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| The Basics | Pipe oilfield profits into your pocket
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Oil and gas pipeline partnerships deliver solid returns, offer rock-solid security -- and produce outsize dividends year after year.
By Harry Domash
Within its group, pipeline operator Teppco Partners is a run-of-the-mill performer. Sure, it's up 9% a year over the past five years, easily beating the S&P 500 Index's ($INX, news, msgs) 3%-a-year loss.
And sure, over those five years, Teppco Partners (TPP, news, msgs) has paid out more than $12 per share in cash dividends, meaning its total return is actually 17% a year. (To put that into perspective, a 17% return doubles your money in less than five years.)
But Teppco's record is no big deal among master limited partnerships, the group to which it belongs. In fact, its 17% annual return is below average for the MLPs turned up by the screen Ill describe below.
MLPs explained
MLPs are partnerships that trade on major exchanges just like regular stocks. MLPs, though, pay big dividends because they dont have to pay federal income taxes if they pay out most of their cash flow to shareholders.
Dont confuse MLPs with the partnerships common in the 1980s that were organized solely to generate income-tax losses for investors. Modern MLPs were first authorized by the Tax Reform Act of 1986. In 1987, that law was modified to require qualifying MLPs to receive 90% of their income from activities in real estate, commodities or natural resources. A small number of MLPs in existence before 1987 were grandfathered in and allowed to continue operating as MLPs, even though their business definitions didnt meet the new requirements.
The special tax treatment afforded MLPs seems to have special appeal to oil and gas producers. Many of them have transferred their petroleum and natural-gas pipeline assets to MLPs.
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The way MLPs are structured, a general partner runs the business, while individual investors are limited partners. The general partner receives a percentage of the MLPs profits off the top, before the limited partners receive their cut.
Pipeline MLPs are such boring investments because not much can go wrong. Sure, in the short-term, the winter could be too warm or the summer too cool, reducing transported volumes below expectations. But pipelines dont go out of fashion. They are not in danger of being made obsolete by new products. And, since pipelines usually dont duplicate each others' routes, they dont have competition.
Increasing energy-price exposure
MLP pipelines come in two types: petroleum pipelines carrying crude oil or refined petroleum products, and natural-gas pipelines.
Petroleum-pipeline operators base their fees on the volume of product transported. Theyre not affected much by the price of oil.
By contrast, natural-gas pipeline operators frequently also run gas-gathering systems, which connect wells to public pipelines as well as processing plants. Typically, gathering and processing contracts expose pipeline operators to changes in the price of natural gas and its byproducts. So natural-gas pipeline operators profit margins can vary with the price of the commodity. Some operators employ hedging strategies to reduce their susceptibility to price swings. But not all do because that limits their upside potential.
While several pipeline MLPs focus on natural gas exclusively, some petroleum-pipeline operators have recently acquired natural-gas assets and others are planning to do so. It appears that eventually, most pipeline MLPs will have at least some natural-gas pipelines, and thus, at least moderate susceptibility to price swings.
By the way, because MLPs are partnerships, not corporations, some special terminology is involved. Specifically, you own units instead of shares, and an MLPs payouts are called distributions instead of dividends.
Tax considerations
MLPs offer a possible tax advantage because roughly 80% to 90% of distributions are considered a return of your original investment instead of income. Thats great if youre a long-term investor, because you dont pay taxes on that part until you sell. However, when you do sell, you pay taxes, mostly at ordinary income rates, on the portions previously designated as return of capital.
There is another complication if you hold MLPs in a tax-sheltered account such as an IRA. If you receive MLP distributions totaling more than $1,000 in a year, the amount exceeding that figure may be considered unrelated business income and subject to taxes. So consult with a tax expert if you fall into that category.
Finding the right partners
MSN Moneys Deluxe Screener has a parameter for pinpointing pipeline operators, making it easy to find MLPs. Heres a simple screen I used for finding MLP candidates.
First, I selected the Oil & Gas Pipeline industry.
Screening Parameter: Industry Name = Oil & Gas Pipelines
Since MLP investing is as much about income as it is about price appreciation, dividend yield is priority number one. Most viable MLPs pay distributions equating to yields of 5% or higher.
Screening Parameter: Current Dividend Yield >= 5
Because they pay out most of their profits to shareholders, MLPs often borrow to fund expansion. However, too much debt signals potential problems.
The leverage ratio, which divides total assets by shareholders' equity, is a convenient debt measure. A company with no debt would have a 1 ratio. The higher the debt, the higher the ratio. Most pipeline MLPs carry moderate debt with leverage ratios in the 2-to-4 range. With that in mind, I set my maximum acceptable leverage ratio at 6.
Screening Parameter: Leverage Ratio <= 6
My screen listed 14 pipeline MLPs. I added one more, Energy Transfer Partners (ETP, news, msgs). The screener missed Energy Transfer because, in addition to operating natural-gas pipelines, its also a propane retailer and MSN lists it in the Oil & Gas Refining & Marketing Category.
Nine MLPs turned up by my screen have been in business at least five years. Those firms averaged an annual return of 21%, counting both dividends and price appreciation, over the past five years.
| 15 pipeline MLPs | | Name | Type | Dividend yield % | 5-year historical annual return | | Atlas Pipeline Partners (APL, news, msgs) | Natural Gas | 6.4 | 31% | | Buckeye Partners (BPL, news, msgs) | Petroleum Prod | 6.2 | 18% | | Enbridge Energy Partners (EEP, news, msgs) | Both | 6.7 | 15% | | Genesis Energy (GEL, news, msgs) | Both | 5.9 | 19% | | Holly Energy Partners (HEP, news, msgs) | Petroleum Prod | 5.3 | n/a | | Kinder Morgan Energy Partners LP (KMP, news, msgs) | Both | 5.9 | 26% | | Magellan Midstream Partners (MMP, news, msgs) | Petroleum Prod | 5.8 | n/a | | Northern Border Partners L.P. (NBP, news, msgs) | Natural Gas | 6.7 | 19% | | Pacific Energy Partners (PPX, news, msgs) | Petroleum Prod | 6.4 | n/a | | Plains All American Pipeline (PAA, news, msgs) | Both | 5.8 | 27% | | Sunoco Logistics Partners L.P. (SXL, news, msgs) | Petroleum Prod | 6.7 | n/a | | TC Pipelines (TCLP, news, msgs) | Natural Gas | 6.6 | 21% | | Teppco Partners (TPP, news, msgs) | Both | 6.6 | 17% | | Valero L.P. (VLI, news, msgs) | Petroleum Prod | 6.0 | n/a | | Energy Transfer Partners (ETP, news, msgs) | Natural Gas | 5.7 | n/a |
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To narrow down the list of candidates, check:- Historical 5-year Dividend Growth (in the screener's Company Report section): History is a good teacher when it comes to distributions. MLPs with strong historical dividend growth are likely to continue their winning ways.
- Forecast Next 5-year Earnings Growth: Distributions come from cash flow, not earnings. Nevertheless, the MLPs with the strongest earnings growth are likely to be the fastest distribution growers, too.
- Whats cooking? (listed under Key Developments): Earnings and distribution growth comes from building or expanding pipelines and from acquisitions. Checking the Key Developments log is a good way to find out what expansion activities an MLP has in the works.
Find expected return
Heres a rule of thumb you can use for setting up a target expected return for each of the candidates.
Over the long term, an MLPs unit price will probably track its earnings growth. So assume that the forecast 5-year future annual earnings growth is correct, and that the unit price grows at the same rate. Total return is unit price appreciation plus distributions, so calculate the targeted annual return by adding forecast earnings growth to the current dividend yield.
For example, Kinder Morgans current dividend yield is 5.9%; analysts are looking for 8.3% annual earnings growth. So its target total return is 14%.
In my experience, the old tale about the tortoise and the hare applies in spades to the stock market. Successful investors get rich slowly. Pipeline MLPs are tortoises worth considering.
Harry Domash owns or controls positions in Atlas Pipeline Partners, Energy Transfer Partners and Teppco Partners.
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