diverse than just oil and gas pipeline companies.

Too Much Debt? Slow Growth?

Now historically I’ve always though of MLP’s as being heavily loaded down with debt and having extremely slow-growing cash distributions.  How slow?  Maybe only fast enough to keep up with inflation.

I used to think that MLP’s were like really volatile bonds that tended to be heavily loaded down with debt.  In addition to that, I didn’t see any way there could be significant internal compounding (because all cash flow was distributed to unit holders)… aka no growth.

All this created a risk-return profile I wasn’t terribly comfortable with.  Hence my historical lack of interest in MLP’s.

However, the recent explosion of shale drilling in the U.S. has made me challenge those previous assumptions.  In some cases I was flat-out proven wrong.  Really wrong.

Why?

An incredible number of new pipelines and other oil and gas infrastructure have been built in recent years to take advantage of those newly developed shale energy resources.  Typically the General Partner of a MLP (usually a large oil company) builds the new infrastructure and then “drops down” the assets to the MLP structure.

To pay for that growth, the MLP then issues new “units” (MLP’s don’t use shares) and issues additional debt.  If the deal is structure correctly existing unitholders shouldn’t see the diluted, and the MLP doesn’t become over-leveraged.  As a result, existing unit holders often realize distribution growth (aka dividend growth) in excess of inflation.

In this way, the General partner and the existing limited partners both benefit from this unusual growth process (if the deal was done fairly).

Here’s one example of this growth I’m talking about — Consider a MLP called EQM Midstream Partners (Symbol: EQM).  They’re mostly an operator of natural gas collection pipelines.  Yet because of this unique growth process, they’ve been able to grow distributions significantly over the last 6 years.

As you can see from the chart above, EQM has successfully grown distributions for MLP unit holders at a incredible clip.  Roughly 20% a year.  To do so, they’ve borrowed money, and issued new share-units at an equally fast speed.

As you can see, there’s been plenty of dilution to fund all this growth, but the dilution wasn’t bad for existing unit holders.  They realized significant distribution growth.  EQM (and many other MLPs like it) have managed this growth process in a healthy way for all stakeholders.

Other great MLP distribution “growers” include Magellan Midstream Partners (Symbol: MMP), Energy Transfer (Symbol: ET), Phillips 66 Partners (Symbol: PSXP), and Enterprise Products Partners (Symbol: EPD).

Just go look at the distribution growth on some of those MLP’s.  You’ll be impressed.  In contrast, the S&P 500 averages annual dividend growth of 6%.

MLP’s Are Unloved Assets

Every once in awhile I see a sector or industry that’s absolutely hated by both Wall Street and individual investors.  That industry that gets no love for one reason or another.  I think MLP’s fit this description right now.

Despite having a history of good distribution growth, share prices of almost every MLP I can name are down over the last 5 years.

Are there babies being “thrown out with the bathwater”?  Could this be an example of the market being irrational and miss-pricing assets?  It very well could be!

However, I can also think of a few reasons why this unloving behavior might be justified:

1.  Like bonds, when interest rates rise the prices of fixed-payment assets should fall.  Interest rates are rising.  If MLP’s are considered to be “fixed payment” assets, this could partially justify why unit prices have fallen in recent years.  Fast growing MLP’s might be unfairly penalized here.
2. The price of oil and gas crashed back in 2015, and several energy companies cut dividends.  Kinder Morgan (Symbol: KMI) was one, as well as Enbridge Energy Partners LP, NGL Energy Partners (Symbol: NGL), and Plains All American Pipeline (Symbol: PAA).  They cut dividends, and the entire MLP sector sank in fear of additional cuts.
3. At the end of 2018, Enbridge repurchased Enbridge Energy Partners — effectively wiping-out investors that held shares of the MLP through the oil price crash.  This forced long-term investors to take capital losses.  It also set into motion a disturbing precedent — one that might cause investors to avoid MLPs.

Conclusion

While I’m not currently invested in any Master Limited Partnerships, I’ve never been so happy to be proven wrong about an entire asset class before.  Yes, I was wrong about MLP’s.  They’re not all bad. (To be fair, some are junk.)

In the past, I didn’t think highly of MLP’s because I considered them wildly volatile, and highly leveraged income plays with flat distributions.  Well, I was wrong.  MLP’s aren’t junk, and many of them are well managed with fixed fee income that doesn’t fluctuate as wildly as energy prices.

In recent years, many energy MLP’s have been able to grow distributions considerably faster than the S&P 500.  Think of a dividend rocket-ship and you wouldn’t be far from the truth.

Much of the shale revolution’s growth has been realized through master limited partnerships, and as a sector I absolutely missed it.

The energy revolution in the U.S. isn’t done yet however…  Based on EIA estimates, there is still plenty of growth to be had as the world’s demand for energy continues to grow.

In other words, I might consider adding MLP investments into my portfolio.  There’s definitely some tax advantages to owning MLP’s that fit very nicely with early-retirees like myself (people who lack a traditional W-2 income).

MLP’s aren’t perfect, but going forward I think it would be extremely foolish of me to ignore the sector further.  It’s safe to say my old prejudices against MLP’s have been proven quite wrong!

Have you ever invested in a MLP?  Tell me about your experience in the comments below!

[Image Credit: Flickr1, Flickr2]