Crude oil, natural gas, and gasoline prices have soared in recent months, yet returns for major oil company stocks have been flat. Is there another way to get in on the action in energy?
Energy-sector master limited partnerships (MLPS) and income (or royalty) trusts are just that. They've shown high returns, tax advantages, and a knack for consistently increasing distributions. Current yields run about 7.5% for MLPs and 11% for trusts vs. 2.1% for the Standard & Poor's 500 Energy index. Over the past five years, MLPs posted a total return of 27.2%, while trusts returned 25%, compared with 21.3% for the energy index.
While both entities are required to pay out essentially all of their cash flow in distributions, neither pays income taxes, which eliminates the issue of double taxation of dividends. Here's a look at how these vehicles operate, and some pros and cons of owning them.
What is an MLP?
An MLP has a general partner who manages the business, and limited partners who invest capital. Limited partner units trade like stocks. MLPs pay quarterly cash distributions. Stock analysts who cover other energy companies often follow MLPs and income trusts.
How do MLPs generate cash flow for their distributions?
The bulk of MLPs own "infrastructure" assets -- such as pipelines and storage facilities -- that are used to process, transport, and store oil, natural gas, and refined petroleum products. They collect revenues for their services and are highly dependent on how much volume they can push through, say, a pipeline. As demand for commodities increases, so will demand for services. But MLPs are not directly exposed to energy price fluctuations.
Pipelines and other fee-based assets have a long economic life, generate lots of depreciation, and produce stable cash flow. Because the MLP is not taxed, most of that cash flow passes directly to the investor. In any given year, an MLP investor will typically pay income tax on only 10% to 20% of the cash distributions. Taxes on the remaining 80% to 90% are deferred until the investor sells the units and pays the capital-gains tax rate.
Pension funds and mutual funds cannot own MLPS. However, there is now legislation before Congress that would eliminate that ban and open the door to new investors.
How do MLPs today differ from those that went bust in the 1980s?
Energy-related MLPs two decades ago offered high yields but very little growth, leaving them unable to sustain their distributions. The new breed of MLPs, which was pioneered in the late 1990s by Houston-based Kinder Morgan Energy Partners LP, focuses on high yields and also on growth. That's driven mostly by acquiring fee-earning assets from major oil and power companies that don't regard them as part of their core operations. Kinder Morgan plans to hike its payout by 8% this year, to about $2.90 a unit, says President Michael C. Morgan.
How do income trusts differ?
Most U.S. income trusts hold royalty interests in producing oil and gas reserves, but they do not buy other assets. As assets are depleted, distributions fall. Most Canadian trusts continue to purchase assets and grow. They focus mainly on oil and natural gas production, making them highly sensitive to price fluctuations. "If oil and gas prices stay high, that's good," says S&P credit analyst Michelle Dathorne. "But if they revert substantially, distributions could go down, and that needs to be factored in by investors."
What impact will rising interest rates have on these entities?
As yield-oriented investments, they tend to decline when interest rates are rising. Indeed, since mid-April -- when rates began their climb -- MLPs are off an average of 8.3%, vs. 1.5% for the S&P 500-stock index during the same one-month period. But some argue the drop has created a buying opportunity because entities will be able to raise distributions to more than offset rising rates. "The stocks have been oversold," says analyst Yves Siegel of Wachovia Securities (WB ). "Most of the damage has already been done."
Are there other disadvantages to investing in MLPs and income trusts?
Taxes on the investments are one of the biggest headaches and could include filing income taxes in various states where the MLPs and trusts have assets. RBC Capital Markets' Mark S. Easterbrook advises: "If you're going to invest, get an accountant because things could be very complicated."
By Stephanie Anderson Forest