Back in 1986, the U.S. government passed a landmark tax reform act that has had a profound impact on millions of investors. That piece of legislation set up a special tax loophole for a select group of companies known as master limited partnerships (MLPs).
To spur the development of vital energy infrastructure assets, Congress essentially granted these businesses an exemption from federal income taxes. But favorable tax treatment is only one reason why income investors have flocked to this group.
The attraction lies in the highly stable business model of MLPs, the double-digit yields, and their ability to hike distributions every year.
The vast majority of MLPs operate in the energy business. These companies own and operate networks ranging from pipelines to liquefied natural gas (LNG) terminals -- which transport, process and store crude oil, natural gas and petrochemicals.
In short, these critical 'midstream' functions serve as a vital link in the chain enabling oil and gas producers to get their products from the ground to the market. And this business has some highly attractive features:
-- Aside from routine maintenance, pipelines and other facilities don't require much in the way of ongoing capital expenditures and can stay in service for decades.
-- Most companies have staked out different territories, and since overlapping pipelines are rare, competition tends to be minimal in many regions.
-- Unlike other sectors, disruptive new technologies and product obsolescence aren't much of a threat -- pipelines aren't going out of style anytime soon.
-- In general, MLP income is largely based on the volume of oil and gas flowing through the system, not the prices of the underlying commodities.
-- Pipelines that cross state lines are often regulated at the federal level, with rates tied to the Producer Price Index, so tariffs ratchet higher over time to match inflation.
Because MLPs aren't involved in the actual production and sale of commodities, many pipeline owners care little about commodity prices. As long as oil and gas are flowing through the system, the company responsible is well-compensated for its services.
Very few industries can count on inelastic demand, natural barriers to entry, strong operating leverage, and partial insulation against fluctuating prices. So it's not surprising that MLPs are famous for their ability to generate highly stable and predictable cash flows in both good times and bad.
And just like utilities, these mature companies usually distribute their profits to shareholders (technically known as 'unitholders' in partnership lingo) as fast as they take them in. In fact, MLPs typically distribute about 90% of their cash flows each quarter -- and in this case, Uncle Sam doesn't take a cut of the proceeds.
Commodity prices can fluctuate wildly from day to day -- but demand for crude oil and natural gas is fairly level and increases at a steady pace each year. Most experts agree that world oil consumption (which now stands at 85 million barrels per day) will continue to increase at a +1.25% annual clip during the next 20 years.
That might not sound like much, but consider that most MLPs are busy making acquisitions. By expanding pipeline systems, firms can rake in more cash even if product volume remains flat.
More cash in the company's coffers means dividend distributions could continue to increase. During the past decade, MLPs have parlayed gradually rising demand, built-in inflation adjustments and billions in expansion projects into dependable average annual distribution increases of more than +7%.
I would be remiss if I didn't mention that for all their benefits, MLPs can create some headaches at tax time. Distributions are usually a mixture of net income and a return of capital (an allowance for depreciating assets). Fortunately, those who invest in this sector through a fund rather than individual stocks can bypass most of these complications. Still, you may want to consult your tax advisor before investing.
In any case, it's easy to see why MLPs are prized for their unique mix of stability, income and growth. There has arguably never been a better time to invest in this attractive sector.