How to Utilize Master Limited Partnerships (MLP) as a High Yield, Growth-Oriented Investment

Saturday, September 1, 2012

Is there a pipeline in your investment fu­ture? Master limited partnerships (MLPs) are a type of publicly traded holding struc­ture employed widely in the natural resources energy infrastructure space, which includes pipelines, storage facilities and anything in the transportation chain, from the wellhead to the market consumer.

“Yield-starved investors are dying for ideas, so here’s an idea of a niche asset class that has high current income, growth potential and some tax-deferred characteristics,” says John Micklitsch, CFA, director of wealth manage­ment with Ancora Advisors LLC. “They bring some diversification to a portfolio because they have a low correlation with stocks and bonds, and they have the potential to hold up well in an inflationary environment because they are a hard asset and their distributions are growing.”

Smart Business spoke with Micklitsch about the advantages of MLPs and why this might be a smart investment for you.

 

How do MLPs work?

MLPs trade on major stock exchanges such as the New York Stock Exchange or NASDAQ like any corporate stock, but instead of being a common shareholder of a corporation, you are a unitholder in a limited partnership. Like stocks, there are no liquidity or minimum pur­chase requirements. Some MLP examples in­clude Kinder Morgan Energy Partners (KMP) and Energy Transfer Partners (ETP).

Ninety percent of a MLP’s income must de­rive from natural resources production, trans­portation or storage, real estate, dividends or interest income. As it turns out, the majority of publicly traded MLPs are in the natural re­sources production, transportation and stor­age sectors. Basically, the government decided in order to have a strong energy infrastructure in this country, it would give companies par­ticipating in that infrastructure a subsidy by not taxing them, provided they distribute their income out to unitholders.

 

Why are they potentially attractive investments?

MLPs have the highly sought after charac­teristics of strong current income and future growth potential. The business model is very predictable and simple to follow, as MLPs are paid fees, based on long-term contracts, for the natural resources that go through their pipelines or storage facilities. Generally, mid­stream MLPs take no ownership of the un­derlying commodity and therefore have little or no exposure to commodity price volatility. This fee-based, steady income stream allows them to pay out high distributions.

The Alerian MLP Index, which represents the universe of publicly traded MLPs, showed yields above 6 percent as of June 30. Compar­atively, utilities were around 4.1 percent, real estate investment trusts near 3.9 percent, the Dow Jones Industrial Average was 2.7 percent and the S&P 500 was 2.2 percent.

In addition, MLPs are predicted to grow be­cause energy production is transforming due to the technological breakthroughs associated with horizontal drilling and the exploration and production of the country’s shale resourc­es, known as fracking. Whether the newfound natural gas and oil is consumed in this coun­try, as is likely, or exported, those resources are too valuable to sit in the ground and will find their way to market to the benefit of these volume-based infrastructure providers.

The distributions a given MLP would be able to pay are expected to grow 5 to 7 per­cent over the next several years. When added to current yields, you could be talking about potential low double-digit returns.

 

What else might impact MLP performance?

Many people are currently worried about in­flation, but MLPs are hard assets. In addition, their distributions, which are not fixed and are expected to grow, stand a better chance of preserving people’s living standards in an inflationary environment.

When purchased directly, there are some po­tential tax-deferral benefits for investors, mak­ing MLPs and the income they produce poten­tially a tax-advantaged asset. However, it is important to work with an adviser to find the best ownership fit for you, direct or through a fund, as both have certain considerations.

One other advantage the MLP universe has exhibited in the past is a relatively low corre­lation with both the stock and bond markets, making them a good diversification tool. For example, in 2008 and 2009, MLP prices fell, but importantly, MLPs not only met their distribu­tions but many of them continued to increase those distributions. MLP business models are very resilient to economic and commodity volatility.

 

What does the future look like for these invest­ment vehicles?

The future is extremely bright for MLPs based on domestic energy production, led by this horizontal drill, shale/fracking revolution and simple demographics. The aging popula­tion will be starved for yield; interest rates are at an all-time low. MLPs’ combinations of high current yield plus distributions that should keep pace with inflation put them in a very attractive position for the key baby boomer demographic over the next five to 15 years.

In addition to yield-starved individual in­vestors, institutions — endowments, founda­tions, defined benefit plans — are becoming more aware of MLPs and their benefits. Insti­tutions could increasingly become involved in the MLP space over the next decade as they search for sources of return that allow them to hit their long-term actuarially driven targets. Even though they face the hurdle of unrelated business taxable income, it can be solved by a variety of ownership structures.

What should investors remember about MLPs?

MLPs are a very interesting asset class that’s growing in stature and awareness, due to the attractive combination of high current yields and growth potential of distributions, but MLPs do have several nuances that make their incorporation into your overall portfolio best accomplished with the help of an experienced adviser well versed in the space.


John Micklitsch, CFA, is the director of wealth management with Ancora Advisors LLC. Reach him at (216) 593-5074 or johnmick@ancora.net.