With the stock market indices setting new highs — especially this many years into a bull market — many conservative investors will be looking to move some of their gains into safer havens. Master Limited Partnerships (MLPs) may be an attractive income option for investors seeking relatively steady yields. Most subscribers probably understand the basics of MLPs. If so, please skip the following review and move on to the next section.

MLP Basics

The main attraction of an MLP from an investor’s point of view is that MLPs don’t pay corporate income tax. Profits are passed directly to unitholders via (usually) quarterly distributions. Corporate profits are taxed a second time via the personal income tax on dividends. In contrast, MLP distributions are taxed just once, at the individual level.

But MLP distributions aren’t immediately fully taxed either. In fact most of the distribution — typically 80 to 90 percent — is classified as a return of capital under the depreciation allowance, which subtracts capital depreciation from net income to account for the fact that assets like pipelines and wells lose value over time.

The depreciation allowance lowers the immediate tax bill but also the cost basis of the MLP investment, resulting in a larger capital gain when the MLP is sold. Over time the tax-deferred income can be invested elsewhere, allowing investors to compound returns that would have otherwise been taxed, while also earning a steady stream of income. This has made MLPs an extremely popular income investment.

The partnerships, in turn, gain access to a broader pool of stable capital to finance projects. There are currently more than 100 publicly traded MLPs representing some $445 billion in capital. Approximately $400 billion has gone into qualifying energy and natural resource projects, and much of that — perhaps 80 percent — into midstream projects such as oil and gas pipelines. These midstream MLPs usually derive most of their income from fee-based businesses, insulating them from the volatility of the commodity markets and allowing them to maintain a predictable income stream.

MLP investors have been richly rewarded over the past decade. The 10-year annualized return of the Alerian MLP Index (AMZ) — a composite of the 50 most prominent energy MLPs — is 15.7 percent, versus 7.7 percent for the Dow and 7.6 percent for the S&P 500. The yield of the AMZ is also higher at 5.9 percent, versus 2.3 percent for the Dow and 2.1 percent for the S&P 500.

MLPs for Bakken Crude

In the previous issue of The Energy Strategist, I discussed the pipeline companies that move oil out of the Williston Basin, where the famous Bakken Formation — and the less famous Three Forks Formation — are located. While most of the Bakken’s oil is transported out of the region by rail — with Warren Buffett’s BNSF railway leading the way — there are a few pipeline MLPs operating in the area.  

Enbridge Energy Partners (NYSE: EEP) yields 7.4 percent, and owns 61 percent of the current Bakken pipeline export capacity (the rest is primarily privately-owned). Plains All American Pipeline (NYSE: PAA) will add 40,000 bpd in 2014 with its Bakken North pipeline. PAA currently yields 4.8 percent.

Oneok Partners (NYSE: OKS), which yields 5.7 percent, has a natural gas liquids (NGL) pipeline that exports unfractionated liquids from the Williston Basin. OKS is also the largest independent natural gas gatherer and processor in the Williston Basin. However, this partnership is somewhat exposed to commodity prices (undesirable from the standpoint of many MLP investors), as its natural gas processing contracts are primarily compensated via a percentage of the product sale proceeds. This may not be the safest haven for those seeking shelter from potential market volatility.

Oneok Partners’ natural gas gathering and processing investments in the Williston Basin

In October, Crestwood Midstream Partners (NYSE: CMLP) finalized its merger with Inergy Midstream. Following the merger, Crestwood announced the acquisition of Arrow Midstream for $750 million, which gave it 150 miles of crude gathering lines, 160 miles of natural gas gathering pipes and 150 miles of water pipes in the heart of the Bakken formation. According to Crestwood the deal will allow the partnership to process 18 percent of the Bakken’s crude production.

The partnership also owns the COLT Hub — an open-access rail terminal serving producers, refiners and marketers — which it inherited from Inergy. The hub has 720,000 barrels of crude oil storage and two 8,700-foot rail loops, and can accommodate 120-car unit trains with a capacity of more than 120,000 barrels per day by rail (and is currently being expanded to 160,000 bpd).

Wells Fargo upgraded Crestwood Midstream to Outperform on Oct. 11. Units currently yield 7.8 percent.

In January Targa Resources Partners (NYSE: NGLS) completed a major acquisition giving it a footprint in the Bakken with the $950 million purchase of Saddle Butte Pipeline, LLC’s interests in its Williston Basin crude oil pipeline and terminal system, along with natural gas gathering and processing operations. The acquired business was renamed Targa Badlands and has combined crude oil operational storage capacity of 70,000 barrels, including the Johnsons Corner Terminal with 20,000 barrels of storage capacity (expanding to 40,000 barrels) and the Alexander Terminal, with storage capacity of 30,000 barrels. The business also includes approximately 155 miles of crude oil gathering pipelines, 95 miles of natural gas gathering pipelines and a 20 thousand cubic feet per day (MMcf/d) natural gas processing plant with an expansion underway to increase capacity to 40 MMcf/d.

Targa Resources units are up 41 percent year-to-date. The annualized yield is presently 5.9 percent. The coverage ratio for the third quarter — that is, the partnership’s definition of distributable cash flow (DCF) divided by the amount of cash returned to unit holders  — was 1.08.

Summit Midstream Partners (NYSE: SMLP) has assets that include more than 175 rigs operating in the Williston Basin. The partnership is targeting crude oil production from both the Bakken and Three Forks formations. The partnership also gathers and compresses associated natural gas, which it  forecasts will be a major growth area due as drillers seek to limit the significant volumes of natural gas currently flared — i.e., wasted — in North Dakota.

The partnership owns 259 miles of low-pressure polyethylene pipeline and 70 miles of high-pressure steel pipeline with an average natural gas throughput of 16.8 MMcf/d in the most recent quarter and a capacity of 22 MMcf/d at six compressor stations. The partnership is presently expanding compression capacity to increase total system capacity to 30 MMcf/d. The partnership’s low-pressure gathering services are provided primarily under fee-based contracts.

SMLP units have been on a tear this year, returning more than 72 percent year-to-date. Even a recent earnings miss didn’t have much impact on the unit price. Units have advanced another 4 percent since the miss was announced, even as many MLPs were showing signs of weakness. At the current unit price, the annualized yield is 5.4 percent.

For those interested in IPOs, Enable Midstream is a Delaware limited partnership formed by affiliates of CenterPoint Energy (NYSE: CNP), OGE Energy (NYSE: OGE) and ArcLight Capital Partners. The $500 million IPO is expected to take place in the first quarter of 2014.

The partnership owns, operates and develops strategically located natural gas and crude oil infrastructure assets. The partnership’s initial assets include approximately 11,000 miles of gathering pipelines, 11 major processing plants with approximately 1.9 billion cubic feet per day of processing capacity, approximately 7,800 miles of interstate pipelines, approximately 2,300 miles of intrastate pipelines and eight storage facilities with 86.5 billion cubic feet of capacity.

The asset base includes Bakken gathering assets contributed by CenterPoint Energy. The gathering system began operations last month and is expected to be in full operation in the third quarter of 2014. Enable Midstream estimates it could spend as much as $110 million on the Bakken system. The company’s Bakken system will have a capacity of 19,500 b/d when fully operational, with the entire amount contracted through 2028.

Conclusion

Oil and gas output in the Bakken continue to surge, posing challenges as well as opportunities for midstream operators. Several offer investors another attractive income stream with a growth kicker and limited exposure to volatile commodity prices.