Many of you have probably heard of master

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1 Uncovering the Intricacies of Master Limited Partnerships: A Primer By Peter H. Chen, Ph.D., and David E. Stout, Ph.D. EXECUTIVE SUMMARY Master limited partnerships (MLPs) are complex corporate structures. Management accountants who are considering them as investment options whether for their own personal investment or in their role as a member of the finance team should ensure they have a thorough understanding of MLPs so they can make informed investment decisions. Many of you have probably heard of master limited partnerships (MLPs), but our experience is that few management accountants have anything but a cursory knowledge of these investment vehicles. We suspect, too, that even many finance personnel have little more than a vague understanding of the intricacies of MLPs. In an effort to demystify them as an investment vehicle, we have endeavored to provide a descriptive account of MLPs: what they are, how they are organized and managed, how these entities (and their unit-holders) are taxed for U.S. income tax purposes, the primary lines of business in which MLPs operate, and the relevant risks and benefits of investing in these vehicles. Given the broadened role of accounting and the blurring of the lines of demarcation between accounting and finance functions, this information should be of interest to a wide array of management accounting professionals both as a personal investment option and from the standpoint of the management accountant s role as a member of an organization s finance team. Legal Structure of MLPs An MLP is the more common term used to describe a publicly traded partnership (PTP). An MLP can be organized either as a limited partnership (LP) or as a limited liability com- M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 1 W I N T E R , V O L. 1 5, N O. 2

2 pany (LLC) choosing partnership taxation. Shares of ownership in these entities are referred to as units, which are traded on a stock exchange, such as the New York Stock Exchange (NYSE), NASDAQ, or one of the regional exchanges in the United States. Owners of units are referred to as unit-holders. To qualify for treatment as a partnership for U.S. federal income tax purposes, at least 90% of the partnership s gross income must be derived from qualifying income. As defined in 7704(d) of the U.S. Internal Revenue Code (IRC), qualifying income includes: Interest, dividends, and capital gains; Rental income and capital gain from the sale of real estate; Income and capital gains derived from exploration, development and production, mining, gathering and processing, refining, compression, transportation, storage, marketing, distribution (but not retail sales, except for propane) of minerals, fertilizer, geothermal energy, timber, industrial carbon dioxide, biofuel, crude oil, gasoline, and other petroleum products; Income from commodity investment or futures, forwards, or options with commodity as underlying assets; and Capital gains from the sale of assets used to generate the above income. Because ownership units in MLPs are publicly traded, they offer the liquidity of corporate investments, such as stocks and bonds. Since they are partnerships, however, MLPs are not treated as separate entities for federal (and, in most cases, state) income tax purposes. Instead, MLPs are considered pass-through entities, which means that they pay no corporate taxes and that their income passes through to individual partners (unit-holders) who pay income taxes at their individual levels. MLPs also pass through their depreciation and depletion deductions to their unit-holders. Most MLPs provide regular cash distributions, although some can also use the cash for their own growth opportunities (e.g., by acquiring additional pipelines and/or storage facilities). There are approximately 120 MLPs traded in the United States, with a total market value of approximately $420 billion. 1 As shown in Figure 1, the majority of these entities are in the energy (oil and gas) sector. Financial analysts and corporate executives often separate the energy supply chain into upstream business (exploration and production), midstream business (transportation of oil and gas), and downstream business (delivery of final refined products, such as diesel and gasoline, to customers). As Figure 1 shows, most MLPs operate in the midstream sector of the oil and gas supply chain. Table 1 provides a list of the five largest MLPs, in terms of market value, as of the date of this writing. Ownership Structure of MLPs Each MLP has one general partner (GP) that actively manages the businesses and assets of the partnership in conjunction with the board of directors. In most cases, the general partner is completely controlled by the MLP s founding entity (which could be a group of partners, a single individual, a private company, a publicly traded company, or even another MLP). Figures 2 4 show the fictionalized organizational structures of different types of MLPs. All three are based on actual companies. Figure 2 illustrates the organizational structure ABC Partners LP, an MLP with a general partner that is a private company. Figure 3 presents Pipeline Midstream Energy Partners LP, an MLP with a general partner that is a publicly traded corporation also listed on the NYSE. Figure 4 shows the organizational structure of Pipeline MLP LP, which has another MLP as its general partner. In addition to a general partner, there also can be many limited partners (LP) within any MLP. These are investors who provide capital but do not run the business or control the MLP s assets. Limited partners are entitled to a cash distribution generated from the MLP s operations and can trade their partnership units on a public exchange, similar to what investors in corporate stocks and bonds can do. As Figures 2 4 demonstrate, the ownership structure of MLPs can be very complicated. Due care is warranted on the part of investors to study and fully understand the structure of a particular MLP as part of the investment decision-making process. M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 2 W I N T E R , V O L. 1 5, N O. 2

3 Figure 1: MLPs by Industry Sector, 2013 Source: National Association of Publicly Traded Partnerships (NAPT), Used with permission. Table 1: Top Five MLPs in Terms of Market Value Name Stock Symbol Exchange Market Value* Enterprise Products Partners LP EPD NYSE $61.93B ( Kinder Morgan Energy Partners, LP KMP NYSE $33.51B ( Williams Partners LP WPZ NYSE $21.94B ( Plains All American, LP PAA NYSE $19.44B ( Energy Transfer Partners, LP ETP NYSE $19.08B ( *As of March 6, 2014 Source: and Yahoo! Finance ( M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 3 W I N T E R , V O L. 1 5, N O. 2

4 Figure 2: Organizational Structure of ABC Partners LP, an MLP Whose General Partner Is a Private Company XYZ LLC (XYZLLC) ABC Company (ABCCO) and private affiliates 100% 36.9% LP (1) ABC Holdings LLC (General Partners) 0% GP ABC Partners L.P. (Partnership) 100% LP (2) ABC Public (excluding ABCCO and its privately held affiliates) 100% % LLC ABC OLPGP, Inc % LLC (managing member) ABC Operating LLC (ABCO) GP = General Partner Interest LP = Limited Partner Interest LLC = Limited Liability Company Interest 100% Subsidiaries of ABCO (1) Percentage reflects 340,462,655 common units owned by XYZLLC, the Estate of XYZ, WYZD, and certain trusts and privately held affiliates of ABCO and XYZLLC. (2) Percentage includes 5,381,485 common units owned by directors and executive officers of the general partner other than WYZD, representing an aggregate 0.6% of outstanding limited partner interests. Note: Based on an actual company; names have been changed to preserve anonymity. M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 4 W I N T E R , V O L. 1 5, N O. 2

5 Figure 3: Organizational Structure of Pipeline Midstream Energy Partners LP, an MLP Whose General Partner Is a Publicly Traded Company Note: Based on a real company; names have been changed to preserve anonymity. M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 5 W I N T E R , V O L. 1 5, N O. 2

6 Figure 4: Organizational Structure for Pipeline MLP LP, an MLP Whose General Partner Is Another MLP Public LP unitholders Gathering & Processing Public LP unitholders Pipeline Energy, L.P. 60 % Ownership LP Interest GP Interest IDRs Public LP unitholders LP Interest GP Interest IDRs Public LP unitholders LP Interest GP Interest IDRs R.S. Partners, L.P. Pipeline Energy, L.P. 40 % Ownership (Board Majority) L.S. Partners, L.P. 30% interest 70% interest Contract Compression Contract Treating JVs Alamo NGL LLC NGL Intrastate Interstate Midstream 50% interest 49.99% interest 50% interest 50% interest Midwest Express Pipeline HPC Citron Corp Dunn Express Pipeline FGT PEP Holding Corp. L.S. Inc. SUS Company Retail & Marketing LDC Divisions Peninsula Energy SU Gas Services Note: Based on a real company; names have been changed to preserve anonymity. M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 6 W I N T E R , V O L. 1 5, N O. 2

7 Table 2: Sunoco Logistics Partners Incentive Distribution Rights Schedule Total Quarterly Marginal Percentage Interest Distribution Target In Distribution Amount Per LP Unit General Partner (GP)* LP Unit-holders Minimum Quarterly Distribution (MQD) $0.45 2% 98% First Target Distribution Up to $0.50 2% 98% Second Target Distribution Above $0.50 up to 15% 85% $0.575 Third Target Distribution Above $0.575 up to 37% 63% $ Thereafter Above $ % 50% *Energy Transfer Partners, LP (NYSE: ETP). Source: Sunoco Logistics news release, January 26, Cash Distributions and Incentive Distribution Rights An MLP s general partner typically is compensated in two ways. First, most general partners also hold LP units in the partnership, which entitles them to the same cash distributions as other limited partners. Second, the general partner may also receive incentive distribution rights (IDRs), which are extra cash distributions based on a predetermined performance formula. Different MLPs have different incentive distribution rights. For example, Sunoco Logistics Partners LP (NYSE: SXL), a crude oil and gasoline pipeline MLP, has an IDR arrangement with its general partner, Energy Transfer Partners, LP (NYSE: ETP), illustrated in Table 2. When an MLP intends to go public and files its prospectus with the U.S. Securities & Exchange Commission (SEC), it includes a statement regarding the intention to distribute a specified minimum level of cash distributions on a quarterly basis. This amount is referred to as the minimum quarterly distribution (MQD). The split of the total quarterly cash distribution between the general partner and the limited partners is specified in the IDR provision of the partnership agreement. As Table 2 shows, to motivate the general partner to increase cash distributions to the limited partners, the percentage split to the general partner increases as the total cash distribution to the limited partners generally increases. As such, investors should be cognizant of the specific terms of the incentive distribution rights before investing in a particular MLP. Further discussion of Table 2 may be instructive in terms of illustrating how incentive distribution rights work. Table 2 shows that for the minimum quarterly distribution, the limited partners in Sunoco Logistics Partners would receive $0.45 per unit (i.e., per share) held. The specified split of the minimum quarterly distribution for SLX is 2% (GP) and 98% (LPs). Thus, $0.45 per LP unit represents 98% of the combined LP and GP distribution per LP unit. This implies that the aggregate cash distribution per unit would be $ (i.e., $0.45/$0.98). The $ per-unit difference between $ and $0.45 is the per-lp-unit cash distribution to the general partner. As of the second quarter of 2013, SXL had million LP units outstanding. If each of these units received a $0.45 cash distribution, the cash distribution to the general partner would have been approximately $959,560 (i.e., $0.0092/unit million LP units). In actuality, in the second quarter of 2013, SXL announced a cash distribution of $0.60 per LP unit. Based on the IDR plan reflected in Table 2, the per-unit cash distribution for the limited partners and the general partner (per LP unit) would be as shown in Table 3. M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 7 W I N T E R , V O L. 1 5, N O. 2

8 Table 3: Sunoco Logistics Partners Actual First Quarter 2013 Per-Unit Cash Distribution: LPs vs. GP Per-LP-Unit Per-Unit Total Per-LP-Unit Incentive Distribution to Distribution to Distribution to GP LPs Both GP and LPs Minimum Quarterly Distribution (MQD) $ $ $ First Target Distribution $ $ $ Second Target Distribution $ $ $ Third Target Distribution $ $ $ Thereafter $ $ $ Total Distribution $ $ $ With million LP units outstanding, the general partner s total cash distribution in the second quarter of 2013 would have been $2.086 million (i.e., $0.02/unit million units). At this time, Energy Transfer Partners (the GP) also owned 32.4% of the LP units in SXL, which would have provided an additional $ million (i.e., 104,300,000 units 32.4% $0.60/unit). In total, therefore, the 2013 second quarter cash distribution from SXL to Energy Transfer Partners would have been $ million ($20,275,920 from its holding of LP units and $2,086,000 from the IDR agreement). The idea of incentive distribution rights is to encourage the general partner to take actions and make decisions that maximize cash distribution to holders of LP units. But the higher the incentive distribution right, the less cash there is to pay LP unit-holders. Also, a higher incentive distribution right may also mean less cash for the MLP to service its debt, make acquisitions, and expand. Therefore, the existence and structure of an IDR for an MLP should be an important consideration for investors. Because the general partner can be a publicly traded MLP itself, investors could take advantage of a high IDR arrangement by investing in the GP entity instead of in the LP units of the MLP. In recent years, several MLPs have voluntarily changed their IDR formula in order to attract investors. For example, Enterprise Products Partners LP and its general partner agreed to eliminate its incentive distribution right after founder Dan Duncan passed away in Tax Considerations As noted, MLPs are considered pass-through entities for tax purposes, which means they pay no income taxes. Instead, the annual income of the MLP is passed through to unit-holders each year via information reported to investors on Schedule K-1 (Form 1065). Unitholders enter their share of the MLP s income, gains, deductions, losses, and credits on their own tax returns. Therefore, income taxes are paid at each individual investor s marginal rate. Table 4 presents a hypothetical example of the netof-tax cash flow for a corporate shareholder compared to an MLP unit-holder. As the table shows, certain investors can secure tax benefits (depending on the investor s and the corporation s marginal tax rates at both the federal and state level) by investing in an MLP rather than a taxable corporate entity s stocks or bonds. In this example, the after-tax cash flow to the investor is greater for the unit-holder of the MLP. For most MLPs, the annual cash distribution to unitholders is usually larger than the net income generated by the partnership. The difference between cash distribution and net income arises principally from depreciation and depletion charges. Unit-holders of an MLP pay tax only on the net income of the entity, regardless of cash received. Note, however, that the unit-holder s tax basis in the investment in an MLP is decreased by the M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 8 W I N T E R , V O L. 1 5, N O. 2

9 Table 4: Hypothetical Net-of-Tax Cash Flow (Corporation Shareholder vs. MLP Unit-Holder) Corporation MLP Net Income (assumed) $1.00 $1.00 Federal Income Tax (35% marginal rate, assumed) $0.35 $0.00 State Income Tax (5% marginal rate, assumed) $0.05 $0.00 Shareholder (Corporation) vs. Unit-holder (MLP) After-tax Net Income $0.60 $1.00 (assumed all paid out as a dividend) Federal Income Tax on Dividend/Cash Distribution (20% for taxable $0.12 $0.40 corporate dividends and 40% for partnership income) State Income Tax on Dividend/Cash Distribution (assumes 5%) $0.03 $0.05 Net-of-Tax Cash Flow to Shareholder (Corporation) vs. Unit-holder (MLP) $0.45 $0.55 excess (if any) of the cash distribution for the year divided by the MLP s net income for the year. Once the investor s tax basis in the MLP reaches zero, the investor must pay ordinary income tax on the whole cash distribution received. When MLP shares are sold, the difference between the tax basis at time of sale and the original purchase price of the investment is taxed as ordinary income, while the difference between the original purchase price and sale price at disposition is taxed as capital gain. Table 5 provides an example of the intricacies of tax-related effects associated with disposal of units by a unit-holder. When investors hold MLP units in a retirement account, such as an IRA or a Roth IRA, unrelated business income tax (UBIT) consequences should be evaluated. According to the U.S. Internal Revenue Code (IRC), UBIT is the tax associated with an activity engaged in by a tax-exempt entity (including an IRA or Table 5: Income Tax on Disposal of a Hypothetical MLP Investment Year 1: 100 units of an MLP purchased at $60 per unit Tax Basis at Acquisition Date $6,000 In year 1, a $600 cash distribution is received by the unit-holder. Schedule K-1 (Form 1065) for the unit-holder shows $120 in net income and $480 in pass-through deductions for the MLP. Income tax on net income (40%, assumed) $48 Adjusted tax basis, end of year 1 $6,000 $480 = $5,520 Exactly one year and one day later, all 100 units are sold for $70 per share: Total gain (selling price adjusted basis) $7,000 $5,520 = $1,480 Long-term capital gain ($7,000 $6,000) $1,000 Long-term capital gain tax (20% tax rate, assumed) $200 Recapture of capital (from Schedule K-1 (Form 1065)) $480 Ordinary income tax on recapture of capital (40% tax rate, assumed) $192 Total tax (long-term capital gain + ordinary income tax on $440 recapture of capital) M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 9 W I N T E R , V O L. 1 5, N O. 2

10 401(k) retirement plan) that is not related to the taxexempt purpose of that entity. 2 Because MLPs are passthrough entities, the tax-exempt retirement account (i.e., the investor s IRA or 401(k) plan) directly earns an allocable share of an MLP s business income (the income of which is considered unrelated to the taxexempt purpose of the account) rather than usual investment interest or dividends (related tax-exempt purpose) of the account. Therefore, net income from MLP units held in an IRA or 401(k) account is taxed. The account custodian for the IRA should file a separate tax return and pay tax from the account s funds. Some financial advisors suggest that the UBIT should not discourage investors from investing their retirement fund in an MLP because the UBIT arises only when total net income is more than $1,000 in a year. The tax is levied on net income (i.e., excluding depreciation and depletion charges), not on the cash distribution the investor receives. Put another way, passthrough depreciation and other noncash deductions (such as depletion) are not taxed. For most MLPs each year, the amount of noncash deductions passed through to unit-holders is generally between 80%-90% of the net income reported by the MLP. For purposes of determining whether the provisions of the UBIT apply, the share of taxable net income allocated to the unitholder would be below the $1,000 critical value. An alternative view is that investing IRA or 401(k) funds in MLPs should not be encouraged because most cash distributions from MLPs are already tax deferred, as illustrated in the hypothetical example presented in Table 5. Putting tax-deferred assets in a tax-deferred retirement account would therefore not likely maximize an investor s tax benefit. A better tax strategy would be to invest funds from a regular (i.e., a taxable) account in MLP units and to invest nontax-deferred assets (such as regular stocks, bonds, or equity mutual funds) in taxdeferred retirement accounts. For example, suppose you have $5,000 in a retirement account that is tax deferred and $5,000 in a regular stock brokerage account that is not tax deferred. You normally would not want to invest funds from the taxdeferred retirement account in MLP units while investing your remaining funds ($5,000) in a regular mutual fund, such as an S&P 500 index fund. This is because most MLP cash distributions are already tax deferred, while capital gains and dividends associated with the investment in the S&P 500 index fund would not be tax deferred. To defer the tax on capital gains and dividend income received, you would probably want to buy a regular stock mutual fund, such as an S&P 500 index fund, with funds from a tax-deferred retirement account. Rather than investing the remaining $5,000 in a taxable account, the savvy investor should consider an investment in an MLP since most of the cash distributions are tax deferred, as shown in Table 5. This investment strategy would maximize your tax advantages of the total $10,000. Of course, risk considerations would also factor into the decision of how the available capital is invested. Purchasing MLP Shares For most investors, the most cost-efficient way to invest in the U.S. equity market is to buy a mutual fund, exchange-traded fund (ETF), or exchange-traded note (ETN). Investors in these instruments can achieve targeted levels of diversification at a relatively low cost. There are MLP-based ETFs. The JP Morgan Alerian MLP ETN (NYSE Arca: AMJ) is the largest and most popular, and the ALPS Alerian MLP ETF (NYSE: AMLP) and Oppenheimer SteelPath MLP Income Fund Class A shares (NYSE: MLPDX) are also popular choices. 3 Yet the cost effectiveness of buying shares of MLPfocused ETFs is not straightforward. First, the tax advantages of these funds generally are reduced. For example, AMLP is organized as a corporation and thus must pay corporate tax on its Form K-1 income before paying investors. Cash distributions from AMJ are considered bond interest and therefore taxed as ordinary income. Second, these funds are not well diversified because several big firms dominate this industry. Top- 10 holdings of these funds account for more than 60% of total assets for this business sector. Finally, these funds charge a relatively high management fee based on investor holdings. For instance, both AMJ and AMLP charge 0.85% while MLPDX charges 1.35%. In short, because of the fees charged and reduced tax advantages, it can be argued that MLP-based ETFs do not provide cost-efficient diversification. M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 10 W I N T E R , V O L. 1 5, N O. 2

11 On the other hand, investing in mutual funds that hold MLPs provides two primary benefits to investors: (1) Instead of having to deal with Form K-1 each year, investors would get a familiar Form 1099 from the fund, and (2) investors are able to invest retirement-account money into these funds without worrying about UBIT. MLP Businesses Before investing in an MLP, investors should have a firm understanding of the business sector in which the MLP operates. As indicated in Figure 1, MLPs are mostly involved with energy products primarily crude oil, natural gas, refined products, and coal. Yet the net income and distributable cash flows of most MLPs are not related to energy product prices. Because most MLPs are in the midstream sector of the energy supply chain, they generate revenue based on volume processed or shipped. Natural Gas Processing and Natural Gas Liquid Fractionation Natural gas used by consumers is primarily methane, while raw natural gas from underground sources contains other hydrocarbons, including ethane, propane, butane, and pentanes. These associated hydrocarbons are called natural gas liquid (NGL). In addition, raw natural gas may also contain water vapor, hydrogen sulfide, carbon dioxide, helium, nitrogen, and other components. MLPs, such as Enterprise Products Partners, LP, own natural gas processing plants that separate methane (also called dry natural gas) from natural gas liquid and other components. This is known as natural gas processing. Dry natural gas is injected into a pipeline and shipped to natural gas utilities, storage facilities, or power plants. In the next step, natural gas liquid must be further decomposed into ethane, propane, butane, and pentanes before it can be sold for a variety of different uses, including oil recovery in oil wells, materials for refineries or petrochemical plants, and as a source of energy. This process is called NGL fractionation. Product Pipelines Some MLPs own pipelines that carry dry natural gas, crude oil, gasoline, diesel, and other liquid industrial gas to refineries or storage facilities. These MLPs typically charge a fee based on the volume of gas that travels through their pipelines. The fee is often regulated by the Federal Energy Regulatory Commission (FERC). Once an interstate pipeline is built, the FERC has the authority to ensure that pipeline rates are just and reasonable. These rates are set to cover operating and maintenance expenses as well as an allowed return on investment (defined as a percentage of the capital invested in facilities used to serve customers). The FERC sets rates on a pipeline-by-pipeline basis and approves the maximum allowable rate, or a rate cap, for each pipeline. But pipeline customers can and often do demand discounts from these maximum allowable rates. Thanks to fracking and the recent energy boom in the United States, domestic natural gas and crude oil production have increased significantly. As a result, many MLPs with large pipeline assets have reported record volume-based revenue and operating cash flows. Product Storage Some MLPs invest in gas storage facilities, the revenues of which are based on a competitive fee related to the volume of gas stored. Sometimes, however, an MLP that owns a storage facility will lease out a portion of the facility s capacity for a preset fixed fee on a longer-term basis. While natural gas and crude oil production have risen quickly in the United States during the last decade, available storage capacity has not expanded quickly enough to keep pace with that demand. Thus storage capacity is an extraordinarily valuable asset in this market situation. Furthermore, in the natural gas and crude oil futures market, the normal shape of the futures contract price is referred to as contango, a situation where the futures contract price is higher than the current spot price. An MLP could take advantage of contango by simultaneously buying natural gas or crude oil at the spot price and then selling the corresponding futures. 4 When the futures mature, the MLP can deliver the products stored at its facility for a higher price than the spot price paid. 5 MLP Valuation and Risk Assessment To evaluate how expensive a share of common stock is, M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 11 W I N T E R , V O L. 1 5, N O. 2

12 investors often use the P/E ratio (current price per share of stock divided by net income per share) or P/B ratio (price per share divided by book value per share). For MLPs, however, these ratios do not accurately reflect the true earning power or asset base of the underlying business of an MLP. Most MLPs have large amounts of noncash expenses (i.e., depreciation and amortization), the deduction of which some would argue may underestimate the amount of economic earnings reported by these entities. Overly inflated P/E ratios would depress the attractiveness of an MLP from an investment standpoint. In addition, the cumulative effect of historical-cost depreciation/depletion over time for MLPs with large pipeline assets likely results in reported book values on the balance sheet that greatly underestimate the current market value of these assets. Therefore, using a P/B ratio to help assess unit value for an MLP may not be appropriate either. Given the above challenges, what can the investor or potential investor use to help inform the investment decision regarding MLPs? Two metrics are recommended one related to valuation and the other to risk assessment. One potential measure of valuation would be current selling price per unit divided by distributable cash flow per unit. Distributable cash flow is defined as net income plus depreciation, amortization, and other noncash expenses minus maintenance expenditures. 6 For risk assessment, a coverage ratio relates to the risk position of an MLP. As noted earlier, many investors are attracted by the high dividend payouts of MLPs, but the dividend yield does not tell the whole story. Because they typically retain less than 10% of earnings each year, MLPs constantly have to issue new units to finance their operations and expansion. In theory, an MLP not making any profit could still pay high dividends for an extended period by issuing new units. Therefore, to evaluate the sustainability (or risk) of an MLP s high dividend rate, investors could calculate the so-called coverage ratio, defined as the ratio of distributable cash flow for the year to the actual cash payout for the year. Some investors view a favorable coverage ratio as greater than 1.3 under the assumption that this level of coverage indicates the business has ample cash to continue paying distributions to unit-holders. Investing in MLPs: Benefits and Risks Investments in MLPs can be highly rewarding for a number of reasons: Most MLPs engage in fee-based crude oil, gasoline, and natural gas pipeline transportation businesses. As new exploration technology increases domestic oil and gas production volume in the United States, revenues generated by these MLPs will steadily increase, regardless of volatile oil and gas prices. Pipeline is the most cost-efficient method to transport crude oil and gas. It remains competitive over other methods, such as rail and trucking. As indicated in Figure 1, the vast majority of MLPs are involved in the midstream sector of the U.S. energy supply chain. Most MLPs commit to deliver a high annual cash distribution to their unit-holders, and they strive to increase cash distribution as often as possible. Many investors who need current income would find investing in MLPs highly attractive. Investing in MLPs provides tax benefits, as previously discussed. On the other hand, investing in MLPs has significant risks: The U.S. Congress might eliminate or reduce favorable tax treatments on the net income of MLPs and consequently reduce cash distributions to unit- holders. Crude oil, gasoline, coal, and natural gas the main products for MLPs might eventually be replaced by renewable energy sources, devaluing these fossil fuels to a significant degree. Most MLPs are highly leveraged. Therefore, rising interest rates will significantly affect future levels of net income and cash distributions from these entities. Because MLPs distribute most of their operating cash flows (i.e., revenues earned minus noncash charges such as depreciation and depletion) to unitholders, there are little to no retained earnings to serve as a source of funds (e.g., to fund expansion). Rather, these entities have to constantly issue new units on the market, which has a dilutive effect on existing unit-holder shares. M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 12 W I N T E R , V O L. 1 5, N O. 2

13 The organizational structure for some MLPs can be very complicated (as illustrated in Figure 3). Some investors may have trouble understanding an MLP s business structure, which would inhibit their ability to critically evaluate the performance prospects and risks associated with a particular MLP. As noted, due diligence on the part of the investor is needed as part of the decision-making process. Informed Investment Decisions MLPs represent a unique asset class with highly attractive features (and some risks) for investors. In their expanded role within the finance function, management accountants should have greater familiarity with the intricacies associated with MLPs. The descriptive information we included should help management accountants make more informed decisions regarding investments in MLPs from both a professional and a personal perspective. Peter H. Chen, Ph.D., is an associate professor of finance at Youngstown State University in Youngstown, Ohio. You can contact him at (330) or hchen01@ysu.edu. David E. Stout, Ph.D., is the Andrews Chair and Professor of Accounting at Youngstown State University. He is also a member of IMA s Akron Chapter. You can contact David at (330) or destout@ysu.edu. Endnotes 1 Data according to the National Association of Publicly Traded Partnerships ( 2 IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations, March 2012, p598.pdf. 3 NYSE Arca ( previously known as ArcaEx, an abbreviation of Archipelago Exchange, is a securities exchange on which both stocks and options are traded. It is owned by NYSE Euronext ( which merged (as NYSE Group) with Archi - pelago Holdings in a reverse merger in According to wikinvest.com ( Contango), contango means the price of a commodity (e.g., crude oil or natural gas) for delivery at a future date is significantly higher than the current or spot price. This makes it profitable for companies to store the commodity and enter into contracts to sell futures contracts on the commodity, even after accounting for storage costs and opportunity cost of capital (i.e., money tied down on the inventory not earning a return). (A futures contract is a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price.) Also referred to as an upward sloping forward curve, contango persists until the futures prices come down, current prices go up, or the cost of storage becomes very high. 5 Although contango might seem to represent an arbitrage situation on the surface, it is technically not the case because of the storage cost associated with the gas or oil. Once the company locks in the price in a futures contract, market changes do not matter. For example, assume that the spot oil price is $102 per barrel and an oil futures contract is currently trading at $110 per barrel. An MLP with a storage facility can buy and store at its facility, say, one million barrels of oil today for $102 per barrel. At the same time, it may sell 1,000 oil futures contracts (1,000 barrels per contract) at $110 per barrel. When the futures contract matures, the MLP will deliver the oil for $110 per barrel, for a profit of $8 million. This level of profit would be independent of what happened to the spot market and what happened to the specified futures market from the present to the point when the futures contracts matured. 6 Those familiar with the notion of Economic Value Added (EVA ) will note the parallel of distributable cash flow (or earnings) to EVA (economic) income. M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y 13 W I N T E R , V O L. 1 5, N O. 2