A Guide to MLPs

Investors seeking dividend yield have conventionally employed traditional fixed income investments for this portion of their portfolio. In today’s low interest rate environment, filling this part of the portfolio has become more and more difficult. Given the inverse relationship that bonds have with interest rates, a rising rate environment is suboptimal for conventional fixed income. This has lead investors to seek out other types of arrangements to generate cash flow.

Non traditional or unconstrained income sources could include variable rate preferred’s or Master Limited Partnerships (MLPs). Some investors have an adverse view of MLPs due to characteristics they associate them with. Usually there is a conceptual aversion to the idea of K-1s, the tax documentation associated with partnerships. Having such a narrow view, unfortunately, leads many investors to not include MLPs in their portfolios. However in today’s rising rate environment, MLPs might be exactly what is needed to generate higher yields.

MLPs at their core are a tax advantaged corporate structure. The structure came about in the 1980’s in the Reagan era. The MLP space is primarily occupied by companies involved with the production, refinement, and transportation of natural resources. MLPs are typically misunderstood in the industry, contributing to many investors missing out on them as an investment instrument. However for investors searching for high yielding instruments, MLPs can play a key role inside of a portfolio. To understand if MLPs would be an appropriate investment it is key to understand their structure and history, the basic types, and their current environment.

Legally speaking, an MLP is simply a legal partnership. It is similar to any partnership in that there is both a general partner and a limited partner. The general partner will control all operations and management of the MLP. The limited partner will have no role in the operations or management of the structure. The limited partner exists to participate in the income produced by the partnership. For MLPs, the general partners will typically be a large energy corporation. They will manage the business and retain a small ownership of the entity.

The origin of MLPs brings us back to the Tax Reform Act of 1986 under President Ronald Reagan. It was in this Tax Reform Act that the modern definition of an MLP was first established. Essentially the definition declared that in order “To maintain pass-through status and pay no entity-level tax, a publicly traded partnership must derive at least 90% of its income from qualifying sources.” Companies desire the MLP registration because as a partnership, it will not be subject to federal income tax. “As it currently stands, Section 7704(d)(1)(e), the relevant section for energy MLPs, defines qualifying income as follows

interest, (B) dividends, (C) real property rents, (D) gain from the sale or other disposition of real property (including property described in section 1221(a)(1)), (E) income and gains derived from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or products thereof), or the marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber), or industrial source carbon dioxide, or the transportation or storage of any fuel described in subsection (b), (c), (d), or (e) of section 6426, or any alcohol fuel defined in section 6426(b)(4)(A) or any biodiesel fuel as defined in section 40A(d)(1), (F) any gain from the sale or disposition of a capital asset (or property described in section 1231(b)) held for the production of income described in any of the foregoing subparagraphs, and (G) in the case of a partnership described in the second sentence of section 7704(c)(3), income and gains from commodities (not described in section 1221(a)(1)) or futures, forwards, and options with respect to commodities. Section 7704(d)(4) provides that “qualifying income” also includes any income that would qualify under section 851(b)(2)(A) or section 856(c)(2).

MLPs are traditionally the the midstream companies involved with the production of energy. When it comes to the production of energy , the players will be considered the upstream, midstream, or downstream. Upstream companies are the companies that are involved with the exploration and production of energy resources. This would be the location, extraction, and processing of oil and gas from the earth. Midstream companies, where the MLP space primarily lives, are involved with the transportation, processing, and storage of crude oil and natural gas. The downstream companies are where the oil and natural gas are further processed into the final product.

The most common MLP in the marketplace is transportation. In North America, this is most often accomplished by a pipeline. Other modes of transportation would include truck, railroad, or oil tanker.

There are also MLPs associated with processing. These MLPs could include any firm that operates in transforming raw energy sources into a usable format. This could be as simple as filtering and purifying different energy sources. Storage MLPs are the storage facilities such as tanks or wells used to store liquid energy. These are primarily used as large energy dependent corporations manage their energy supply to be available throughout different price cycles.

By occupying the midstream portion of the production cycle, MLPs are able to benefit from a consistent stream of income payments. The revenue model of an MLP is similar to how a toll road would operate. A toll road collects a fee each time a car passes through the toll. In theory, the more cars driving down the road equates a higher number of tolls being collected. With MLPs focusing on the midstream companies, this would apply in the storage and transportation of energy. Trucking, pipelines, and railways used to transport energy are all forms of MLPs. As the energy supply in the US continues to increase, so will the need for the transportation and storage of it.

So, why MLPs now? The United States’ approach to energy experienced a major shift in the mid 2000’s. A significant component of this was technological innovations such as horizontal drilling. This shift we saw was a shift more towards production and exporting of energy. Say what you will about the direction of energy prices, what is fairly certain is that there will be a continuation of the increase in supply. With an increased supply comes a increase in the need for storage and transportation. As we know, storage and transportation of energy is the sweet spot for MLPs. Clearwater Capital Partners believes that exposure to MLPs is best executed through the use of an exchange traded product. This is done for two primary reasons; diversification and tax treatment. By employing an MLP ETN (or ETF) we are able to gain broad exposure to a large index of MLPs, eliminating single company risk. Additionally, MLP ETN’s do not issue K-1s. Instead they report income on a 1099 which most investors find much more convenient.

As investors continue their search for yield, MLPs cannot be ignored as an asset class as apart of a well diversified investment strategy. Gone are the days of employing a simple bond strategy for the yield part of a portfolio. Unconventional sources of cash flow become a necessary part of a portfolio, as interest rates remain low. Yes, interest rates are beginning to increase, this will most likely be a slow and gradual process. The seemingly certain narratives about the US’s approach to energy leads us to conclude the supply will continue to increase. With increased supply comes increased need for storage and transportation. As these “toll roads” continue to operate at increased capacity, MLPs will continue their cash flows.