Why I Still Like MLPs For High Yields In 2023…
They’re one of the most popular investment vehicles on the market today – for investors who know about them.
Some are drawn to their stable cash flows and favorable tax treatment. Others appreciate their durable, fee-earning assets and predictable dividend hikes.
Oh, and did I mention that they also routinely offer rich yields of 6% to 8%?
I’m talking about master limited partnerships, or MLPs.
First created in the 1980s, this special class of securities packages the liquidity and accessibility of common stock with the tax advantages of a partnership. Ownership is divided up into units, rather than shares, but they trade similarly on an exchange.
From a legal standpoint, these entities are structured as “pass-through” vehicles, much like real estate investment trusts (REITs). That means they enjoy a unique perk: provided they distribute at least 90% of their taxable income to unitholders, MLPs don’t have to pay corporate taxes.
As a result, they can afford to dish out handsome yields three to four times the market average.
These businesses were built to handle natural resources. A few are involved with coal and timber, but most operate in the oil and gas sector. Only a handful actually produce these commodities (so-called upstream MLPs). The rest own pipelines, storage terminals, processing plants, and other midstream infrastructure.
The Case For MLPs
As you may be aware, the United States has surpassed Saudi Arabia as the world’s largest energy producer. Thanks to bountiful shale plays such as the Permian Basin of West Texas, the nation’s crude oil output has topped previous highs set in the 1970s, and continues to climb. Natural gas production has also spiked to recent record highs.
According to the Energy Information Administration (EIA), the United States was recently a net oil exporter for the first time in 75 years. But this boom wouldn’t be possible without pipelines and other critical infrastructure.
And that spells opportunity for investors.
Given this, it’s no surprise that MLPs have been swamped with demand. Typically, these companies sell out the capacity on a new pipeline project long before construction even begins. In fact, oil production has exploded so quickly in some drilling hotspots that pipeline owners haven’t been able to keep pace.
Even better, these assets aren’t really exposed to volatile price fluctuations. Some facilities (such as processing plants) are partially dependent on the spreads between different commodities, but most of these assets earn fixed fees based on the volume of products flowing through, not their underlying prices.
Translation: It doesn’t matter if the crude flowing through sells for $50 or $100 per barrel, the pipeline owner gets paid the same regardless.
Things To Consider…
As with any asset class, MLPs do involve certain risks.
Because MLPs dish out most of their profits to investors, they don’t retain much cash to invest for tomorrow. So they periodically tap the capital markets for funding. When access to cash tightens and borrowing costs rise, these companies can run into liquidity problems. That’s why it pays to evaluate the balance sheet as well as the income statement.
Also, keep in mind that part of the appeal of these vehicles stems from their high yields. As such, they compete with other fixed-income instruments. That makes them somewhat vulnerable to rising interest rates. If equally attractive returns can be found elsewhere, then investors will rotate money out of higher-risk MLPs and into lower-risk bonds.
One last thing to consider. While MLP distributions are generous, they can create some headaches at tax time. These companies typically issue complex K-1 statements, rather than the simple 1099-DIV. They might also be unsuitable for IRAs and other retirement accounts due to the generation of “unrelated business taxable income” (UBTI). Consult your tax advisor.
But those drawbacks are offset by some key advantages. Because of hefty depreciation charges, cash distributions often exceed partnership income. When that happens, the dividends are treated as a return of capital to the limited partners. This income isn’t taxable, it simply reduces your cost basis, allowing for tax-deferred growth until the units are sold.
More Income And Growth Ahead
With cash flows tied to multi-year contracts, these fee-for-service businesses offer some of the most stable cash flows around. And as they expand, so do their dividend distributions.
One longtime favorite in this space has raised distributions 67 times in the past 70 quarters. Another has increased its distribution 77 times since 2001, raising its annual dividend by 660% as of this writing.
With most of the profits going back to shareholders, what will drive growth in the years ahead? Well, if these companies profit by gathering, transporting, storing, and processing commodities, then the surest path to boost distributions is to plow more capital into expansions and new construction projects.
But due to environmental backlash and tighter regulations, new pipelines have become increasingly tougher to build in North America. President Biden revoked the permit for the Keystone XL pipeline on his first day in office. That makes existing oil and gas conduits even more valuable.
Keep in mind, producers like Occidental (NYSE: OXY) have targeted 11,000 undeveloped drilling locations in the Permian Basin alone. That’s just one company. As we continue tapping into massive shale deposits, nearly all of this incremental production will travel by pipeline from the wellhead to regional refineries and processing plants and export terminals.
And somebody will get paid to move it.
Bottom line, I believe these pipeline and storage owners will continue generating outsized returns for years to come. My advice: if you’re looking for high yields in 2022, this is where you should start your search.
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