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MLP "Clones" Open Up a New World of Income for Energy Investors

by | published May 24th, 2013

The “midstream” segment in oil and gas markets is undergoing some very interesting changes these days.

Remember, these are the companies that connect “upstream” (field production of oil and gas) and “downstream” (refining, processing, wholesale, and retail distribution) functions. Throughput – moving and storing volume – is the major component of midstream activities, as well as the primary source of revenue. And lots of it.

This market is still the domain of master limited partnerships (MLPs) and other partnership arrangements and used to be primarily populated by pipeline companies.

But the sector is diversifying in an exciting way.

MLP “clones” are starting to emerge, controlling more expanded activities and new product-specific focuses that never existed before.

That means brand-new investing opportunities for you.

The Advent of MLPs Altered the Investing Landscape

Since the late 1980s, MLPs have allowed for the movement of profits directly to partners, avoiding the payment of corporate taxes.

These arrangements were not in the ballpark for average investors, since they require heavy initial commitments.

However, once MLPs decided to float stock issuances, the situation changed dramatically. Now, retail investors can buy and sell shares of MLPs the same way they do any other stock.

There is also one (big) additional advantage. An MLP’s stock represents a fixed percentage of the partnership. That means you receive a fixed percentage of the profits, translating into a higher dividend than market averages – sometimes significantly higher.

Initially, these partnerships were structured to center around the ownership and management of pipeline networks. But the newer MLP hybrids feature more traditional service targets and are increasing the alternatives available to generate investment return, in addition to the now firmly entrenched MLP and equity opportunities.

Now New Approaches Are Surfacing

First, there are the broader applications within the midstream segment itself.

These include gathering, initial processing, terminal, and storage facilities. There are also specialty assets related to specific natural gas, gas liquids, and oil products, combined with holding facilities for field production (especially those located onshore for offshore drilling).

All of these are staples among midstream operations. Storage remains a major component here, especially in natural gas operations, where many regions of the U.S. still have a majority of pipeline capacity locked up for storing gas, not transporting is.

But what makes things interesting is the way in which functions previously considered as separate components are now being combined. The connecting of activities closer to upstream (such as gathering) with the actual transit assets and elements abutting downstream (preliminary treatment, with gas fractionating and separating locations) is resulting in increasing efficiency and enhanced bottom lines for many companies.

Second, developments are beginning to cross what used to be distinct segment boundaries.

Partnerships that had been exclusively concerns with pipelines are now beginning to acquire working interests in field operations (upstream) and refineries (downstream).

Some of these latter developments are now even extending into the distribution of end-user products.

This parallels an earlier move among oil majors to become vertically integrated oil companies (VIOCs). That movement had its high point from the mid-1970s into the 1990s. The idea was to utilize “transfer pricing”to increase profitability.

Such an idea seems simple enough. If the same corporation controls upstream, midstream, and downstream elements in a single value chain, movements between segments can take place more cheaply than arms-length deals with third parties. Overall corporate savings would result in increased profitability.

Well, those days are largely over. There are still some companies going the VIOC route. But for each of these contemporary examples, there are several other moves in the opposite direction – bigger companies spinning off sector components into separate operations.

Specialization is the hallmark today, not size.

What differs with the midstream-based applications currently underway is the focus. Here, the emphasis is upon function. The vertical integration taking place is to streamline what still remains a midstream-focused operation. This has already resulted in fewer genuine competitors in what is still a function-limiting environment.

What is happening here with midstreams is similar to consolidations elsewhere.

For example, major oil field service (OFS) providers are becoming larger – both by absorbing horizontal competitors (other OFS companies) and by moving “upstream” to acquire the manufacturers of OFS equipment.

What makes the midstream application different is the attempt to combine what had been separately considered revenue sources in the same overall process sequence.

Third, and perhaps most significant, midstream partnerships (both MLPs and other limited ventures) are acquiring interests in specialized product lines, bridging the distinction between midstream and downstream almost completely.

This may well be the most significant “clone” emerging for MLPs.

Now, the MLP structure has been governed by legislation allowing for asset-based formations. At the outset, this was essentially limited to pipelines. But the application is expanding to other assets. That includes the product produced as an asset class. Such a change will take a while to work itself out, but comprises a main interest for the investor. Already, examples are emerging.

Here’s what’s so interesting about this…

We’ll have the ability to take a single product – for example, propane – and invest in a single partnership that combines raw material access, transport, processing, and distribution centered upon that single product.

This is, of course, the latest variation of increasing return by verticalizing process. It differs from the earlier VIOC movement in two ways:

  • It retains an initial asset foundation in midstream services; and
  • It involves a specific product.

As natural gas becomes an even more relied-upon energy source for petrochemical feeder stock, industrial usage, and fuel, such specialized approaches will provide some genuine opportunities for enhanced investment return.

Actually, propane is a good example in this respect.

In addition to its employment in all of these end-user categories, it is also the primary energy source in rural America. That means it is a main bridge into a completely separate market sector – agriculture.

As these new midstream developments unfold, we will be using them to improve our investment prospects.

And the way this is going to be done will be laid out right here for you. Stay tuned.

Sincerely,

Kent

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