(05/01/12) Kinder Morgan Critics Running in Circles?

The relationship between the general partner and the limited partner is crucial to understand when you're buying Master Limited Partnerships...but don't get too lost, writes Elliott Gue of The Energy Strategist.

US equities have endured a difficult decade, with the S&P 500 posting an average annual gain of less than 5%. If you purchased stocks at the height of the tech bubble in 2000 or the credit bubble in 2007—or sold positions in a panic when these bubbles burst—you’re probably nursing considerable losses.

The S&P 500 Energy Index, on the other hand, has returned a whopping 185% over the past ten years, equivalent to an average annual gain of roughly 11%. Meanwhile, the Alerian MLP Index, which tracks the 50 largest energy-focused MLPs, is up more than 340% over the same period, and sports a beta of 0.71. The Alerian MLP Index has generated market-beating returns with less volatility than the S&P 500.

One stock has outperformed the Alerian MLP Index over the past decade and exhibited even less volatility: units of Kinder Morgan Energy Partners LP (KMP), one of North America’s largest pipeline transportation and energy storage companies.

If you had invested $10,000 in Kinder Morgan Energy Partners in late March 2002 and reinvested the quarterly distribution, your position would be worth almost $50,000. In comparison, the same initial investment in the S&P 500 would be worth $15,000 and the same stake in the Alerian MLP Index would be worth $44,000.

At the same time, Kinder Morgan Energy Partners’ stock has a beta of about 0.5; the units don’t fluctuate in price as much as the Alerian MLP Index, and exhibit half the volatility of the S&P 500. Better still, Kinder Morgan Energy Partners’ units offer a distribution yield of 5.65%.

Over the past five years, the firm has increased its quarterly payout at an average annualized pace of more than 7%. The MLP has never cut its distribution. and raised its payout by almost 20% between the end of 2007 and the first quarter of 2010, overcoming plummeting oil and natural gas prices, the worst economic downturn since the Great Depression, and a severe credit crunch.

In light of this strength, you’d expect Kinder Morgan Energy Partners and its longtime CEO Richard Kinder to be the darlings of the financial media. The publicly traded partnership has its fair share of admirers, including yours truly—we’ve held the stock in The Energy Strategist’s portfolio since the service launched seven years ago. Investors who followed our lead and purchased the stock have been well rewarded.

Nevertheless, I’ve read innumerable articles over the years that are down on Kinder Morgan Energy Partners and its management team, which is remarkable given the firm’s impressive asset base and the stock’s outperformance.

Negative sentiment toward Kinder Morgan Energy Partners often stems from the firm’s incentive distribution rights (IDR) structure. MLPs consist of two entities: a limited partner (LP) and a general partner (GP), which oversees day-to-day operations and makes major business decisions. Some GPs are publicly traded companies; others are privately held firms.

The best GPs take steps to grow the LP’s distributable cash flow. For example, some GPs will drop down assets to their LP at sale prices that make the deal immediately accretive to cash flow, enabling the limited partner to increase its distribution. The best GPs help their LPs to finance acquisitions, provide direct financial support when business or market conditions and provide solid leadership.

The GP doesn’t perform these functions out of charity. The relationship between GP and LP is governed by the partnership agreement, which also establishes the fees that the LP pays to the GP in exchange for its services. These IDRs are based on the size of the quarterly distribution made to LP unitholders.

IDRs are tiered such that the GP gets a larger percentage cut of the cash flow when the LP distribution increases. In other words, the GP’s take only rises when the LP hikes its payout to its unitholders.

Investors must analyze the relationship between the GP and LP before investing in an MLP. Subscribers often ask how much a particular GP is charging LP unitholders to manage the business. To answer this question, you need to understand how a tiered IDR structure works.

Here’s a look at Kinder Morgan Energy Partners’ current IDR structure:

Tier 1: 98% of cash flow goes to holders of Kinder Morgan Energy Partners and 2% to the GP, up to a quarterly distribution of $0.15125 per unit.
Tier 2: 85% of cash flow goes to Kinder Morgan Energy Partners and 15% to the GP, up to a quarterly distribution of $0.17875 per unit.
Tier 3: 75% of cash flow goes to Kinder Morgan Energy Partners and 25% to the GP, up to a quarterly distribution of $0.23375 per unit.
Tier 4: 50% of cash flow goes to KMP and 50% to the GP for all quarterly distributions greater than $0.23375 per unit.

In the most recent quarter, Kinder Morgan Energy Partners distributed $1.20 per unit—much more than $0.23375 per quarter. In industry parlance, Kinder Morgan Energy Partners is in the “high splits” with its GP, which is owned by Kinder Morgan Inc (KMI).

Investors who avoid Kinder Morgan Energy Partners are being pennywise and pound foolish. Although the MLP’s IDR obligations may exceed those of its peers, the firm’s long-term performance and future growth prospects overshadow this concern.

In the end, Kinder Morgan Energy Partners’ distribution growth and the stock’s price appreciation speak more loudly than an army of scribblers and talking heads.

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