Non-traditional income investments – Part 2 of 3
This past week, the S&P500 set a new all-time closing high at 1859, the NASDAQ tapped its highest point in 14 years and the small-cap Russell2000 index set a new high, as well. The Dow closed within a couple hundred points of its record high. (1)
Five years ago this coming week, on the 9th, things were quite a bit different. Nine years to the day after the NASDAQ had first closed above 5000, the S&P ended the trading day at 676. (2) The 9thof March, 2009, was the day the market started the recovery that’s still going on today. Since that time, the S&P has gained over 170% and, if you include dividends, it’s up over 200%. (3)
All you had to do to participate in these gains was to stay invested, stick with your strategy and ignore the headlines. Please keep this in mind the next time things get “interesting,” such as the case may be with Ukrainian developments. I believe you should treat any potential market downturn from that as you would any other selloff.
Last week, we looked at the REITs as a non-traditional (in the stock market sense) income source. This week, the focus is on MLPs –Master Limited Partnerships. Before getting into that, I want to reiterate an important point that most income investors ignore.
The consensus view is that income is strictly a function of only the current cash flow coming in the form of dividends and/or interest. That’s flawed thinking. If you’re planning for any long-term goal, you must think in terms of your total return. That is, your current income plus any growth you realize during the time you own something. As you can see from the S&P results above, those together make a significant difference to your return.
By simply focusing on your current return, you could be penalizing yourself. If, as we’ve suggested, the utility sector is generally over-valued, then simply investing for what appears to be a high current income alone could be a bad idea. You must also consider what the longer-term growth potential could be. Surrendering some current income for the potential of a nice total return could be very productive.
Those long-term investment goals should be thought of like water in your long-term asset well. Some of the “water” source is in the form of dividends and similar distributions; the other is made up of your long-term gains. When you use some of the contents, you want to have a source to replace what’s been removed…otherwise, it’ll run dry. That’s why it’s important to have sources of both gains and income.
What are MLPs?
The MLP structure is almost exclusively the domain of energy-related companies. They were set up primarily as a place for the pipeline and storage facilities of those companies. The MLPs are managed by a general partner which, typically, owns about 2% of the partnership. Investors, who purchase units of the partnership, as opposed to shares in a company, are considered limited partners. Similar to stock, these units are traded daily on the exchanges. As a limited partner, you have no involvement in the operations of the MLP. Further, as with a stock investment, the investors total risk is limited to their investment only.
This has nothing to do with fishing – unless you’re trolling for monetary gains…
The midstream term here refers to where in the overall energy production process you may well want to best position yourself. Upstream is the term for all the higher-risk part of the business…primarily, drilling and exploration. Downstream is the distribution portion – gas stations, etc. –returns on which are highly market price dependent. So – why midstream?
Here are the two major reasons that, in my opinion, make these attractive investment choices.
First – and this is majorly big – pipelines offer stable, regulated returns. That’s because Congress has set tariffs for the pipelines. This allows the pipeline operators to recoup their capital and maintenance costs, plus a reasonable rate of return.
Unlike a traditional energy stock investment, there’s almost no exposure to changes in price for either oil or natural gas. The pipelines and storage facilities charge for the transport or storage – regardless of the prevailing commodity price. This helps to keep your cash flows fairly steady and consistent over time. But, because fees are based on volume, profitability can vary with demand for oil or gas transport, primarily in the smaller operators. The offset to that is that, regardless of overall economic situation, we need what the pipelines bring us.
The second reason has to do with the tax treatment of your distributions. MLPs allow you to defer much of your personal income tax liability for years into the future. That’s because your distributions can have a significant component that’s treated as a return of capital. This means, no current tax is due on that portion of your earnings. Your total distributions will reduce your cost basis and are only taxed at capital gains rates when liquidated. So, you get to keep more of what you make, both in income and at the ultimate sale.
General MLP investment sectors
Here’s some background on different sectors which offer MLPs in order to help you decide which type or combination may suit you best.
According to Reuters, more than 110 liquefied natural gas (LNG) facilities now operate in the US. Some of these export the super-cooled liquid, while others turn natural gas into an energy form that occupies up to 600 times less space than natural gas for vehicle fuel or industrial use. Worldwide, LNG trade is expected to more than double by 2040, according to the Energy Information Administration.
Reuters also said that, because of the big cost advantage we enjoy, up to a dozen long-term export deals, each worth billions of dollars, have been signed by American natural gas producers with companies in China, Japan, Taiwan, Spain, France and Chile. The Energy Department has authorized companies to export up to 8.5 billion cubic feet per day of liquefied natural gas – which is only about 13 percent of current daily production.
Given the established oil and gas industry, access to shipping and regional resources, the Gulf Coast seems set to become the epicenter of the coming liquefaction boom, as is evidenced by all the building of pipelines and facilities there right now.
Another category is natural gas storage facilities. These charge a competitive fee, based on the volume of gas stored. Sometimes, MLPs owning storage facilities will lease out a portion of their capacity for pre-set fixed fee on a longer-term basis. While natural gas demand has risen quickly in the US during the last decade, available storage capacity is still catching up in order to keep pace with that demand. Storage capacity, therefore, seems to be a pretty valuable asset. For example, the building of liquefied natural gas (LNG) facilities along the Gulf Coast will eventually mean imports of gas need to be stored near the import facilities. Companies with storage facilities located near these regions should benefit from all that imported LNG.
Refined product pipelines carry petroleum-based products like gasoline, diesel and jet fuel from refineries to terminals for distribution. Typically, pipeline owners charge a fee based on the volume of product that travels through their lines. Oftentimes, however, refined product pipelines are dedicated for a particular refinery; refiners often agree to a minimum fee, regardless of how much gasoline ships across the lines. Refined product pipelines are typically a very stable, cash-generative asset. And, because demand for refined products is relatively stable over time, volumes don’t fluctuate a great deal.
Gathering pipelines are small diameter pipes that connect a single well or a group of wells to processing facilities and eventually the national interstate pipeline grid. Gathering lines “gather” hydrocarbons from wells; it’s the first step in the process of moving gas from wellhead to consumer. Companies that own pipelines charge a fee based on the volume of gas gathered. Gathering pipelines aren’t regulated by the government; they’re in a competitive business with rates charged for transporting gas set by overall supply and demand conditions. Gathering lines have exposure to drilling activity, so the risk may be relatively higher.
Basic product pipelines are those which transport the natural gas or crude oil – shale or traditional source – from the various fields to storage facilities and/or refineries/processing plants. These simply charge for moving the product from A to B. A simple, yet rewarding, approach.
The biggest drawback of MLP investing, in the eyes of some investors, is that as a partner, you receive a K-1 statement, instead of a 1099. These are issued by all partnerships. Those take longer to create and, therefore to receive. It’s my belief that, given the benefits of the taxation of the income, it’s probably worth the wait.
According to Alerian, as of year-end 2013, the average current yield of MLPs was 5.8%. With a relatively high current income, together with the tax benefit, along with the potential for unit price appreciation, you may do well to consider adding this type investment to your holdings.
(1) CNBC, 28 Feb 2014
(3) S&P/Dow Jones Indices
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Past performance is not indicative of future returns. Investing in securities of any type involves certain risks, including potential loss of principal. Investment return and principal value in a bond and/or securities portfolio will fluctuate so that investments, when sold or redeemed, may be worth more, or less, than the original investment.
Investing in sectors may involve a greater degree of risk than investments with broader diversification. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.