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November 19, 2010

Equity Research

November 19, 2010 E quity Research MLP Primer -- Fourth Edition Everything You Wanted To Know

MLP Primer -- Fourth Edition

Everything You Wanted To Know About MLPs, But Were Afraid To Ask

Primer Fourth Edition - A Framework For Investment. This report is an update to our previous MLP Primer (third edition) published in July 2008. The purpose of this reference guide is to familiarize investors with the Master Limited Partnership (MLP) investment. In this fourth edition, we have included some new information based on questions and feedback we have received from investors over the past couple of years. In addition, we have added and updated sections detailing topical issues and developments related to the MLP sector.

topical i ssues and developments rela ted to the MLP sector. Please see page 149 for

Please see page 149 for rating definitions, important disclosures and required analyst certifications

Wells Fargo Securities, LLC does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of the report and investors should consider this report as only a single factor in making their investment decision.

MLPART111910-225541

Master Limited Partnerships

Michael Blum, Senior Analyst (212) 214-5037 michael.blum@wachovia.com

Sharon Lui, CPA, Senior Analyst (212) 214-5035 sharon.lui@wachovia.com

Eric Shiu, Associate Analyst (212) 214-5038 eric.shiu@wachovia.com

Praneeth Satish, Associate Analyst (212) 214-8056 praneeth.satish@wachovia.com

Hays Mabry, Associate Analyst (212) 214-8021 hays.mabry@wachovia.com

Ronald Londe, Senior Analyst (314) 955-3829 ron.londe@wachovia.com

Jeffrey Morgan, CFA, Associate Analyst (314) 955-6558 jeff.morgan@wachovia.com

(314) 955-3829 ron.londe@wachovia.com Jeffrey Morgan, CFA, Associate Analyst (314) 955-6558 jeff.morgan@wachovia.com

MLP Primer -- Fourth Edition

WELLS FARGO SECURITIES, LLC EQUITY RESEARCH DEPARTMENT

Table Of Contents

I.

Introduction

 

7

II.

Why Own MLPs?

7

A. MLP Total Return Value Proposition

7

B. Attractive Yield

 

8

C. Strong Performance Track Record

8

D. Tax Advantages

 

9

E. Portfolio Diversification

9

F. A Lower Risk (Beta) Way To Invest In Energy

10

G. An Effective Hedge Against Inflation

10

H. Estate Planning Tool

 

11

I. Demographics

11

J. Resilient Business Model During Periods Of Economic Weakness

12

III.

Who Can Own MLPs?

12

A. Mutual Funds Can Own MLPs

13

B. Challenges Remain For Mutual Fund Ownership Of MLPs

13

Timing Issues

13

State Filing Requirements

13

C. Tax-Exempt Vehicles Should Be Cautious In Owning MLPs

13

IV.

Risks To Owning MLPs

13

V.

How To Build An Effective MLP Portfolio

14

A. Balance Risk And Growth

14

B. Diversify Among MLP Sectors

14

C. “Anchor Tenants”

 

15

D. Invest With Top Management

15

VI.

The Basics

 

15

A. What Is An MLP?

15

Who Are The Owners Of The MLP?

15

B. What Qualifies As An MLP?

15

C. What Are The Advantages Of The MLP Structure?

16

D. How Many MLPs Are There?

16

E. What

Is

The

K-1 Statement?

17

F. What Is The Difference Between An LLC And An MLP?

17

G. Are MLPs The Same As U.S. Royalty Trusts? Canadian Royalty Trusts?

17

H. What Are I-Shares?

18

The I-Share Discount

18

What Are The Tax Consequences Of Owning I-Shares?

19

I. Why Create An MLP?

 

19

A Premium Valuation

19

A Tax-Advantaged Structure With Which To Pursue Growth Opportunities

19

The Ability To Maintain Control Of The Assets (Via The GP Interest)

19

Incentive Distribution Rights (IDR)

19

VII.

Key Terms

 

20

A. What Are Distributions?

20

B. What Are Incentive Distribution Rights (IDR)?

20

C. Calculating Incentive Distribution Payments

20

D. What Is The Difference Between Available Cash Flow Versus Distributable Cash Flow?

21

E. Are MLPs Required To Pay Out “All” Their Cash Flow?

21

F. What Is The Distribution Coverage Ratio And Why Is It So Important?

21

G. What Is The Difference Between Maintenance Capex And Growth Capex?

22

VIII.

Drivers Of Performance

23

A. Distribution Growth

23

B. Access To Capital

23

C. Commodity Prices

24

D. Credit Spreads

24

E. Interest Rates

25

Master Limited Partnerships

WELLS FARGO SECURITIES, LLC EQUITY RESEARCH DEPARTMENT

 

F. Economic Activity (GDP Growth)

26

G. MLP Fund Flows And Liquidity

26

IX.

How Did MLPs Fair During The Credit Crisis?

27

X.

Tax And Legislative Issues

30

A. Who Pays Taxes

30

B. What Are The Tax Advantages For The LP Unitholder (The Investor)?

30

C. Some Tax Considerations And Disadvantages For The LP Unitholder

31

D. The Mechanics Of A Purchase And Sale Of MLP Units And The Tax Consequences

32

E. Return Of Capital Versus Return On Capital

33

F. Foreign Investor Ownership

34

G. Treatment Of Short Sales

34

H. Can MLPs Be Held In An IRA?

34

I. MLPs As An Estate Tax Planning Tool

35

J. Current Tax And Legislative Issues

36

What Is The National Association Of Publicly Traded Partnerships (NAPTP)?

36

What Is The Risk Of MLPs’ Losing Their Tax-Advantaged Status

36

Canadian Royalty Trusts Tax Status Still On Track To Change In 2011

37

Public MLP Unitholders Unlikely To Be Affected By Carried Interest Legislation

37

MLPs Included In FERC Process For Determining Pipeline ROEs

37

MLPs Income Tax Allowance In Pipeline Ratemaking

38

XI.

MLP Accounting Nuances

38

A. How Can MLPs Pay Out More Than They Earn?

38

B. Mark-To-Market Hedge Accounting

39

C. Hedge Accounting

40

D. Partners Capital -- Implications For Debt-To-Capital Ratio

40

XII.

Sector Trends

40

A. Dramatic Growth Of MLP Sector

40

MLP Average Trading Volume Continues To Grow

41

B. MLP Investor Base Has Been Evolving

41

Institutional Investor Interest Growing

42

C. Shift In Supply Resources Is Driving Energy Infrastructure Investment

42

Natural Gas

43

Natural Gas Liquids

47

Crude Oil

50

Renewable Energy

53

D. Acquisition Capital Deployed Has Been Steadily Rising

54

E. MLPs Continue To Enjoy Access To Capital Markets

56

F. MLPs Have Employed Creative Financing Solutions To Fund Growth

57

PIPEs (Private Investments In Public Equity)

57

Hybrid Securities

58

Convertible Preferred Equity

58

Paid-In-Kind (PIK) Equity

59

G. Publicly Traded General Partners – Recognizing The Value Of The GP

59

What Makes The GP So Valuable?

59

Power Of The IDRs

60

The Multiplier

60

The Power Of Equity Issuance

61

A

Brief History Of GPs

63

Pure-Play GPs Are IPO’d As Stand-Alone Entities

64

Cost Of Capital Drives GP Transactions

65

Cost-Of-Capital Considerations Driving GP Elimination Transactions

65

Recent GP Transactions Could Be Also Be Motivated By Potential Carried Interest Legislation

67

Owning The GPs Better Aligns Investors With Management

67

GP Subsidies

68

IDR Reset Option Enables Management To Better Control Cost Of Capital

68

General Partner Nuances – Not All GPs Are Created Equally

68

Is

It Better To Own The GP Or Underlying MLP?

69

GP/LP Conflicts Of Interest

70

The MLP And GP Growth Rates Should Converge Over Time

71

MLP Primer -- Fourth Edition

WELLS FARGO SECURITIES, LLC EQUITY RESEARCH DEPARTMENT

H. Understand An MLP’s Cost Of Capital

72

There Are Three Components To An MLP’s Cost Of Capital

73

Incentive Distribution Rights Increase Cost Of Capital

73

CAPM Understates The Cost Of Equity

74

Is An MLP’s Cost-Of-Capital Advantage Overstated? Yes And No

74

I. Upstream MLPs

75

Return Of Upstream MLPs

75

Upstream MLPs Failed In The 1980s. Why?

75

What Should Be The Criteria To Invest Today?

75

Upstream MLPs Are Faced With Unique Challenges And Risks

75

J. Emergence Of MLP Products

76

MLP Indices

76

The Wells Fargo Securities MLP Index

76

Financial Products Facilitate Participation In MLPs

77

MLP Closed-End Funds (CEFs) Proliferate

78

MLP Exchange Traded Notes (ETNs)

79

Exchange-Traded Fund – Alerian MLP ETF

80

Open-End Funds – The SteelPath MLP Funds Trust

80

Options

81

Total Return Swaps

81

Credit Default Swaps

81

XIII. Valuation Of MLPs

82

A. Distribution Yield

82

B. Three-Stage Distribution (Dividend) Discount Model

82

C. Price-To-Distributable Cash Flow

83

D. Enterprise Value-To-Adjusted EBITDA

83

E. Spread Versus 10-Year Treasury

83

XIV. Types Of Assets In Energy MLPs And Associated Commodity Exposure

84

A. A Brief Review Of The Evolution Of The MLP Sector

84

B. Asset Overview – Relative MLP Distribution Security

84

C. The Natural Gas Value Chain

86

D. The NGL Value Chain

94

E. The Crude / Petroleum Products Value Chain

105

F. Propane

109

G. Marine Transportation

111

H. Coal

114

I. Upstream (E&P)

115

J. Refining

116

K. Asphalt

116

L. Liquefied Natural Gas

117

Appendix

119

Master Limited Partnerships

WELLS FARGO SECURITIES, LLC EQUITY RESEARCH DEPARTMENT

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MLP Primer -- Fourth Edition

WELLS FARGO SECURITIES, LLC EQUITY RESEARCH DEPARTMENT

I. Introduction -- A Framework For Investment

This report is an update to our previous MLP Primer (third edition) published in July 2008. The purpose of this reference guide is to familiarize investors with the Master Limited Partnership (MLP) investment. In this fourth edition, we have included some new information based on questions and feedback we have received from investors over the past couple of years. In addition, we have added and updated sections detailing topical issues and developments related to the MLP sector. As always, feel free to contact us with any questions or feedback.

II. Why Own MLPs?

Since the publication of our last primer, the total market capitalization of MLPs has increased to $220 billion from $134 billion in July 2008 despite a decline in the number of publicly traded MLPs to 72 from 78 (primarily due to consolidation and ongoing private transactions). Although the size of the asset class, in terms of market capitalization, has grown approximately 146% over the past two years, we suspect that energy MLPs are still relatively under-owned in comparison to other asset classes. There are several reasons investors should consider owning MLPs as part of an overall investment portfolio, in our view. These include the following:

1. MLP Total Return Value Proposition

2. Attractive Yield

3. Strong Performance Track Record

4. Tax Advantages

5. Portfolio Diversification

6. A Lower Risk (Beta) Way to Invest In Energy

7. An Effective Hedge Against Inflation

8. Estate Planning Tool

9. Demographics

10. Resilient Business Model During Periods Of Economic Weakness

A. MLP Total Return Value Proposition

MLPs are well positioned to generate high-single-digit to low-double-digit total returns over time consisting of a tax-advantaged 6-8% yield and annual distribution growth of 3-5%. We view MLP yields as secure and near- term distribution growth as highly visible. Our growth forecast is underpinned by a relatively healthy fundamental environment and the continued need for additional infrastructure investment to support shale play development (for both oil and natural gas), strong demand for NGLs by the petrochemical sector, and opportunities to build and expand storage to address supply and demand imbalances and support the development of renewable fuels.

Figure 1. MLP Value Proposition

11.7%

6.4% 5.3%
6.4% 5.3%
6.4% 5.3%

6.4%

5.3%
5.3%
6.4% 5.3%
6.4% 5.3%
6.4% 5.3%
6.4% 5.3%
6.4% 5.3%

Current Yield

+

Source: Wells Fargo Securities, LLC

3-Year Distribution Growth Estimate

=

Total Return Potential

Master Limited Partnerships

WELLS FARGO SECURITIES, LLC EQUITY RESEARCH DEPARTMENT

B. Attractive Yield

Given the uncertain global economic outlook, a low interest rate environment, and continued market volatility in 2010, MLPs have been attracting incremental capital as investors focus on income-oriented securities. MLPs provide yields ranging from 5% to 10% with the potential for distribution growth of 3-5%. The group’s yield compares favorably to other income-oriented investments on a risk-adjusted basis, in our view.

Figure 2. MLP Yield Versus Other Yield Investments

9% 7.1% 6.3% 6.0% 6% 4.9% 4.7% 4.4% 2.8% 3% 1.9% 0% ML U.S. B-BB
9%
7.1%
6.3%
6.0%
6%
4.9%
4.7%
4.4%
2.8%
3%
1.9%
0%
ML U.S. B-BB
High Yield
Wells Fargo
Moody's BAA
Moody's
FTSE NAREIT
S&P 500
U.S. 10-Year
S&P 500
Securities
(Investment
Municipal
Index
Utilities
Treasury
MLP Index
Grade) Index
Bond Index
Index
Current Yield (%)

Note: Wells Fargo Securities MLP Index yield is based on float-adjusted market capitalization Source: Bloomberg, FactSet, and Wells Fargo Securities, LLC

C. Strong Performance Track Record

From 2000 to 2009, the Wells Fargo Securities MLP Index outperformed the S&P 500 Index in eight out of ten years (on a total return basis). During this time frame, MLPs delivered an annual total return of 22.7% with lower risk (average beta of 0.38 over this time frame), versus 1.2% for the S&P 500.

Figure 3. MLP Total Returns Versus S&P 500 TR Index

Total Return (2000-2010YTD) 76% 80% 60% 45% 43% 42% 40% 33% 29% 27% 26% 17%
Total Return (2000-2010YTD)
76%
80%
60%
45%
43%
42%
40%
33%
29%
27%
26%
17%
16%
20%
11%
12%
8%
5% 5%
5%
(0%)
0%
(9%)
(20%)
(12%)
(22%)
(40%)
(38%)
(37%)
(60%)
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010YTD
Wells Fargo Securities MLP Total Return Index
S&P 500 TR Index
Index
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010 TD
Wells Fargo MLP Index (TR)
S&P 500 Index (TR)
S&P REIT Index (TR)
S&P Utilities Index (TR)
42.9%
41.8%
(0.3%)
45.2%
16.5%
4.8%
26.6%
11.7%
(38.2%)
75.9%
33.3%
(9.1%)
(11.9%)
(22.1%)
28.7%
10.9%
4.9%
15.8%
5.5%
(37.0%)
26.5%
7.5%
NA
6.5%
(8.8%)
28.8%
29.2%
12.5%
41.6%
(17.1%)
(41.2%)
25.0%
21.5%
57.2%
(30.5%)
(30.0%)
26.3%
24.3%
16.8%
21.0%
19.4%
(29.0%)
11.9%
3.4%
Total Return

Source: FactSet, Standard & Poor’s, and Wells Fargo Securities, LLC

MLP Primer -- Fourth Edition

WELLS FARGO SECURITIES, LLC EQUITY RESEARCH DEPARTMENT

In addition to real estate investment trusts (REIT) and Utilities, MLPs have also outperformed other yield- oriented securities, such as high yield and investment grade bonds, and the U.S. 10-Year Treasury. For the trailing three-, five-, seven-, and nine-year periods, MLPs generated annual total returns of 13.6%, 14.7%, 14.7%, and 15.7%, respectively. These MLP returns have exceeded investment grade bond returns (as measured by Moody’s Corporate BAA Index) of 2.0%, 1.0%, 1.2%, and 3.0%, respectively, over these same periods and also compare favorably to high yield bond returns of 7.1%, 2.1%, 0.7%, and 4.5%. To note, for the trailing three-, five-, seven-, and nine-year periods, REITs generated annual returns of (4.8%), 1.0%, 6.8%, and 6.9%, respectively, while Utility annual returns were (5.6%), 3.8%, 9.6%, and 4.5%.

Figure 4. Total Return Performance Versus Other Indices

50% Wells Fargo MLP Index (TR) S&P REIT Index (TR) S&P Utilities Index (TR) U.S.
50%
Wells Fargo MLP Index (TR)
S&P REIT Index (TR)
S&P Utilities Index (TR)
U.S. 10-Year Treasury
40%
Investment Grade Bonds
Merrill U.S. High Yield B-BB
30%
20%
10%
0%
(4.8%)
(5.6%)
(10%)
YTD
Trailing 1-Year
Trailing 3-Year
Trailing 5-Year
Trailing 7-Year
Trailing 9-Year
Total Return Performance
30.3%
22.1%
3.1%
25.9%
6.1%
12.5%
44.1%
29.7%
9.7%
14.3%
4.0%
16.3%
13.6%
11.3%
2.0%
7.1%
14.7%
1.0%
3.8%
8.6%
1.0%
2.1%
14.7%
6.8%
9.6%
5.3%
1.2%
0.7%
15.7%
6.9%
4.5%
5.6%
3.0%
4.5%

Source: FactSet, Standard & Poor’s, and Wells Fargo Securities, LLC

D. Tax Advantages

MLPs offer investors a tax-efficient means to invest in the energy sector. An investor will typically receive a tax shield equivalent to (in most cases) 80-90% of cash distributions received in a given year. The tax-deferred portion of the distribution is not taxable until the unitholder sells the security. (Please see The Mechanics Of A Purchase And Sale Of MLP Units And The Tax Consequences for more details.)

E. Portfolio Diversification

Historically, MLPs have exhibited low correlation to most asset classes and thus, provide good portfolio diversification, in our view. Prior to the credit crisis/market correction in 2008, MLPs were not highly correlated with other asset classes, commodities, interest rates, or other yield-oriented investments, and thus, provided good portfolio diversification. During the credit crisis (2007-09), MLPs’ correlation increased dramatically, beta doubled, and price performance essentially mirrored the overall market (i.e., S&P 500 Index). As markets have normalized, MLP correlations to crude oil, 10-year Treasuries, credit spreads, and the S&P 500 Index have notably weakened.

Specifically, MLPs’ correlation to the S&P 500 Index has declined considerably, to 0.45 from 0.96 during the credit crisis. In addition, the correlation between MLPs and both the high yield and investment-grade spread to Treasuries increased to negative 0.92, respectively, during the credit crisis (2007-09) from pre-credit crisis (2000-06) levels of negative 0.76 and negative 0.64, respectively (i.e., as spreads increased, the MLP Index declined). For 2010 to date, the correlations between MLPs and high-yield and investment-grade spreads have declined significantly, to 0.01 and 0.68, respectively.

Pre-credit crisis, MLPs were more correlated to the movement in crude oil prices than natural gas prices. Over this time period, the crude oil correlation was 0.81, versus 0.46 year to date, and the natural gas correction was 0.63, versus negative 0.63 year to date. Although MLPs’ exposure to commodity price risk varies, overall, we believe it is generally low relative to other companies’ in the energy industry. Clearly though, the perception of commodity price risk can influence stock prices (over the short term), in our view.

Master Limited Partnerships

WELLS FARGO SECURITIES, LLC EQUITY RESEARCH DEPARTMENT

Figure 5. Wells Fargo Securities MLP Index Correlation To Other Asset Classes

1.50 1.00 0.50 0.00 (0.50) (1.00) (1.50) Correlation (0.05) 0.63 0.81 (0.57) 0.68 0.94 (0.87)
1.50
1.00
0.50
0.00
(0.50)
(1.00)
(1.50)
Correlation
(0.05)
0.63
0.81
(0.57)
0.68
0.94
(0.87)
(0.76)
(0.64)
0.96
0.52
0.40
0.86
0.88
0.90
(0.89)
(0.92)
(0.92)
0.45
(0.63)
0.46
(0.76)
0.82
0.81
(0.86)
0.01
0.68

Pre-Credit Crisis (2000-06)

0.82 0.81 (0.86) 0.01 0.68 Pre-Credit Crisis (2000-06) S&P 500 10 Yr Treas ML HY Bond

0.82 0.81 (0.86) 0.01 0.68 Pre-Credit Crisis (2000-06) S&P 500 10 Yr Treas ML HY Bond

S&P 500 10 Yr Treas

ML HY Bond0.68 Pre-Credit Crisis (2000-06) S&P 500 10 Yr Treas Credit Crisis (2007-09) Natural Gas Utilities HY

Credit Crisis (2007-09)

S&P 500 10 Yr Treas ML HY Bond Credit Crisis (2007-09) Natural Gas Utilities HY Spread

S&P 500 10 Yr Treas ML HY Bond Credit Crisis (2007-09) Natural Gas Utilities HY Spread

Natural Gas

Utilities

HY Spread To US10YrML HY Bond Credit Crisis (2007-09) Natural Gas Utilities 2010 TD Crude Oil REITs IG Spread

Crisis (2007-09) Natural Gas Utilities HY Spread To US10Yr 2010 TD Crude Oil REITs IG Spread

Crisis (2007-09) Natural Gas Utilities HY Spread To US10Yr 2010 TD Crude Oil REITs IG Spread

2010 TD

Crude Oil

REITs

IG Spread To US10YrGas Utilities HY Spread To US10Yr 2010 TD Crude Oil REITs   HY IG Spread Spread

 

HY

IG

Spread

Spread

 

S&P

Natural

Crude

10 Yr

ML HY

To

To

500

Gas

Oil

Treas

Utilities REITs

Bond

US10Yr

US10Yr

Pre-Credit Crisis (2000-06)

(0.05)

0.63

0.81

(0.57)

0.68

0.94

(0.87)

(0.76)

(0.64)

Credit Crisis (2007-09)

0.96

0.52

0.40

0.86

0.88

0.90

(0.89)

(0.92)

(0.92)

2010 TD

0.45

(0.63)

0.46

(0.76)

0.82

0.81

(0.86)

0.01

0.68

Source: Bloomberg, FactSet, Standard & Poor’s, and Wells Fargo Securities, LLC estimates

F. A Lower Risk (Beta) Way To Invest In Energy

MLPs offer investors an alternative way to invest in energy, with lower risk as measured by beta. MLPs had an average beta of just 0.61 over the past year and an average beta of 0.68 over the past five years (2005-09). Traditional energy companies such as those involved in exploration and production, oilfield services, and utilities have exhibited comparably more volatility, with an average beta of 1.29, 1.38, and 0.75, respectively, over the past five years. During this time frame, the beta for the S&P 500 Oil & Gas Exploration & Production Index ranged from 0.98 to 1.36 each year, while the beta for the S&P 500 Oil & Gas Equipment & Services Index ranged from 1.20 to 1.60. The beta for the S&P 500 Utilities Index was between 0.58 and 1.01. This compares to a range of 0.32 and 0.86 for MLPs.

G. MLPs Are An Effective Hedge Against Inflation

MLPs’ current and (growing) income stream can provide an effective hedge against inflation for the following reasons:

1. Inflation adjusters. Many pipeline MLPs have contracts, which adjust for inflation annually (PPI + 1.3%, for example);

2. Higher commodity prices. Inflation would likely cause commodity prices to increase, which would increase revenue and margin for commodity-sensitive MLPs (principally gathering and processing and upstream);

3. Distribution growth. Distribution growth has largely outpaced increases in the Consumer Price Index (CPI), making MLPs a good hedge against inflation;

4. Low price correlation with inflation and interest rates. MLP price performance is not as sensitive to interest rate movements and/or inflation as commonly perceived. While sudden spikes in interest rates have caused declines in MLP price performance, there has been only a 0.27 correlation between MLP price performance and the 10-year Treasury over the past five years.

Current MLP yields range from approximately 5% to 10% (excluding GPs). Further, MLPs have increased distributions at a historical five-year compound annual growth rate (CAGR) of 7.9%. In contrast, inflation as measured by the CPI has averaged 2.6% over the same period. We estimate 3.4% distribution growth in 2010 and 5.0% growth in 2011.

MLP Primer -- Fourth Edition

WELLS FARGO SECURITIES, LLC EQUITY RESEARCH DEPARTMENT

Utility stocks, with their regulated earnings stream and significant dividend yields, are the most comparable energy securities to MLPs, in our view. Utilities provide a median yield of about 4.4% and have increased dividends at an annual growth rate of approximately 4.4%, on average, over the past five years. For the next three years, we forecast distribution growth of 5.0% (5.3% including GPs), supported by MLPs’ participation in the ongoing buildout of the U.S. energy infrastructure.

Figure 6. MLP Distribution Growth Versus The CPI

14% 12% 11% 10% 10% 10% 9% 8% 6% 6% 5% 5% 5.0% 4% 4%
14%
12%
11%
10%
10%
10%
9%
8%
6%
6%
5%
5%
5.0%
4%
4%
4%
4%
3.4%
2.9%
2%
1%
0%
(2%)
Median Distribution Growth
CPI
Median Distribution Growth
1998A
1999A
2000A
2001A
2002A
2003A
2004A
2005A
2006A
2007A
2008A
2009A
2010E
2011E

Source: Partnership reports, U.S. Bureau of Labor Statistics and Wells Fargo Securities, LLC estimates

H. Estate Planning Tool

MLPs can be utilized as a tax-efficient means of transferring wealth. When an individual who owns an MLP dies, the individual’s MLP investments can be transferred to an heir. When doing so, the cost basis of the MLP is reset to the price of the unit on the date of transfer. Thus, the tax liability created by the reduction of the original unit holder’s cost basis is eliminated. To note, the step-up in cost basis may not be applicable this year due to the repeal of federal estate tax for 2010. We recommend that investors consult a tax or estate planning professional for advice.

I. Demographics

Demographic trends should drive demand for income-oriented investments, in our view. Retiring Baby Boomers are likely to seek current income in a tax-efficient structure, which could drive demand for MLPs. According to the latest available data published by the U.S. Census Bureau, the age profile of the U.S. population for those older than 45 years of age is expected to account for approximately 41% of the total U.S. population by 2020, versus 35% in 2000. The U.S. Census Bureau projects the U.S. population to reach almost 336 million by 2020, of which more than 138 million (or 41%) will be 45 years of age or older. In 2000, the total U.S. population was 282 million and 98 million people (or 35%) were 45 years of age or older. Based on this time frame and data, this represents an approximate 42% increase in people 45 or older.

Master Limited Partnerships

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Figure 7. U.S. Population Age Profile Projection

100% 7% 7% 7% 7% 7% 7% 90% 20% 19% 19% 19% 22% 20% 80%
100%
7%
7%
7%
7%
7%
7%
90%
20%
19%
19%
19%
22%
20%
80%
70%
60%
31%
31%
32%
32%
34%
37%
50%
40%
23%
23%
22%
30%
25%
26%
22%
43%
20%
39%
41%
42%
35%
16%
16%
17%
10%
14%
11%
11%
4%
5%
0%
2%
2%
2%
3%
2000A
2010E
2020E
2030E
2040E
2050E
Ages 85+
Ages 65-84
Ages 45-64
Ages 20-44
Ages 5-19
Ages 0-4
Percent of total U.S. population

Source: U.S. Census Bureau

J. Resilient Business Model During Periods Of Economic Weakness

Perhaps the best illustration of MLPs’ resilient business model has been the sector’s ability to maintain and, in most cases, increase distributions during periods of economic weakness or market turbulence. During the most recent credit crisis or economic downturn, of 2007-09, MLPs continued to demonstrate the long-term sustainability of their business model and cash flow stream. Although MLP price performance was poor (as all asset classes were almost perfectly correlated), a majority of the MLPs were able to successfully navigate through the turbulent period. Notably, approximately 78% of all energy MLPs either maintained or increased distributions during this period of severe economic stress, including all 16 large-cap pipeline MLPs. Only 16 out of 74 energy MLPs either cut or suspended their distributions during that time period. This compares favorably to the U.S. REIT industry, whereby 104 out of 122 domestic REITs (or 85%) either cut or suspended dividend payments during the most recent economic downturn.

III. Who Can Own MLPs?

MLPs have historically been predominantly owned by retail investors. This is still true today. However, MLP ownership by institutions has become more prevalent as the asset class has grown. Since MLPs generate unrelated business taxable income (UBTI), tax-exempt investment vehicles such as pension accounts, 401Ks, individual retirement accounts (IRAs), and endowment funds do not typically own MLP units.

Figure 8. 2009 MLP Ownership Type

Foreign

Ownership 8% Institutional Ownership 27% Retail Ownership 65%
Ownership
8%
Institutional
Ownership
27%
Retail Ownership
65%

Retail Ownership8% Institutional Ownership 27% Retail Ownership 65% Institutional Ownership Foreign Ownership Source:

Institutional OwnershipOwnership 27% Retail Ownership 65% Retail Ownership Foreign Ownership Source: PricewaterhouseCoopers LLP,

Foreign OwnershipOwnership 65% Retail Ownership Institutional Ownership Source: PricewaterhouseCoopers LLP, Partnership reports, and

Source: PricewaterhouseCoopers LLP, Partnership reports, and Wells Fargo Securities, LLC estimates

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A. Mutual Funds Can Own MLPs

With the passage of the American Jobs Creation Act in October 2004, mutual funds were permitted to own MLPs. However, there are some restrictions to investment: (1) no more than 25% of a fund’s asset value may be invested in MLPs and (2) a fund may not own more than 10% of any one MLP.

In April 2010, SteelPath launched the first MLP open-end (mutual) fund. The SteelPath Funds are registered investment companies and submit regular filings like other mutual funds. Yet unlike most mutual funds, which enjoy the tax benefits of being a regulated investment company, the SteelPath Funds elected to be a corporation (a C-Corp) for IRS reporting purposes. (Filing as a corporation allows SteelPath to invest more than 25% of its funds in MLPs) Consequently, the SteelPath Funds must pay corporate- level income taxes. For more information please see Open-End Funds – The SteelPath MLP Funds Trust.

B. Challenges Remain For Mutual Fund Ownership Of MLPs

Despite the passage of the American Jobs Creation Act, mutual funds have not participated in the MLP sector in large numbers to date. This is due to a number of administrative challenges, including the following:

Timing issues. Mutual funds begin processing their investors’ 1099s in November, but may not receive their MLP K-1s until late February or early March. Mutual funds are required to designate investors’ income as ordinary income, long-term capital gains, and return of capital. However, without the K-1s, a mutual fund would have to make estimates that could prove incorrect. In certain instances this could lead to excise tax liability for the mutual fund or a mutual fund investor paying taxes not owed.

State filing requirements. There are potential administrative burdens related to state filing requirements. Since some MLPs have operations (e.g., pipelines and storage tanks) in many states, a mutual fund owner of a partnership may be required to file income tax returns in every state in which the MLP conducts business (even if no taxes are owed). Clearly, the administrative burden required for such an undertaking could be prohibitive. Please see the Appendix for a list of states in which each MLP operates.

C. Tax-Exempt Vehicles Should Be Cautious In Owning MLPs

Tax-exempt investment vehicles such as pension accounts, 401-Ks, IRAs, and endowment funds should carefully evaluate whether they should own MLP units because MLPs generate unrelated business taxable income (UBTI). This means MLP income is considered income earned from business activities unrelated to the entity’s tax-exempt purpose. If a tax-exempt entity receives UBTI (e.g., income from an MLP and other sources of UBTI) in excess of $1,000 per year, the investor would be required to file IRS form 990-T and may be subject to taxes on the excess UBTI above the $1,000 threshold. We recommend consulting a tax advisor before investing in MLPs through any of these structures.

IV. Risks To Owning MLPs

Tax and legislative. While there is no legislation currently aimed at MLPs, a removal or alteration of MLPs’ favored tax treatment would negatively affect performance. Further, legislation aimed at the oil and gas industry could affect MLPs (e.g., through carried interest, derivative legislation, cap and trade, and the climate bill).

Capital markets access. MLPs are highly correlated to credit spreads and reliant on equity and debt markets to fund growth. Further, because MLPs pay out the majority all of their cash to unitholders, they must continually access the debt and equity markets to finance growth. If MLPs were unable to access these markets or could not access these markets on favorable terms, this could affect price performance and inhibit long-term distribution growth.

A severe economic downturn. Energy demand is closely linked to overall economic growth. A severe economic downturn could reduce the demand for energy and commodity products, which could result in lower earnings and cash flow.

Commodity price risk. Some MLPs have significant exposure to commodity price fluctuations, including partnerships involved in oil and gas production, gathering and processing, and coal. In addition, MLP unit prices tend to move in sympathy with commodity prices. For example, the Wells Fargo Securities MLP Index exhibited a correlation with crude oil prices of 0.89 in 2009.

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Rising interest rates. As evidenced from the period from 1998 to 1999, MLPs have generally underperformed during periods of rapidly rising interest rates. Thus, during periods when investors fear rapidly rising rates in the future or if rates were to rise faster than expected, this could affect performance.

A decline in drilling activity. A slowdown in drilling activity could reduce oil and gas producer revenue, gathering fees, throughput volume into processing plants, and ultimately, pipeline volume.

Execution risk related to acquisitions and organic projects. MLPs’ ability to grow is dependent, in part, on their ability to complete organic growth projects on time and on budget, and/or to successfully identify and execute future acquisitions.

Regulatory risk. MLPs are regulated across a number of industries. Interstate pipelines are regulated by the Federal Energy Regulatory Commission (FERC). Coal is one of the most heavily regulated industries in the country, being subject to regulation by federal, state, and local authorities. Any number of regulatory hurdles could affect MLPs’ ability to grow.

Environmental incidents and terrorism. Many MLPs have assets that have been designated by the Department of Homeland Security as potential terrorist targets, such as pipelines and storage assets. A terrorist attack or environmental incident could disrupt the operations of an MLP, which could negatively affect cash flow and earnings in the near term.

Conflicts of interest with the GP. For certain MLPs, the GP of the partnership and the parent company that owns the GP are controlled and run by the same management teams. Some potential areas of conflict include (1) the price at which the MLP is acquiring assets from the GP, (2) the GP aggressively increasing the distribution to achieve the 50%/50% split level rather than managing distribution growth to maximize the long-term value of the underlying MLP, (3) the potential for management to place the interests of the parent corporation or the GP above the interests of the LP unitholders, and (4) underlying MLP equity issuances to fund growth initiatives benefit the GP regardless of whether the acquisition or project is accretive.

Weather risk. Some MLPs’ cash flow, particularly those involved in the transportation (pipeline) and distribution of propane, are significantly affected by seasonal weather patters. For example, if an MLP’s operating region experiences unseasonably warm weather, propane demand, and therefore, volume, could be negatively affected. In addition, weather patterns can affect coal MLPs via electricity generation end-user demand

V. How To Build An Effective MLP Portfolio

In building a diversified MLP portfolio, we believe there are four primary factors that investors should take into consideration:

A. Balance Risk And Growth

Like all investments, MLPs present risk/reward propositions. Investors should consider their risk-tolerance level and make investments accordingly. In general, a balanced portfolio, which includes lower-risk but potentially lower-return MLPs and higher-risk MLPs with potentially higher returns, should be considered.

Figure 9. Risk And Growth

Risk

and

Growth

- Capital requirements

- Market position

- Leverage

- Organic versus acquisition dependent

- Stock liquidity

- Visibility

- Execution

- Track record

- Commodity exposure

- Size

- Weather

- Strength of sponsor

Source: Wells Fargo Securities, LLC

B. Diversify Among MLP Sectors

Investors should diversify within the energy MLP sector. Figure 99 displays the MLPs based on their risk profile by sector. The Asset Overview – Relative MLP Distribution Security section describes the basic types of MLPs and fundamentals underlying each MLP sector that investors should consider when constructing an MLP portfolio.

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C. “Anchor Tenants”

Investing in “anchor” or core MLPs is an effective way to build a solid foundation for an MLP portfolio. The anchor tenants are partnerships that have established a successful track record of delivering solid and sustainable results year after year. In addition, these MLPs are typically larger entities that have grown and diversified their asset base to limit cash flow volatility during economic cycles and have investment grade credit ratings.

D. Invest With Top Management

Prior to making any investment, individuals should evaluate the strength of the company’s management team. Investors should consider a management team’s (1) track record in successfully managing its business, (2) project management capabilities (i.e., ability to keep projects on time and on budget), and (3) ownership interests, i.e., aligned with those of the limited partnership (LP) unitholders.

VI. The Basics

A. What Is An MLP?

A master limited partnership is an entity that is structured as a limited partnership instead of as a C

corporation (C corp.). Limited partnership interests (limited partner units) are traded on public exchanges (i.e., NYSE, NASDAQ, and AMEX) just like corporate stock (shares). However, unlike a C corp., MLPs do not pay corporate-level taxes. Instead, taxes are paid (on a partially deferred basis) by public limited partner unitholders (i.e., MLPs are pass-through entities).

Figure 10. The MLP Versus A Standard C Corp Structure

 

Typical

 

Structure comparison

MLP

C corp.

Corporate level tax

Unitholder / shareholder level tax

Tax shield on distributions / dividends

Tax reporting

K-1

1099

General partner

Incentive distribution rights

Voting rights

Source: Partnership reports

Who Are The Owners Of The MLP?

MLPs consist of a general partner (GP) and limited partners (LP).

The general partner (1) manages the daily operations of the partnership, (2) typically holds a 2% equity ownership stake in the partnership, and (3) is usually entitled to receive incentive distribution payments.

The limited partners (or common unit holders) (1) provide capital, (2) have no role in the partnership’s operations and management, and (3) receive quarterly cash distributions.

B. What Qualifies As An MLP?

To qualify as an MLP, a partnership must receive at least 90% of its income from qualifying sources such as

natural resource activities, interest, dividends, real estate rents, income from sale of real property, gain on sale

of assets, and income and gain from commodities or commodity futures. Natural resource activities include

exploration, development, mining or production, processing, refining, transportation, storage, and marketing

of any mineral or natural resource. For practical purposes, most MLPs are involved in the energy markets.

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Figure 11. Types Of Publicly Traded Partnerships

Mortgage Investment / Securities Financial Miscellaneous 3% 9% 4% Real Estate 3% Minerals & Timber
Mortgage
Investment /
Securities
Financial
Miscellaneous
3%
9%
4%
Real Estate
3%
Minerals & Timber
2%

Energy Related

MLPs

78%

Source: National Association of Publicly Traded Partnerships

C. What Are The Advantages Of The MLP Structure?

Due to its partnership structure, MLPs generally do not pay entity-level income taxes. Thus, unlike corporate investors, MLP investors are not subject to double taxation on dividends. This enhances the partnership's competitive position vis-à-vis corporations in the pursuit of expansion projects and acquisitions, in our view.

D. How Many MLPs Are There?

Currently, there are 93 MLPs traded on public exchanges. Of those, 72 are energy related.

Figure 12. Number Of MLPs

80 72 70 60 50 40 30 20 9 10 4 3 3 2 0
80
72
70
60
50
40
30
20
9
10
4
3
3
2
0
Energy
Minerals &
Real Estate
Mortgage
Investment /
Miscellaneous
Related MLPs
Timber
Securities
Financial
Number of Partnerships

Source: National Association of Publicly Traded Partnerships

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E. What Is The K-1 Statement?

The K-1 form is the statement that an MLP investor receives each year from the partnership that shows his or her share of the partnership’s income, gain, loss, deductions, and credits. It is analogous to a Form 1099

received from a corporation. The investor pays tax on the portion of net income allocated to him or her (which

is shielded by losses, deductions, and credits) at his or her ordinary income tax rate. If the partnership reports

a net loss (after deductions), it is considered a “passive loss” under the tax code and may not be used to offset

income from other sources. However, the loss can be carried forward and used to offset future income from the same MLP. K-1 forms are usually distributed in late February or early March, and some can be retrieved online

(via the partnership’s website or at www.taxpackagesupport.com).

F. What Is The Difference Between An LLC And MLP?

As of November 2010, there were 64 energy MLPs registered as limited partnerships (LP). Eight entities, Constellation Energy Partners, Copano Energy, Enbridge Energy Management, Kinder Morgan Management, Linn Energy, Niska Gas Storage Partners, NuStar GP Holdings, and Vanguard Natural Resources are registered as a limited liability company (LLC). LLCs have all the tax advantages of MLPs, including no corporate level of taxation and tax deferral for unitholders. The primary differences between LLCs and MLPs are that LLCs do not have a GP or incentive distribution rights, but may have management incentive interests (MII). In addition, LLC unitholders have broader voting rights, whereas MLP limited partner unitholders generally have only limited voting rights.

Figure 13. Structure Comparison

Structure comparison

LP

LLC

C corp.

Non-taxable entity

 

Tax shield on distributions

Tax reporting

K-1

K-1

1099

General partner

Incentive distribution rights

Management incentive interests

Voting rights

Source: Wells Fargo Securities, LLC

MLPs Structured As C-Corps. There are three shipping MLPs: Capital Product Partners L.P., Navios Maritime Partners, L.P., and Teekay Offshore Partners, L.P., which elected to be taxed as corporations for U.S. federal income tax purposes. Based on this election, U.S. unitholders will not directly be subject to U.S. federal income tax on the partnerships’ income, but will be subject to U.S. federal income tax on distributions received from the MLPs and sale of the MLPs’ units. In addition, since these MLPs are structured as corporations, investors would receive a Form 1099 rather than a K-1.

These MLPs also provide percentage estimates of total cash distributions made during a certain period that would be treated as “qualified dividend income” (this is similar to the percent estimate of federal taxable income-to-distributions provided by standard MLPs). The qualified dividend income would be taxable to the U.S. common unitholder at the capital gains tax rate versus the ordinary income tax rate. The remaining portion of this distribution is to be treated first as a nontaxable return of capital to the extent of the purchaser’s tax basis in its common units on a dollar-for-dollar basis and thereafter as a capital gain.

G. Are MLPs The Same As U.S. Royalty Trusts? Canadian Royalty Trusts?

No, U.S. royalty trusts are yield-oriented investments and have unique investment characteristics; however, they are not MLPs. A U.S. royalty trust is a type of corporate structure whereby a cash flow stream from a designated set of assets (typically oil and gas reserves) is paid to shareholders in the form of cash dividends (on either a monthly or quarterly basis). A trust’s profit is not taxed at the corporate level provided that a certain percentage (e.g., 90%) of profit is distributed to shareholders as dividends. The dividends are then taxed as personal income.

Unlike MLPs, U.S. trusts are not actively managed entities. Thus, they do not make acquisitions or increase their asset base. In addition, U.S. royalty trusts typically have no debt, which also reflects the royalty nature of their business. The U.S. royalty trusts’ cash flow is paid to investors as it is generated and only until the underlying asset is depleted. As a result, dividends from trusts fluctuate with cash flow and should eventually dissipate. In contrast, MLPs are actively managed entities that can make acquisitions and investments to increase their asset base and sustain (and grow) cash flow. Over the long term, MLP distributions are managed to be steady and sustainable (and often growing).

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On the other hand, Canadian royalty trusts are more similar to upstream MLPs in that Canadian trusts are actively managed entities (i.e., make acquisitions or investments to grow production). However, the primary differences between upstream MLPs and Canadian royalty trusts are that the trusts (1) are involved in the exploration and production of crude oil and natural gas (whereas upstream MLPs are involved in exploitation and production) and (2) tend to hedge a smaller percentage of their current production volume (while upstream MLPs typically hedge approximately 70-90% of the current year’s production). To note, Canadian royalty trusts will be required to change to a corporate form of taxation on January 1, 2011.

H. What Are I-Shares?

In order to expand the universe of potential investors in MLPs to institutional investors and tax-advantaged accounts such as individual retirement accounts (IRAs), an investment vehicle similar to LP units was created known as i-shares (the i stands for institutional). In May 2001, Kinder Morgan Management, LLC (KMR) was the first i-share created and mirrors Kinder Morgan Energy Partners (KMP). Currently, the only other i-share security is Enbridge Energy Management, LLC (EEQ), the i-share for Enbridge Energy Partners (EEP).

The i-shares are equivalent to MLP units in most respects, except that distributions are paid in stock instead of cash. Distributions to i-shareholders are treated similarly to stock splits. The cost basis of the initial investment does not change, but instead, is spread among more shares. One year after purchase, all gains from disposition are treated as long-term capital gains. Unlike MLP securities, i-shares do not require the filing of K-1 statements and do not generate UBTI. Thus, i-shares can be owned in an IRA account without penalty. The i-share structure is analogous to an automatic dividend reinvestment plan, in our view. Thus, for investors who prefer to reinvest dividends, the i-share security could be an appropriate investment.

The I-share discount. Historically, both EEQ and KMR have traded at a discount to their MLP unit equivalent; though recently, EEQ has traded at a premium to EEP. Currently, EEQ trades at a 0.2% premium to EEP and KMR trades at a 10.3% discount to KMP. The discrepancy between valuations can be attributed to a number of factors, in our view, including the following:

Cash is king. Investors prefer cash distribution to stock dividends.

Liquidity. I-shares have average daily trading volume of only 317,000, versus 1,025,500 for the two MLP units, in an aggregate.

No natural arbitrage. MLP units are difficult to sell short. Thus, no natural arbitrage opportunity exists that would cause the units to trade more closely.

No conversion provision. The ability to convert an i-share to a common unit was removed by the partnerships soon after the public offerings. Hence, the i-shares are not entirely pari passu with the MLP common units.

Figure 14. EEP And KMP Relative To The Underlying I-Shares

30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% (5.0%) (10.0%) EEP-to-EEQ Premium/ (Discount) KMP-to-KMR Premium/
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
(5.0%)
(10.0%)
EEP-to-EEQ Premium/ (Discount)
KMP-to-KMR Premium/ (Discount)
Note: Based on a 4-day moving average
Source: FactSet
Jan-05
Apr-05
Jul-05
Oct-05
Jan-06
Apr-06
Jul-06
Oct-06
Jan-07
Apr-07
Jul-07
Oct-07
Jan-08
Apr-08
Jul-08
Oct-08
Jan-09
Apr-09
Jul-09
Oct-09
Jan-10
Apr-10
Jul-10
Oct-10

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What Are The Tax Consequences Of Owning I-Shares?

When a shareholder receives a quarterly distribution in the form of additional i-shares, this does not trigger a taxable event. A taxable event occurs only when a shareholder sells his or her share. An i-shareholder pays capital gains tax on the sale (long-term capital gains if the holding period is greater than one year). An investor’s tax basis is calculated as the initial amount paid for the shares divided by the total number of shares received both from the initial purchase and the subsequent quarterly distributions. (This is similar to the way a stock split is calculated.) If shares were acquired for different prices or at different times, the basis of each lot of shares can be used separately in the allocation. Otherwise, the first-in, first-out (FIFO) method is used. The holding period for shares received as distributions is marked to the date at which the original investment in the shares was made.

I. Why Create An MLP?

An MLP provides a number of benefits to the sponsor, including the following:

A premium valuation. Assets within the MLP structure typically trade at higher valuations in the market than those same assets within a C-corp. structure. For example, MLPs with C-corp. sponsors currently trade at an estimated median 2011 enterprise value-to-adjusted EBITDA multiple of 12.6x, versus 7.0x for the associated C corp.

Figure 15. Valuation Variance Between MLP And C-Corp. Sponsor

18.0x 17.0x 16.0x 14.0x 13.1x 13.0x 12.9x 12.6x 12.0x 10.0x 10.0x 9.4x 8.9x 8.7x 8.5x
18.0x
17.0x
16.0x
14.0x
13.1x
13.0x
12.9x
12.6x
12.0x
10.0x
10.0x
9.4x
8.9x
8.7x
8.5x
8.1x
8.0x
7.4x
7.3x
6.8x
5.9x
5.5x
6.0x
5.2x
4.0x
2.0x
0.0x
2011 EV / EBITDA Multiple
CHKM
CHK
EPB
EP
EXLP
EXH
PSE
PXD
SEP
SE
TGP
TOO
TK
WES
APC
WPZ
WMB

Note: MLP multiples are enterprise value (EV)-to-adjusted EBITDA Source: FactSet and Wells Fargo Securities, LLC estimates

A tax-advantaged structure with which to pursue growth opportunities. MLPs typically enjoy a competitive advantage relative to corporations, due to their tax-advantaged status. In general, MLPs should be able to either (1) pay more for an acquisition than a corporation and realize the same cash flow accretion or (2) realize more accretion from an acquisition given the same acquisition price. In addition, MLPs have traditionally enjoyed good access to capital, which makes financing acquisitions and organic projects feasible.

The ability to maintain control of the assets (via the GP interest). The general partner can retain control of the asset while maintaining just a 2% equity interest in the MLP.

The opportunity to capture potential upside from incentive distribution rights (IDR).

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VII. Key Terms

A. What Are Distributions?

Distributions are similar to dividends. MLPs typically pay cash distributions to unitholders on a quarterly basis.

B. What Are Incentive Distribution Rights (IDR)?

At inception, MLPs establish agreements between the general partner and the limited partners that outline the percentage of total cash distributions that are allocated between the GP and LP unitholders. The incentive distribution rights, which are typically owned by the general partner, entitle the GP to receive increasing percentages of the incremental cash flow as the MLP raises distributions to limited partners. Initially, the general partner receives only 2% of the partnership’s cash flow. However, as certain pre-determined distribution levels are met, the GP receives an incremental 15%, then 25%, and up to 50% of incremental cash flow. The purpose of the IDRs is to incentivize the general partner to raise the quarterly cash distribution to reach higher tiers, which benefits the LP unitholders, as well. Typically, the GP must increase the distribution by 50% from the initial public offering (IPO) to reach the 50% IDR tier. (Please see the Appendix for a list of energy MLPs and their incentive distribution tiers.)

C. Calculating Incentive Distribution Payments

In the following table we illustrate the mechanics of how cash flow is allocated between the limited partners and the general partner based on a hypothetical incentive distribution rights schedule (see Figure 16). Based on this schedule, Tier 1 includes all distributions less than or equal to $2.00 per unit, Tier 2 includes distributions greater than $2.00 per unit but less than or equal to $2.50 per unit, and Tier 3 includes distributions greater than $2.50 per unit but less than or equal to $3.00 per unit. Tier 4 (i.e., 50/50 splits), or the high-splits tier, is achieved when distributions are greater than $3.00 per unit.

Figure 16. MLP XYZ Distribution Calculation

 

LP distr.

 

LP%

GP%

up to:

Tier 1

98%

2%

$2.00

Tier 2

85%

15%

$2.50

Tier 3

75%

25%

$3.00

Tier 4

50%

50%

Above $3.00

Source: Wells Fargo Securities, LLC estimates

In this example, we assume MLP XYZ declares a distribution of $4.00 per LP unit. As outlined in Figure 17, at Tier 1, between $0.00 and $2.00, the LP receives $2.00, which represents 98% of the distribution at that tier. The GP receives 2%, or $0.04 per unit, of that distribution at Tier 1. This $0.04 is derived by dividing the $2.00 distribution to LP unitholders by 98% and then multiplying by 2% ([$2.00 ÷ 98%] × 2%). In other words, the $2.00 received by LP unitholders represents 98% of the total cash distribution paid to the GP and LP unitholders. This same formula is applied at the subsequent tiers.

At Tier 2, which is the incremental cash flow above $2.00 and less than or equal to $2.50, the LP receives $0.50, which represents 85% of the distribution at that tier. The GP receives 15% of the incremental cash flow, which equates to $0.09 per unit. At this level, the LP receives $2.50 per unit and the GP receives $0.13 per unit. In other words, the GP receives approximately 5% of the total distribution paid.

At Tier 3, which is the incremental cash flow above $2.50 and less than or equal to $3.00, the LP receives $0.50, which represents 75% of the distribution at that tier. The GP receives 25% of the incremental cash flow, which equates to $0.17 per unit, and $0.30 in total (or approximately 9% of total distributions paid).

At Tier 4, which is the incremental cash flow above $3.00, the LP receives $1.00, which represents 50% of the distribution at that tier. The GP also receives 50% of the incremental cash flow, which equates to $1.00 per unit. Thus, if the MLP wants to raise its distribution to limited partners by $1.00, it actually needs $2.00 in hand, one to pay the LPs and one to pay the GP.

At the declared distribution of $4.00 in our example, the LP unitholders would receive 76% of total cash distributions, while the GP would receive 24%. As the cash distribution is increased beyond $4.00, the GP would receive 50% of the incremental cash. Thus, if the distribution is increased to $5.00 per limited unit, the formulas for Tiers 1-4 would apply, and for the incremental $1.00 ($4.00 to 5.00), the LP would receive $1.00 and the GP would receive an additional $1.00, as well.

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MLP XYZ’s yield of 8.0% reflects distributions made only to the LP unitholders (i.e., $4.00÷50.00 per unit).

However, the adjusted yield of 10.6% reflects distribution payments to both the LP and GP (i.e., $4.00 + $1.30

= $5.30 $5.30 ÷ $50.00).

Figure 17. MLP XYZ Incentive Distribution Tiers

 

Cumulative

 

Distribution

Cumulative distribution

 

Distribution

per unit

per unit

allocation of cash flow (%)

MLP XYZ

LP%

GP%

up to:

LP

GP

Total

LP

GP

Total

LP

GP

Stock price

$50.00

Tier 1

98%

2%

$2.00

$2.00

$0.04

$2.04

$2.00

$0.04

$2.04

98%

2%

Distribution to LPs

$4.00
$4.00

Tier 2

85%

15%

$2.50

$0.50

$0.09 $0.59

$2.50

$0.13

$2.63

95%

5%

Yield

8.0%

Tier 3

75%

25%

$3.00

$0.50

$0.17 $0.67

$3.00

$0.30

$3.30

91%

9%

Total distributions

$5.30
$5.30

Thereafter

50%

50%

Above $3.00

$1.00

$1.00

$2.00

$4.00
$4.00

$1.30

$5.30
$5.30

76%

24%

Adjusted yield

10.6%

Source: Wells Fargo Securities, LLC estimates

D. What Is The Difference Between Available Cash Flow Versus Distributable Cash Flow?

We define available cash flow as the cash flow that is available to the partnership to pay distributions to both LP unitholders and the GP. On the other hand, we calculate distributable cash flow as the cash flow available to the partnership to pay distributions to LP unitholders. Available and distributable cash flow are commonly calculated in the following ways:

Figure 18. Available And Distributable Cash Flow Calculation

Net income (+) depreciation and amortization (-) maintenance capex

Available cash flow

(-) Cash flow to general partner

Distributable cash flow to LP unitholders

Source: Wells Fargo Securities, LLC estimates

OR

EBITDA (-) interest expense (-) maintenance capex

Available cash flow

(-) Cash flow to general partner

Distributable cash flow to LP unitholders

Distributable cash flow can also include cash distributions received from equity interests and reflect adjustments for non-cash items such as mark-to-market adjustments for derivative activity.

E. Are MLPs Required To Pay Out “All” Their Cash Flow?

Under a typical partnership agreement, the MLP is required to pay out all “available cash” to unitholders in the form of distributions. However, the board of directors for an MLP has significant discretion in determining what is considered available cash flow. This usually excludes all cash flow that would be required for “the proper conduct of the business.”

Some MLPs have generated significant excess cash (or maintain higher distribution coverage ratios) for reinvestment in organic growth projects. Management’s rationale for withholding cash flow is that the current earnings may not be sustainable due to unusual circumstances, e.g., high coal prices (ARLP) or wide commodity spreads (PAA). Thus, this “windfall” of cash is used to pay down debt or to fund internal growth projects, thereby increasing the partnership’s base of sustainable earnings. Paying out the vast majority of cash flow is a strong discipline that incentivizes management to operate the partnership efficiently and to take extra precautions when contemplating acquisitions and/or organic capital projects, in our view.

F. What Is The Distribution Coverage Ratio And Why Is It So Important?

A partnership’s distribution coverage ratio is the ratio of cash flow available to LP unitholders and the general

partner to the cash paid to an MLP’s LP unitholders and the general partner (i.e., available cash flow for the GP

and LP divided by distributions paid to the GP and LP).

Figure 19. Distribution Coverage Ratio Calculation

Distribution coverage ratio =

Available cash flow (to GP and LP)

Distributions paid (to GP and LP)

Source: Wells Fargo Securities, LLC estimates

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Coverage ratios vary depending on the type of MLP and the inherent cash flow volatility in the underlying assets of the partnership. For example, propane MLPs that have a cash flow stream sensitive to weather, typically target coverage ratios of at least 1.1x. In contrast, most pipeline MLPs have coverage ratios in the 1.0-1.1x range, reflecting the stable, fee-based cash flow that underpins their businesses.

The distribution coverage ratio is significant for two reasons:

Traditionally, investors have considered the coverage ratio to be representative of the cushion that a partnership has in paying its cash distribution. In this context, the higher the ratio, the greater the safety of the distribution.

All else being equal, a higher coverage ratio would give management increased flexibility to raise its distribution.

G. What Is The Difference Between Maintenance Capex And Growth Capex?

Maintenance capex is typically defined as expenditure that is made to (1) replace partially or fully depreciated/obsolete assets, (2) maintain the existing operating capacity or operating income of an MLP’s assets, and (3) extend the useful life of assets (e.g., routine equipment and pipeline maintenance).

On the other hand, growth capex is capital expenditure that is made to increase the partnership’s long-term operating capacity or cash flow. Some examples of growth capex include acquisitions, and the construction and development of additional facilities.

Well connects…maintenance or growth capex? There is some discrepancy among gathering and processing MLPs on their classification of expenditure for new well connections. The more conservative approach is to classify well connects required to replace expected reductions in natural gas gathering volume as maintenance capex, in our view. However, there are some MLPs that classify new well connections as growth capital as these partnerships consider well connects as bringing new production onto their systems (and not as replacements for the declining production of current wells). Assuming all else being equal, the use of the more conservative approach will result in lower distributable cash flow, whereas the classification of well connects as growth capital could potentially overstate an MLP’s true sustainable distributable cash flow.

Limited visibility into pipeline integrity spending. Although the FERC requires companies to disclose costs associated with natural gas pipeline maintenance on Form 2 filings, the agency does not require companies to report total pipeline integrity spending (i.e., costs associated with inspection plus repairs). Consequently, absent voluntary disclosure by individual companies, it is difficult to analyze pipeline spending trends within the industry.

In addition to limited disclosure, accounting methodologies can further obscure the actual amount of maintenance-related spending a company undertakes. Notably, costs associated with pipeline inspection are expensed on a partnership’s income statement. In contrast, costs associated with pipeline repair are capitalized and do not affect the income statement. However, pipeline repair costs are included in maintenance capex and hence, deducted before calculating distributable cash flow (a non-GAAP measure).

Finally, maintenance capex spending can vary from year to year as improvements in pipeline inspection technology can lead to spikes in pipeline integrity expenses. For example, the increased use of pipeline inspection gauges (PIGS) following the Pipeline Safety Act of 2002 resulted in an uptick in maintenance capex spending as these instruments utilized sophisticated magnetic and ultrasonic imaging technology to identify pipeline anomalies that had previously gone unnoticed.

Maintenance capex and upstream MLPs. Upstream MLPs are currently divided on how to define maintenance capex. There are currently three prevailing maintenance capex definitions used by upstream MLPs:

Under the strictest sense, maintenance capex can be defined as the capital required to maintain production and to replace reserves.

A more lenient approach is to define the metric as the capital required to replace annual production.

Finally, maintenance capex can be viewed as the capital needed to sustain cash flow.

We prefer the first definition, which seems most conservative, as it fully reflects the cost of maintaining the asset base. Focusing on maintaining production may not be sustainable over the long term, as reserves would also need to be replaced at some point. The third definition is the least meaningful, in our view, as it places a disproportionately large emphasis on commodity prices. Given its effect on distributable cash flow, variance in the definition of maintenance capex can have significant ramifications for distribution policy and valuations.

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VIII. Drivers Of Performance

A. Distribution Growth

Distribution growth has been one of the primary drivers of MLP price performance. Empirical evidence suggests that there is an inverse relationship between anticipated distribution growth and MLP yield. Faster- growing MLPs command lower yields, while slower-growing MLPs have traded at higher yields. For example, publicly traded GPs have an average estimated three-year distribution growth CAGR of 7.9% and consequently, trade at a lower than average yield of 4.3%. In comparison, upstream MLPs have a forecasted three-year distribution CAGR of 3.8% and trade at an above-average yield of 8.0%.

The following chart plots our three-year distribution growth CAGR estimates against current yields. An MLP that is able to increase its forecasted annual distribution growth rate by 1% via accretive acquisitions, organic growth projects, or cost-saving synergies should benefit from an approximate 0.2% reduction in yield, based on an estimated 0.59 correlation between the two variables (i.e., 35% of the variation is explained). This level of correlation does not preclude an MLP with a forecasted distribution growth rate of 8% from trading at a similar yield to an MLP with a forecasted distribution growth rate of 10%. In addition, the potential flaw with this analysis is that our distribution growth forecasts could be incorrect. Alternatively, the market may be forecasting different growth assumptions for certain MLPs or factoring in different levels of risk.

Figure 20. Correlation Between Yield And Distribution Growth

11% y = -0.2105x + 0.0783 R 2 = 0.3515 9% 7% 5% 3% 0%
11%
y = -0.2105x + 0.0783
R 2 = 0.3515
9%
7%
5%
3%
0%
2%
4%
6%
8%
10%
12%
14%
16%
Yield

3-Year Distribution CAGR

Note: Dotted lines represent +/- one standard deviation Source: FactSet and Wells Fargo Securities, LLC estimates

Drivers behind MLP distribution growth include (1) broader economic conditions, which govern access to capital and credit spreads, (2) sensitivity to commodity prices, (3) organic growth opportunities, and (4) acquisitions. We discuss the first two aforementioned drivers in more detail in the text that follows. Please refer to pages 43-55 on a discussion on energy infrastructure investment and acquisitions.

B. Access To Capital

Access to capital remains a key to MLP distribution growth as acquisitions and organic investments are mostly funded with external capital (i.e., new debt and equity). This is due to the fact that MLPs distribute the majority of their cash flow in the form of distributions each quarter. An MLP generates value for unitholders by investing in projects that generate returns in excess of the partnership’s cost of capital. MLPs with investment grade credit ratings generally enjoy better access to capital at a lower cost, all else being equal. However, most MLPs have historically enjoyed good access to the capital markets.

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Figure 21. Historical Equity And Debt Issuances

$25,000 MLP Equity Issuances MLP Debt Issuances $20,586 $20,000 $18,801 $16,257 $14,920 $15,000 $10,760 $9,563
$25,000
MLP Equity Issuances
MLP Debt Issuances
$20,586
$20,000
$18,801
$16,257
$14,920
$15,000
$10,760
$9,563
$10,000
$7,119
$3,579
$5,000
$3,540
$0
2003
2004
2005
2006
2007
2008
2009
$ in millions
$4,965
$4,598
$5,150
$5,610
$5,505
$9,415
$4,100
$14,701
$11,506
$9,080
$8,975
$7,282

Source: Partnership reports

C. Commodity Prices

The influence of commodity prices on MLPs varies significantly by sub-sector. Near-term fluctuations in natural gas, natural gas liquids, and crude oil prices are unlikely to have a material impact on pipeline MLPs, but are likely to affect earnings (on the unhedged portion of production or volume processed) of upstream and gathering and processing MLPs. Longer term, a sustained reduction in natural gas, natural gas liquids, or crude oil prices could curtail drilling by producers. As a result, even long-haul pipeline MLPs could be affected from reduced transportation volume and/or fewer infrastructure opportunities. Although MLPs’ exposure to commodity price risk varies, historically it has been low relative to other companies in the energy industry, in our view. For a more detailed discussion of the impact of commodity prices, please see the “Asset Overview – Relative MLP Distribution Security” section beginning on page 86.

Figure 22. Impact Of Commodity Prices On MLPs

Short-Term Increase In Prices

Sustained Increase In Prices

 

Natural Gas

NGLs

Crude Oil

Natural Gas

NGLs

Crude Oil

Pipeline MLPs

None

None

None

Positive

Positive

Positive

Gathering

& Processing MLPs 1

Negative

Positive

Positive

Negative

Positive

Positive

Upstream MLPs

Positive

Positive

Positive

Positive

Positive

Positive

Note 1 : For primarily keep-whole contracts Source: Wells Fargo Securities, LLC

D. Credit Spreads

A significant change in credit spreads (relative to the 10-year United States Treasury) typically signals that investors have begun to re-rate default expectations. Widening credit spreads typically put pressure on all yield- oriented securities as the market is pricing in a greater risk premium into equities. As a result, access to capital could become more challenging (i.e., more expensive), though still viable. In addition, widening spreads across the capital structure could cause investors to flock to alternative investments with more attractive yields or lower perceived risk profiles. Furthermore, during times of uncertainty, some investors may prefer to own the public bonds of specific MLPs rather than the equities, given their relative seniority in the capital structure and attractive yields. Currently, investment grade and high-yield spreads stand at 316 basis points (bps) and 427 bps, respectively, versus a five-year historical average (2005-09) of 263 bps and 515 bps. During the recent sub-prime credit crisis, the investment grade and high-yield credit spreads peaked at 1,622 bps and 614 bps, respectively.

Notably, the correlation between MLP performance (as measured by the Wells Fargo Securities MLP Index) and high-yield credit spreads in 2009, over the past three and five years was (0.96), (0.88), and (0.74) respectively.

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Figure 23. High Yield And Investment Grade Credit Spreads To The 10-Year Treasury

1,800 High-Yield (ML U.S.) Spread To Treasury 1,600 Investment-Grade (Moody's) Spread To Treasury 1,400 1,200
1,800
High-Yield (ML U.S.) Spread To Treasury
1,600
Investment-Grade (Moody's) Spread To Treasury
1,400
1,200
1,000
800
Historical High Yield
Spread Average
600
400
200
Historical Investment
Grade Spread Average
0
Basis-point spread to Ten-Year U.S. Treasury
Jan-00
Jun-00
Nov-00
Apr-01
Sep-01
Feb-02
Jul-02
Dec-02
May-03
Oct-03
Mar-04
Aug-04
Jan-05
Jun-05
Nov-05
Apr-06
Sep-06
Feb-07
Jul-07
Dec-07
May-08
Oct-08
Mar-09
Aug-09
Jan-10
Jun-10
Nov-10

Source: Bloomberg

E. Interest Rates

The movement of interest rates and investor anticipation of a rise in interest rates have historically been important drivers of MLP performance. This is due to the fact that MLPs are yield investments that were traditionally viewed as bond-like substitutes. MLPs have underperformed during certain periods of rapidly rising interest rates because as interest rates increase, investors are able to receive a higher risk-adjusted rate of return from government-backed debt or Treasury securities. For example, in 1999, the Fed increased the target rate three times, to 5.75% from 5.00%. Over that same period, our MLP Composite declined 20.5%, while the Composite yield increased to 10.6% from an average of 7.7%. MLPs have historically traded at an average spread of 339 bps to the 10-year U.S. Treasury (from 2000 to 2010 year to date).

As MLPs have become more growth oriented, the impact of modest interest rate movements on MLP price performance has decreased. Between 2001 and 2007, MLPs accelerated distribution growth to approximately 11% in 2007 from 5% in 2001. Consequently, the average spread between MLP yields and Treasury yields declined to a low of 16 bps in 2007 from an average of 302 bps in 2001. Over the past five years, the correlation between the 10-year Treasury yield and MLPs has been only 0.27. MLPs are now trading at a median yield of 6.4%, which represents approximately a 359-basis-point spread above the 10-year Treasury yield. The spread between midstream MLP yields and Treasuries has averaged 339 bps since 2000 and has ranged from 16 bps to 512 bps.

Figure 24. Historical MLP Yield Spread To The 10-Year Treasury

1,800 MLP Yield Spread To Treasury 1,600 1,400 1,200 1,000 800 Historical MLP Yield Spread
1,800
MLP Yield Spread To Treasury
1,600
1,400
1,200
1,000
800
Historical MLP Yield
Spread Average
600
400
200
0
(200)
Basis-point spread to
Ten-Year U.S. Treasury
Jan-00
Jun-00
Nov-00
Apr-01
Sep-01
Feb-02
Jul-02
Dec-02
May-03
Oct-03
Mar-04
Aug-04
Jan-05
Jun-05
Nov-05
Apr-06
Sep-06
Feb-07
Jul-07
Dec-07
May-08
Oct-08
Mar-09
Aug-09
Jan-10
Jun-10
Nov-10

Source: FactSet

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1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

F. Economic Activity (GDP Growth)

The overall health of the U.S. economy is a determining factor in MLP performance, in our view. Historically, U.S. energy consumption has closely tracked overall economic activity levels. On a historical basis, the average correlation of U.S. GDP growth versus total energy consumption is about 0.86. An increase in energy consumption should lead to an increase in the production, handling, and transportation of energy commodities, which generally benefit MLPs.

Figure 25. Annual Percent Change In Energy Consumption And Gross Domestic Product

6% 4% 2% 0% -2% -4% -6% Annual % Change
6%
4%
2%
0%
-2%
-4%
-6%
Annual % Change
Product 6% 4% 2% 0% -2% -4% -6% Annual % Change Total Energy Consumption Gross Domestic

Total Energy Consumption

0% -2% -4% -6% Annual % Change Total Energy Consumption Gross Domestic Product Note 1: Energy

Gross Domestic Product

Note 1: Energy consumption in 2001 and 2009 was negatively affected by the downturn in economic activity Source: Bureau of Economic Analysis and EIA

G. MLP Fund Flow And Liquidity

Given the relative illiquidity of the MLP sector, fund flow is a meaningful driver of MLP performance, in our view. Notably, the market cap of the entire energy MLP sector is approximately $220 billion, versus $350 billion for Exxon Mobil. In addition, the median daily trading volume for MLPs is only 218,000 units, versus 22.3 million shares for Exxon Mobil. MLPs have traditionally been a predominantly retail-owned product. However, the rising institutional interest has led to new fund flow into the sector, which has resulted in increased overall trading liquidity. Institutional investors as a percentage of total MLP ownership increased to 27% in 2009 from 23% in 2005, according to the data from PricewaterhouseCoopers. Year to date, there have been 12 new MLP products announced. The total capital raised from these products is approximately $3.0 billion.

Figure 26. Median MLP Daily Trading Volume

250 218 200 162 144 150 97 98 92 100 82 53 50 0 2003
250
218
200
162
144
150
97
98
92
100
82
53
50
0
2003
2004
2005
2006
2007
2008
2009
2010 TD
Median Daily Trading Vol. (000s)

Source: FactSet

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IX. How Did MLPs Fair During The Credit Crisis?

Performance. MLPs actually underperformed the broader stock market during the period described as the “credit crisis” of July 2, 2007, to December 31, 2008. For the period, the Wells Fargo MLP index decreased 49%, versus a loss of 41% for the S&P 500. On a total return basis, the Wells Fargo MLP index generated a loss of 43%, versus 39% for the S&P 500. At its peak, the Wells Fargo MLP index was yielding 5.3% as of July 13, 2007, while at its trough, the index yield was 14.3% at November 21, 2008.

Figure 27. MLP Performance During The Credit Crisis

480 PIPE unwinding 440 Total return swaps 400 Hedge fund redemptions 360 Credit spreads widen
480
PIPE unwinding
440
Total return swaps
400
Hedge fund
redemptions
360
Credit spreads
widen dramatically
320
Lehman goes
280
bankrupt
240
Closed end fund
deleveraging
200
Retail investor
capitulation
160
Jan-02
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Wells Fargo Securities MLP Index Performance

Source: FactSet

What drove this performance? A unique confluence of factors contributed to the overall volatility and steep decline in MLP valuations during this period. These factors can be separated into fundamental and technical reasons that explain the sector’s performance during this period.

Fundamental Drivers

(1) Access to capital. Since MLPs pay out the majority of their cash flow in the form of distributions but spend significant capital to grow, they are highly dependant on the debt and equity capital markets. During the credit crisis, many MLPs could not access the public debt or equity markets, nor could they access other forms of capital (i.e., bank debt, private equity, etc.) on reasonable terms. With many MLPs in the midst of capital projects, their ability to fund these projects became a source of concern for investors, which pressured valuations.

(2)

Higher cost of capital. As a result of the credit crisis and the resulting decrease in equity valuations, the cost of incremental capital became very high. As a result, the growth projects of some MLPs already under way became breakeven to dilutive. In addition, the hurdle rate to justify new projects was very high, thereby reducing the amount of capital deployed and lowering future distribution growth expectations for MLPs.

(3)

Widening credit spreads. High-grade and high-yield credit spreads widened to historic levels, causing most yield-based securities to widen in sympathy.

(4)

Lower commodity prices. From July 3, 2008 to December 22, 2008, crude oil prices declined to a low of $31.41 from a high of $145.29 per barrel. This price volatility caused many commodity-sensitive MLPs (e.g., upstream and gathering and processing) to experience significant volatility in cash flow. Some were forced to reduce or suspend distributions due to a decrease in cash flow or because of (potential) debt covenant violations.

Technical Drivers

In addition to the fundamental factors described in the preceding text, MLP equity valuations were affected by a number of technical factors, which exaggerated the downward movement in prices, in our view. These factors highlighted another fundamental risk to the sector, namely, the relative lack of liquidity for MLPs (see risks on page x). The period leading up to the credit crisis was marked by an inflow of institutional investor capital, including several general and MLP-dedicated hedge funds. This inflow of capital helped fuel the run-up in prices as MLPs enjoyed unprecedented access to large pools of capital. However, this rapid influx ultimately led to higher volatility to the downside when these institutional investors became forced sellers of MLPs into a relatively illiquid market.

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PIPEs concentration. From 2003 to 2007, the MLP industry experienced a rapid increase in private investment in public equity (PIPE) transactions as hedge funds and closed-end funds made significant direct investments in MLPs. In total, MLPs raised $8.5 billion of PIPE equity in 2007, including two deals in excess of $1 billion. While PIPEs enabled certain MLPs to finance large acquisitions and grow rapidly, the transactions created significant concentration risk as a small group of institutional investors held significant interests in MLPs, which represented multiple days of the MLPs’ average trading volume.

Total return swaps (TRS). Certain funds began investing in the MLP sector via total return swaps for a number of reasons, including(1) to avoid the administrative burdens of receiving K-1’s, (2) as a way for non- U.S. investors to gain exposure to the MLP sector, and (3) as a means of “masking” their positions to their competitors. While TRS increased fund flow into the MLP sector, they were ultimately another form of leverage for institutional investors as the investment banks that offered swap products typically required only 10-20% of collateral.

What is a total return swap? Investors can gain exposure to an MLP without direct ownership via a total return swap agreement. In a total return swap, an investor receives a synthetic security that mimics the performance of the underlying security. This includes any distributions generated by the underlying MLP and the benefit of the MLP’s price appreciation over the life of the swap. However, if the price of the MLP decreases over the swap’s life, the holder of the TRS will be required to pay the counterparty (usually a brokerage firm) the amount by which the asset has declined in price. The counterparty owns the underlying MLP security and receives payments from the investor over the life of the swap based on a set rate.

Forced selling by leveraged funds. In retrospect, many of the institutional funds that invested in the sector did so with significant leverage. As the credit crisis worsened, both the cost of lending and stock performance were negatively affected. As a result, these funds experienced redemptions and forced de- leveraging, which, in turn, caused the forced selling of MLP securities into a relatively illiquid market.

Lack of sector liquidity. While MLPs are generally a rather illiquid sector (average daily liquidity of $219 million for large-cap pipeline MLPs in 2010, compared to $1.8 billion for Exxon Mobil during the same period), the overall market experienced reduced liquidity during the credit crisis, which was even more impactful for MLPs. Thus, a lack of liquidity contributed to exaggerated movements in price as institutional investors were forced to sell positions into a weak market.

The credit crisis, the ultimate test of MLP durability? While MLPs underperformed the overall market during the credit crisis on a price-performance basis; the sector performed relatively well from a fundamental perspective. Specifically, all 13 investment grade MLPs and all 20 pipeline MLPs maintained or increased distributions during the period, demonstrating the sustainability and durability of their underlying cash flow and business model, in our view. In total, only 16 out of 74 MLPs were forced to reduce or suspend distributions (or 23%). In contrast, 85% of REITs (or 104 out of 122 U.S. equity REITs) reduced or suspended dividends during the credit crisis, according to Wells Fargo Securities’ REIT Equity Research Team. The MLPs that did reduce or eliminate distributions were involved in more cyclical or commodity-sensitive businesses, including upstream, gathering and processing, and marine transportation.

Figure 28. MLP Distribution Reductions And Suspensions During The Most Recent Credit Crisis

 

Quarterly Distributions Declared

 

Date Of Final Distrib.

Ticker

Q1'08A Q2'08A Q3'08A Q4'08A

Q1'09A Q2'09A Q3'09A

Cut/Suspension

CLMT 1

$0.45

$0.45

$0.45

$0.45

$0.45

$0.45

$0.45

Q1'08

BKEP

$0.40

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

Q2'08

USS

$0.45

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

Q2'08

QELP

$0.41

$0.43

$0.40

$0.00

$0.00

$0.00

$0.00

Q4'08

AHD

$0.43

$0.51