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Master Limited Partnership

Down but not defeated…

Karatzas-Basil


By Basil M. Karatzas


Chief Executive, Karatzas Marine Advisors & Co.

www.karatzas.com

 

MLPs may be out of favour, but their potential cannot be ignored, says industry expert

The master limited partnership (MLP) investment structure has worked well for risk-averse small investors because its revenue streams are locked in for years and not tied to commodity prices. Some have questioned whether MLPs can insulate small investors from a turbulent energy market. But rumors of their demise have been exaggerated, says industry expert Basil M. Karatzas

Pipelines are an interesting type of investment since they require a lot of resources and the whole capital investment upfront, even before a barrel of oil can be shipped. But, once in place, they almost can guarantee to perpetuity predictable cash flows. Every time a barrel passes through the pipeline, a toll must be paid, even when the original pipeline was laid several decades ago.

This pipeline investing model has functioned as a template for the master limited partnerships (MLP) investment structure in the United States, where investors (unit holders) come to expect steady predictable cash flows over long periods of time with relatively little market risk. MLPs are publicly traded partnerships in which small, unsophisticated retail investors can participate, while at the same time being exempt from corporate taxation in the US (corporate profits are passed tax-free to the unit holders, who pay tax at their personal level, thus eliminating double taxation).

Revenue streams that can be generated from real estate, commodities and natural resources can satisfy the MLP structure and thus many capital-intense projects related to these industries can be offered to investors on such a basis: pipelines, oil storage and other energy infrastructure; tanker companies, where their vessels are employed under long-term charters with investment-grade charterers. A few notable names in the space are Kinder Morgan, Genesis Partners, Teekay LNG Partners and Teekay Offshore Partners.

Advantages

MLPs have distinct advantages because they allow smaller, risk-averse investors to provide finance for costly projects that will pay off for years to come. For investors seeking predictable dividends and yield without taking direct exposure to the underlying markets (mostly energy), MLPs are a solid investment strategy to consider. On the other hand, for projects where the employment of the assets is ‘captive’ or assured by a highly creditworthy party, it’s a structure with a lower cost of capital that can benefit the consumer, the taxpayer or even a government by allowing services to be offered at a lower cost.

While the business model of MLPs is distinct and independent in its own right, MLPs came to be strongly associated with the energy industry; and often, for right or wrong, MLPs follow the fortunes of the energy industry. Pipelines and the energy industry have been the blueprint for MLPs but, again, just because the price of oil fluctuates and the economic growth of a country can vary, this doesn’t mean that oil (or its by-products) stop passing through pipelines. The volumes may vary, but the tariffs are constant. Variance in revenue should not be of grave concern, since the MLP does not have high operating expenses and the assets have long economic lives. Thus, even when revenue drops, the survival of the company is never at risk (minimal opex) and the dividend payout can still be very strong compared with other industries.

So much are MLPs associated with the energy sector that the Alerian MLP Index was down by 40 per cent in 2015, in line with the drop in the price of oil and versus an effectively flat stock market in that year. The shares of energy MLPs were decimated in 2015 and MLPs in the maritime industry have also seen their shares perform poorly. Again, the revenue streams are not tied in any way to the price of the underlying commodity and the MLPs have revenue streams locked in for years to come; but, nevertheless, their shares have performed as if they were commodities. Some observers have even questioned whether the MLP structure is viable at all since it has failed to insulate the risk-averse small investor from the vicissitudes of the market gyrations.

Proclaiming the death of the MLPs just because of the current market dislocation is likely to be an exaggeration. Disheartening as it is, poor share performance and strong association with commodity pricing cannot be the end of MLPs.

The fact that MLPs may be undervalued at present is a question for the individual investor to consider. Of greater importance is the question of whether the recent performance of MLPs may have a negative impact on new projects seeking financing where the MLP structure could have been a suitable structure. After all, if existing MLPs have not performed well – seemingly for the wrong reasons – what’s the incentive for the general partners to consider new projects? If an MLP-related oil storage facility sees its valuation reflecting the value of the commodity stored instead of the revenue generated from the service of storing, what are the odds that a natural gas facility will have better appreciation by the investors?

The negative impact from the MLPs may be felt disproportionally in markets and geographies that could optimally had benefitted from such structures. Thinking locally, the Caribbean Basin may be a geography that could have seen the benefit from this structure and its cheap cost of capital. As the region focuses on development and preservation, on new infrastructure and environmentally friendly trends, the MLP structure could have been ideal for financing such aspirations. As the region considers turning away from smelly diesel power generation and to natural gas, as the region looks to attract more tourism and trade that will require enhanced port infrastructure, MLPs could be the ideal springboard to finance such projects in the international capital markets. Given that such projects would have a ‘captive’ market of the local consumer, with minimal support from the local government, such energy and infrastructure projects could offer a public good at a cost likely to be lower that the sovereign credit could command.

Likely, as the fortunes of the MPL market caught off guard by the oil’s (mostly unforeseen) precipitous drop, the investors still have to absorb the game-changing news and the new baseline that the collapse of oil and shale has generated. Eventually investors will make clear the separation between the commodities business (and its risks trading such commodity) with the boring but distinct business of providing services in the commodities market (shipping, transport, storage, etc). For governments, economies and companies that have long-term projects to undertake with long-term assured cash flows, a new wave of MLPs cannot be far away.

Prospect

The prospect of utilizing the MLP platform to finance energy and infrastructure projects in the Caribbean Basin is very enticing from many points of view. First, US residents have been extensively vacationing on the islands of the Caribbean for several decades now, and they are familiar with – besides the exceptional weather – the overall stable political environment in the region and also the business opportunities. Many of these vacationers would stand to benefit personally from any investments in the region via better services; thus, considering investing in MLP energy and infrastructure projects provides them with an opportunity to invest in an area they know and appreciate, and they have the opportunity to make a profit every time they spend money in the region.

Conversely, the MLP platform allows the local governments to access a big and wealthy pool of investors in their backyard in order to obtain inexpensive financing to build infrastructure and to play on the region’s commercial advantages, including higher tourism revenue from the very same market where the investors come from. Just imagine the opportunity of power generation plants on a pristine island in the Caribbean that use natural gas as feedstock imported by ship from the United States. Imagine an improved port infrastructure, with deeper-draft terminals equipped with cranes that could accommodate more efficient ships, thus lowering the cost of transporting material to and from the islands.

And, if one dares to think big, imagine a container transshipment center in the region that would allow large containerships to discharge containers destined for the US. Utilizing the MLP platform can be a win-win situation for the local governments and for the local population (consumer and taxpayer), while investors and tourists can go on enjoying sun-kissed beaches without environmental pollution while receiving higher quality services and having the pleasure of seeing their investments at work each time they go island-hopping.