U.S. energy’s steady middlemen look neglected

May 25, 2011

By Christopher Swann
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

NEW YORK — Oil and gas pipelines offer market-beating returns. Mostly held in so-called master limited partnerships, they looked dear for a while. But the $245 billion sector again looks affordable. Many shun the complexity, but it means higher returns for those prepared to invest.

Over the past 15 years, firms that build and run the nation’s energy arteries have provided a total return of 17 percent a year, dwarfing the 7 percent generated by the S&P 500 index, according to UBS. Yet with rare exceptions, like El Paso’s move on Tuesday to separate its refining and pipeline operations, they generate few headlines.

Falling oil prices have lopped about 7 percent off the industry’s value since the end of April. This doesn’t make much sense. Energy-sector MLPs draw fees from transporting and processing fuel and so are largely insulated from the gyrations of commodity prices.

Still, the result is that MLPs now offer a yield 3.1 percentage points above Treasuries, in line with the 15-year average and up from 2.4 percent last month. Promised capital gains look juicy, too. The need for new pipes to transport America’s domestically produced natural gas liquids and oil will produce annual growth of at least 6 percent, according to fund manager SteelPath, giving an expected all-in annual return of around 12 percent for the next several years.

The recent dip should entice value hunters. But one reason MLP returns are high is that they are a niche investment. Though the partnerships don’t pay corporate tax and the income that flows to investors is highly tax-efficient, only a select few can take full advantage. Pension funds and other institutional investors usually steer clear because a quirk in the law means they can actually end up paying more tax when they invest in MLPs than in regular stocks.

Foreign investors don’t get the full benefit either. And mutual funds, though able to invest in MLPs for the past seven years, mostly aren’t enthusiastic about agonizingly complicated tax filings. Meanwhile, many private investors — and their accountants — find the partnership structures arcane and the tax paperwork off-putting.

Yet with returns that frequently top those of hedge funds and private equity, perhaps more investors should brave the complexity. MLPs look fairly priced by historical standards. And these steady energy middlemen don’t need to be cheap to offer generous returns.

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