Options Trading in Master Limited Partnership

By January 15, 2016 Newsletter No Comments

MLP is a type of partnership which is limited and traded publicly. It combines the tax benefits of master limited partnership with the liquidity of public traded securities. This kind of partnership includes two parties (two different partners): A limited partner and a general partner. A limited partner is a person or a group that supplies capital to the partnership and periodically receives income from the MLP’s budget – basically, the limited partner is the investor. A general partner is responsible to manage all MLP’s affairs and this party receives fees which depend on the performance of the whole venture.

Master Limited partnership

Why Master Limited Partnerships are formed

The main reason for establishing the limited partnerships is cash flow. The fundamentals of MLP as a business enterprise are all measured by its predictability and the stability of cash flow it has. If you look at it as a tax pass-through entity, there is an increase in cash flow. MLPs are not taxed on the entity level as Regular Corporation are, they act as pass-through entities for income tax purposes at both state and federal levels.

The Structure

In general, an MLP’s structure is two-tiered. A master limited partnership is a traded limited partnership the main value of which comes from its ownership of an LLC or LP. In both cases, the first tier entity is also called the operating entity. Because of this, most MLPs refer to the “operating company”, as it owns the most operating assets.

Characteristics

One of the unique characteristics an MLP must have in order to be recognized as a legal MLP is that the whole partnership has to derive most of its cash infusions from exploration, mining, extraction, refining of oil and gas and the production of alternative fuels like biodiesel.

Pros and cons

MLPs are famous for enabling steady and slow opportunities for investment. This means that the risks are low. With a steady cash flow, you will have regular cash distributions. Another appealing fact is that the company avoids having to pay double taxes, due to a slip caused by the passing of income to the unit holder. This also means that there will be more capital available for future investments, ultimately leading the company to becoming more competitive in its market.

One of the biggest downsides of becoming a limited partner is the fact that you will be obligated to file Form K1. This form is very complicated, meaning that you will have to pay your accountant more, regardless of whether or not you sold any units. Another bad side is the fact that you cannot use net loss for offsetting some other income. Any net losses you may have must be carried out a year ahead.

Why Do Investors Invest

There are two main reasons why investors find it suitable to put their cash in master limited partnership. The first reason is connected to the high yields they have. Almost all MLPs are structured in such fashion that they return most of their earnings to partners. The other reason is connected to the tax advantages we mentioned before.

In Which Industries Are Master Limited Partnership Formed

Master limited partnerships are only formed in industries where they are legally allowed. After the IRS proposed regulations in 2015, only the companies whose business revolves around transportation, production and processing of natural gas, coal and oil have the possibility for qualifying for mild tax treatment. Furthermore, businesses that get lower rent can qualify if they meet the standards found in the Internal Revenue Code.

Income Source of a Master Limited Partnership – Commodity, Fee-based Assets

Besides creating income from natural and mineral resources, MLP can generate money in many other ways. The categories for further income include:

  1. Real property income – including rent income coming from real property and property sale income;
  2. Interest income – this doesn’t apply for financial or insurance businesses;
  3. Dividends;
  4. Income from futures, commodities and related gains;
  5. Income coming from selling assets that usually generate qualifying gains.

Strong Balance Sheet Requirement

One of the most important requirements for the foundation of MLP is a strong balance sheet. As an investor you should find out and MLP that has higher investment credit rating which is BBB- and higher. In order to invest properly in MLP, you will need to have a strong balance sheet. So, if you want to find suitable partners but don’t know, One of the ways to find a good company to invest is to use the stock screener programs on financial sites such as Yahoo.

Low Debt to EBITDA

EBITDA (earnings before interest, taxes, depreciation and amortization) is basically a net income report showing a company’s financial performance. It can be used to compare and analyze a certain company’s performance with the rest of the industry. Because it eliminates all factors of accounting decisions and financing, it is very suitable for MLPs. All energy transfer partners look towards the future, since the current backlog of all projects done based on EBITDA is going to multiply by six to eight times. This means that each program will pay for itself in around 7 years. Experts on MLP recommend that MLP should have Debt to EBITDA ratio of 4 times or less.

Strong Distribution Coverage

Experts recommend that investors should avoid MLPs that are paying out more than 100% of their distributable cash flow as any setback could lead to distribution cut.

History of Strong Rising Distribution Growth

Good MLPs have strong history of distribution growth. Therefore, it is prudent to invest in such companies. One such company is Philips 66 Partners (PSXP).

The Apache Corporation (APA) was the first one to form an MLP in 1981 in order to consolidate over 33 gas and oil drilling limited partnership programs. In the late 80s, the use of MLP diminished due to federal restrictions. However, growth continued in modern MLP structures due to the interaction between LLC law, tax requirements, market developments, Delaware partnership and the unique business options this structure offered to modern businesses.

Two Examples of Stock Having Master Limited Partnership – PSXP and NGLS

PSXP: Philips 66 Partners is an MLP which began trading in July 2013 on the New York Stock Exchange. They are focused on growth while developing, operating and acquiring fee based natural gas liquids, crude oil, pipelines, terminals, etc.

NGLS: Targa Resource Partners LP, a North Texas group focusing in acquiring gas and gas pipelines. The expectation is that macro business investments will achieve growth in the future, since the economic crisis is reaching its end. It is expected to see robust activities in the MLP space.

In summary investors should invest in those MLPs which have strong balance sheet, secure fee-based cash flow, history of rising distribution growth and lots of projects in backlog.

Source: Investopedia and Wikipedia

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