North America is reshaping global energy market dynamics as a low cost producer. Immense shale resources, new technologies and exports we believe will meet the world’s future energy needs. We invest in the midstream portion of the energy value chain, firms that own the critical infrastructure linking energy supply sources with demand centers. This Knowledge Center aims to keep you up to date with key trends and to help you learn more about the space.
About Midstream Energy Security Types and Characteristics
- Master Limited Partnerships (MLPs): These are companies formed under U.S. law that do not have entity-level taxation. Because of depreciation adjustments that result in return of capital, they maximize the delivery of tax-deferred income. While the majority of MLPs operate midstream energy assets, a small portion are focused on diﬀerent segments of the energy value chain or on other sectors, such as financials. We exclude non-midstream partnerships from our investable universe.
- General partner C-corps (GPs): GPs manage the operations of MLPs. Though some GPs have elected to be taxed as partnerships, the majority are structured as traditional corporations.
- Midstream corporations: With the completion of Kinder Morgan’s “roll-up” in 2014, a new segment of midstream corporations was created. These companies own midstream energy assets such as pipelines but have elected to house them in corporations and do not use the GP/LP structure.
- Diversified utilities: Certain utilities have significant stakes in natural gas pipeline assets and/or general partnership interests in MLPs, though a substantial portion of their cash ﬂows are derived from the utility assets.
- Canadian midstream companies: A number of companies that own both U.S. and Canadian midstream assets are domiciled in Canada. These businesses have similar underlying fundamental drivers to U.S. midstream investments
About Midstream Energy & MLPs
Is midstream investing more than just MLPs? Yes, we believe it is crucial for investors to understand the composition of the midstream energy universe. Midstream companies feature relatively predictable income streams generated from businesses that gather, process, transport and distribute crude oil, natural gas and natural gas liquids. The midstream space encompasses a broad set of entity structures, including both master limited partnerships (MLPs) and traditional corporations.
How does the MLP structure work? Similar to REITs, MLPs were designed specifically with the goal of passing income directly to investors in mind. By law, they can only be used for businesses where 90% or more of the revenue is being generated from certain qualifying activities, such as managing natural gas pipelines or storing crude oil—industries that generate steady income streams, but that also require large investments in infrastructure that need to be depreciated over long periods of time.
What makes MLPs tax efficient? As a pass-through entity, income is passed to unitholders directly, as if that investor had personally earned the income, with no corporate level taxation. This allows income to be taxed only once, on the individual investors tax filing, and MLP income is taxed as ordinary income. Any capital gains passed through from the MLP distributions would also be treated the same way for individual tax purposes. MLPs tend to be capital intensive, and are able to write-off business expenses and depreciation of capital expenditures (e.g. the significant cost of building a pipeline). This means that income paid out from the MLP is often treated as nontaxable return of capital (ROC). Typically 70-100% of MLP distributions are ROC.
How does ROC work? The MLP investors original cost basis of investment is reduced by the amount of ROC income received. Eventually, at the time of sale, the investor will have to pay taxes, but at some time in the future. And those future taxes may not necessarily be at capital gain tax rates, due to ordinary income recapture rules, and in general, a significant portion of those future taxes will be at the lower capital gains tax rate, with the exception of cases where the cost basis has reached the zero bound.
That sounds like great tax-efficiency, what deters investors from direct MLP ownership? Buying shares in individual MLPs creates significant company-specific risk, requires the holder to pay income taxes in every state the MLP operates, generates a burdensome K-1 tax form (often requires a dedicated tax advisor) and investors are subject to unrelated business taxable income (UBTI). K-1’s can be mailed to investors as late as March 15, in some cases forcing last minute changes and tax resubmissions.
Who are the different investors in a partnership? MLPs are structured as partnerships, with limited partners (LPs), general partners (GPs) and may include additional entities with controlling interests, structured as C-corps or LLCs. The tax status of GP interests may also vary. Some GPs may elect to be taxed as C-corps and some as partners. The traditional MLP investor often owns the limited partner interests. These securities are bought and sold in units. Each unit represents a direct interest in the overall partnership.
What is the difference between limited and general partners? It varies widely across MLPs, but historically, when the underlying LP business is doing well, this implied the GP was managing the overall business well, and thus, once certain predetermined LP payout thresholds were reached, the GPs were entitled to an increasing proportion of the LPs cash flows. These are called incentive distribution rights (IDRs).
Thuy Quynh Dang
Thuy Quynh Dang
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The views and opinions are as of the date of publication and are subject to change without notice. This material represents an assessment of the market environment at a specific point in time, should not be relied upon as investment advice, is not intended to predict or depict performance of any investment and does not constitute a recommendation or an offer for a particular security. We consider the information in this presentation to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of suitability for investment. Please consult with your investment, tax or legal professional regarding your individual circumstances prior to investing.
Please consider the investment objectives, risks, charges and expenses of the Fund carefully before investing. A summary prospectus and prospectus containing this and other information may be obtained by calling 1.800.330.7348 or visiting cohenandsteers.com. Please read the summary prospectus and prospectus carefully before investing.
Risks of Investing in MLP Securities
An investment in MLPs involves risks that differ from a similar investment in equity securities, such as common stock of a corporation. Holders of equity securities issued by MLPs have the rights typically afforded to limited partners in a limited partnership. As compared to common shareholders of a corporation, holders of such equity securities have more limited control and limited rights to vote on matters affecting the partnership. There are certain tax risks associated with an investment in equity MLP units. Additionally, conflicts of interest may exist among common unit holders, subordinated unit holders and the general partner or managing member of an MLP; for example a conflict may arise as a result of incentive distribution payments.
MLPs are subject to significant regulation and may be adversely affected by changes in the regulatory environment including the risk that an MLP could lose its tax status as a partnership. MLPs may trade less frequently than larger companies due to their small capitalizations which may result in erratic price movement or difficulty in buying or selling. MLPs may have additional expenses, as some MLPs pay incentive distribution fees to their general partners. The value of MLPs depends largely on the MLPs being treated as partnerships for U.S. federal income tax purposes. If MLPs were subject to U.S. federal income taxation, distributions generally would be taxed as dividend income. As a result, after-tax returns could be reduced, which could cause a decline in the value of MLPs. If MLPs are unable to maintain partnership status because of tax law changes, the MLPs would be taxed as corporation and there could be decrease in the value of the MLP securities.