Master Limited Partnerships: Investing Essentials

An introduction to master limited partnerships and how to invest in them.

Jul 30, 2014 at 12:00AM

It's not cheap to explore and produce oil and gas. Recognizing this, energy companies have explored a variety of ways to raise capital from investors to drill the next well or build a pipeline from producing wells to the marketplace. One of the more successful industry strategies for raising capital from investors is by using the master limited partnership structure.

What are master limited partnerships?

A master limited partnership, or MLP, is basically a pass-through entity. By law, an MLP must derive 90% of its income from approved sources such as natural resources and pay out a large portion of the cash flow in distributions to investors, who are called unitholders. In so doing, MLPs pay no corporate tax, so investors avoid the "double taxation" of dividends in which profits are first taxed at the corporate level and then again at the personal level.

A further benefit is that the distributions from MLPs are generally tax deferred. In most cases, the distribution reduces an investor's cost basis in the partnership, which results in a higher capital gain or lower loss when the units are sold.

What is the history of master limited partnerships?

Apache Oil established the first master limited partnership in 1981. It used the MLP structure to raise capital from investors by offering them a partnership investment. This situation was unique in that it combined the liquidity and price appreciation potential of owning a stock with the tax advantages of being in a partnership.

Master Limited Partnership Apache

Pumping unit in the Permian Basin. Source: Apache Corp. 

Apache's success drew other oil and gas companies to the structure. Before long, real estate and other industries that were constantly seeking investor capital were also forming MLPs. By the mid-1980s MLPs became so popular that restaurants, hotels, and even the Boston Celtics became MLPs.

The surge in popularity raised concerns that many of these companies were switching just for the tax advantages of being an MLP. Congress revamped the tax code in 1987 to specify that 90% of an MLP's income must come from specific sources, such as natural resources-related activities including exploration, production, transportation, and storage.

How many master limited partnerships are there?

The popularity of MLPs has ebbed and flowed over time. While oil and gas MLPs were popular early on, these companies abandoned the structure after slumping oil and gas prices made it nearly impossible for them to maintain the large cash distributions investors had come to enjoy. Instead, energy companies began selling or spinning off midstream assets such as pipelines and processing plants into MLPs, as these assets had the stable cash flows needed to maintain distributions.

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Source: Kinder Morgan.

Today the bulk of the master limited partnership marketplace involves midstream-focused MLPs, which own, operate, and build pipelines, processing plants, and a range of other energy infrastructure. There are well over 100 MLPs trading on major stock exchanges, with new entrants to the market arriving all the time. Energy companies are increasingly selling a stake in their midstream assets in an initial public offering or spinning the asset into a newly publicly traded entity, as today's low-rate environment has investors craving the yield that can be generated by stable midstream assets. Meanwhile, investment firms are pooling capital together to buy or build midstream assets and then sell the entity to other MLPs or to the public through an IPO. In addition, renewable energy assets are being put into MLP-type vehicles and sold to the public to meet investors' desire for income-generating assets.

Why invest in master limited partnerships?

As a pass-through entity an MLP delivers a vast majority of its cash flow to unit holders. This tax-advantaged income stream draws investors to MLPs. With the right management team and assets in place, this income should be largely secured from contracts and will grow over time as the partnership buys or builds additional income-generating assets.

There are two other important characteristics of MLPs. If the units are publicly traded, an investor has ample liquidity to monetize his or her holdings if a need arises. An investor can also hold the units and pass them down to heirs at a basis that is stepped up to the fair market value. This means the heir receives a fresh start, which could reduce the tax burden when the units are sold.

Master limited partnerships offer income-seeking investors several benefits not found in common stocks. While these benefits are not without challenges, especially from additional forms at tax time, they outweigh the challenges by a wide margin, which is why MLPs remain a popular investment vehicle. 

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