Eureka! When gold was first discovered in California during the winter of 1848, it set off a massive migration of eager prospectors with ambitions of striking it rich. To this day, the lore of the so-called “Forty-niners” continues to fascinate students of history. Perhaps one day the exclamation “Bismarck” will convey the same sense of possibility.
Today's modern boom-towns are arising from the revolution in hydraulic fracking of shale oil and gas formations. Towns from Texas to North Dakota are seeing economic booms that stem from increased oil and natural gas production made possible by fracking. Oil giant BP recently reported that U.S.-based petroleum production increased 13.9% in 2012, the largest increase on record. North Dakota, the center of the shale boom, currently reports 3.3% unemployment, the lowest rate in the country. Partially based on this revolution, North America is expected to surpass Saudi Arabia as the largest oil producer by 2020 (International Energy Agency, 2013).
Despite the gains made by alternative fuels and the expected increase in the use of electric cars, global demand for oil and natural gas is expected to rise for years to come. According to IHS Global, the current energy boom is estimated to support double the number of jobs in the sector to over 3.5 million by 2035. Shale gas alone, which has quadrupled in production since 2007, is projected to support 870,000 jobs by 2015.
Political stability, infrastructure, skilled labor, and geological research make North America a more attractive energy investment target than the Middle East, Venezuela, or Nigeria. As a result, we are already seeing large multinational firms selling foreign assets to invest in US and Canada. ConocoPhillips, Hess, Devon, Marathon, Anadarko, and Murphy have all sold foreign assets so as to redirect investment back to North America. Based on America's development and early adoptions of these new techniques, U.S. energy companies are shaping up to be world leaders in the sector.
The boom is benefiting companies that are active in every area of the energy supply chain: upstream, midstream, and downstream. However the “upstream” players (those participating in exploration and production) will continue to deal with unpredictable global trends that affect the price of oil and regional factors affecting the price of natural gas. The downstream providers struggle with unpredictable demand for their products. Energy services, on the other hand, should increase as the sheer volume of production requires that more and more oil and natural gas be transported, stored, processed, and refined. This is where the “midstream” players come in. According to Natural Gas Association of America, an estimated 84 billion dollars is already scheduled to be invested in a range of midstream businesses across both the US and Canada. But midstream businesses may be the sweet spot.
Investment structures in the United States called Master Limited Partnerships (MLPs) offer a means for retail investors to participate in midstream energy businesses. MLPs, which trade on public exchanges, benefit from the tax advantages of limited partnerships and the liquidity typically associated with corporate stocks. The structure that defines MLPs is not available to all sectors of the economy. In order to qualify, a partnership must derive 90% of its cash flows from qualifying sources, such as activities related to the production, processing or transportation of oil, natural gas or coal. In fact, Congress specifically created the MLP parameters to direct investment flows to the energy sector. It is unlikely that the political wind will shift on this topic.
Like REITs in the real estate market, MLPs are not subject to corporate income taxes. Instead they pass through earnings directly to limited partners (the equivalent of shareholders for common stock), thereby avoiding double taxation.
In addition to paying out taxable income, distributions may be made as return of capital. This means that limited partners are not only entitled to a share of earnings, but also to a share of depreciation. The MLP structure offers investors an opportunity for current income and tax deferral.
As a result, North American MLPs may be an ideal choice for suitable investors looking for opportunities in the energy sector. Obviously, in order to maximize tax benefits, the MLP would have to be held outside a qualified plan and even then, all investors should consult with an accountant or tax expert ahead of time.
Generally speaking, MLPs produce a lot of cash, which translates into high levels of distributions. Current distributions in the sector tend to range from 4% to 10%. And because MLPs include pipelines and other midstream businesses, income tends to also be more consistent than other types of energy investments.
But MLPs can be growth vehicles as well. Because they avoid double taxation, they can have lower capital costs than non-MLP energy businesses. This makes it much easier to grow their operations organically or through acquisitions. Since inception in August 2010, an ETF tracking the performance of an energy infrastructure MLP Index has returned a little more than 14 percent cumulatively without factoring in distributions of more than 5 percent annually.
Although MLPs operate throughout the supply chain, for the reasons above we believe MLPs that focus on midstream activities such as storage, transportation, pipelines, and refineries may be more attractive. In particular, we believe pipelines, which are the fastest and most cost effective medium of transporting energy, merit particularly close attention. Other trends to consider may be the increasing levels of energy consumption abroad. Firms with capabilities to distribute internationally should be considered.
Contact a Euro Pacific broker to discuss options in this space.
Discussion of tax treatments in this material is not intended as tax advice. Consult your tax professional for more information.