Master Limited Partnerships
High Yield, Ever Growing Oil "Stocks Income Investments for a Secure, Worry Free and Comfortable Retirement
by
Richard Stooker
SMASHWORDS EDITION
Published by Richard Stooker on Smashwords
Copyright © 2010-2012 by Richard Stooker and Gold Egg Investing LLC.
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DISCLAIMER
I am not a broker.
I am not a licensed securities dealer or representative of any kind.
I am no legal right to sell you securities and I’m not trying to do so.
Nothing in this book is to be construed as a solicitation or offer to sell you securities.
Nothing in this book is to be construed as personal financial advice.
I have no legal right to give you personal financial advice. Even if I was a registered financial adviser, which I’m not, I don’t know you or your individual financial situation.
This book is the result of my research and is believed accurate. It consists of my opinions and suggestions.
I’m not making any representations as to how much money you will make if you invest according to the guidelines I set forth —that will depend upon the payouts of dividends and interest of the precise securities you decide to invest in, and nobody can predict the future.
That is part of the problem with mainstream financial advice — it assumes the future will repeat the past. It doesn’t.
Past performance is not indicative of future results.
This book is for education and entertainment. Nothing in this book is to be construed as professional advice. For that, you should consult your attorney, accountant or financial adviser.
I am not responsible for the results of your investment decisions.
You must read, think over what I say, make your own investment decisions and take responsibility for your own life, including the results of your investment decisions.
Continuing to read this book implies your acceptance of these terms.
LEGAL NOTICE
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The sole purpose of these materials is to educate and entertain. Any perceived slights to specific organization or individual are unintentional.
Legal Notice Copyright 2007 by Curt Dillion & The-Librarian.com
Full Disclosure
In the field of investment writing there can be a suspicion the author is practicing some form of “front running.”
That is, promoting a particular security the writer has already bought, so more people will buy it, driving up the price and therefore giving the writer the chance to sell their shares at a big profit.
Some advice newsletter companies and writers have been accused of this kind of “pump and dump” or “short and distort” activity. And it certainly takes place in Internet investing chat rooms and via spam.
I believe some companies such as BARRON’S do not allow their staffers to buy shares in companies they write about, to avoid even the appearance of impropriety. BARRON’S has enough readers and clout to drive market prices up or down.
Nobody has paid me to write this book. I wrote it because I’m interested in income-producing investments and there are no other books devoted to Master Limited Partnerships. Therefore, it was an unfilled niche.
My own investing philosophy is to continue to buy income producing investments and then reinvest the proceeds. And hold forever.
Therefore — and I know this is a novel concept, but it’s logical — I’m better off if the price of my securities remains as low as possible. The lower their market prices, the more shares or units I can buy when I buy more shares or units and when I reinvest the income from my portfolio.
Therefore, it would be better for my personal portfolio to keep the market price of Master Limited Partnerships as low as possible.
But I also have a professional obligation as an author to bring you the best information possible.
And besides, I have no expectation this book will sell enough copies (it’s not in the same league as BARRON’S!) to influence the market price of any MLP.
I do plan to continue to buy MLP units and related investments, along with other income-generating investments such as the ones I describe in my other book Income Investing Secrets, for my own accounts for the rest of my life.
I’m writing about Master Limited Partnerships for the same reason I’m investing in them — because I believe, as a group, they’re the best and safest income investments available.
Table of Contents
The Extraordinary Benefits of MLPs
The “Catches“ of Investing in MLPs
The Business Risks Master Limited Partnerships Face
History of Master Limited Partnerships
How MLPs Save You Money on Taxes
The Business of Master Limited Partnerships
Why Master Limited Partnerships are Created
Master Limited Partnerships Industry Terms
National Association of Publicly Traded Partnerships
Master Limited Partnerships Indexes
Wells Fargo Securities, LLC MLP Index
Distributable Cash Flow — Money in Your Pocket
MLPs and Taxes — Huge Opportunity or Obstacle
MLPs and Tax-Deferred Accounts
MLPs and Taxes if You’re Outside the U.S.
Master Limited Partnership I-Units
Master Limited Partnership Closed-End Funds
The Cushing MLP Total Return Fund
Fiduciary/Claymore MLP Opportunity Fund
Kayne Anderson Energy Development Company
Kayne Anderson MLP Investment Company
MLP & Strategic Equity Fund Inc
Tortoise Energy Capital Corporation
Tortoise Energy Infrastructure Corp
Master Limited Partnership Exchange Traded Notes
Investing in MLP General Partners
Guidelines for Investing in MLPs
Balancing MLPs and the Rest of Your Portfolio
If You Sell Your Master Limited Partnership Units
If You Keep Your MLP Units Until You Die
List of Energy/Natural Resource-Related MLPs
Pipelines and Other Midstream Operations, Compressing, Refining
Calumet Specialty Products Partners
Pioneer Southwest Energy Partners
Natural Resources - Coal, Other Minerals, Timber
Penn Virginia Resource Partners
I wrote this book because nobody else did.
You can buy books about Real Estate Investment Trusts (REIT), Canadian income trusts, ordinary dividend paying stocks, bonds and utility stocks. You can buy books that have a chapter or appendix about Master Limited Partnerships.
But -- until now -- you could not buy a book devoted solely to Master Limited Partnerships.
I cover a lot of material that applies to all energy-related MLPs, but my strong recommendation is you confine your investment dollars to those in what are called "midstream" MLPs. More on that later.
I'll start off with a chapter that explains the many benefits of investing in midstream Master Limited Partnerships.
Followed by a chapter on the "catches" -- the aspects individual investors sometimes stumble over.
Followed by information on the business risks of MLPs.
Then information on their history, structure and businesses both from the financial side and the petroleum industry side. This includes why businesses convert their assets to MLPs. And why such high yielding investments are still available in today's otherwise low-yield financial marketplace.
Then we'll cover everybody's favorite topic -- taxes. The tax and tax filing consequences of owning MLP units. I'll also cover the various tax forms and how to complete them.
Then ways of investing in MLPs that, in terms of tax paperwork and filing, are the same as investing in stocks. So you can add MLPs to your tax-deferred accounts or simply avoid the extra paperwork created by direct ownership of MLP units.
How to Invest in MLPs -- All Aspects
There're chapters on MLP i-units, on each MLP-related closed-end fund and MLP Exchange Traded Notes.
Then there're chapters on all the MLP indexes.
Then tips on putting this information together to benefit from MLPs in your taxable broker account and your tax-deferred accounts.
And how to balance MLPs with the rest of your portfolio.
Then a chapter on what happens if you -- against my advice -- sell MLP units.
And a chapter on what happens if you follow my advice and hold your MLP units until you die.
Then chapters on each individual energy or natural resource related MLP available today.
If there are any omissions or errors I need to correct in a future edition (if any), email me at -- rick@inforingpress.com .
Why You're Going to Love Master Limited Partnerships
Before we get into a lot of detail, let me explain up front the bottom line --
Smart Investors -- With One Exception -- Should Love Master Limited Partnerships
There's a lot of reasons for that, and I hope you'll read the best of this book so you understand I'm not speaking off the top of head and so you believe what I'm saying.
(What's the "one exception?" Tax-deferred accounts such as IRAs, 401(k) plans, the government's Thrift Savings Plan, 403(b) plans, Keogh plans and all other such accounts should never own MLP shares. I'll explain why in a later chapter. I'll also examine the various ways people try to get around this, and why they all -- in my opinion, fall short. For now all you need to know is that for ordinary, taxable individual portfolios, MLPs are WONDERFUL.)
But I want you to know -- from the get-go -- why reading this book (and of course, actually acting on this information) will make you money.
Lots of money.
Master Limited Partnerships --
1. Pay out large amounts of cash on a quarterly basis.
This varies, but it's not unusual to find MLPs yielding an average of seven or eight percent.
If you buy an S&P 500 index fund, you'll receive a 1.78% yield (as I write these words in February 2010). If you count only the S&P 500 stocks that actually pay a dividend, you'll still receive only 2.42% yield.
And that's in a stock market which is still below a high it broke in April 1999.
2. For about the first five years you own units of an MLP, roughly 80% of that cash is NOT taxable until and unless you sell your units. If you never sell them, you never pay taxes on that part of the income you received from them.
3. That quarterly cash generally goes up every year. That's not guaranteed or universal of course, but the historical average is around 9% annual growth.
2008 and 2009 were hard on some MLPs, but not as hard as they were on the rest of the world's financial markets.
4. Over the past fifteen years according to one of the MLP index, the types of MLPs this book concentrates on have gone up in market price 550%. That's an average compound total annual return of 14.5%.
The S&P 500 has gone up 120%, or just 5.6% annually.
Those are averages, but the only period MLPs as a whole did not go up in price more than the general stock market was 1998-1999, the height of the dot com high tech boom.
For the twelve-month period ending October 31, 2009 (one of the most unnerving periods in the history of the financial markets), MLPs posted a gain of 24.22% while the S&P 500 went up just 9.80%.
And remember -- the broad stock market is right now still about where it was in April 1999.
5. The amount of cash paid quarterly has one-third the volatility of the S&P 500 stock dividends. That means your cash income from MLPs is three times as likely to remain high or higher than dividends from average S&P 500 stocks -- which can be cut. During the current recession, many were.
6. Market performance does not correlate strongly with the stock market.
This means MLP share prices can rise even while the S&P 500 market is going down. Therefore, owning MLPs can act as a hedge on your portfolio.
I must point out, however, this is historically true in the long run, BUT in the financial crisis of 2008 through March 2009 ALL securities suffered, MLPs included (but not as much as most types of investments).
7. Are in a business with high and relatively inelastic demand -- energy.
Energy demand does fluctuate, and during the 2002 and current recessions, it remained flat -- but not down.
8. Are in a business with growing demand.
Experts believe American demand for energy will continue to grow at least 1% per year for the next twenty years.
9. Do not depend on a high price for gas on oil.
During slow economic periods, the price for oil goes down. But that doesn't affect MLPs. Unlike oil companies, MLPs make a profit whether oil is selling for $10 per barrel or $150.
10. Prices are set by regulators who guarantee they make a profit.
MLPs are regulated by the Federal Energy Regulatory Commission (FERC). They're guaranteed a profit, much like utilities. However, unlike utilities, they're not required to share cuts in expenses with their customers.
This means a good management team has an incentive to cut costs as much as possible -- which means more money for you.
11. If and when society transitions to alternative, non-petroleum based sources of energy, many MLPs can be converted to ethanol and hydrogen.
Mmm, Let's See . . .
An investment that pays out a quarterly cash yield about four times the S&P 500 average, and is largely tax deferred until you sell the security (which means taxes can be forever deferred), and that distribution grows an average of 9% annually, and that security price goes up faster than the S&P 500 average even when the S&P 500 market falls, and which is in a business necessary to civilization as we know it, with price protection enforced by the government, and with a future all but assured . . .
If you're not excited yet, you need to check your pulse or you're so rich already you're bored by money.
So by now you're probably like the people in some radio ads, asking, "What's the catch?"
The "Catches" of Investing in Master Limited Partnerships
There are four.
1. As mentioned above, MLPs are NOT for tax-deferred accounts.
Frankly, if your entire investment portfolio is a tax-deferred account, direct ownership of Master Limited Partnerships are not -- yet -- for you. But there are ways you can benefit from their extraordinary cash flow. I cover these in a later chapter.
2. In February or March of every year, you receive a partnership tax form K-1 instead of an ordinary 1099 in January.
Frankly, K-1 forms are a lot more complicated and confusing than an ordinary 1099 form.
And they require you keep good records, which you should do anyway.
That's why there's a chapter on them in this book. If you do your own taxes, you'll learn what you need.
Plus, any competent accountant knows how to use a K-1 form to prepare your tax return. So if you don't do your own taxes, you don't have to sweat about it all.
And almost all MLPs use an online service to export your K-1 information to Turbo Tax.
3. With some MLPs, you're legally supposed to report your earnings to every state in which the MLP does business.
4. If you are foolish enough to sell your MLP units, your original tax basis amount is taxed as ordinary income. If the price you receive back is higher, the difference is taxed at capital gains rates.
You can obviously avoid this catch, simply by never selling your MLP units. That's my advice.
Maybe you're thinking there must be another catch, something else I'm not telling you.
I don't blame you for not believing all the above benefits. They sound too good to be true, like a fairy tale.
That's the purpose of the remainder of this book -- to explain Master Limited Partnerships in detail, so you understand the technical, legal and practical reasons why they're such great investments.
They seem like perfect businesses to invest it, but there're always risks.
The Risks of Master Limited Partnerships
No investment is free of risk. Therefore, I've compiled a list of the risks faced by Master Limited Partnerships.
1. Business risk
Some management teams simply perform better than others.
2. Regulatory risk
There's always the possibility Congress could someday change the regulatory structure, law, regulations or practices of the Federal Energy Regulatory Commission (FERC) to something less favorable to MLPs.
That does not appear likely right now, but nobody can predict the future.
Their trade group, the National Association of Publicly Traded Partnerships, will fight any such proposal.
3. Terrorism
Some parts of the energy processing system are natural targets.
Pipelines can run for thousands of miles however, so the risk of damage to them is limited. Refineries, oil wells and other areas with a large concentration of equipment are more vulnerable.
Master Limited Partnerships are highly conscious of security. And they buy insurance against terrorism.
4. Weather
In the fall of 2005 we saw how the damage Hurricane Katrina did to the Gulf Coast oil industry drastically affected gas prices.
Some MLPs, such as natural gas and propane, can be adversely affected by warm weather in the winter which slows down demand from people heating their homes.
5. Cap and Trade
This is a proposal for the government to set a limit on the amount of carbon dioxide (CO2) the country could release into the atmosphere. Companies could buy and sell permits to release CO2. Over time, the amount of CO2 allowed would go down.
Industries that release a lot of CO2, such as those that rely on burning oil, natural gas and coal, would eventually have to pay a lot of money for the permits. Those costs would be passed on to consumers, amounting to huge price increases for goods and services.
In effect, the federal government would be claiming the right -- new in law -- to govern the amount of CO2 released into the atmosphere. And it would charge companies for releasing CO2 into the atmosphere.
Because burning carbon fuel has never before been controlled or regulated, this would be in effect a massive new federal tax -- which is why its critics often refer to it as "Cap and Tax."
Any extra taxes on energy usage would adversely affect MLPs.
6. Interest rates
There's a misconception MLPs are a sort of fixed-income security such as a bond. And therefore, when interest rates go up, the price of MLPs goes down.
That is not correct. MLPs are not like bonds at all. However, higher interest rates do mean a higher cost of capital for MLPs, and therefore reduce their profits.
This is true of all businesses. Higher interest rates make it harder and more expensive to borrow money.
7. Economic downturns
The effects of recessions on MLPs is limited, because demand for energy is considered "inelastic." And many MLPs have contracts which require a certain volume of business from their customers.
However, in a drastic scenario, if energy prices go up a lot or Americans are otherwise faced with hard times, they would cut back on energy usage. That would reduce demand for oil and natural gas.
8. Legislative
It's conceivable Congress could pass a law rescinding the tax-exempt status of MLPs.
It does not appear likely, but we cannot predict the future.
Their trade group, the National Association of Publicly Traded Partnerships, will fight any such proposal.
9. Environmental liability damage
No MLP wants to cause an Exxon/Valdez type of tragedy, but anything in life is possible.
All MLPs carry a lot of insurance against environmental problems.
10. Supplies of energy to transport
Every pipeline needs something to transport. If there's a disruption of oil or natural gas supply, that can be a problem.
This could be caused by a disruption affecting imported forms of energy. For example, a war in the Middle East.
It could also be caused by one customer going bankrupt or taking their business to another pipeline.
11. Equity Crisis
MLPs depend on ready access to capital, especially because they're required to distribute their cash to unit holders.
During a liquidity crisis such as 2008-2009, access to capital is a lot more difficult and more expensive.
12. Legal problems
Any person or company with cash can become a target for lawsuits. MLPs are no exception.
13. Exposure to energy price fluctuations
There's a misconception Master Limited Partnerships are a way to invest in "commodities."
In general, especially for the "midstream" MLPs this book recommends, that is not true. Pipeline MLPs make money by transporting crude oil, refined petroleum products and natural gas based on volume, NOT their cost.
However, some MLPs are involved to some degree in other parts of the energy business process. That is, they can be hurt when energy prices are low.
Midstream MLPs can be hurt to a degree when energy prices are so high they discourage consumption -- and therefore their volume of business is reduced.
14. Extreme technological change
What if someone invents a cheap and easy way for everyone to use solar, wind or water power for everything we need from running our cars to powering our computers?
There'd be no need for carbon-based energy products.
However, nobody believes this is more than a "green" daydream -- at least for now.
Master Limited Partnerships are real world businesses. They face real world problems. For investors, they have many advantages.
The real world comes with problems.
However, MLPs deal with them as well as possible.
And all other businesses face many of the same risks. For instance, when interest rates go up, all businesses are affected. Therefore, there's no way for a stock market investor to "escape" that risk.
(You could buy bonds, but then you're exposed to the investment risk of owning bonds.)
Master Limited Partnerships Have One Major Advantage Over All Other Businesses -- Everything Else Relies on Them
Energy is the most basic, fundamental need of human beings and our civilization.
You can freeze to death faster than you can starve to death.
And food depends on fertilizer, which uses energy.
Besides, while "food" in some form is a basic need, consumers can choose whether or not to buy chicken or spaghetti or go out to McDonalds.
You have many fewer choices about the forms of energy you must use in your daily life.
Let's see. You can now choose to drive a hybrid or an all-gasoline car. To buy Regular or Premium gasoline. To cook with gas or electricity. Or to put a windmill in your backyard or solar panels on your roof.
That's about it.
For the foreseeable future, until we build a totally green society based on local, renewable energy or descend back into primitive barbarity, we need the forms of energy Master Limited Partnerships deliver to us.
But just what is a Master Limited Partnership?
Let's start by examining what is a limited partnership.
What's a Limited Partnership
A Master Limited Partnership is a special form of limited partnership.
So, to understand them, it helps to understand what a limited partnership is.
And to understand limited partnerships, let's start with partnerships.
You and Joe Start a Pizzeria
Let's say you and your buddy Joe have a great idea for a pizzeria. You work together, you both put in some money, you both work long and hard to make the business successful.
You and Joe are partners.
You own the business together. You've both invested your time, sweat and money. At the end of every month when your accountant figures out your profits, you and Joe split them fifty-fifty.
You don't think about it much, but you and Joe are also splitting the risk -- only that split is not fifty-fifty, it's more like one hundred-one hundred.
How can that be? You both are fully liable for the business debts and problems.
One day Joe mixes up a batch of bad pizza dough, and it turns the customers' hair green. They find a good class action lawyer and sue you and Joe for one million dollars.
You get a lawyer too but, what you can do? -- the customers have green hair, so you lose the case. You and Joe sell the pizza oven on eBay and give them that money, but it's a far cry from one million dollars.
With the pizzeria closed, the customers' lawyer goes after you and Joe personally.
Turns out Joe has no money. You, however, have a nice house and some stocks in your brokerage account.
When the opposing lawyer comes to collect the million dollar court settlement, they get nothing from Joe, but take your house and your stock -- all one million dollars.
Yes, although you were not responsible for turning the customers' hair green and although you received only half the profits of the business, you're responsible for one hundred percent of its debts. Just because they couldn't get any money out of Joe.
You and Joe are Pizza Partners Again
Now let's say your buddy Joe is the only one who wants or knows how to run a pizzeria. You don't have the time or expertise.
But you've got the money it'll take to buy an oven, cheese and sauce, rent out a location, hire some employees, and advertise on the radio.
Joe makes you an offer. You put up the money. He does all the work. At the end of the month, you still split the profits fifty-fifty.
You know Joe and you're sure he knows a lot about running pizzerias. You also believe he's honest and competent and you trust him.
So maybe you figure that's a good deal. Joe works eighty hours a week in the business. You work zero hours. But you receive half the profits.
Besides, you figure if the business goes under, you can also sell the pizza oven on eBay and make back half your money.
(In the real world, the details could change. Depending on how well you and Joe know and trust each other, and how desperate he is for the startup capital you might receive ten percent or net profits or ninety percent.)
(Also, many times the partner with the money is a seasoned, successful business person. They don't work the business, but they give advice that helps the business succeed, not just money.)
Again, all goes well for a while -- and then Joe mixes that batch of bad pizza dough and the customers' hair turns green and you again wind up paying the entire million dollars.
Ordinary Partnerships Are Risky Forms of Business
This is why any business adviser worth their salt will tell you to be extremely careful who you go into business with. In an ordinary partnership, they split profits fifty-fifty but are each responsible for one hundred percent of the debts.
It's not unusual for one person to abandon the business, sticking the other partner with all the debts.
Limited Partnerships Limit the Risk
Now, let's say that Joe is still trying to raise the money to start up his pizzeria and he approaches you.
He needs more money than you can pay by yourself. But you have nine good friends who'd like the chance to invest in a pizzeria and share in the profits while Joe spends eighty hours a week topping pizzas with pepperoni in front of a five hundred fifty degree pizza oven.
The nine of you agree to each put in the same amount of money and to share equally in the profits.
As the worker, Joe will get fifty percent of the net profits.
The ten financial backers will each get one-tenth of the remaining fifty percent, or 5% each.
However, the ten of you are street smart. You've been burned before. You trust Joe, but you still want to make sure you'll never be ripped off again.
Therefore, you go to a lawyer who draws up an official partnership agreement you all sign off on.
You ten financial backers agree to put in the required money. (Let's say $10,000 each.) In return, you agree to accept 5% of net profits every month.
You also agree you will not try to run the business for Joe.
Joe agrees to run the business. He will not put in any money, but he is one hundred percent responsible for hiring, firing, making pizzas, delivering pizzas and so on.
He also agrees the ten of you are not responsible for putting in any money other than the original $10,000.
This is a limited partnership.
You and your nine friends play a significant but limited role -- you put in $10,000 each.
You do no work.
You have no other risk.
When Joe mixes up that bad batch of dough and turns the customers' hair green, what happens?
The business closes. Joe sells the pizza oven on eBay and turns over that money to the opposition attorney.
The other attorney goes after Joe. Because Joe has nothing more to pay, the customers and their lawyer wind up with next to nothing.
You and your friends have lost your $10,000 investment. You're not happy about that. But nobody sues you or your friends for your personal money.
Why not?
Limited Partners in a Limited Partnership are Responsible Only for the Money They Invest in the Business
Your liability is limited by the terms of the partnership. Yes, you do lose the $10,000 you invested in Joe's Pizzeria -- but that's it. You keep your house, your bank account, your stocks, and everything else.
The opposition lawyer has no legal recourse against you -- unless perhaps he can prove you were somehow responsible for mixing up that batch of bad dough.
So you're safe.
In this case, Joe was the partnership's General Partner.
You and your nine friends were the partnership's Limited Partners.
The General Partner runs the business.
The Limited Partners put up the funds but generally have nothing to say about running the business. That's the job of the GP.
And Limited Partners have limited risk -- it's limited to the amount of money they invest. They can lose that, but nothing else.
A lot of businesses are Limited Partnerships. As you can see, they make a lot of sense.
Now, as I Mentioned, a Master Limited Partnership is a Special Kind of Limited Partnership
Let's say after a few years of being a Limited Partner behind Joe's Pizzeria, you decide you'd like to sell your share of the partnership and move to Florida. You enjoy the monthly income, but you need a lot of cash to buy a condo on the beach.
Unless it's forbidden by the original partnership agreement, you can do that.
Maybe you have another friend who turned down the original deal and now he's sorry, because Joe and his pizzeria are so successful.
So you go to that friend and negotiate a deal. You sell him your share of the Limited Partnership for whatever amount of money the two of you agree is fair.
Maybe $10,000, maybe a lot more. That's between the two of you.
After you accept his money and sign the paperwork, you have no more right to that 5% of Joe's Pizzeria's monthly net profits. They go to your friend while you go swimming at the beach in Florida.
And if Joe mixes up that batch of bad pizza dough a month later, that's tough luck for your friend.
But let's say you don't know anybody who wants to buy your limited partnership share of Joe's Pizzeria.
What can you do?
Aside from beating the bushes, advertising on Craig'sList, listing it with a business broker and otherwise looking around for willing buyers -- nothing.
Somebody can buy it from you, but you have to find them through informal channels of friendship or business, or through a listing with a business broker. It could take some time.
But let's say you really want to buy that Florida beach condo and you have enough stock in your brokerage account, what could you do?
Simple, sell the stock. Call your broker. Boom. It's done. You get the funds in three days.
Wouldn't it be nice if you could have sold your share in the limited partnership just like shares of stock, by calling your broker have having someone on the New York Stock Exchange buy it from you right away?
That, in Essence, is What a Master Limited Partnership Is
Limited Partnerships in certain businesses can be bought and sold on stock exchanges just as though they were shares of stock.
Pizzerias are not one of those kinds of businesses, and that's just as well.
History of Master Limited Partnerships
The first publicly traded partnership was Apache Oil Company, launched in 1981. Other oil and gas, and also real estate limited partnerships, followed.
In 1987 Congress passed more legislation to define and limit publicly traded partnerships. This created Section 7704 of the Tax Code.
Sec. 7704(b) allows units of some limited partnerships to sell on stock exchanges and through the secondary market just as though they were common shares of corporations. These are, therefore, Publicly Traded Partnerships (PTP).
However, Not All PTPs are MLPs
Under Section 7704(a), a publicly traded partnership is normally taxed as a corporation. This book is not about PTPs which are taxed as corporations.
Under Section 7704(c), a PTP can be taxed as a partnership if 90% of its income can be classified as passive, "qualified income." That is: interest, dividends, real property rents, gains from the sale or other disposition of real property, income and gains derived from natural resources, gains from the sale or disposition of a capital asset, and income and gains from commodities.
Mineral or natural resources activities include exploration, development, production, mining, refining (including fertilizers), marketing and transportation (including pipelines), of oil and gas, minerals, geothermal energy, or timber.
A PTP that receives 90+% qualifying income from energy and commodity related businesses is a Master Limited Partnership, with a lot of tax benefits.
A PTP not receiving 90+% qualifying income must pay taxes as a corporation.
Some PTPs that did not receive qualifying income were grandfathered. Most of these have since gone private, been acquired or have converted to other business entities. Only two of them are still PTPs.
And MLPs do not have to pay any income taxes so long as they distribute at least 90% of their earnings to unit holders on a quarterly basis. Those are called Quarterly Required Distributions (QRD).
This makes MLPs "pass-through" entities. The cash passes through their hands into yours. This eliminates the double taxation of income issue that is so unfair to shareholders of corporations, allowing you the investor to keep a lot more cash.
By around 1995, however, there were only six MLPs listed on the stock exchanges.
However, the structure has gradually become more popular with energy companies and better-known to investors. Now, around seventy Master Limited Partnerships are available.
In the President Bush's 2008 Emergency Economic Stabilization Act (EESA) (P.L. 110-343) -- also known as TARP or "the bailout bill" -- the definition of qualifying income was expanded. MLPs can now earn income and gains from industrial carbon dioxide; the transportation and storage of alcohol and biodiesel fuel mixtures; some alternative fuels; neat alcohol not derived from alcohol, gas, or coal or having a proof under 190; and neat biodiesel.
Therefore, MLPs can now adapt to "green" power as necessary in the future, and still receive the benefit of no taxation.
No Taxes on Master Limited Partnerships Means More Money for You
You can probably figure out the general benefit of owning a piece of a business that doesn't have to pay taxes, but I want to go into more detail because so many Americans don't understand how unfair the double taxation of corporate income is.
Double Taxation of Corporate Dividends Explained
You own 100 shares of the XYZ Corporation. Let's say that's 1% of the total shares of the corporation. The XYZ Corporation figures out their 2007 net income is $1 million. Logically and technically, 1% of that -- $10,000 -- belongs to you.
However, the XYZ Corporation has to pay income taxes on that $1 million. For the purposes of illustrating this point, let's say they have to pay 35%, which is $350,000. They write that check to the IRS and send it in with their tax return.
Therefore, they have $650,000 left.
Remember -- your 100 shares of XYZ stock makes you a 1% owner of the corporation. So you as 1% owner just paid $3,500 in taxes to the IRS. You as 1% owner now have $6,500 remaining inside XYZ Inc's bank account.
XYZ Corporation's Board of Directors votes a 50% payout dividend, which is generally as generous a dividend as a corporation is ever going to pay. Soon after, you get a check for $3,250. That's one-half of the remaining $6,500.
If the corporation didn't have to pay income taxes, you'd be getting $5,000 (One half of $1 million times 1%).
But now that you've gotten your $3,250 dividend check -- guess what?
The IRS wants some of that money too!
In effect, as a 1% owner of the XYZ Corporation, you have already paid $3.500 in taxes.
Yet now that you've gotten a $3,250 check with your name on it, the IRS wants a cut of that too.
So it's true that dividend investors get whacked twice by the IRS.
One of the great things about Master Limited Partnerships is they don't pay taxes. Of course, you do. But you'll receive a lot more income from them on which to pay the taxes.
But just what do these businesses do to create so much cash flow?
The Business of Master Limited Partnerships
The business of energy (oil, coal, and natural gas) is technical and complicated.
However, it can be boiled down to three components:
1. The beginning (upstream)
2. The middle (midstream)
3. The end (downstream)
The beginning consists of exploration (finding the energy source) and then extraction (digging or pumping it out of the ground).
The middle consists of processing (refining), storing and transporting the energy from the beginning to the end.
The end of course is when it's sold to the end user. You buy gas at your local gas station. You pay your gas bill to a local utility company.
The beginning and the end get all the attention.
Perhaps that's just a natural result of human perception. If you're given ten items to remember, you'll remember the first ones and the last ones but struggle with the middle ones.
The beginning of the energy business is romantic and dramatic. Texas wildcatters gambling their fortunes on the next big oil field and Arab sheiks riding around on camels.
The end of the energy business gets our attention every time we fill up at the gas station or pay our light and gas bills.
Yet we tend to forget a huge infrastructure lies between the two. We normally take it for granted.
Getting Gas and Oil From There to Here
In the U.S., 280,000 miles of pipelines transport 63 billion cubic feet of natural gas. About 25% are held as Master Limited Partnerships. Another network of 100,000 miles of pipes hauls 20 million barrels of crude oil daily. About 70% of that belongs to MLPs.
Crude oil must also be refined. Gas is processed into Liquidified Natural Gas (LNG). It must be transported, often in special tankers. These products must be stored until they're used. And so on.
Some MLPs are also involved with the exploration and production phases of energy.
If you want to invest in "energy" because we're running out of easy supplies of it while world demand is growing, I certainly can't and won't argue with that logic.
However, you'll face ups and downs in energy prices.
If you stick to energy infrastructure MLPs ("midstream"), you'll make money from the entire energy process no matter what the price of a barrel of oil.
The pipelines are regulated by the Federal Energy Regulatory Commission (FERC).
When they started, FERC set a certain tariff. That is, companies shipping their oil and natural gas through the pipes pay a certain amount per volume.
Every year, that amount goes up based on the Producer Price Index (PPI) for Finished Goods -- which is the business version of the Consumer Price Index (CPI) -- plus an additional 1.3%. That is set by the 1992 Congressional Energy Policy Act. The rate increase goes into effect on July 1 of every year.