The Invesco White Paper Series
Why the Long-Term Case for MLPs
Transcends Oil Price Fluctuations
Summary
Darin Turner
Portfolio Manager
Invesco Real Estate
Master limited partnerships (MLPs) have not been spared from the damage lower oil prices have
caused for prices of energy-related assets. While it is unclear how long volatility in the oil sector will
continue in the short term, we believe on a long-term basis that the underlying rationale for investing
in MLPs — attractive yields and valuations, growth potential and tax benefits — has not changed as
demand in North America for pipelines and other infrastructure capable of transporting natural gas,
natural gas liquids and oil from the new shale beds to consumers is expected to remain in the coming
decades. With that, we believe that the proper selection of MLPs can still be a means of generating
income with the potential for attractive total returns over the long term.
MLPs, which began 2014 on a positive note, were undercut in the closing months of the year by
plunging oil prices. Though MLP prices have started to show signs of stabilization, we believe that
long-term investors may see the full potential of the asset class by wading through these temporary
headwinds. Even with the possibility for production levels to decline in 2015, the US is still positioned
as one of the largest global energy producers, with the ability to still achieve energy independence in
the future. This environment still creates opportunities for MLPs, whose capital is required to build and
operate the infrastructure needed to bring oil and gas production to market. In this paper, we examine:
•The evolution of MLPs since their introduction in 1980s — from offering unpredictable income
streams to providing stable income with attractive distribution growth.
•The different types of MLPs and how they service the market.
•The growth of institutional interest in MLPs and the key drivers behind the trend.
•Ways investors can gain or increase exposure to MLPs, as well as the potential benefits and
considerations for the asset class.
Introduction
Prior to the recent surges in the US, crude oil and natural gas production declined about 20% from
1980 to 2006,1 primarily as a consequence of decreasing productivity on existing domestic wells.
However, fracturing technology has brought new life to US production, laying the foundation for the
extraction of hydrocarbons from previously uneconomical locations. As a result, energy production
in the US could grow nearly 77% from 2006’s levels to 57,000 trillion BTU in 2030.1
History suggests that the steep drop in oil prices will not be sustained, and we believe the supplydemand imbalance will shorten as a response to growing global demand. Moreover, while we recently
have seen a high correlation between MLPs and oil prices, over time, MLPs have had positive, yet
low, correlations with energy prices, as their direct exposure to commodity prices is relatively low.
Longer-term exposure to MLPs is also bolstered by our belief that the US will likely remain the
primary source of additional cost-effective oil supply globally. Based on estimates from the US Energy
Information Administration, proved reserves of US shale oil are approaching 40 billion barrels, up from
just 20 billion barrels five years ago.1 We believe this trend could continue as technology improves,
potentially reducing exploration and production costs. We also believe shifts in US energy policy could
allow exportation of oil at some point in the future, which could also change the dynamics of the global
oil industry.
The US has embarked on the journey from being a long-time energy importer, to a nation of energy
independence and global energy exportation — a transformation that could occur over the next decade
or so. To get there, however, takes more than just drilling. The US must invest substantially in its
energy infrastructure to be able to transport, process and store oil and gas that energy companies
remove from domestic soil.
Currently, that will be challenging considering that the US infrastructure network today is generally
underequipped to handle the volume — in 2013, the American Society of Civil Engineers issued a
D+ grade to the country’s energy infrastructure.2 Moreover, the American Petroleum Institute
estimates it will take $890 billion in total direct investment of oil and natural gas transportation
and storage infrastructure through 2025 to support increased production levels.3
Need for Energy Infrastructure
Requirement for New Production and Exports
• Current Flows (Import-Oriented)
• Future Flows (Export-Oriented)
Bakken
Marcellus
Niobrara
Haynesville/
Bossier
Permian
Eagle
Ford
Source: Invesco with information provided by IHS Global Inc.
We believe MLPs can play an important role in supporting the US energy transformation by providing
capital for infrastructure projects that link US energy supply with the long-term trend of rising global
demand. We also believe MLPs can play an important role in investors’ portfolios, as their distinctive
characteristics can potentially provide income and growth, as well as diversify investors’ existing portfolios.
The evolution of MLPs
MLPs are limited partnerships that are publicly traded on stock exchanges. Unlike corporations,
MLPs do not pay federal income tax. Rather, they pass their income to their unit-holders, who may
be subject to income tax on the distributions.
While MLPs are not new investment vehicles — they have been around since the 1980s — they have
evolved over time. Initially, MLPs were open to a variety of sectors; the Boston Celtics NBA team was
once owned by an MLP, for example. However, with concerns that many corporations would switch
to the tax-friendly MLP structure, Congress limited the formation of MLPs in 1987 to companies
where at least 90% of their income was considered “qualified income,” which includes income and
gains from the exploration, development, mining, production, processing, refining, transportation,
or marketing of natural resources.
MLPs were reinvented in the 1990s when energy companies began moving their more stable assets,
such as pipelines, to the tax efficient MLP structure. Over time, this led to a focus of MLPs on midstream
energy infrastructure that transported, processed and stored crude oil, natural gas and natural gas liquids.
This was an important shift for the asset class as it made MLPs less sensitive to potentially volatile
energy prices.
By the late 1990s, MLPs were beginning to make large acquisitions, develop growth projects and raise
distributions. One notable acquisition occurred in 1997 when Kinder Morgan Energy Partners acquired
liquid pipeline assets from Enron. This partnership is often regarded as the original growth MLP.
In 1995, there were 16 publicly traded MLPs.4 Today, there are more than 130 publicly traded MLPs,
with a market cap near $600 million.5
Types of MLPs
MLPs are typically placed into three major categories, with each containing a different set of characteristics.
Type of Energy MLP
Characteristics
Upstream MLPs
Involved in the exploration, recovery, development and production of crude oil and natural gas. In
2013, the upstream represented 14% of the activities taken by energy and natural resource MLPs.6
Midstream MLPs
Involved in the gathering, processing, storage and transportation of oil and gas. The majority of MLP
activities (55%) focus on midstream operations.6
Downstream MLPs
Involved in the distribution of fuels to end customers, including residential, industrial and agricultural
entities. Comprised 7% of the MLP activities in 2013.6
MLPs are also segmented into several sub-sectors as listed below.
Sub-Sector
Characteristics
Pipeline and Terminaling Includes pipeline assets that transport crude oil, natural gas and refined petroleum products.
Income is generated through tariffs that are tied to the quantity and distance transported.
They are not directly exposed to fluctuating commodity prices.
Gathering and
Processing
Owns and operates infrastructure that aggregates natural gas from multiple wells and delivers it
to a processing plant that removes natural gas liquids and impurities.
Exploration and
Production
Typically owns long-lived reserves with low well decline rates and focuses more on production
than exploration.
Marine Transportation
Transports refined products by waterborne vessels, which are a critical link for liquefied natural
gas (LNG).
Coal
Generates royalty revenues from coal production.
Propane
Contains wholesale and retail distribution networks that sell propane for heating, crop-drying and
cooking. Also transports to rural areas where natural gas is not available.
Institutional interest in MLPs
From an asset perspective, the most direct comparison for MLPs are real estate investment trusts
(REITs). The asset classes share many similarities, but also have some clear differences. For example,
both asset classes own tangible, long-lived assets with underlying contracts providing a stable income
profile. However, REITs are required to distribute a percentage of their cash flow, while MLPs are not.
In addition to their legal structures, which enable both asset classes to avoid being taxed at a corporate
level, we believe MLPs and REITs will share a similar coming-of-age story. For example, REITs were
initially dominated by retail investors, but saw more institutional investors participate as more capital
flows entered the market. Institutional ownership benefits the MLP market as it fosters greater
transparency. Also, as more sophisticated investors enter the space, mispriced securities, in theory,
should be removed from the market. Currently, institutional investors make up about 35% of the MLP
market. For US REITs, institutional investors make up about 80% of the market.7
The participation of institutional investors in the REIT market helped change the mindset of investing in
real estate. For example, the initial mindset of early investors was that REITs offered the potential for a
recurring revenue stream. Eventually, REIT investors realized that the asset class could be viewed from a
total return standpoint because of the growth potential they offer during times of economic prosperity.
This type of perception evolution is being seen today in the MLP space, as investors are coming to
appreciate their total return potential (Figure 1), along with their relatively high level of income (Figure 2).
Additionally, MLPs can be used to diversify investors’ portfolios (Figure 3).
Figure 1 — Competitive Returns Versus Other Asset Classes
• MLPs
• US Equities
%
• US REITs
• US Fixed Income
15 Years
• US Utilities
10 Years
5 Years
30
25
20
18.3
16.7
15
10
5
14.0
13.8
12.7
8.7
8.3
4.2
5.7
16.9
15.5
9.6
7.7
4.7
4.5
Note: MLPs represented by Alerian MLP Index; US REITs represented by FTSE NAREIT All Equity REITs Index; US utilities
represented by Dow Jones Utilities Index; US equities represented by S&P 500 Index; US fixed income represented by
Barclays US Aggregate Index.
Source: Invesco Real Estate using data from StyleADVISOR (Dec. 31, 2014). Past performance is not a guarantee of future
results; current performance may be lower or higher. An investment cannot be made directly into an index.
The current low interest rate environment has many investors searching for income outside of
traditional sources. MLPs, with their stable, long-term cash-flow based contracts, are able to offer
relatively attractive recurring income compared with most other typical equity and fixed income
sources. Furthermore, the average distribution growth of MLPs has surpassed that of US REITs and
US utilities over the last 10 years. Even in the current commodity price environment, we believe
there is further distribution growth to come as energy companies decide to spin off or drop down
their midstream energy assets to partner MLPs.
Figure 2 — Relatively Attractive Current Income
Yields %
MLPs
US REITs
US Utilities
US Fixed Income
3.2
3.1
US Equities
8
6
6.1
4
3.6
2
2.0
Note: MLPs represented by Alerian MLP Index; US REITs represented by FTSE NAREIT All Equity REITs Index; US utilities
represented by Dow Jones Utilities Index; US equities represented by S&P 500 Index; US fixed income represented by
Barclays US Aggregate Index.
Source: Invesco Real Estate using data from Alerian and StyleADVISOR (Dec. 31, 2014).
Lastly, there has been significant demand in recent years from investors seeking opportunities to
increase their allocation to alternatives, and specifically real assets, which may already include REITs and
commodities. MLPs have historically exhibited not only low correlation with US equities, but also US REITs
and US utilities. Moreover, MLPs have exhibited very little correlation with commodities such as oil and
natural gas, and practically no correlation with US fixed income investments. Thus, MLPs can be used to
diversify a wide range of existing portfolios — whether they are more geared toward capital growth or,
income production — and provide exposure to real assets.
Figure 3 — Demonstrated Low Correlation to Commodities, Equities and Fixed Income
0
0.2
0.4
0.6
0.8
1.0
US Fixed Income
US Natural Gas
US Oil
US REITs
US Equities
US Utilities
0.9 to 1.0
Very highly correlated
0.7 to 0.9
Highly correlated
0.5 to 0.7
Moderately correlated
0.3 to 0.5
Low correlation
Less than 0.3
Little, if any correlation
Note: MLPs represented by Alerian MLP Index; US oil represented by S&P GSCI Crude Oil Index; US natural gas represented by
S&P GSCI Natural Gas Index; US REITs represented by FTSE NAREIT All Equity REITs Index; US utilities represented by Dow Jones
Utilities Index; US equities represented by S&P 500 Index; US fixed income represented by Barclays US Aggregate Index.
Source: Invesco Real Estate using data from StyleADVISOR (Dec. 31, 2014). Past performance is not a guarantee of future
results. Diversification does not guarantee a profit or eliminate the risk of loss. Correlation indicates the degree to which two
investments have historically moved in the same direction and magnitude. Data from October 1999 through December 2014.
How to participate in US energy growth with MLPs
Today, investors have many options to gain or increase their access. But because the income and tax
liabilities from MLPs may flow through to the investor, ownership of individual MLP units can be a
complicated endeavor, causing not only income tax reporting at the federal level, but also for every
state in which an MLP operates. As a simplified alternative, MLP strategies are also available through
other types of vehicles as well, such as mutual funds, ETFs, ETNs, or through a separate account.
Each investment option has its own set of unique structures, which may make particular vehicles more
appropriate for some investors.
The table below highlights some of the pros and cons of each type of vehicle for investors.
Exchange-Traded Funds
Open-End Mutual Funds
Key Advantages
Individual Ownership
– This method is tax
– These accounts receive
efficient.
pass-through taxation
– The majority of revenue
status to avoid double
is tax-deferred.
taxation.
– Taxable investors do not – Investor is responsible
pay taxes until they sell.
for the taxes on gains
received.
Separate Account
– ETFs provide easy and
diversified access
to MLPs.
– Investors receive 1099
for tax reporting.
– These funds provide
– Entity does not pay
easy and diversified
corporate tax.
access to MLPs.
– Investors receive 1099
– Distributions are
for tax reporting.
tax-advantaged, allowing
investors to postpone tax
payments until the
shares are sold, thus
becoming eligible for
lower capital gains taxes.
– Investors receive 1099
for tax reporting.
Potential
Disadvantages
– Tax reporting
is complex.
– Investor receives
a Schedule K-1.
– Investor must file state
income taxes in each
state where the MLP
operates.
– They are subject to
corporate-level taxes.
– They must rebalance
holdings whenever the
underlying index
constituents change,
regardless of the
long-term investment
potential.
– Rebalancing creates
potential taxes.
– They are subject to
corporate-level taxes.
– Strategies with higher
portfolio turnover may
create larger potential
tax liabilities for
shareholders.
– Investment minimums
are high.
– These accounts are
typically reserved for
institutional investors.
Exchange-Traded Notes
– Investors must pay
ordinary income tax
on the entirety of the
coupon income
distributed by the ETN.
– Investors take on credit
risk associated with
bank that is backing
the note.
– Many ETNs trade
at a premium.
For illustrative purposes only.
Conclusion
MLPs have garnered heightened interest from a variety of investors over the last decade, including
institutional investors, who have been drawn to the asset class by their attractive yields and historical
total return performance.
While their businesses are not directly tied to oil prices, MLPs, nevertheless, have been affected by
the broader market selloff that has been tied to falling oil prices.
This has caused some short-term volatility in the asset class, which we believe could be a potential
attractive entry point for long-term investors. Investors should be selective, we believe, when
choosing which MLP companies to invest in, particularly exercising caution with highly leveraged
partnerships and companies with a limited dividend cushion.
Overall, our long-term rationale for investing in MLPs has not changed, as new fracturing technology,
among other technological advances, have opened a new realm of possibilities for production in the
US. Despite the recent fall in oil prices and resulting volatility, we believe that MLPs over the long
term will continue to be a force driving the construction of US energy infrastructure, and that their
potential for income generation, total returns and portfolio diversification will also continue to drive
interest from institutional investors.
1
2
3
4
5
6
7
Source: US Energy Information Administration, Data as of end of 2013, stat released on December 4, 2014.
Source: The American Society of Civil Engineers.
Source: ”Oil & Natural Gas Transportation & Storage Infrastructure: Status, Trends, & Economic Benefits,” IHS Global Inc., December 2013.
Source: Alerian, “MLP: No Longer an Emerging Asset Class,” 2014.
Source: Invesco Real Estate with information provided by US Capital Advisors and Wells Fargo as of Dec. 31, 2013.
Source: National Association of Publicly Traded Partnerships.
Source: Invesco Real Estate with information provided by US Capital Advisors and Wells Fargo as of Dec. 31, 2013.
FOR US INSTITUTIONAL INVESTOR USE ONLY — NOT FOR USE WITH THE PUBLIC
All investments are subject to risk and may lose value. Diversification does not guarantee a profit or eliminate the risk of loss. Businesses in the energy sector may
be adversely affected by foreign, federal or state regulations governing energy production, distribution and sale as well as supply-and-demand for energy
resources. Energy infrastructure MLPs are subject to a variety of industry specific risk factors that may adversely affect their business or operations and are also
subject to significant federal, state and local government regulation. MLPs are also generally considered interest-rate sensitive instruments. All material presented
is believed to be reliable and current, but accuracy cannot be guaranteed. Past performance is not an assurance of future results. This is not to be construed as an
offer to buy or sell any financial instruments, nor constitute a recommendation of any investment strategy for a particular investor. The opinions expressed herein
are based on current market conditions and are subject to change without notice. As with all investments, there are associated inherent risks. Please obtain and
review all financial material carefully before investing. All data is as of December 31, 2014 unless stated otherwise.
Invesco Advisers, Inc. is an investment adviser; it provides investment advisory services to individual and institutional clients and does not sell securities.
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