The Alerian MLP ETF Could Be Appealing To Income-Seeking Investors
MLPs remain one of the few assets suitable for generating income in the zero interest rate environment. The Alerian MLP ETF offers a way to gain access to a diversified MLP portfolio without the credit risk of an ETN. Most of the ETF’s assets are pipeline companies, which have proven quite resistant to the decline in oil prices. The future outlook of pipeline companies is quite bright. The Alerian MLP ETF does not pass through the usual tax benefits of these assets, but retirement investors will not get them anyway. Historically, one of the best sources of income for retirees has been master limited partnerships, which are business structures that have some similarities to real estate investment trusts or business development companies but which operate primarily in the energy space. As a result of being primarily energy companies, the recent declines in both oil and natural gas prices have caused investors to largely flee from these assets. However, many master limited partnerships have not been significantly affected by the decline in energy prices and this could be creating an opportunity for income-focused investors to generate outsized profits. One of the best ways that an individual investor can take advantage of this opportunity is by purchasing units of the Alerian MLP ETF (NYSEARCA: AMLP ). Master limited partnerships are business entities designed to combine the taxation benefits of a limited partnership with the liquidity of a publicly-traded security. The most significantly of these taxation benefits is that a master limited partnership is considered to be a “pass-through” entity, which means that not only is an investor’s proportionate share of the company’s earnings taxed at the investor’s ordinary income tax rate (and not taxed at all at the company level), but also that the investor’s proportionate share of the company’s depreciation and amortization can also be deducted against this, reducing an investor’s tax liability. In order to obtain these tax benefits, there are only a few industries that a master limited partnership is permitted to operate in, per IRS rules. These industries are the production, processing, and transportation of crude oil, coal, or natural gas. Unfortunately, there are two caveats here. The first is that investors that hold units of a master limited partnership in a tax-advantaged account, such as an IRA, lose the ability to deduct their proportionate share of the firm’s depreciation and amortization expenses. The second is that investors that hold their partnership interests in a unit investment trust, fund, or ETF also lose this ability. Therefore, investors in the Alerian MLP ETF lose some of the tax benefits of investing in master limited partnerships directly. However, as we will shortly see, that may not be a significant concern. As the price of oil and, to a lesser extent, natural gas declined over the past sixteen months, the unit prices of many master limited partnerships have been under pressure. However, what the market has not considered is that many of the largest master limited partnerships are midstream pipeline operators and not exploration and production companies. For example, here are the largest holdings of the Alerian MLP ETF: (click to enlarge) Source: Morningstar, Yahoo! Finance, Company Web Pages As the table shows, nearly all of the significant holdings of the Alerian MLP ETF are pipeline operators. In addition, for most of them, natural gas transportation is a much larger aspect of their operations than crude oil transportation, although many of these companies do operate several different types of pipeline. Notice however that few of these companies actually produce oil and natural gas themselves. This gives them an advantage in the current market. This is because of the way that the pipeline industry works. Unlike upstream oil and gas producers, pipeline companies have no direct exposure to the prices of the commodities that they transport. Instead, these companies are simply paid a fixed rate, often under a long-term contract, by the oil and gas company that actually produced the commodity to transport it over their network. These prices, aside from generally being contractually set, are also not completely subject to market forces. This is because the rates that pipeline operators charge their customers are regulated by the Federal Energy Regulatory Commission, which typically sets rates at a level that will allow pipeline operators to enjoy relatively stable margins. Thus, there will not be significant fluctuations in rates regardless of moves in commodity prices. While pipeline operators, such as those that comprise the majority of the holdings of the Alerian MLP ETF, are largely insulated from fluctuations in commodity prices, they are vulnerable to changes in the quantity of oil, gas, and refined products shipped through their pipeline networks. This is because, as already mentioned, their customers pay a relatively fixed rate for each of a given quantity of the commodity shipped through their pipeline network. In some ways, it can be considered analogous to a consumer’s electric bill, in which the consumer pays a fixed rate for each unit of electricity consumed. Therefore, a decline in the quantity of oil, natural gas, or refined products shipped through their respective pipelines would result in a reduction of revenues. Fortunately, it does not appear likely that this scenario will occur. According to the U.S. Energy Information Administration, worldwide liquids demand growth is expected to exceed production growth over the next year. While global inventories increased at an average pace of 2.3 million barrels per day in the second quarter of 2015 compared to an average of 1.8 million barrels per day in the first, this is expected to slow to an average of 1.5 million barrels per day in the second half of 2015 and then to 0.8 million barrels per day in 2016. Source: Energy Information Administration It is a similar situation in the United States. According to the Energy Information Administration , the nation’s consumption of petroleum and related products will remain relatively stable until 2040, while consumption of natural gas is expected to increase from today’s levels over the same period. In addition, oil production over the same period is expected to remain relatively stable while natural gas production is expected to rise. This will result in steady to increasing business for the pipeline companies. (click to enlarge) (click to enlarge) Source: U.S. Energy Information Administration As I mentioned earlier in this article, investors using retirement accounts (or other tax-advantaged accounts) cannot take advantage of the tax benefits of investing in a master limited partnership. The same is true of investors in the Alerian MLP ETF. However, there is the potential for tax consequences if a master limited partnership is held in a tax-advantaged account. This is known as the unrelated business income tax and it takes effect if the income generated by a master limited partnership came from a business activity that such companies are normally not permitted to engage in. While it is rare for a master limited partnership to do this, it is theoretically possible and if so, the tax advantages of a retirement account do not apply to that income. An investor in the Alerian MLP ETF will not be subject to this tax, should it occur. Most investors that are seeking retirement income are investing in retirement accounts and so therefore are unable to take advantage of the inherent tax benefits of master limited partnerships anyway. For these investors, the ETF may be an excellent alternative. Its 9.43% dividend yield is practically unheard of in the current market and its stable underlying asset base should provide some security to investors. This fund could be worth a look.