Master Limited Partnership Primer

Transcription

1 Advisors, LP 1100 Louisiana St. Suite 4550 Houston, TX centercoastcap.com Master Limited Partnership Primer Advisors, LP is a registered investment adviser headquartered in Houston, Texas focusing on energy related Master Limited Partnerships (MLPs). Center Coast manages MLP assets with an investment process focused on due diligence from an owner operator perspective. This process results in a portfolio of the highest quality MLPs possessing the most durable cash flows, transparent growth prospects and quality management teams in order to generate a high level of risk adjusted returns. Center Coast uses its unique experience and access to an extensive information network to conduct thorough due diligence and structured investment decision making to ensure investment in the highest quality public MLP investments. Nothing in this document should be considered a solicitation to buy or sell shares in any of the products. This document does not represent a recommendation to undertake transactions in MLPs and is provided for informational purposes only, and may not be reproduced or redistributed. There is no representation that the information is accurate, complete or current, or that it reflects the current opinion or all information know to Center Coast, its principals, associates or affiliates. Past performance is no guarantee of future results. This primer was prepared by Advisors, LP and is under protection of copyright laws.

2 Table of Contents Executive Summary 3 What are Master Limited Partnerships?...4 The History of MLPs..4 Why Own MLPs?...5 Description of Midstream MLP Assets..6 Natural Gas/Natural Gas Liquid Value Chain..6 Gathering & Processing Segment...6 Natural Gas Transportation & Storage....7 NGLs Transportation & Fractionation and Storage. 8 Crude Oil/Refined Products Value Chain...9 Types of Investors Suitable for MLPs..11 Forms of MLP Ownership 11 Taxation of MLPs..12 Risks of Investing in MLPs..12 Glossary Terms..14 2

3 Executive Summary Master Limited Partnerships (MLPs) are publicly traded partnerships engaged in the exploration, production, transportation, storage, processing, refining, marketing and mining of minerals or natural resources. These partnerships trade like any other equity on public stock exchanges. Born out of tax friendly legislation in the early 1980s, MLPs have evolved to their current state, a sector comprised of around 75 partnerships with approximately $200 billion in market cap. Center Coast concentrates on the midstream sector or the MLP value chain, these segments include: gathering & processing (G&P), natural gas transportation & storage, natural gas liquids (NGLs) transportation & fractionation & storage, as well as, crude oil & refined products. Historically, MLPs as an asset class have offered investors: an impressive historical track record attractive yield versus other alternatives low correlation to other yield oriented investments & commodity prices the potential to act as an inflation hedge and favorable tax treatment A distinct advantage of investments in MLPs, is that they represent an investment in the continued expansion of US energy infrastructure. New discoveries continue to change how oil, gas and liquids move in the US, all of which require new infrastructure. MLPs are suitable for individual, tax deferred and institutional investors and can be accessed through direct ownership, MLPdedicated mutual funds, private partnerships, hedge funds, closed end funds, exchange traded notes and exchange traded funds. MLPs are considered pass through entities, thus investors can profit from certain tax advantages, like tax shielding and no taxation at the corporate level. Like any other investment vehicle, there are unique risks to investing in MLPs, such as limited controls, energy sector concentrations and tax risks. Considering all this, it is the belief of Center Coast that investors should consider MLPs as inclusion in their portfolios. Figure 1: Map of United States Energy Infrastructure. 3

4 What are Master Limited Partnerships? Master Limited Partnerships (MLPs) are publicly traded partnerships engaged primarily in the production, processing, and transportation of energy related natural resources. The oil and gas industry is generally divided into three sectors: upstream, midstream and downstream. The upstream sector is comprised of the exploration and production (E&P) companies, whose primary focus is the searching and recovery of crude oil and natural gas. The downstream sector is involved in the preparing of the natural resources for consumer use, which involves the refining of crude oil and the selling and distribution of natural gas. The midstream sector is the middleman between these two sectors providing processing, storing, gathering and transportation of crude oil, natural gas and natural gas liquids. MLPs are traded on public exchanges, like the NYSE, NASDAQ and AMEX, and are therefore regulated by the Securities and Exchange Commission (SEC). They are typically high yield investments and are managed in a similar fashion to traditional corporations. However unlike corporations, MLP ownership is separated into two categories, general partners (GPs) and limited partners (LPs). General partners usually have a 2% ownership stake and operational control of the partnership, but have unlimited liability. Limited partners ownership is structured in units instead of shares and income passed on to the LPs is referred to as distributions instead of dividends. The History of MLPs MLPs were created in the early 1980s out of tax friendly legislation in the Economic Recovery Act of These early MLPs were largely comprised of exploration & production (E&P) companies and quickly fell victim to falling energy prices and depleting reservoirs. However with the passing of the Revenue Act of 1987, the modern day MLP structure began to take form. The Act aimed to encourage investment in the US energy infrastructure by providing a tax sheltering structure for companies that derived at least 90% of their income was derived from natural resource activities. The activities included the exploration, development, mining, production, processing, refining, transportation, or marketing of any mineral or natural resource. size and quantity as billions of dollars were invested in the space because of increased divestures, deregulation, and consolidation. By the end of 2002, the MLP industry had grown to over 30 companies with a total market capitalization around $30 billion. Figure 2: Total Market Cap & Number of Energy MLPs Market Capitalization ($ in billions) $250 $200 $150 $100 $50 $ Market Capitalization of Energy MLPs Source: FactSet, National Association of Publicly Traded Partnerships, and Wells Fargo Securities, LLC estimates From 2002 to 2007, MLPs continued to grow within various segments of the industry including the resurgence into the E&P areas, and other financial vehicles like the general partners. Billions of Private equity dollars poured into the space as well, allowing for continued M&A activity. With the passing of the American Jobs Creation Act of 2004, classified MLP distributions as qualified income. As a result investment groups, like hedge funds and mutual funds, increased their ownership in the industry, accounting for increased volumes and volatility in MLP trading over that time period. By the end of 2007, the MLP industry had reached a market capitalization of over $145 billion and accounted for 75 individual energy related companies. Today, there are still only about 75 energy related MLP companies operating in multiple subsectors, yet the market capitalization of the industry has grown to an all time high of $220 billion and the average daily trading value has increased by 10 fold over the last 7 years. 36 Number of Energy MLPs Figure 3: Average Daily Trading Volumes of MLPs $600 $ In the late 1990s, Merger & Acquisition (M&A) activity started to pick up in the MLP space, causing a significant amount of assets to change hands due to consolidation, divestiture, and rationalization within the midstream segment. At the same time, recognition of the MLP tax efficiency was catching on as a way to raise money at a lower cost of capital. Over the next few years, MLPs continued to grow in $ in millions $400 $300 $200 $100 $ Average Daily Trading Volumes of MLPs 4 Source: FactSet, National Association of Publicly Traded Partnerships, and Wells Fargo Securities, LLC estimates

5 Why Own MLPs? Strong historical track record. The MLP asset class, represented by the Wells Fargo MLP Index, has demonstrated strong historical total returns generating 1 year, 3 year, 5 year, and 10 year returns of 37.3%, 14.8%, 16.5%, and 18.1% respectively. Historically MLPs have had low correlation to other yieldoriented investments and commodity prices. Because most MLP revenues are dependent upon energy supply and demand fundamentals, MLPs have exhibited low correlations to economic and commodity cycles. Figure 4: Annualized MLP Returns Figure 6: Asset Correlations with MLP Universe for 10 years Ending 12/31/ % Wells Fargo MLP (TR) Index 1.00 BarCap US Corporate High Yield TR USD % 14% 17% 18% AMEX Natural Gas PR USD 0.45 MSCI EAFE GR USD % 1% S&P 500 TR % 1 year 3 Year 5 Year 10 Year MLP Index S&P 500 Source: Wells Fargo, Standard & Poors FTSE NAREIT Composite TR BarCap Municipal 20 Yr TR USD Cushing, OK WTI Spot Price FOB Attractive yield versus other alternatives. MLP yields have exceeded those of other yielding asset classes including REITs, utilities, corporate and treasury bonds. Citi Treasury Bill 3 Mon USD BarCap US Agg Bond TR USD Figure 5: Distribution Yield Comparison Yield + Distribution Growth Rate 12.0% 10.0% 8.0% 6.0% 4.0% Source: Ibbotson, EIA, Wells Fargo Potential Inflation Hedge. Historically MLP distribution growth has outpaced inflation. MLPs have Producer Price Index ( PPI ) escalators built into their contracted pricing models, which may provide predictable growth and an inflation hedge for investors. Figure 7: Historical MLP Distribution Growth versus CPI 2.0% 0.0% MLP Index Utilities REITs Bonds Equities Current Yield Expected Distribution Growth Rate Source: Wells Fargo, U.S. Treasury and Standard & Poors 500. Demand for energy infrastructure points to continued strong growth. Center Coast believes that new oil and gas discoveries, particularly unconventional shale resources, and a US government desire to reduce reliance on foreign energy sources create a need for new energy infrastructure. % Distribution Growth (all MLPs) / CPI 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% (2.0%) 1998A 1999A 2000A 2001A 2002A 2003A 2004A 2005A 2006A 2007A 2008A 2009A Median Distribution Growth (for all MLPs) Consumer Price Index (CPI) Source: Bureau of Economic Analysis and Bureau of Labor Statistics, FactSet and Wells Fargo 5

6 Favorable Tax Treatment. Due to the unique partnership structure of MLPs, they are able to return a majority of their excess cash flows back to the unitholders. In addition, MLPs do not pay corporate taxes and are able to pass on a large portion of their earnings to their limited partners. Because MLP distributions are considered mostly 100% return of capital, and thus not taxable, investors benefit from this favorable tax treatment until the units are sold or their adjusted tax basis reaches zero. However, there is the potential for administrative burdens as some unitholders may be required to file tax returns in states where the company conducts business. the remaining light gas component (methane) must be processed or separated from the heavier NGL components. What are left are marketable natural gas and a raw mixed stream of natural gas liquids. Figure 9: Gathering & Processing Site Description of Midstream MLP Assets Natural Gas / Natural Gas Liquid Value Chain The natural gas & natural gas liquid (NGL) value chain begins at the wellhead of the E&P companies. The value chain is comprised of three distinct segments: 1) gathering & processing (G&P), 2) gas transportation & storage, and 3) NGL transportation & fractionation. All of these segments are typically described as midstream because they provide distinct services to the upstream producer and downstream end user. Figure 8: Natural Gas & NGL Value Chain Exploration & Production Upstream Gas Gathering Processing & Treating Midstream NGL (Raw Mix) Transportation Gas Transportation NGL Fractionation Gas Storage NGL Storage Independent Power Generation Downstream Purity NGL Transportation Gas Distribution Power Distribution Refined Products Petro Chemicals Fuels Users Gas Markets Power Markets Segment 1: Gathering & Processing (G&P) The natural gas gathering & processing segment gathers wellhead natural gas. The wellhead natural gas contains impurities, a light gas component, and a heavy liquid component which must be removed or separated in order to meet interstate pipeline specifications. The impurities include water, CO2, sulfur, and H2S which are removed in a dehydration or treater. After the impurities have been removed Source: Copano Energy Factors that affect G&P Segment: Commodity Prices Exploration & Production economics are largely dictated by commodity prices. Prolonged periods of low commodity prices can result in a drilling reduction which could lead to volume declines for the Gatherer & Processor. Contract structure Fee Based Producers pay a fee for gathering, dehydration, treating, and processing services. Percent of Proceeds Producers and Processors share the commodity price risk by sharing a certain percentage of proceeds received in the sale of the natural gas and NGLS. A typical sharing arrangement can be characterized by 90 / 10 where the producer keeps 90% of the proceeds and processor keeps 10%. Keep Whole NGLs typically have a higher BTU (British Thermal Unit) value than methane. In a keep whole contract the processor extracts the NGLs and sells them. The processor then purchases natural gas or pays the producer cash to replace the extracted BTU value in essence keeping the producer whole. Basins Natural gas basins contain different characteristics in geologic formation, gas quality, drilling costs, infrastructure, take away capacity, and price net backs. Each of these 6

7 characteristics factor into producers drilling decisions making some basins more favorable than others. Recent Trends in the G&P Segment: Unconventional Shale Plays The emergence of unconventional natural gas shale plays such as the Bakken, Eagleford, Haynesville, and Marcellus has resulted in strong demand for the construction of gathering & processing infrastructure. Wet versus Dry Gas Wet natural gas has a strong natural gas liquid content versus Dry gas that is mostly methane. Strong natural gas liquid prices and depressed natural gas prices have caused producers to focus on liquid rich wet gas basins over dry gas basins. Fee base Rising and falling commodity prices result in cash flow volatility for the commodity price exposed percent of proceeds and keep whole contracts. This volatility has led to management teams to seek more fee based revenue. Recent gatherer & processor MLP IPO s have been nearly 100% fee based revenue. Segment 2: Natural Gas Transportation & Storage Natural Gas Transportation: Natural gas transportation pipelines are interstate and intrastate pipelines that receive natural gas from gathering systems and transport for delivery to industrial end users, utility companies, or storage facilities. Interstate pipelines are regulated by the Federal Energy Regulatory Commission ( FERC ), a government body that regulates tariffs and allowed rate of returns for pipelines. Allowed rates of returns are typically between 11 13% return on investment above operating costs, depreciation, and applicable taxes. Intrastate pipelines are monitored by state agencies, such as the Texas Railroad Commission ( TRC ), and operate in a competitive market where rates are set by demand. Factors that affect Natural Gas Pipelines: Rate structure Natural gas pipeline rates are established by one of four methods. Max Rate Maximum rate allowable by the FERC, which is based on the pipelines average cost of providing service Discounted Rate Discounted rate from the maximum rate allowed Market Based Rates The rate is set by supply and demand dynamics in a competitive market. Negotiated Rate the rate is mutually agreed upon by a provider and its customers Contract Structure Dependability of revenue can be influenced by whether a pipeline s contract structure is firm or interruptible. Firm A shipper (pipeline customer) reserves capacity on a pipeline and agrees to pay the tariff whether the capacity is utilized or not Interruptible A customer is only required to pay tariff when capacity is utilized Natural Gas Drilling An increase in natural gas drilling resulting in supply growth results in more volume available to ship for pipelines. Volumes in pipelines have averaged 2 3% annual growth over the years. This in inline with historical overall energy demand growth. A reduction in demand or reduced drilling will result in less volume available for shipment. Regulation Changes in regulations can impact the profitability of the pipelines Recent Trends for Natural Gas Pipelines: Unconventional Shale Plays The emergence of unconventional natural gas shale plays such as the Bakken, Eagleford, Haynesville, and Marcellus has resulted in strong demand for the construction of interstate and intrastate pipelines. Shifting Basis Differentials Shale plays are creating new supply sources and are changing the way natural gas flows from location to location affecting basis differentials or the difference in the price of natural gas between two locations. Natural Gas Storage: Historically, produced natural gas is injected into depleted reservoirs, salt caverns, or aquifers during summer months and withdrawn during winter periods to satisfy the winter heating demand. Storage plays a vital role in balancing the natural gas supply and demand. Customers of natural gas storage include utilities and marketers. Utilities contract storage space to ensure certainty of supply to meet peak demand heating days in the winter or cooling days in the summer. Marketers contract storage space to take advantage of summer to winter spreads and price volatility. Pipeline operators utilize storage to balance operations. 7

8 Figure 10: Natural Gas Storage Facility Source: Enbridge Energy Factors that affect Natural Gas Storage: Storage Location Market Based Storage near the end user that serves as a critical function for utilities and pipelines. Utilities will generally pay higher prices to obtain a surety of supply. Pipelines will also pay higher rates as storage is a critical function in fulfilling contracted obligations. Supply Based Storage near supply areas are utilized by producers, marketers, utilities, and pipelines. Dependent upon connectivity, supply based storage can capitalize on arbitrage opportunities in addition to summer to winter spreads. Types of storage Depleted Reservoir Reservoirs are the most common form of US Natural Gas storage representing approximately 85% of US Gas Storage (source: EIA and AGA). Reservoirs are relatively inexpensive to construct, operate, and maintain and generally provide slower injection and withdrawal rates compared to salt cavern storage. The porosity and permeability determines the amount of natural gas the formation can hold and injection and withdrawal rates, respectively. Salt Cavern Storage facilities formed out of underground salt caverns. Salt caverns are more expensive to build but allow for faster injection and withdrawal rates allowing for a greater number of turns for the facility compared to other types of storage. Salt caverns are generally located in the Gulf Coast and Northeast for connectivity and access to market based regions. Aquifer Underground rock formations that act as natural water reservoirs where natural gas can be stored. Aquifers are the most costly type of storage and are generally found in regions that do not contain depleted reservoirs. Contract Structure Firm Storage Long Term Contracts generally ranging in 3 5 years terms under fee based arrangements. The higher the number of turns (defined by getting gas into and out of storage), the higher the fee. Contracts also contain volumetric fees where the customer is charged for injections and withdrawals. Short Term Contracts generally less than one year in duration. The value of the contract is typically based on the summer to winter spread. A wider spread will result in a larger fee for the storage owner. Interruptible Park and Loan Refers to an interruptible service where a pipeline will allow to park (buy) or loan (sell) on unutilized capacity. Wheeling The ability to move natural gas across a storage system with multiple connections to take advantage of arbitrage opportunities. Market dynamics determine the volume and rate storage operators can charge for the service. Optimization or Marketing The use of unutilized capacity or the leasing of storage space by the operator for their own benefit. Optimization revenue can vary by utilization rates and market dynamics. Marketing revenues can vary given market dynamics. Current Trends in Natural Gas Storage: Growing Production A growing natural gas supply could dampen the value of natural gas storage as there is ample supply to meet demand. Flattening Basis Lower basis differentials could dampen arbitrage opportunities for storage customers as new supply 8

9 sources emerge along with new pipelines changing natural gas flows. Salt Gas Caverns There has been a large number of high deliverability salt dome facilities in recent years. Over the past several years, approximately 600 billion cubic feet (Bcf) of natural gas storage capacity has been constructed in the United States, of which an estimated 90% consists of highcycle salt dome facilities primarily located in the Gulf Coast. While this incremental capacity represents only 17% of total U.S. capacity of 4,100 Bcf, it constitutes 51% of total deliverability. This high deliverability storage should be ample to quickly satisfy the peaking needs of the natural gas markets, dampening overall volatility (Source: Wells Fargo). Segment 3: Natural Gas Liquids ( NGLs ) Transportation & Fractionation and Storage Natural Gas Liquids that have been removed from the natural gas stream are in a raw NGL mix or y grade form. The Y Grade NGL product are gathered from processors and transported via pipelines to fractionators. Fractionators then separate the Y Grade into purity ethane, propane, iso butane, normal butane, and pentane components. This leg of the chain is often referred to as T&F for transportation & fractionation. T&F contracts are generally fixed fee, long term contracts with inflation adjusters. The purity products are then stored before being delivered downstream to customers via pipelines, rail cars, trucks, or barges. Storage and delivery are also generally fixed fee contracts. Given the fixed fee nature of the assets the primary risk factor is volume. Factors that affect NGL Transportation & Fractionation and Storage: Economic environment A weak economic environment can lead to weak NGL demand resulting in reduced volumes. Conversely, a strong economic environment can lead to strong NGL demand resulting in greater throughput volumes. Commodity Prices Wide NGL and Natural Gas price differentials, typically characterized by high crude oil prices and low natural gas prices, incentivizes processors to remove as many liquids as possible resulting in elevated volumes. Conversely, narrow differentials potentially provide processors less incentive to remove NGLs resulting in reduced volumes available for shipment. Current Trends in NGL Transportation & Fractionation and Storage: Constrained Market The overall fractionation market is tight right now giving fractionators pricing power over their customers and leading to fractionation expansion projects. Historical contracts of $.02 $.03per gallon for fractionation are being renewed at $.05 $.07 per gallon. The imbalance between supply and demand has resulted in the announcement of ~450 MBbls/d in additional fractionation capacity, roughly a 19% increase to current US capacity. Location, Location, Location The Gulf Coast region contains the majority of the US petrochemical demand resulting in premium NGL prices, particularly ethane. Limited connectivity between Midcontinent and Gulf Coast markets creates arbitrage opportunities when supply & demand are disrupted in different market conditions. Got NGLs? Elevated NGL prices and low natural gas prices have caused producers to focus on basins containing higher NGL content. These areas include the Eagleford and Bakken shales along with the Granite Wash in the Midcontinent region. Crude Oil/Refined Product Value Chain The crude oil / refined product value chain is composed of 2 segments separated at the refinery. The 1) crude oil portion of the value chain is upstream of the refineries while the 2) refined product value chain is downstream. The crude oil services include gathering, transporting, storage, terminalling, and delivery of crude oil to refineries. Refined Product services include transportation, storage, and terminal services of the refined product. Figure 11: Crude Oil Value Chain Source: Wells Fargo MLP Primer IV, Plains All American Pipeline, L.P. 9

10 Segment 1: Crude Oil Gathering, Transportation, and Storage Crude oil is gathered at the wellhead via pipelines, trucks, and barge / tankers and delivered to mainline injection points where the crude is moved onto terminals & storage assets and then down to refineries. The gathering and transportation segments are largely fee based operations and regulated by the FERC. Terminal and storage are largely fee based operations but can be impacted by crude oil price differentials and forward crude oil prices. Factors that affect Crude Oil Gathering, Transportation, and Storage: Indexing Maximum rate a pipeline can charge is adjusted annually by the Producer Price Index for Finished goods plus 1.3%. The adjustment was intended to provide funding for maintenance and power costs. This rate structure also provides margin protection in inflationary environments. The adjustment is reviewed by FERC every 5 years. The current adjustment of PPI + 1.3% will commence July 1, Indexing Methodology Cost of Service Pipeline tariff is based on actual costs experienced by the pipeline Settlement Rate Rate is agreed upon by all shippers on the pipeline Market Based Rates The rate is set by supply and demand dynamics in a competitive market Negotiated Rates For new service, the rate can be a special contractual agreement between the customer and the pipeline. Forward markets The shape of future prices are deemed in contango if the current price is cheaper than the forward price. They are deemed in backwardation if the current price is more expensive than the forward price. Storage is more valuable in a contango market because there is financial incentive to purchase crude oil, store it, and sell at a future date at a higher price. Increased Price Volatility Elevated volatility in commodity prices increases demand for storage as wide swings in oil prices leads to increased storage utilization as producers and energy traders try to produce arbitrage opportunities. Crude Oil Shales Crude oil shales are beginning to emerge across the US (Eagleford, Niobrara, and Bakken) resulting in increased demand for gathering and transportation. Segment 2: Refined products Refined products pipelines are regulated common carrier transporters of refined petroleum products, such as gasoline, diesel fuel, and jet fuel. Primary pipeline customers are refiners and marketers of the product being shipped. End user destinations include airports, rail yards, and terminals/truck racks, for further distribution to retail outlets. Refined product pipeline cash flow is stable based on the relatively inelastic base load demand from end users of gasoline, diesel fuel, etc. However, throughput can exhibit fluctuations depending upon economic cycles. Terminalling operations provide storage, distribution, blending, and other ancillary services. Terminals distribute products to third parties which deliver product to end users, such as retail gas stations. Figure 12: Refined Products Value Chain Current Trends in Crude Oil Gathering, Transportation, and Storage: Changing supply sources US crude oil production peaked in 1970 and has been in a steady decline since. Declining domestic supply has increased demand for crude oil imports from Canadian Oil Sands. Increased oil sands demand has led to increased demand for pipeline capacity from the Canadian producing regions to US markets in the Midwest and Gulf Coast. Water borne supplies have increased demand for marine terminals. Source: Wells Fargo MLP Primer IV, Plains All American Pipeline, L.P. Factors that affect refined products: A weakened economy can result in volume throughput declines as demand for diesel, jet fuel, and gasoline declines. Refined product demand is relatively inelastic. However, as crude oil approached $150 in 2008 the US demand for gasoline, diesel, and jet fuel experienced declines in volume throughput. Refinery outages or closures can result in a reduction of supply resulting in volume throughput declines. 10

11 Current Trends in refined products: Oil majors have been divesting refined product assets to help fund capital expenditure budgets providing growth avenues for refined product MLPs. In order to compete for these acquisitions MLPs have been reducing cost of capital by eliminating or resetting the Incentive Distribution Rights (IDRs) made to the general partner. Ethanol currently cannot be transported via pipeline due to corrosion issues. Therefore, ethanol is blended into gasoline at the gasoline terminals. This has led to increased blending opportunities for terminal operations. Types of Investors Suitable for MLPs Individual Investors. MLPs were initially designed to appeal to individual investors by offering current income along with the potential for capital appreciation. Individuals were also attracted by the favorable tax treatment of the partnerships. Upon death an investor is able to gift MLP units. The recipient receives a step up in basis to the then current market price this effectively eliminates the deferred tax that has accrued based upon the distributions received to that date, which makes MLPs an excellent tool for estate planning. Tax Deferred Investors. When a tax exempt entity is a limited partner, its share of MLP income is considered Unrelated Business Tax Income (UBTI) and may subject the entity to UBTI. As a result, it is generally recommended that individual MLPs not be held in retirement funds such as IRAs and 401Ks. There are several other MLP investment vehicles which may be held in retirement funds and not be subject to UBTI, which we discuss in the section on MLP Investment Vehicles. As always please consult your tax advisor for advice on tax matters. Institutional Investors. Due to recent sector growth, past performance and favorable legislation, the MLP investor base has expanded to include institutional players. Beginning in 2007, institutional capital began flowing into MLPs, mainly in the form of hedge funds, attracted by MLPs lack of correlation to the broader markets and strong return profile. During the financial crisis of 2008, there was a net outflow of institutional investments in the MLP space. However, now there is a slow return of institutional capital back into MLPs in the form of family offices, pensions, endowments, mutual funds, and hedge funds. Figure 13: MLP Institutional Ownership Percent Ownership 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 22% 22% 2% 4% 76% 74% Source: PricewaterhouseCoopers LLP, Partnership reports, and Wells Fargo Securities, LLC estimates Forms of MLP Ownership 31% 29% 27% 62% 63% 65% Direct. As of September 30 th, 2010 there were 72 companies listed as energy related MLPs. Investors have access to direct ownership in these companies via public exchanges just like any other equity. However, navigating among the various companies can prove to be challenging to the novice investor in the MLP space and the tax reporting can become complex. Mutual Fund. MLP dedicated mutual funds issues shares redeemable at the net asset value of the fund s portfolio at the option of the shareholder. Mutual fund shares may be created or redeemed on a daily basis and the mutual fund uses the proceeds to buy MLP units or sells MLP units to raise cash to fund the redemptions. MLP dedicated mutual funds are structured as C corps and therefore pay tax at the fund level. Investors in mutual funds receive a 1099 at the end of the year for tax filing purposes. An investor typically pays a management fee to the mutual fund s investment advisor. Private Partnership/Hedge Fund. There are several private investment partnerships which invest exclusively in MLPs. The investment strategy varies by fund some are long only while others are long short, some utilize leverage, while others do not. These are not publicly traded and investor s capital is typically locked up for a specified period of time or is subject to an early redemption penalty. Liquidity is generally either monthly or quarterly. These partnerships are pass through entities. Investors in private partnerships receive a single K 1 for tax filing purposes. An investor typically pays a management fee along with an incentive fee. 7% Retail Foreign Investors Institutional 8% 8% 11

12 Closed End Fund. MLP dedicated closed end funds issue a fixed number of shares in an initial public offering or secondary offering and use these proceeds to build a portfolio of MLPs. Closed end funds are traded on exchanges just like stocks and their price is determined by the market, rather than the net asset value of the underlying portfolio. As a result, they may trade at a premium or a discount to the net asset value. Closed end funds are able to use leverage and most utilize 15 20% leverage. Most MLP dedicated closedend funds are structured as C corps and therefore pay tax at the fund level. Investors in closed end funds receive a 1099 at the end of the year for tax filing purposes. An investor typically pays a management fee to the closed end fund s investment advisor. Currently there are thirteen publicly traded, MLP dedicated closed end funds. Exchange Traded Note (ETN). MLP dedicated exchange traded notes are senior, unsecured debt securities issued by a financial institution to investors that offer a return based on exposure to an MLP index. As such, the holder of an exchange traded note bears the credit risk associated with the note issuer. The notes are publicly traded. The value and performance of the ETN shares is expected to track that of the underlying index on a daily basis. Their performance over longer periods of time may differ significantly from the performance of the underlying index, something referred to as tracking error. Coupons paid by the ETNs are treated as ordinary income. Investors in exchange traded notes receive a 1099 at the end of the year for tax filing purposes. Investors pay a tracking fee to the issuer of the note. Currently there are seven publicly traded, MLP dedicated ETNs. Exchange Traded Fund (ETF). An MLP dedicated exchange traded fund issues shares to investors, which are publicly traded and invests the sale proceeds into a portfolio of MLPs based on an index. The value and performance of the ETF shares is expected to track that of the underlying index on a daily basis. Their performance over longer periods of time may differ significantly from the performance of the underlying index, something referred to as tracking error. The current MLP dedicated exchange traded fund is structured as a C corp and therefore pays taxes at the fund level. Investors in exchange traded funds receive a 1099 at the end of the year for tax filing purposes. Taxation of MLPs As previously discussed, the partnership structure of MLPs provides beneficial tax advantages. Because MLPs are considered pass through entities, cash distributions paid by the MLPs are passed Risks of Investing in MLP Units. An investment in MLP units involves risks that differ from a similar investment in equity securities, such as common stock, of a corporation. As compared to common shareholders of a corporation, holders of MLP units have more limited control and limited rights to vote on matters affecting the partnership. Additional risks inherent to investments in MLP units include cash flow risk, tax risk, risk associated with a potential conflict of inalong to the unitholders. In addition, each partnership unit assumes the share of the expense deductions associated with running the business, resulting in a reduction of the taxable income on the distribution. Also, MLPs do not pay tax at the corporate level, thus allowing them to avoid the double taxation in which most corporations are subject. Under the current tax code, MLPs carry a tax shield because distributions are considered a tax deferred return of capital. Most MLPs carry a tax shield of around 80%. An after Tax Yield Calculation is provided below. Figure 14: MLP Tax Example MLP Unit Price $10.00 Distribution $ 0.80 Effective Yield 8.0% Taxable Yield (20%) 1.6% Tax Deferred Yield (80% return of capital) 6.4% Taxable Income $ 0.16 Deferred Income $ 0.64 Tax Owed (35% rate) $ 0.06 After Tax Distribution $ 0.74 After Tax Yield 7.4% With all the tax benefits of MLP ownership, the one drawback in their taxation is their burdensome tax reporting. For every MLP owned, an investor receives an individual K 1 statement which contains the LPs share of the partnership s income, deductions, and credits. However, there are certain investment vehicles that have found a solution to this tax reporting burden. For example, the new open/closed end MLP mutual funds are structuring themselves as C corps and paying taxes at the fund level, allowing for a simple 1099 form to be distributed to their investors. Risks of Investing in MLPs 12

13 terest between unit holders and the MLP's general partner, and capital markets risk. Equity Securities Risk. MLP units and other equity securities held can be affected by general market or economic conditions, perceptions regarding the industries in which the issuers of securities held by the Fund participate, changes in interest rates, and the particular circumstances and performance of particular companies whose securities the Fund holds. Liquidity Risk. MLP common units and equity securities of MLP affiliates, including I Shares, often trade on national securities exchanges. However, certain securities, including those of issuers with smaller capitalizations, may trade less frequently. The market movements of such securities with limited trading volumes may be more abrupt or erratic than those with higher trading volumes. Energy Sector Concentration Risks. A substantial portion of the MLPs are engaged primarily in the energy sector of the economy. As a result, investments will be susceptible to adverse economic or regulatory occurrences affecting the energy sector. Risks associated with investments in MLPs and other companies operating in the energy sector include but are not limited to the following: Commodity Risk. MLPs and other companies operating in the energy sector may be affected by fluctuations in the prices of energy commodities. Fluctuations in energy commodity prices would directly impact companies that own such energy commodities and could indirectly impact MLP companies that engage in transportation, storage, processing, distribution or marketing of such energy commodities. Supply and Demand Risk. MLPs and other companies operating in the energy sector may be impacted by the levels of supply and demand for energy commodities. Regulatory Risk. MLPs and other companies operating in the energy sector are subject to significant regulation of their operations by federal, state and local governmental agencies. Acquisition Risk. MLPs may depend on their ability to make acquisitions that increase adjusted operating surplus per unit in order to increase distributions to unitholders. Interest Rate Risk. Rising interest rates could increase the costs of capital thereby increasing operating costs and reducing the ability of MLPs and other companies operating in the energy sector to carry out acquisitions or expansions in a cost effective manner. Extreme Weather Risk. Weather plays a role in the seasonality of some MLPs cash flows, and extreme weather conditions could adversely affect performance and cash flows of those MLPs. Catastrophic Event Risk. MLPs and other companies operating in the energy sector are subject to many dangers inherent in the production, exploration, management, transportation, processing and distribution of natural gas, natural gas liquids, crude oil, refined petroleum and petroleum products and other hydrocarbons. Any occurrence of a catastrophic event, such as a terrorist attack, could bring about a limitation, suspension or discontinuation of the operations of MLPs and other companies operating in the energy sector. Tax Risks. Tax risks associated with investments include but are not limited to the following: General MLP Tax Risk. Partnerships do not pay U.S. federal income tax at the partnership level. Rather, each partner of a partnership, in computing its U.S. federal income tax liability, must include its allocable share of the partnership s income, gains, losses, deductions, expenses and credits. Partnership distributions to partners are not taxable unless the cash amount (or, in certain cases, the fair market value of marketable securities) distributed exceeds the distributee partner s basis in its partnership interest. A change in current tax law, or a change in the business of a given MLP, could result in an MLP being treated as a corporation for U.S. federal income tax purposes, which would result in such MLP being required to pay U.S. federal income tax on its taxable income. The classification of an MLP as a corporation for U.S. federal income tax purposes would have the effect of reducing the amount of cash available for distribution by the MLP and could cause any such distributions received by the Fund to be taxed as dividend income. Thus, if any of the MLPs owned by the Fund were treated as corporations for U.S. federal income tax purposes, the after tax return to the Fund with respect to its investment in such MLPs could be materially reduced. 13

14 Glossary Terms Backwardation: A market condition in which future commodity prices are lower than spot prices. A backwardated market usually occurs when demand exceeds supply. Basis differential: The difference between the Henry Hub spot natural gas price and the corresponding cash natural gas spot price in another location (e.g. Carthage, Katy, Waha, etc.). The differential relates to factors like product quality, location, and available takeaway capacity (options). Contango: A market condition in which future commodity prices are greater than spot prices. The higher future price is often due to the cost associated with storing and insuring the underlying commodity. Cost of Service: A ratemaking concept used for the design and development or rate schedules to ensure that the filed rate schedules recover on the cost of providing the service plus an allowed rate of return. Depleted Reservoir: Natural gas can be stored underneath the ground in depleted reservoirs, salt caverns, or aquifers. Depleted reservoirs are naturally occurring formations wherein all recoverable natural gas or oil has been produced, leaving a void capable of holding natural gas. Discounted Rate: A discounted rate from the maximum rate allowed. Dry gas: This gas contains less than 1 gallon of recoverable NGLs per Mcf of gas (GPM) and is composed primarily of methane. The amount of NGLs contained in the natural gas stream can vary depending upon the region, depth of wells, proximity to crude oil, and other factors. Ethane: Ethane is typically the second largest component of natural gas (methane is the largest). It is primarily used as a feedstock for ethylene production by the petrochemical industry. Thus, the demand for ethane is tied closely to ethylene production, which, in turn, is tied to the demand for plastics, or more broadly speaking, the health of the overall economy. Fee Based: Contract when a MLP receives a fee for the volume of commodity that flows through an asset. Gross margin is directly related to the volume, not the price, of the commodity flowing through the system and the contracted fixed rate. Firm Contracts: Type of service offered by operators in which contracts consist primarily of take or pay agreements, with minimal price or volumetric risk. Flattening Basis Differentials: When the price of natural gas between two points, basis, is reduced. Fractionation: The process that involves the separation of the NGLs into discrete NGL purity products (i.e. ethane, propane, normal butane, iso butane, and natural gasoline). Incentive Distribution Rights (IDR s): IDRs allow the holder (typically the general partner) to receive an increasing percentage of quarterly distributions after the MQD and target distribution thresholds have been achieved. In most partnerships, IDRs can reach a tier wherein the GP is receiving 50% of every incremental dollar paid to the LP unit holders. This is known as the 50/50 or high splits tier. Interruptible Contracts: The customer contracts for capacity on a spot market basis at prevailing rates. Capacity is not guaranteed and is offered only if available. Iso butane: Has the same molecular formula as normal butane, but a different structural formula. Isobutane is used in refinery alkylation to enhance the octane content of motor gasoline. Keep Whole Contract: A type of contract where the processor retains title to the NGLs produced from the natural gas stream to sell at market prices. By extracting the NGLs, the volume and BTU content of the dry gas is reduced. The processor must then replace the BTUs that it extracts from the natural gas stream with the equivalent BTUs of natural gas. A holder of keep whole contract would be long on NGL prices and short on natural gas prices. Market Base: If a pipeline operator can demonstrate to FERC it lacks market power, it may be allowed to price at market based rates to gain market share. Maximum Rate: Maximum rate allowed by FERC for an operator to charge a customer. The rate is based upon the pipelines average cost of providing service plus an allowed rate or return on investment. Methane: Methane is equivalent to dry natural gas, it is the primary component of natural gas. Negotiated Rate: An alternative to traditional cost of service rates, where a rate for a service varies from a pipeline's otherwise applicable tariff and is mutually agreed upon by a pipeline and its customer. At the time a customer is considering a negotiated rate, a recourse rate that is on file in the pipeline's tariff must also be available to that customer. Normal butane: Normal butane is used as a petrochemical feedstock for the production of ethylene and butadiene (used to make syn 14

15 thetic rubber), as a blendstock for motor gasoline, and as a feedstock to create iso butane through isomeriztion. (The isomerization process is accomplished by heating normal butane in the presence of a catalyst to create iso butane.) Optimization Revenue: Revenue generated from storage capacity the storage operators have set aside for maximizing on the value of its storage, much like their customers would for example by taking advantage of arbitraging seasonal spreads and cycling storage when market opportunities present themselves. Park & Loan: The storage operator will either loan gas to a market participant on a temporary basis or will park gas in its facility on a temporary basis for a fee. Again, this service is opportunistic in nature and depends upon market demand and storage capacity availability. step in the NGL value chain, that the raw NGL mix is further separated into individual NGL components. Salt Caverns: Natural gas can be stored underneath the ground in depleted reservoirs, salt caverns, or aquifers. Salt caverns are formed out of underground salt deposits. Salt caverns are usually leached or solution mined, by injecting fresh water via drills into the salt cavern. Take Away: The amount of volumetric capacity which is available to transport commodities out of a particular basin or region. Wet gas: This gas contains at least 1 gallon of recoverable NGLs per Mcf of gas (GPM) and up to as much as 5 6 GPM. The amount of NGLs contained in the natural gas stream can vary depending upon the region, depth of wells, proximity to crude oil, and other factors. Pentane components: An alkane containing 5 carbon atoms. They are used in some fuels and are employed as specialty solvents. Percent of Proceeds Contract: A type of contract where the processor gathers and processes natural gas on behalf of producers. The MLP sells the resulting reside gas (dry, pipeline quality gas) and NGLs at market prices and remits to the producer an agreed upon percentage of the proceeds based on an index price. A typical contract would entitle the producer to 80% of the proceeds from the sale of natural gas and NGLs through the plant, while the remaining 20% would be assigned to the processing plant operator. PPI escalators: The FERC has allowed interstate natural gas and oil pipelines to increase the (maximum) rates charged to shippers based on the use of an index system. The index system is based on the Producer Price Index for Finished Goods plus 1.3%. Companies are allowed to increase their rates on an annual basis on July 1st. Price Net Backs: The price the producer receives for a commodity after netting out gathering fees, transportation fees, and basis differentials. Propane: Propane is the third largest component of the natural gas stream. It is primarily used as a feedstock by the petrochemical industry to produce ethylene and propylene. The bulk of remaining propane consumption is related to its use as a heating fuel in the residential and commercial markets. Hence, demand for propane is closely tied to the overall health of the economy and fluctuations in weather patterns. Raw NGL Mix: Raw NGL mix or y grade refers to the heavier NGL components that are extracted via natural gas processing. The resulting NGL mix is commingled product consisting of ethane (depending on whether ethane rejection took place), propane, butane, isobutane, and natural gasoline. It is not until fractionation, the next Wheeling: A storage operator will move gas across its facilities from one pipeline interconnect or another, which enables customers to deliver their gas to the desired market. The storage operator collects a fee for this service; however, this service is performed on a spot basis and is driven by market factors. Widening Basis Differentials: When the price of natural gas between two points, basis, increases. 15

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