Energy master limited partnerships, or MLPs, have proved to be excellent investments over the past few years. The tax-advantaged group, which consists largely of companies supplying oil and gas infrastructure, has returned close to 16% annualized in the past 10 years, compared with just 4%-5% for the Dow and the S&P500.
But a sell-off last month, which sent the benchmark Alerian MLP Index tumbling nearly 9% in just 10 days, suggested that the market may be apprehensive regarding the looming fiscal cliff's impact on MLPs.
This raises an important question -- was the sell-off simply a one-off event driven by fear or poor logic, or does it signal trouble ahead for MLPs?
A quick primer on MLPs
MLPs operate primarily in the energy space, though there are notable exceptions such as Terra Nitrogen (NYSE: TNH), which produces fertilizer products, and Stonemor Partners (STON), which operates within the death-care industry.
When we talk about energy MLPs, most people probably think of the midstream operators. These companies handle the transportation and storage of commodities such as crude oil, natural gas, and natural gas liquids. In recent years, their allure has grown steadily, mainly because of high yields and an appealing business structure.
MLPs are pass-through entities that are shielded from corporate income taxes. Hence, they're required to distribute the bulk of their income to unitholders in the form of quarterly distributions. This special tax treatment has proffered numerous benefits for MLPs and their unitholders.
But as fears over the looming fiscal cliff mount, many are questioning whether MLPs' tax treatment will remain sacrosanct as Congress scrambles to come up with a solution.
Does the fiscal cliff threaten MLPs' tax treatment?
America's fiscal position, which has deteriorated significantly over the past decade, is precarious at best and fatal at worst. Last year, U.S. gross government debt to GDP surpassed 100% for the first time ever. It is abundantly clear that some combination of tax increases and spending cuts is necessary to nurse the country back to fiscal health.
According to some commentators, Congress may eliminate MLPs' tax-advantaged status in its quest to increase tax revenues. However, this is unlikely for two major reasons.
First, the revenues received would be insignificant in the grand scheme of things. At the beginning of the year, the Congressional Joint Committee on Taxation conducted a study that measured the fiscal impact of ending MLPs' special tax treatment.
According to the committee's estimates, the average cost per year of MLP tax breaks to the U.S. government would be a paltry $300 million. That comes out to roughly 0.03% of this fiscal year's $1.1 trillion budget deficit.
Second, policymakers don't really have any incentives to tamper with the energy industry, one of the main beacons of hope for the U.S. economy. Domestic oil production is the highest it's been in 15 years, and natural gas production is expected to reach an all-time high this year, according to the U.S. Energy Information Administration (EIA).
Not only is the U.S. energy sector helping reduce America's import bill and our reliance on foreign oil, but it's also creating tons of jobs. According to a report by IHS CERA, a leading global research firm, America's unconventional energy boom has already resulted in 1.7 million jobs. This number could rise to 3 million by 2020, the firm estimates. Hence, Congress is unlikely to introduce policies that would discourage investment in this booming sector of the American economy, of which MLPs are a crucial part.
With these factors in mind, it then appears that the MLP sell-off last month was unwarranted. As it stands, there have been no fundamental changes affecting the attractiveness of MLPs as an investment. Yes, the fiscal cliff is one of the biggest threats to the global economy. But besides its broader potential negative impact on the economy, it has no direct consequences for MLPs with regard to taxation.
Final thoughts, and reasons MLPs are still attractive
At any rate, the fundamentals for MLPs remain intact. The asset class offers an average yield greater than 6%, relatively low correlation with other stocks and asset classes, and strong prospects for distribution growth, owing to the high demand for energy infrastructure and low-cost capital that has allowed many to pursue ambitious growth projects.
For instance, Plains All American (PAA 2.17%) has some $4.1 billion in expansion and acquisition capital invested or expected to be invested in servicing key plays in Canada, the Bakken, the Midcontinent and Rockies, South Texas and the Eagle Ford, and the Permian Basin from 2009 to 2013. Similarly, Energy Transfer Partners (NYSE: ETP) has announced more than $3.1 billion in growth projects since the end of 2010.
Even PVR Partners (NYSE: PVR), an MLP that has traditionally focused on coal, is now redirecting its focus to natural gas midstream assets with several growth projects, servicing major plays such as the Marcellus, due for completion in 2013 and 2014.
In addition to MLPs' general acceleration of investment spending, which bodes well for future distribution increases, they should continue to benefit because of a couple of key characteristics.
The first is their simple yet highly lucrative and stable business model. They essentially act as toll collectors, charging energy companies fees for using their pipelines. These fees tend to be very stable and are secured by long-term contracts. Hence, midstream MLPs tend to have very limited direct exposure to commodity prices.
Second, MLPs tend to be relatively insulated from broader economic shocks. This feature of MLPs became quite clear during the 2008 financial crisis. As most companies were running scared and slashing dividends left and right, several MLPs actually managed to raise their distributions. This resilience to broader economic downturns is just another reason MLPs should continue to thrive even if we go over the fiscal cliff.