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Time to Dive Into Downstream MLPs

Little wonder that investors are giving master limited partnerships plenty of attention these days. After all, the Federal Reserve’s low interest rate policies have sent many investors into any vehicle that throws off a decent yield.

At the same time, America’s new energy reality, thanks to the hydraulic fracturing revolution, has spotlighted the nation’s constrained energy logistics sector. Pipelines, both new and old, are the linchpin for delivering energy to end users around the country and reducing America’s reliance on imported foreign oil.

That has made pipeline industry stalwarts such as Kinder Morgan Energy Partners (NYSE:KMP) and Williams Partners (NYSE:WPZ) portfolio staples for many income seekers. Nonetheless, master limited partnerships in the energy sector aren’t just for pipeline companies anymore.

In the 1980s, the federal tax code created rules for MLPs that have historically made them attractive to pipeline firms with relatively stable streams of revenue. At their core, these companies transport a hydrocarbon-based product for a fee, acting as a toll-way. However, over the last five years, others in the energy sector have begun taking another look at this often-misunderstood corporate legal form to seek tax and capital-raising benefits.

For investors, that could spell big dividend growth opportunities outside the world of pipelines and storage assets. Perhaps some of the most compelling possibilities lie within the downstream and refining sector.

Bouncing Back

It’s been quite an interesting ride for the refiners and downstream energy sector in 2012. The situation earlier this year was pretty grim when higher crude oil prices put severe pressure on the refiners’ margins, and many firms within the sector struggled.

However, that pressure seems to be fading. Crude oil prices have drifted relatively lower from their peaks and the glut of natural gas is helping to not only alleviate higher feedstock costs but lower refiners’ energy bills as well. Not to the mention the sector’s newfound love affair with exporting record amounts of gasoline. Overall, downstream players seem finally back on surer footing.

Refiners have also been making some serious coin by spinning off various assets into MLPs. With refining assets and chemical plants, as well as pipelines that feed these facilities, the appeal of the using the MLP tax structure is simple: Many of these assets will earn a higher multiple as part of an MLP than within a traditional corporate structure.

At the same time, MLPs help avoid taxation issues and provide their general partners —  i.e. the sponsoring refining firms — generous distribution payouts. Almost of all of them now have publicly traded MLP subsidiaries, and that number keeps growing.

Most recently, smaller refiner Alon USA Energy‘s (NYSE:ALJ) limited partnership unit, Alon USA Partners, filed with U.S. regulators to raise up to $230 million in an initial public offering of its common units. Likewise, Marathon Petroleum’s (NYSE:MPC) board has approved a plan to explore the formation of an MLP to house certain pipeline assets.

All this activity creates plenty of opportunities for investors to score some big dividends.

Two Great “Drop-Down” Picks

Tesoro (NYSE:TSO) means “treasure” in Spanish, and this independent refiner has certainly been living up to its name. The company’s latest deal has it purchasing assets from beleaguered energy major BP (NYSE:BP) for a song. Included in that purchase are various midstream holdings that Tesoro will sell to its Tesoro Logistics (NASDAQ:TLLP) MLP subsidiary for $1 billion. That’s where investors can grab some hefty dividends.

Spun-off from its parent in 2011, Tesoro Logistics benefits greatly from relationship with asset-rich Tesoro, which maintains a 56% stake in the MLP. First, the relationship shields the pipeline operator from competitive pressures in midstream energy because its sole purpose is to carry hydrocarbons for the refiner. That provides TLLP with stable cash flows and growth opportunities.

Second, the partnership benefits from “drop-down” transactions like the BP purchase. These “drop-downs” are immediately accretive to Tesoro Logistics’ distributable cash flow and are used to boost cash distributions. That’ll help lift the partnership’s 4.2% yield higher and higher as time goes on.

Also benefiting from the “drop-down” relationship is MLP Holly Energy Partners (NYSE:HEP). Spun off from refiner HollyFrontier (NYSE:HFC) in 2004, the pipeline firm holds roughly 2,500 miles of pipelines and is continuing to add to that via the partnership. The latest deal involves HEP buying a 75% interest in a 400-mile, 12-inch refined products pipeline from HollyFrontier for $315 million in cash and stock.

Like the TSO-TLLP deal, Holly Energy’s purchase in the strategic refined products pipeline will immediately add to its cash flow/distributions, which then benefits HollyFrontier because it maintains a 41% interest in the MLP. The deal also allows HollyFrontier to continue its strategy of redeploying capital in its core refining and marketing assets. Retail investors benefit as well: Holly Energy already yields a delicious 5.4%.

For investors, both Tesoro Logistics and Holly Energy make ideal plays to not only gain some yield, but benefit from the turnaround in the downstream and refining sector.

As of this writing, Aaron Levitt didn’t own any securities mentioned here.

Article printed from InvestorPlace Media,

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