InvestmentPerspectives JUNE 2011

Transcription

1 Investment Stewardship Guidance InvestmentPerspectives JUNE 2011 UNDERSTANDING MASTER LIMITED PARTNERSHIPS NAT KELLOGG, CFA, SENIOR RESEARCH ANALYST Investor interest in Master Limited Partnerships ( MLPs ) has increased substantially over the past decade. This article is meant to take a closer look at MLPs and their suitability in institutional portfolios. MLPs are limited partnerships that trade on a securities exchange just like a share of stock. The MLP structure provides investors structure, but the liquidity of a stock. MLPs typically own energy assets including oil and gas wells, pipelines, storage facilities, and other transportation assets. The partnerships are managed by a general partner who is responsible for the daily operations of the business; a number of limited partners partnership model (vs. incorporation) allows through to the limited partners, and allows the business to avoid paying taxes at the corporate level. As MLPs are listed on an exchange, they provide investors with the same level of transparency as other publically The Tax Reform Act of 1986 and the Revenue Act of 1987 created the modern form of the MLP. The legislation was originally designed to give investors an incentive to make investments in natural resource Exhibit 1: Pipelines General Partner assets by giving favorable tax treatment to the distributions made by partnerships focused on the exploration, production, transportation of oil and natural gas. However, to maintain their favorable tax Limited Partners Terminals status, the partnerships must pay out 90% of earnings to the limited partners and the aforementioned Revenue Act of 1987 limits this structure to natural resource and Oil & Gas assets 180 North LaSalle Street, Suite 3500, Chicago, Illinois PHONE WEB marquetteassociates.com

2 Exhibit 2: Upstream Midstream Downstream Oil & Gas Exploration Oil & Gas Production Gathering & Processing Pipelines Storage Marine Transportation Within the energy industry, MLPs are focused on three areas: upstream, midstream, and appreciation (driven by investor demand), data going back to We would also note that while the historic performance of downstream. Exhibit 2 above provides over the last decade. these indices is impressive it is backward a description of what encompasses looking since the indices were created in each phase. The two most common indices that are used as benchmarks for MLPs are the 2006 and 2007, respectively. As a result the indices have the largest weightings to the MLPs focused on midstream energy Alerian MLP Index and the S&P MLP Index. infrastructure (petroleum transportation, While the two indices are similar they have performance over the last decade. This natural gas pipelines, gathering, processing and storage) have become more common than exploration and processing focused partnerships because the midstream energy infrastructure business tends to be fairly steady and not directly tied to energy prices, some noticeable differences. There are 50 companies in the Alerian MLP index and the of $138.6 billion. The index was launched in June 2006 and has historic data going back to The S&P MLP Index has only skews the performance of the indices historic performance of these indices may overstate the returns a passive investor was likely to realize from investing in MLPs over the past decade. which can be volatile. Instead, pipeline and terminal assets are primarily tied to the demand for energy, which has slowly market cap of $124.7 billion. The index was launched in September 2007 and has The MLP market today is over $200 billion and a number of new investment products increased over time. Energy infrastructure Exhibit 3: focused MLPs typically sign multi-year $5 agreements with energy companies based on the amount of oil and gas transported through their pipelines (or stored in their $4 terminals). These agreements usually have agreement based on either the Producer $3 Price Index (PPI) or the Consumer Price Index (CPI). Consequently, investors in $2 these MLPs receive a steady, and slowly increasing, distribution from the partnership. $1 Due to the large regular distributions 3/2011 from MLPs, it is common for investors $ their total returns from the income S&P MLP Index Alerian MLP Index distributions. However, because of steadily S&P 500 Index increasing distributions MLPs have THE GROWTH OF $1 Understanding MLPs June

3 Exhibit 4: Master Limited Partnership Ticker Price Market Cap ($M) S&P MLP Top 10 Index Alerian MLP Top 10 Index Enterprise Products Partners LP EPD $ , % 15.1% Kinder Morgan Energy Partners KMP $ , % 10.0% Plains All American Pipeline LP PAA $ , % 5.1% Magellan Midstream Partners LP MMP $ , % 4.6% Energy Transfer Partners LP ETP $ , % 5.2% Kinder Morgan Management LLC KMR $ , % 3.8% Energy Transfer Equity LP ETE $ , % 3.2% Enbridge Energy Partners LP EEP $ , % 3.6% Linn Energy LLC LINE $ ,522 N/A 4.2% Oneok Partners LP OKS $ ,323 N/A 3.3% NuStar Energy LP NU $ , % N/A Buckeye Partners LP BPL $ , % N/A have been created to give investors easy access to the MLP universe. In April 2009, J.P. Morgan launched the $1.5 billion Alerian MLP ETN (NYSE: AMJ). In June 2010, Clearbridge Advisors launched the $1.3 billion Clearbridge Energy MLP Fund (NYSE: CEM), a closed end fund focused solely on investing in MLPs. While the steady and growing income provided by MLPs is clearly attractive, historically MLPs have been owned by individual investors because the tax treatment of the distributions has made MLPs more attractive to taxable investors. As the chart below shows, retail investors own approximately 75% of all MLP partnership interests. Exhibit 5: 100% 80% % TOTAL MLP PARTNERSHIPS 60% 40% 20% 0% Retail Institutional Non-US Understanding MLPs June

4 MLPs have mainly been a retail product and risks for institutional clients making an allocation to MLPs. Since MLPs are partnerships, not corporations, MLPs often generate unrelated business taxable income ( UBTI ). This is taxable income that must be paid, even by non-taxable investors. While there are structures that can be created to deal with issues surrounding UBTI, this makes MLPs less suitable for non-taxable institutions and can add unwanted legal and administrative costs. Additionally, MLPs are particularly attractive for taxable investors because both the depreciation of assets and the income these income that MLPs return to their limited partners is shielded from federal income non-taxable clients. Thus, taxable investors may be willing to accept lower yields (and pay higher prices) than non-taxable institutional investors, similar to the municipal bond market. their networks. Since the demand for energy has increased fairly steadily and consistently over time, this is unusual. It should be noted, though, that during the recession of 2008 and 2009 many MLPs did experience a drop in the amount of energy transported through their networks. The other way that cash payments can be diminished is through a dilutive share offering. Considering that MLPs pay out such a high percentage of their income, they typically do not have enough capital to fund growth projects a result, to build or acquire new assets MLPs must raise outside capital through a debt or equity offering. Future distributions to investors will be diluted if the rate of return on new capital raised existing cost of capital. As MLPs must capital, this has enforced a high degree Exhibit 6: 16% 14% of discipline when evaluating new projects, but remains a risk whenever a Secondly, investors are primarily attracted to MLPs because of their distributions. In the past, yields on MLPs yields. Falling bond yields over the past decade have helped to support higher MLP prices; however, a material increase in bond yields would likely have a detrimental effect on MLP prices. Since MLP distributions have increased over time they tend to be less impacted yields are prone to have a negative effect on MLP prices in the short term. Currently MLP yields are close to historic lows, driven to these levels in part by low yields on other assets. Due to these issues, MLPs are not included in the major U.S. equity benchmarks. There are no MLPs in the S&P 500 Index, the Russell 1000 Index, or the Wilshire 5000 Index because of the tax related issues surrounding distributions and UBTI. These issues help to explain why, historically, institutional investors have not allocated much capital to MLP investments. 12% 10% 8% 6% The primary risk associated with investing in MLPs is a decrease in distributions to 4% limited partners. For MLPs that invest in energy infrastructure assets, such as 2% pipelines and terminals, this would primarily be due to a drop in the amount of energy Alerian MLP Index Yield Average MLP Index Yield being transported through, or stored in, Understanding MLPs June

5 Lastly, any change in the tax status of MLPs and their distributions to investors would have a negative effect on MLP prices. The Canadian government passed tax law changes that began taxing Canadian Royalty Trusts (similar to MLPs) as a corporation at the beginning of 2011, and with the ongoing budget issues in the U.S. there has been talk of making similar changes in the United States. In conclusion, the major MLPs indices PREPARED BY MARQUETTE ASSOCIATES 180 North LaSalle St, Ste 3500, Chicago, Illinois PHONE WEB marquetteassociates.com have materially outperformed the broader equity markets over the last decade. While this has made MLPs look increasingly attractive to prospective investors, Marquette believes that this outperformance may be overstated due to the methodology and timing behind the construction of these indices. Marquette believes that the recent drop in MLP yields, and the amount of class, present potential risks for investors allocating capital to MLPs today. Over the long term, if structures arise to help institutional investors deal with the unique tax structure, MLPs have the potential to provide investors increased exposure to About Marquette Associates guides institutional investment programs with a focused three-point approach and careful research. For 25 years Marquette has served this mission in close collaboration with clients enabling institutions to be more effective investment stewards. Marquette is a completely independent and 100% employee-owned consultancy founded with the sole purpose of advising institutions. For more information, please visit Understanding MLPs June