Investing in MLPs After Kinder Morgan: What You Need to Know

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Important Update on Investing in MLPs: My wife, Marina, and I are off to Texas this morning. We're flying into Dallas to complete the next stage in yet another direct oil and gas investment.

I'll have some major news on these developments shortly, so stay tuned!

But before we take off, I wanted to follow up on a piece I wrote last week. It involved Kinder Morgan Inc.'s (NYSE: KMI) bombshell announcement that it was effectively abandoning the master limited partnership (MLP) structure it had helped to pioneer.

Since MLPs have long been the go-to for yield-hungry investors, the piece attracted a lot of attention - along with quite a few comments.

Several readers wrote in to ask whether this means the opportunities in MLPs are over, and if they should sell their holdings.

Investing in MLPs

Others wondered if the government is now about to begin taxing these structures, thereby removing the primary advantage in forming MLPs to begin with.

All of these are understandable concerns.

So let's go through what the Kinder Morgan consolidation really means for the average investor...

The Downside of Very Large MLPs

As you know, MLPs have emerged as a major approach for partnerships that control assets, primarily pipelines and related elements in the midstream sector.

The initial advantage to this structure is the absence of a corporate tax. In an MLP, the profits flow to the individual tax returns of the partners. For the retail investor, that generally has meant higher dividend payments, since an IPO was effectively releasing a portion of the collected profits to be forwarded to equity owners in an issuance of stock.

However, this approach has one major downside. It requires that the partnership must continually expand its ownership of assets to sustain its activities.

And at some point - especially with a very large MLP - that becomes a less than efficient use of capital. As the biggest MLP of them all, that's what happened to Kinder Morgan, prompting the decision to change back into a non-MLP corporate structure.

Unfortunately last week, I neglected to provide one of the basic reasons why this occurs. As so often happens, a savvy Oil & Energy Investor reader was on it.

Here's what Kevin B. pointed out:

"One other factor was the way the company had to fund its expansion.

MLPs cannot retain funds for future expansion; they have to either issue debt or equity at the time of the expansion. And KMI was able to borrow at lower rates of interest than any of its pipeline partnerships could.

This roll-up would result in immediate reductions in future costs of funds for the corporation without having to dilute unit-holders in their pipeline partnerships. It would also result in the corporate parent being able to fund some projects internally, without having to seek funding in the stock or bond markets in the future, resulting in better internal planning at the corporate treasury."

Of course, Kevin's comments were spot-on.

A large MLP needs to find other venues for securing working capital. Since the MLP must pass on all profits to partners, there is no possibility of financing expansion or investment capital from internal funding. At some point, issuing stock shares or incurring debt (even at more favorable interest rates) is not the best way to go.

Yet, for a wide swath of smaller MLPs, there is still considerable latitude when it comes to additional acquisitions. And, as I'll expand upon in a moment, there are some new wrinkles in the types of assets they are likely to acquire.

No, Investing in MLPs Is Not Coming to an End

Then there was this comment by Russ Y. that mirrored the concerns of several other readers.

Russ asked:

"So where does that leave us now? Don't buy any new MLPs? Hang on to the present MLPs for how long? Unload them how soon and replace them with what? Or just put the cash in our mattress for the time being?"

First off, Russ, I can tell you there is no need to panic. The world of MLP investing is not going to collapse simply because Kinder Morgan became too large. Chicken Little is not about to control or end this party!

The simple fact of the matter is that there are a range of MLPs, and many still pay above market average dividends while providing higher share prices. The key is recognizing the new directions and determining what assets each partnership is likely to emphasize.

First off, as I noted in passing last week, MLPs have become interested in controlling more of the strategic assets in the upstream-midstream-downstream sequence. In this case, MLPs are beginning to target specific "pricing points" in order to serve as the "gatekeeper" to broader markets.

It is no longer always necessary for a partnership to acquire additional assets of the same type to obtain the best return. In fact, some of the new asset mixes allow for complementary acquisitions by two or three related partnerships, allowing for increased flexibility and return potential.

In short, the Kinder Morgan move was dictated by its size. Some of the same advantages of the corporate structure are available to other MLPs collecting assets in specific areas by cross-holdings.

In fact, I've already introduced some of these MLPs to Energy Advantage and Energy Inner Circle subscribers. I call them MLP clones because, although they are following the same format, their objective is to maximize their flexibility.

In other words, they may look and act like normal MLPs (maximizing profits to partners and bypassing corporate taxes), but the real objective involves a different asset structure.

And What About Your Uncle Sam?

Finally, Mike R. voiced a concern that several readers also raised.

Mike asked:

"What is your opinion as to whether the Treasury will move to eliminate the MLP as a form of ownership? I understand they have placed a moratorium on new MLPs and are considering eliminating them altogether in order to gain more immediate tax revenue. Would this require legislation? If MLPs were forced to become corporations, what in your opinion would happen to the share price and distributions/dividends of existing MLPs?

First off, Mike, there is currently no moratorium on new MLPs. But there is the question of whether Congress will put an end to this structure to increase tax returns by being able to apply the corporate tax rate (as they now will be able to do with Kinder Morgan and its subsidiaries).

Any move in this direction would require a change in regulatory authority, and that would call for new legislation. If that happened, there would be a cut in dividends, although how it would affect share prices would be determined on a case-by-case analysis of asset positions and performance.

The real question is whether Washington, D.C., would actually move in this direction.

And realistically, I can't foresee any makeup of Congress following the off-year election that would seriously entertain this idea. Politically, it is just not going to happen. What's more, the added tax realized would not be significant in these days of creative corporate auditing.

But there's an even more compelling reason why I believe MLPs are here for the long term.

Now, keep in mind that I don't run the lobbying on this issue. However, there is a central point that should be emphasized by whoever does.

The MLP approach of compiling assets follows the same format an "S" corporation does in creating new businesses. In fact, "S" Corps are now the largest single category of small businesses.

Both bypass corporate taxes and place all tax issues squarely in the laps of the partners (MLP) or owners (S Corp).

Eliminating the MLP structure to allow additional taxes without doing the same for the S Corp would be blatantly discriminatory. And there are very few in Congress who are interested in closing down the "S" Corp while seeking to create an economic recovery.

Not to even mention the firestorm that this idea would cause with constituents back home.

By the way... if you'd like to be notified as soon as I release the details on the next Money Map Project, getting on the priority list for the next direct oil and gas investment is simple.

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle

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