Pipeline MLPs: Providing Income at a Cost

Master limited partnerships (MLPs), especially those in the oil and gas pipeline sector, are popular choices for those looking to boost their investment income. It makes sense, after all; these partnerships provide a necessary service, and many offer sizable and relatively safe distribution yields. As is common on Wall Street, however, there are costs. Here's a quick look at the good and the bad of pipeline MLPs.

The good and bad of MLPs
A master limited partnership is a limited partnership that is publicly traded on a securities exchange. The major benefit of owning one is probably its generous distribution. These payouts generally occur quarterly and are considered relatively safe. This is especially the case with pipeline partnerships, as they tend to have very stable earnings, giving some assurance of a steady distribution.

There are costs associated with this attractive income source, however. One drawback is the complicated ownership structure of MLPs. The partnership usually consists of limited partners, most of whom are individual investors, and a general or managing partner. While individual investors typically put up most of the business capital, the general partner often gets very well compensated for running the business. Differing agendas can sometimes cause a conflict between the general and limited partners.

A partnership's growth path has been known to cause such a clash. Since general partners are often remunerated based on the amount of business transacted, they typically look to grow the business. Meaningful expansions are mostly funded through increased debt or the issuance of new partnership units (which are share equivalents.) Sometimes it's not clear if the initiative is worth the risk of additional debt or the dilution of current limited partners. It's not uncommon to see MLPs trade down noticeably on news of an expansion-related unit offering.

Another disadvantage can be a limited partner's tax complications. While distributions can be taxed at a marginal rate, they may also include return of capital or capital gains, which would incur different tax treatment. Limited partners can also be exposed to business tax liabilities unassociated with distributions. A somewhat complicated Schedule K-1 is provided to help with tax preparation, but this unfamiliar form could suggest professional help might be necessary for those with substantial MLP exposure. 

An interesting pipeline MLP
Though pipeline MLPs have some handicaps, they can be sound investments. El Paso Pipeline Partners is an interesting one. It operates more than 13,000 miles of natural gas pipelines in the Rockies and the Southeast. Kinder Morgan, the third-largest energy company in North America on an enterprise value basis, owns the general partner interest.

El Paso's pipeline business is a steady performer. For 2012, it generated adjusted distributable cash flow of $590 million, up 22% from 2011. The partnership also generated $119 million of cash in excess of distributions, a comforting sign. Asset transfers and cost savings from Kinder Morgan helped boost results.

El Paso is looking to grow by diversification. In January, the partnership and energy giant Royal Dutch Shell announced a venture to develop a natural gas liquefaction plant. The $1 billion-plus project is aimed at exporting liquid natural gas and is expected to get regulatory approval in 2014. 

More than a pipeline MLP
While El Paso wants to expand beyond the transport business, other pipeline MLPs have already diversified their business.

Enterprise Products Partners has a significant transportation and storage business but also derives a significant portion of profits from converting natural gas, through its processing plants and its natural gas liquid (NGL) and propylene fractionation sites, into usable end product.

This business has been highly lucrative in recent years as natural gas and NGL use has increased due to their significant cost advantage over crude oil derivatives. Many chemical, manufacturing, and power companies have switched to using cheaper natural gas-based feedstock for production.

Thanks to this trend, Enterprise Products had a record year in 2012. Strong growth from the shale boom and heavy worldwide demand for NGL helped the partnership generate $4.1 billion of distributable cash flow and increase per-unit cash distributions by 5.6%. It was also able to retain about $1.9 billion of cash flow for growth initiatives, reducing the need to issue additional equity.

NGL-related expansion is a priority of the partnership. Late in 2012, a sixth NGL fractionator was completed, and Enterprise announced in May the planned development of two product export facilities to meet growing demand from international markets. 

Plains All American Pipeline is another interesting diversified MLP. While engaged in the transportation of crude oil and NGL, a significant portion of its business (about 90% of revenues and 40% of operating profit) comes from its supply and logistics business segment. This segment basically trades oil and NGL.

The partnership purchases crude oil or NGL, stores it as inventory, then resells or exchanges it to refiners or other resellers. The idea behind this is to buy low and sell high in volatile energy markets. Plains All American has been doing this for a while. It possesses specialized market knowledge and critical business relationships in the crude oil distribution chain, minimizing the risk of unprofitable transactions.

In 2012, the supply and logistics segment exceeded expectations thanks to increased volumes and attractive margins. That helped Plains All American to post adjusted income of $1.41 billion, up 38% from the prior year. Management believes that continued trading gains may become more difficult, however. Increased infrastructure build-outs in high oil and gas producing regions will likely reduce profitable pricing spreads. 

Bottom line
Pipeline MLPs can be a sound but tricky investment. While they offer attractive and relatively safe income opportunities, they also present some distinctive disadvantages when compared to a typical stock purchase. Investors may find that they are best served by spending some time to investigate an MLP's structure, business, and tax implications before falling prey to an alluring distribution yield.

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The article Pipeline MLPs: Providing Income at a Cost originally appeared on Fool.com.

Bob Chandler has a long position in Plains All American Pipeline. The Motley Fool recommends El Paso Pipeline Partners LP and Enterprise Products Partners L.P.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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