The Advantages (and Risks) of Master Limited Partnerships

Investors looking for opportunities in the energy sector are likely to come across master limited partnerships (MLPs).

Since this investment option may be unfamiliar to many, let’s take a look at the potential advantages (and risks) of master limited partnerships.

What Is a Master Limited Partnership?

These publicly traded partnerships can provide the benefits of a limited partnership while offering the liquidity of publicly traded securities. MLPs are most commonly found in the energy industry, including in oil and gas production, transportation and storage. They typically own and operate cash-generating assets (like pipelines, terminals and refineries) that are involved in nearly every aspect of activities relating to minerals and natural resources.

Master limited partnerships trade on stock exchanges just like regular stocks, enabling investors to buy and sell MLP units on a daily basis. Unlike traditional equity investing, however, MLPs entitle investors to a share of the partnership’s income and cash flow annually in the form of a dividend.

The majority of MLPs “forecast” their intended minimum cash distribution for the next 12 months. Payments are typically distributed on a monthly or quarterly basis. Many MLPs also vow that they plan to continue to pay, and potentially increase, distributions over time depending on cash flows, acquisitions or successful development of productive properties. But this is not guaranteed.

An MLP is formed by two types of partners: General partners and limited partners. General partners are charged with managing the MLP’s operations, and they assume complete liability. They are appointed by the sponsor of the MLP (often a public company) that contributes the initial assets and appoints the general partner’s board of directors. Limited partners are hands-off investors who contribute capital and receive income distributions.

What Are the Advantages of Master Limited Partnerships?

Tax benefits. MLPs’ tax advantages are a primary draw for investors. Since they are classified as partnerships, MLPs are not subject to corporate taxes. Rather, the majority of income is passed to the limited partners, who are then subject to paying taxes on their individual portion of the MLP’s income—thus avoiding the “double taxation” that occurs with investments in regular corporations. With MLPs, you’re only taxed once, on your individual income.

Yield. Since MLPs are required by law to distribute the majority of their income, these securities characteristically can offer competitive distribution yields, particularly in low-interest-rate environments. But remember that MLP distributions aren’t guaranteed and can fluctuate based on the MLP’s performance and energy market conditions.

Growth. When the domestic energy industry is strong and demand for oil and gas transportation and storage is growing, MLPs can appear very attractive. The general partner of an MLP has the ability to increase the partnership by building more infrastructure assets or acquiring assets from a competitor in order to increase income distributions over time.

Inflation protection. Since the typical MLP involves transporting and storing commodities, and since commodity prices are typically correlated to inflation, MLPs have the ability to increase their distributions when inflation picks up—which can offer some inflation protection for potential investors.

What Are Disadvantages of Master Limited Partnerships?

It’s vital to recognize that while MLPs may look good on paper, especially during boom times for the energy sector, they come with some important risks and drawbacks.

Distribution maintenance. An MLP’s inability to maintain distributions can negatively impact the trading price of limited partner units. Because of this, sponsors are incentivized to keep the MLP regularly paying out—even if it requires borrowing by the MLP or prioritizing distributions over capital expenditures. It’s also worth considering that the incentives of the general partner encourage growth in cash flows without their regard for long-term risks for limited partners.

Concentrated industry exposure. Since MLPs are usually focused on a single industry, any investment is going to be highly concentrated in that industry. Just as changes in commodity values can send prices up and increase distributions, they can also negatively affect the value of the investment. Notoriously volatile gas and oil prices can render MLPs acutely sensitive to rapid swings.

Tax liabilities. As noted above, there is some advantage to a master limited partnership’s tax status. But MLP investors must pay all applicable federal, state and local income taxes, even if the MLP fails to provide cash distributions. An example: If an MLP’s debt is discharged in the event of a restructuring or bankruptcy, that discharged debt may be considered income, meaning investors are on the hook despite not receiving cash distributions. This is common during times when oil and gas prices are depressed.

On the surface, MLPs appear to offer attractive yields, some tax benefits and limited liability for the MLP’s debts. However, the near complete dependance on the energy industry creates serious risks during price declines. We strongly recommend consulting with an investment professional to understand the suitability of MLPs for your personal overall financial plan and to fully factor in the associated risks.

Any additional questions about MLPs or your broader portfolio or financial goals? Please contact us to discuss further. We’d be more than happy to help.

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