Master Limited Partnerships: Pipelines Or Pipe Dreams?
Master Limited Partnerships (MLPs) are extremely speculative securities products. MLPs provide investors the opportunity to buy shares of oil and gas partnerships in the form of a publicly traded partnership. MLPs are not stocks, although they may trade on the public exchange. The IRS requires MLPs to distribute their available cash to investors, which has led many investors to regard them as a good source of steady income. If managed correctly, MLPs may also offer tax advantages.
Brokers may advertise units of Master Limited Partnerships as low-risk opportunities to secure regular income, but that description does not include a full picture of the risks associated with these partnerships.
Master Limited Partnerships Definition
The IRS requires that MLPs make at least 90% of their revenue from real estate or natural resources.
Master Limited Partnerships feature two types of partners: General Partners (GPs) and Limited Partners (LPs). The general partner manages the MLP, generally has a 2% interest, and receives payments based on the MLP’s performance. Investors serve as the limited partners. They have no say in management but receive distributions. Individual shareholders are called “unitholders.”
There are riskier versions of MLPs that only trade privately. Privately traded MLPs are unsuitable for the vast majority of investors. Brokers who recommend non-traded MLPs may be suggesting an unsuitable investment in violation of FINRA Rule 2111.
There are three basic types of natural resource MLPs:
- Upstream Funds — Upstream funds own mineral and royalty rights. They also own exploration and production operations.
- Midstream Funds — Midstream funds focus on gathering, processing, transporting, and storing oil.
- Downstream Funds — Downstream funds are involved in refining and marketing oil.
Midstream MLPs and Pipelines
Approximately 80% of all MLPs are midstream MLPs. Midstream MLPs are especially popular because they do not rely on oil prices. They typically own infrastructure like pipelines — infrastructure that gets oil from point A to point B. Midstream MLPs only need to have a reliable product flow to generate returns for their investors. Investors may have heard midstream MLPs referred to as “toll road” MLPs.
From 2009 until 2014, MLPs performed exceptionally well thanks to the boom in U.S. oil production. Starting in 2014, oil production in the U.S. began to wane. Because so many MLPs invest in pipelines, the lessened need for pipelines greatly affected the overall performance of many MLPs. Investors realized that the MLP sector might have limited growth potential.
MLPs rebounded in 2018 and suffered again in 2020 when the oil demand plummeted. While many MLPs have cut back on their distributions, some have adapted to changes in the market by cutting capital expenditures.
MLP Tax structures
MLPs are not taxed at a corporate level — they are “pass-through entities,” meaning that the company passes the tax burden to the investor. Unitholders typically receive a quarterly dividend payment based on the MLP’s earnings.
- When MLP unitholders pay taxes, they get to factor in depreciation of assets, reducing their overall tax burden.
- The distributions unitholders receive are tax-deferred until the security is sold.
- Note: Tax-deferred does not mean tax-free. Unitholders may think they do not need to worry about the tax consequences of their MLP distributions because they do not intend to sell. However, unitholders may want to sell sooner than planned for the reasons listed below.
Risks of MLPS
Financial experts warn that MLPs are not fixed-income alternatives. The energy market is too unreliable for MLPs to work for investors who simply want regular distributions.
Demand Fluctuations. Regardless of price, the oil and gas industry experiences huge fluctuations in supply and demand. During Covid, the demand for fuel plummeted as more people stayed at home. The Alerian MLP index dropped to its lowest level in 10 years. In 2021, as travel ramped up, the demand skyrocketed, but OPEC did not cooperate with requests to increase oil production. No one can predict these types of fluctuations, and everyday investors should not take on the risks associated with such an unpredictable commodity.
- Use of Leverage. MLPs might also borrow significant quantities and may have to pay back their lenders before they pay investors. In an economic crisis, banks might cut back on their lending, limiting an MLPs ability to raise funds.
- Unexpected Taxes.
- MLPs are only tax-deferred until the unitholder wants to sell their security. Once they sell, the unitholder could wind up with an unexpected tax bill.
- Because the IRS considers income earned through an MLP to be a return of capital, payments to unitholders reduce their overall cost basis. Once the cost basis equals zero, the IRS treats the distributions as capital gain, which will add to the unitholder’s tax bill.
- Corporate Roll-Ups. Corporations sponsoring MLPs have the option to consolidate the MLP and give unitholders corporate stock in exchange for their shares of an MLP. This might benefit the company’s shareholders but is a blow to the MLP investors, who will have to pay taxes on the new additions to their stock portfolio.
What Should MLP Unitholders Look Out For?
Remember, the more the Master Limited Partnership promises to pay investors, the more it pays its manager. These high payments may incentivize a manager to promise more than they can deliver. Investors should make sure their broker accurately represents how the profits will be divided between general and limited partners.
Brokers might over-concentrate their investors’ portfolios in these risky securities to reap more of the outsized commissions. Ask your broker how much commission they receive on their MLP recommendations if they do not volunteer that information.
Before You Buy an MLP:
Midstream MLPs typically come with big commissions for brokers and financial advisors. Brokers may claim that MLP units come with returns as high as 7% or 9% — while those returns may be possible, they are far from guaranteed. Your broker should always inform you of any risks associated with an MLP unit.
If you believe a broker-sold you an unsuitable share of an MLP, contact a securities lawyer to figure out the next steps to get your money back.