Week 90 - Pipelines

Situation: Pipelines are another sector of critical infrastructure that the government "builds out" by making tax expenditures. In order to tempt investors into funding the massive up-front costs of laying a new pipeline, the IRS offers these “tax breaks” as an incentive. Pipeline operators get direct support from the Internal Revenue Service (IRS) in the form of a letter stating that no corporate taxes need be paid as long as at least 85% of any profits are returned to shareholders--who also get a tax break (see below). The pipeline company, which is structured as a Limited Partnership that receives initial funding from a General Partner, has to issue bonds if it wants to further expand its pipeline network. Those bonds aren't backed by the government. That's the catch. All of the pipeline companies have to expand their networks (given the ever-growing demand) but also have to maintain an investment-grade rating on their bonds to obtain low-cost financing. They all "push the edge of the envelope" and issue as much debt as the 3 rating agencies (S&P, Moody's, and Fitch) will allow before the rating is dropped to "junk" status. If you’re still reading, you’ve probably figured out that a pipeline company is set up much like a real estate investment trust (REIT).

The fixed costs of a pipeline can be depreciated in 20 yrs even though the pipeline itself has a much longer life. That means “distributions” (i.e., each investor’s share of operating profits minus interest, capital expenditures and payments to the General Partner) are mostly tax-deferred. Investors receive a K-1 tax form each year noting that taxes owed on their share of the return on invested capital (ROIC) are only about 20%. The remaining 80% represents non-taxable depreciation which reduces the investor’s cost basis to zero over time. After that point, distributions are taxed at the going rate for capital gains. When the stock is sold, any gain that is realized (because of price appreciation) is taxed as income. Considering the unusual structure of this investment, it is a great way for you to grow your wealth. Granted, there are tax headaches, e.g. some pipeline routes cross states that require a tax form to be filed.

The current energy boom that has been touched off by “hydrofracking” and horizontal drilling has ignited ~$10 Billion/yr of investment in pipelines that will continue for ~25 yrs. Once a pipeline is built, the fees charged for transporting oil and gas are relatively inelastic, i.e., changes in the price of natural gas or oil have little influence on pricing.
The Table lists 10 Limited Partnerships that represent the spectrum of over 70 such companies. In the past, total returns (distribution rate + rate of growth in the distribution rate) have averaged 13-14%/yr. The Table calls those distributions “dividends” because that is how most investors think of them. But if you’ve read this far, you know that distributions are quite different from dividends. Just remember this: payouts are high and grow smoothly but price appreciation is slow and bumpy. You’ll build your after-tax wealth from the quarterly distributions, not from selling the stock (when you’ll have to pay full income tax on any profits). You’ll need a good accountant to do your taxes.

Bottom Line: Do you want to make real money (after inflation, transaction costs and taxes)? Then look at investing in MLPs (Master Limited Partnerships). Those are mainly pipeline companies that have great economics once the pipeline is built and long-term contracts are in place. There are two main problems you run into: 1) Your accountant will have to file more tax forms; 2) These companies carry a lot of debt and that debt is rated just one or two notches above junk. So you’ll have to do some digging and find companies that have good management. Then keep track of the company’s business plans. We think Kinder Morgan Enterprise Partners (KMP) has exemplary management, and S&P gives Enterprise Products Partners (EPD) an A-rating (the others haven’t yet been assigned a rating).

Risk Rating: 8.

Full Disclosure: I have no stock in an MLP but do have stock in one of the General Partners: Kinder Morgan (KMI).

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