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Industry Analysis: Oil and Gas Distribution Industry
The Oil/Gas Distribution Industry comprises companies that move two of the most important energy commodities, and their derivatives, from the wellhead to the ultimate consumer. These enterprises perform tasks such as the gathering and processing of gas, intrastate and interstate transport, and final delivery to the customer. A majority has no operations outside the United States. Too, most are organized as master limited partnerships, a feature that has important tax consequences.
As income vehicles, the partnerships generally pay out most of their free cash flow in cash distributions and, thus, have well above-average yields. Some corporations in the group also pay dividends. Given that the industry needs to raise capital to grow, appreciation potential is usually below average. But investors seeking income or growth and income can often find good prospects. At times, the group's performance may become exaggerated. For example, energy transport limited partnership units outperformed the broader market over a period lasting nearly ten years in the early part of this century, reflecting rising cash distribution. Nonetheless, the units can fall victim to a rapid turn in investor sentiment, and sell off sharply.
The Energy Outlook
The U.S. economy has grown steadily more energy efficient since the first oil shock in 1973, and that will certainly continue, due to growing conservation measures and rising oil prices. Nonetheless, demand for oil and gas in the United States and Canada will very likely expand almost yearly, though at a somewhat slower pace than the economy. Despite a great deal of publicity, most observers do not think that alternative energy sources can replace much fossil fuel, at least over the near term. Nuclear power is again being viewed as a "clean" energy source, but lingering memories of the Three Mile Island crisis of 1979 will probably keep new plants to a minimum.
More important for this industry, the sources of oil and gas are sure to change over time. New gas deposits will be developed and come online (e.g., the Marcellus Shale in the Northeast and the Barnett and Haynesville Shales in Texas and adjoining states), and will need new pipes. And if oil prices trend above historical averages, mining of the Canadian oil sands in Alberta may well experience improved economics. Pipeline companies with assets near new resources should profit from their development.
The Federal Energy Regulatory Commission (FERC) sets maximum prices on interstate pipelines, but the law generally permits distributors to raise tariffs at the rate of producer price inflation plus 1.3%. While that formula could yield a tariff decrease in rare deflationary times, it more commonly helps. Intrastate activities are overseen by states, and some of the industry's operations, such as gas processing, are unregulated. The FERC also regulates construction of new pipelines, requiring a certificate of convenience and necessity before a permit is issued. That reduces competition, though, as noted, the FERC caps tariffs on interstate pipes.
Revenues and Market Risks
A high proportion of this industry's revenues is not related to the volume of business, offering the investor above-average safety. A majority of pipeline revenues, both interstate and intrastate, stems from transport capacity, with relatively little depending on the volumes of products shipped. Moreover, these companies often sell around 80% of the capacity of new pipelines before they break ground, reducing the risk associated with any new venture. But the industry is somewhat exposed to commodity prices in its midstream gas processing activities, where it is difficult to hedge. Companies also earn money from "efficiency gas", that is, gas retained as part of shipping fees. Profits from efficiency gas depend on the price of the commodity.
Taxes, Distributions and Dividends
Master limited partnerships pay no income taxes, and their cash distributions are not taxable to limited partners (i.e., unit holders) either. Instead, each limited partner pays taxes on his or her proportional share of the partnership's taxable income, which is always lower than GAAP (Generally Accepted Accounting Principles) income, thanks to accelerated depreciation of operating assets. Moreover, limited partners are deemed to receive "passive" income or losses, so losses on a partnership holding cannot be used to offset other income. Additionally, because no taxes are paid at the partnership level, cash distributions do not benefit from the currently low 15% federal tax rate on "qualifying dividends," but, rather, are taxed as ordinary income. That said, a large percentage of the distribution is usually considered a return of capital. Although this portion is not taxable, it results in an adjustment to a holder's cost basis. All told, we suggest that investors in limited partnership units consult a tax advisor.
Format and "Incentive Distributions"
All the company pages in this industry use the standard Value Line industrial presentation. For the partnerships, however, there is a considerable disconnect between "Net Profit" and "Earnings per Unit". The "missing" money represents the general partner's interest in the partnership's net income, and it is subtracted from net income to arrive at earnings per unit. Importantly, the amount of distributable cash flow (DCF) that general partners receive will affect the distributions made to limited partners. For instance, if half of the DCF goes to the general partners, this represents over half of GAAP net income, since depreciation expense is a large part of DCF. In this case, the general partners will receive half of any future increases in DCF, and the growth in distributions to limited partners will be restrained.