Investing In MLP’s (Investing 101 Series 2)
By Eliseo "Jojo" Prisno, CRPC, MS
Chartered Retirement Planning Counselor
PE CAPITAL INVESTMENTS
This article is a continuation of last month’s issue. If you missed the first series, please visit Pinoy 's May 2015 Business archive.
Distribution (Dividend Income) and Taxation of MLP’s
LPs pay their investors through quarterly required distributions (or dividends), the amount of which is stated in the contract between the limited partners (the investors) and the general partner (the managers). Typically, the higher the quarterly distributions paid to limited partners, the higher the management fee paid to the general partner. This provides the general partner with an incentive to maximize distributions through pursuing income-accretive acquisitions and organic growth projects. Failure to pay the quarterly required distributions may constitute an event of default.
Because MLPs are classified as partnerships, they avoid corporate income tax at both state and federal levels. Additionally, limited partners may also record a pro-rated share of the MLP's depreciation on their own tax forms to reduce liability. This is the primary benefit of MLPs and gives MLPs relatively cheap funding. On the investors side, though MLP’s are quite complex to tax, the initial distributions are considered return of principal or your original investment thus creating a tax-free cash flow. Once your original investment had been returned, then future cash flow becomes taxable as capital gains of the investment.
Energy Sector MLP’s
Because of the stringent provisions on MLP’s and the nature of the quarterly required distributions, the vast majority of MLP’s are pipeline businesses, which earn very stable income from the transport of oil, gasoline or natural gas. Energy MLP’s are defined as those owning energy infrastructure in the United States, including pipelines, natural gas, gasoline, oil, storage, terminals, and processing plants, though an MLP need not own all of these or be vertically-integrated: even a small section of pipeline or a single railroad tanker car may qualify under the current law.
Given the recent down turn of this sector (from more than $110 per barrel on crude oil in mid-2014 to a low of $44 early this year and now currently stands at $58, as of this writing), there are a lot of opportunities in this sector. Most energy MLP’s pays distributions from 5% to 13% annually and note this cash flow comes in quarterly and tax free up to your total original investment. My most favored in this sector is Linn Energy Company ticker symbol LINE. This investment pays a dividend of 11% and currently pegged (as of this writing) near its 52 week low. This particular stock peaked at $32 in the summer of 2014 and went as low as $9 when oil prices hit rock bottom. Though there will be volatility along the way until the oil sector shows some form of stability (which most analyst believes already bottomed) , the opportunity here is acquiring the stock on its lowest and the tax free cash flow potential.
Another energy MLP on my list is Energy Transfer Partners, ticker symbol ETP. This particular MLP currently pays 7% in dividend. Though pegged near to its lowest in 52 weeks ($55 per share as of this writing; lowest in 52 weeks is $53 and the highest was $69); this investment is on a rebound. With 4 times the capital of Linn Energy (about $20 billion); ETP shows a more stable beta of 0.72 (a beta of less than 1 signifies less volatility relative to the S&P 500 Index). LINE’s beta on the other is 1.07 or 7% more volatile than the S&P 500 Index. A balanced combination of both investments will deliver a 9% dividend return with a huge upside potential. Assuming oil prices will return to its original peak of $110 per barrel in 3 years and the growth co-relation of these investments will be in line with oil prices, the potential total return is almost 100% or double your money on top of the 9% cash flow per year over the next 3 years. Sounds very promising, however this projection has no guarantee but simply an analysis based on the stocks’ historical highest value (52 week high) and the current entry value (near the 52 week low). Oil as a natural resource and non-renewable will always command value and it’s a matter of supply and demand, with most major economies slowing down (Europe, Japan and China), prices are dragged down because of slow demand however the supply position will surely be depleted.
Thus, even if demand will not return to its normalcy, because of the nature of this commodity (non-renewable) it will have to go up at some point and 3 years is actually a stretch. If you study in detail the historical price of oil, a major correction normally rebounds in 2 years meaning new highs are stablished after 2 years. This scenario are strong headwinds for the MLP’s I mentioned.
If you want learn more on MLP’s and how to invest on them, contact financial professional who are licensed in securities.
About the writer: Eliseo Jojo Prisno is a Chartered Retirement Planning Counselor and for over a decade has managed the wealth of select families and business owners. He founded P/E Capital Investments in 2010, a State Registered Investment Advisory Firm (CRD# 172695) and is the current Managing Director and Senior Investment Advisor of the firm. Mr. Prisno also manages a Fund of Funds Portfolio with Ameritas and runs an All Equity Growth and Income Portfolio in Separate Accounts via E-Trade Financial. If you have questions or desire a complimentary analysis of your retirement readiness, call toll free to 1-888-929-2825 or visit our page on facebook or our website: www.PEcapitalinvestments.com