The Advantages of Investing in Oil and Gas Pipelines

Finding businesses that are the front-runners in industries with very high barriers to entry gets my investment juices up. For those types of businesses where right-of-way permits are a major obstacle, it makes perfect sense to embrace an investment theme where the biggest players only get bigger because of embedded distribution systems that allow the leaders to stay out in front.

Just look at Warren Buffett’s purchase of Burlington Northern Santa Fe (BNSF). Prior to his purchase of BNSF, the Oracle of Omaha consistently raised his stake in the railroad operator for the very reasons stated above. BNSF is one of a handful of companies that dominate the rail freight business, where competition seeking a way in will find entry difficult if not impossible. In political science, this is called a legal oligarchy, and it makes for a nice investment theme.

Another highly concentrated industry that Buffett has invested in during the past decade has been the oil and gas pipeline business. Here, too, we have an industry that has shown stable and steady growth, leveraged on long-term demand from a growing U.S. population and that is not at all dependent on the actual price of the oil and gas. This is a key difference from other energy assets.

Pipelines are generally the most economical way to transport large quantities of oil or natural gas over land. Compared to railroads, they typically have lower cost per unit and higher capacity. Although pipelines can be built under the sea, that process is financially and technically demanding, so the majority of oil at sea is transported by tanker ships.

Oil pipelines are made from steel or plastic tubes, with inner diameter typically ranging from 10 to 120 cm (about 4 to 48 inches). Typically, pipelines are buried at a depth of about 1-2 meters (about 3 to 6 feet). The oil is kept in motion by pump stations along the pipeline and usually flows at a speed of about 1 to 6 meters per second.

Multi-product pipelines are used to transport two or more different products in sequence in the same pipeline. Usually in multi-product pipelines, there is no physical separation between the different products. Some mixing of adjacent products occurs, producing interface. This interface is removed from the pipeline at receiving facilities and segregated to prevent contamination.

For natural gas, pipelines are constructed of carbon steel and vary in size from 2 to 56 inches in diameter, depending on the type of pipeline. The gas is pressurized by compressor stations and is odorless, unless mixed with a mercaptan odorant when required by the proper regulating body. Mercaptan odor is an additive to natural gas that makes it easier to detect in case of a leak.

There currently are about 40 major interstate pipelines connecting to about 100 minor interstate pipelines operating in a highly regulated environment. As I wrote above, the barriers to entry are quite high if you’re considering building a pipeline any time soon. Most of the grid is in place, with access to building new lines ever more difficult because of urbanization. Oil and gas pipelines are simply great fixed assets that offer excellent long-term prospects for income-oriented investors seeking stable cash flow, upside appreciation and tax benefits from the way they are structured for the capital markets.

Because they are capital-intensive businesses, pipeline operators choose a structure that allows them to aggressively depreciate the huge amounts of money that go into building out and maintaining their lines. In practice, master limited partnerships (MLPs) pay their investors through quarterly required distributions (QRDs), the amount of which is stated in the contract between the limited partners (the investors) and the general partner (the managers).

Because of the stringent provisions on MLPs and the nature of the QRD, the vast majority of MLPs are energy-related businesses, of which pipeline operators tend to earn very stable income from the transport of oil, gasoline or natural gas. Because MLPs are a partnership, they avoid the corporate income tax on both a state and federal basis. Additionally, the limited partner (investor) also may record a prorated share of the MLP’s depreciation on his or her own tax forms to reduce liability. This is the primary benefit of MLPs and allows MLPs to have relatively cheap funding costs.

The tax-free income component to oil-and-gas-pipeline MLPs is very attractive to me at a time when higher income taxes are a reality fueled by a debt-ridden government. My view is that income investors seeking tax-advantaged income will continue to own MLPs and other tax-free investments if the tax code remains as is or becomes even more burdensome. I don’t see any major overhaul in the tax code with next year’s election because neither party in Congress has the will to cut spending.

Whatever happens, two things seem evident. One, taxes are going up. And two, long-term domestic energy demand is also going up, and the time to step in and pick up these coveted assets is when they are on sale. Anyone watching the energy markets of late knows that oil and gas assets have been under pressure and are now at much more attractive levels than at any time in the past six years. My top pick in this space for Cash Machine investors is Williams Partners LP (WPZ), which currently is paying out 10.95%.

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In case you missed it, I encourage you to read my e-letter column from last week about the bearish outlook for holiday retail forecasts. I also invite you to comment in the space provided below.