Master Limited Partnerships (MLPs) appear to be a natural way to invest in the changing energy landscape. MLPs are exclusively focused on energy infrastructure in the United States and Canada. North American energy production has become a dominant factor in the price of oil and in the North American drive to be energy independent. Yet, the pricing and performance of MLPs can be complicated, influenced by systemic factors, such as the prices of oil and gas, interest rates, and movement in the equity markets. MLPs are also influenced by the degree of success of each individual partnership in the same way that traditional stocks’ performances are determined by both market and individual factors. Despite recent performance, we believe the sector may still represent a good long-term investment option to potential profit from increased North American energy production.
MLPs are technically partnership interests that issue units, instead of shares, that often trade on national stock exchanges. Partnerships are legal entities that have a pass-through tax structure and do not pay federal or state income taxes. To qualify for this treatment, the partnership must generate more than 90% of its income as “qualifying Income.” Qualifying income has been largely limited to payments related to natural resources, commodities, and real estate. MLPs are typically involved in the transportation and storage of oil and natural gas. Unlike REITs, MLPs are only required to pay out “available capital,” whereas REITs are required to pay out 90% on income received. Because the revenue of an MLP is determined by the amount of oil or gas flowing through the pipeline, not the price of the commodity, MLPs are often referred to as “energy toll roads.”
MLPs are required to pay out most of their income and that income is exempt from income tax. Furthermore, the actual distribution from the MLP is frequently referred to as a return of capital, as opposed to income, so the unit holder does not pay income tax at the time of distribution. MLPs historically have higher yields than the dividend yield on the broad stock market averages or than the yield on investment grade bonds. The tax component may be affected by future tax policy, adding an element of uncertainty.
In 1981, when the U.S. was heavily dependent on imported oil and after suffering two major oil supply shocks in the 70s, Congress created the concept of the MLP to encourage private capital investment in U.S. energy production. It was the development of drilling technologies, most notably hydro-fracturing (fracking) that has led to sustained interest in MLPs. Due to the changes in drilling technology, North America is largely energy self-sufficient. The U.S. imports about 25% of its oil, 45% of which comes from Canada and Mexico, countries where U.S. based MLPs help facilitate movement of energy. Almost all energy consumed in the U.S., quite literally all the natural gas, and over 85% of the oil has some connection to MLPs.
The 2016 election enhanced the future of MLPs. Oil and gas production increased significantly during the last five years despite skepticism about the safety of fracking from the Obama administration and many state governments. The new administration has promised to be more energy friendly, with promises to roll back regulations and approve permits for energy development. According to Bloomberg, there is an estimated $50 billion in energy projects awaiting permitting. One reason for the backlog is that the Federal Energy Regulatory Commissioner (FERC) has only two of its five commissioners seated, and one of those two announced she would not stay on after her term expires this June.
MLPs have lagged the performance of stocks this year, perhaps due to the weakness in oil prices. Oil prices do not have to rise for MLPs to appear attractive, they just need some stability. With interest rates low, MLP yields should be attractive to investors. We see a strong fundamental backdrop for MLPs with increased North American production and what is likely to be an easier regulatory environment. Combined with attractive valuations, we believe MLPs have a role in a diversified investment portfolio.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. To determine which investment(s) may be appropriate for you consult your financial advisor.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Data provided by LPL Financial and Bloomberg.
- Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal, and the potential illiquidity of the investment in a falling market.
- All investing involves risk including loss of principal.
- Indices cannot be invested in directly. Past performance is no guarantee of future results.
- Investing in MLPs involves additional risks as compared with as compared with the risks of investing in common stocks, including risks related to cash flow, dilution, and voting rights.
- MLPs may trade less frequently than larger companies due to their smaller capitalizations, which may result in erratic price movement or difficulty in buying or selling. MLPs are subject to significant regulation and may be adversely affected by changes in the regulatory environment.