- What is a MLP (master limited partnership)?
- Tax Breaks
- From the Wool to the Tailor
- Upstream MLPs: The Shepherds
- Midstream MLPs: The Runners
- Downstream MLPs: The Dealers
- Partnership Profits
- Enterprise Products Partners (NYSE: EPD)
- Grab Your Partner, Dough See Dough Doe
“If everyone is moving forward together, then success takes care of itself.”
Henry Ford
There is nothing quite as powerful as a solid partnership. Partnerships can take many forms: romantic, platonic, business, and pleasure. But one thing is assured in a healthy partnership: both sides lift each other up to a higher plateau than they could alone.
Investing-wise, that much is true when considering Master Limited Partnerships or MLPs.
Even the savviest investor could be forgiven for not giving MLPs a look. They aren’t well-known, aren’t news-grabbing, and are a bit confusing…
MLPs are a relatively new investment vehicle for pulling in some very serious, steady income. The average MLP dividend yield is 8% or so, which absolutely crushes the S&P 500 average.
Here’s what they are and why you should hold them in your portfolio if you want to collect outsized dividend payouts.
What is an MLP (Master Limited Partnership)?
As Investopedia clearly lays out:
A master limited partnership (MLP) is a type of business venture that exists in the form of a publicly traded limited partnership. As such, it combines the tax benefits of a partnership – profits are taxed only when investors actually receive distributions – with the liquidity of a public company.
The MLP is a hybrid legal entity that combines elements of two business structures—a partnership and a corporation. First of all, it is considered the aggregate of its partners rather than a separate legal entity (as is the case with a corporation).
Second, it technically has no employees. The general partners are responsible for providing all necessary operational services. General partners usually hold an approximate 2% stake in the venture and have the option to increase their ownership.
If you couldn’t tell, when I said “clearly,” I was clearly joking… MLPs are a complicated income stream that I’ll attempt to explain in easier language…
First things first — MLPs are indeed a “limited partnership” that is publicly traded like a stock.
The “master” or “general” partners are the guys running the show. They are responsible for operating the business and making all the decisions on how to run said business.
The “limited” part is the investor, like you and I. That is who is funding the projects through their investments. We are also the ones cashing the dividend checks.
But not just any company can call itself an MLP, reap the tax benefits, and shower investors with dividends… There are rules.
So what kind of business qualifies as an MLP?
Well, for starters, an MLP must generate at least 90% or more of its income from the production, processing, storage, and transportation of depletable natural resources and minerals.
This includes:
• Oil, gas, and petroleum products
• Coal and other minerals
• Timber
• Ethanol, biodiesel, and other fuels (transportation and storage only)
• Any other resource that is “depletable” under section 613 of the Federal tax code. That means wells, mines, and natural deposits that deal with substances like uranium, precious metals like gold, silver, and platinum, and industrial metals like copper, cobalt, and lithium.
Tax Breaks
So, how is an MLP any different from a regular stock? There are some tax difficulties involved… and they are a bit complicated. For one, you get a nice tax break on your gains. You actually only pay taxes on some of the dividends you collect.
Since an MLP is treated by the IRS as a “limited partnership,” profits and losses have a “flow-through” (they love the whole “stream” metaphor) tax structure. That means the MLP doesn’t post taxes on its revenues, and investors are only liable for their portion of the MLPs earnings.
Plainly, that means you aren’t double taxed — you only pay your portion, not the runoff from the company’s tax as well. Because of what the bean counters call “depreciation allowance,” up to 90% of your payouts are not taxable when you get them. It is referred to as a “return of capital.”
That allows you to defer taxes. A return of capital essentially returns the money you invested back to you, and taxes on a return of capital are deferred until you sell the MLP.
Let’s say you have $1,000 invested in an MLP that pays 6% in dividends per year. You would receive $60 in dividends. If 80% of that income is a return of capital and tax-deferred, you only pay taxes on $12 of the dividends that year.
(It can get a little complicated, so it would be wise to work with a tax professional when dealing with MLP sales.)
Now that we have that stuff out of the way let’s explore the three different kinds of energy-based MLPs.
From the Wool to the Tailor
An easy way to think about it is like buying a nice suit. That three-piece ensemble doesn’t magically appear at the department store. There are several steps to get that suit from the wool to the tailor to the shop.
1) Upstream: The Shepherds
Upstream MLPs involve companies that focus on finding and recovering energy sources. That means exploration, recovery, development, and production companies. I’d call these “the producers.” They make the product and move it downstream to get shipped and sold by others.
These would be like the shepherds. They will raise the sheep, shear them for the wool, and scour the wool to make it ready for transportation. But in order to make the money, they first have to move that product.
That’s where midstream MLPs come in…
2) Midstream: The Runners
Midstream MLPs are the ones that gather, store, and transport the materials. I’d call these “the runners.” They would be the ones to take the wool, wrap it in jute — or fine rope — and store it in safe environments to protect it from the elements. Midstreamers would then ship it around the world in trucks or on ships or trains.
For my money, I like to stick with midstream MLPs because they have a rather stable business model and consistently send out dividend payments. When investing in dividend stocks, my philosophy is to be as even-keeled and predictable as possible. Upstream companies are highly vulnerable to commodity prices; it’s much harder to justify exploring and drilling for oil and gas if they are trading low. Downstream companies are more dependent on how the economy is faring. You tend to sell far less when consumers are tightening their belts.
Midstream companies, however, are often likened to toll collectors. As I mentioned, midstream companies transport and store oil and gas, including pipelines, storage facilities, and processing plants. They are much like REITs, where you collect “rent” checks from the companies you invest in.
With midstream MLPs, you collect “tolls” as commodities pass through their infrastructure. We are all going to need that crude to move around the country. We’re always going to need a place to store it. And we’ll have to process it into usable energy. You can collect large dividend checks every step of the way.
3) Downstream: The Dealers
Downstream MLPs are “the dealers.” These are the folks who take the product and parse it out to the general public — the point of sale. This is when the product — say oil or gas — is marketed, distributed, and sold to customers. These are the suit makers and sellers. They take the wool, work with haberdashers to make nice suits out of it, and sell the suits at a markup at fine clothing stores.
The long and the short of it is everyone down the “stream” gets paid for their part of the trade. And as an MLP investor, you get paid without having to involve yourself in any of those steps.
You simply collect the checks…
Partnership Profits
Here is my choice for a solid, high-dividend midstream MLP.
Enterprise Products Partners L.P. (NYSE: EPD)
Enterprise Products Partners L.P. (NYSE: EPD) is a prime example of a great MLP. It is relatively new to the midstream MLP game, having been founded in 1968 and going public in mid-1998. Since then, it has grown to a $53 billion company with a dividend yield of 7.99% – right on par with the industry average and over five times the broader S&P 500’s 1.5% yield.
The company has also increased its dividend for 24 consecutive years – one year away from coveted dividend aristocrat status.
They have also returned $45.1 Billion to shareholders from limited partnership distributions & unit buybacks.
Enterprise Products Partners, simply put, is in the business of storing and moving gas and petroleum products. One of EPD’s major advantages is its location. Its network of pipelines and facilities comes very close to the Permian and Eagle Ford formations, which have – and will – see a majority of production growth in coming years.
About 70% of natural gas liquids (NGLs) growth is coming from these two formations. NGLs already account for 56% of EPD’s gross operating margin. Plus it extends to the Northeast coast, which is a massive source of domestic demand.
Enterprise also has storage assets that can hold more than 260 million barrels of liquified natural gas, refined products and crude oil. These assets can store 14 billion cubic feet of natural gas.
EPD has also committed $5.5 billion of major capital projects under construction that should help them claim even more fee-based revenues.
You can see EPDs various revenue streams here:
You may be asking yourself, “If the world is shifting to renewable energy, how stable is a company that deals primarily in oil and gas?”
Pretty darn stable…
- Demand for oil & gas expected to increase by 18% by 2040 per IEA
- It is required to back up intermittent wind / solar / hydro
- Extraction of green metals (cobalt, lithium, nickel, copper, rare earths) will need to significantly increase
- China currently dominates the mining and processing of green metals
Add to that the European energy crisis due in large part to the Russian invasion of Ukraine. European and Asian gas prices spiked to $60–70/MMBtu following the invasion, and Russia has cut natural gas exports by 85%. European countries like Germany are planning for gas rationing this winter.
The U.S. is the leading exporter of LPGs globally, and EPD is one of the largest LPG exporters in the world.
Enterprise Products Partners L.P. (NYSE: EPD) Stats:
Current price: $23.78
52-Week Range: $20.42 – 28.65
Market Cap: $53 billion
P/E Ratio: 10.89
EPS: 2.22
Dividend Yield: 7.99%
Grab Your Partner, Dough See Dough
The world of energy is a cyclical one. We’re going through a turbulent time for the global energy markets.
As my colleague Adam English wrote last week:
Whether we like it or not, the energy sector remains completely dependent on fossil fuels. If anything, more so than ever.
Emerging markets are collapsing under high fuel costs, food costs, and inflation. Europe is hemorrhaging money to try and mask its critical flaw while already at troubling debt levels.
The global energy market is facing geopolitical risks, with countries and companies trapped between costs spiraling upwards and outlooks spiraling downwards. The war in Ukraine is a smoldering dumpster fire, and things can get far worse in winter if Russian energy exports go lower.
In the meantime, energy companies – at least the responsible ones – have cleaned up their balance sheets, are returning money to shareholders, and are leveraging experience from years of volatility from other forces to weather another storm.
MLPs like Enterprise Product Partners are perfectly positioned to weather the storm and provide midstream services during and into the new transition to cleaner fuels. Liquid natural gas will be a massive component of that transition.
And like I said before, MLPs – like all energy companies – are cyclical. So instead of losing money if there is a downturn in energy, you can dollar-cost average your MLP investments while banking a larger dividend and scoring a tax break.
Midstream MLPs are there to collect those tolls in every situation.
If you’re looking for high-yield income, you’ve found the right partner.
Godspeed,
Jimmy Mengel
The Profit Sector
