“A.O.P: The Secret Investment That’s Crushing Gold!”

by Travis Johnson, Stock Gumshoe | August 3, 2010 11:33 am

Now this is a pitch:

“Everyone knows gold[1] is a great investment. Since 2000, it’s gone from $275 to $1,250 an ounce.

“But what if I told you there’s a special type of investment out there that’s not only beaten gold over the past decade but has practically destroyed every asset class on the market as well. In terms of average, annualized returns:

“It’s performed 18-times better than the S&P 500

“It’s beaten mutual funds[2] 17 to 1

“It’s beaten utilities[3] 6 to 1

“It’s beaten bonds 3 to 1

“In fact, we couldn’t find a single type of investment that has even come close to this ‘gold-beater.’

“And the next 12-24 months could be the most profitable period to date for this investment.”

Not that gold is necessarily the one thing we should be comparing all other investments to (personally, I’ve always thought of gold as more of a “store of value” savings vehicle than an investment, but it sure has gone up in recent years) … but whatever you compare it to, those are some nice numbers.

So what is this? The folks at Stansberry Research[4] tell us that they call it the “A.O.P.” — here’s how they put it:

“Spawned by a 31-year old snippet of U.S. corporate tax code, the A.O.P. has been generating capital gains AND progressively higher levels of income since the inception.

“But you won’t find this income opportunity through any government agency website… even though it owes its very existence to an act of Congress.

“Plus – and here’s the kicker – the A.O.P. has historically increased shareholder payouts every year no matter what’s going on in the markets.”

And then, as newsletters are wont to do, they brag about the fact that they’ve been behind this “AOP” investment for a long time, letting their shareholders enjoy a nice run:

“We first wrote about the A.O.P. four years ago.

“At the time the economy was booming, the financial markets were still strong, and people were spending money hand over fist.

“Everyone knows what happened next…

“Banks began to fail, the markets collapsed, the economy went into a tailspin…

“But for those who took advantage of the A.O.P., it’s been a much different story…”

So this made me check back in the Gumshoe files … and yes, the S&A Resource Report did teaser this “AOP” investment in their ad campaigns several years ago — I don’t know if it was really four years ago, since I wasn’t publishing then and the Gumshoe had yet to lay the foundation on our virtual edutainment storefront … but I did write about Matt Badiali[5]’s teaser for his newsletter, which was then called the S&A Oil Report[6], and he was pushing the “AOP” quite hard then.

And from that point, the investments have mostly done quite well — but that’s because they’re roughly flat (not counting dividends[7]) — which, compared to the S&P and other comparables, is pretty good. When I wrote about this sector for the first time back then, in May of 2007 when my inbox was overflowing with A.O.P. stuff, I thought these investments were pretty expensive and would have to come back in to make the yields more competitive and attractive… and they did, taking an outsize hit in late 2008 and early 2009 that made them, in retrospect, insanely cheap.

But I should go ahead and slake your thirst for the “answer”, right? The A.O.P. is their acronym for “American Oil Pension,” and then as now it’s a teaser about investing in Master Limited Partnerships[8] (MLPs), largely those MLPs that make up the majority of the sector, the companies that transport, process and store oil[9] and natural gas[10].

I’d have to assume, however, that Badiali and his copywriters are teasing out different MLPs than they did three years ago — so let’s dig into the tease a bit, shall we?

If you’re not familiar with the MLP term (and don’t worry, no one else sues AOP — that’s just a copywriter invention to help make this seem mysterious, and bolster Badiali’s case that he’s got the inside info you need on this little-known investment), Master Limited Partnerships are a creation of the Reagan-era tax code, designed to help spur investment in our oil and gas infrastructure and domestic energy production.

There were some bad apples in the bunch in the early years that were essentially just created as tax dodges, but the sector is now largely well-run and well-respected, and the larger MLPs are effective and efficient pipeline operators (for the most part) who benefit from the tax code in a couple ways: first, they don’t have to pay taxes on their corporate income as long as they pass it along to their unitholders (not technically shareholders, since these are partnerships, not corporations); and second, they own assets that for the most part are very long-lived and relatively inexpensive to maintain, and that generally depreciate quite a bit faster than they physically deteriorate, so they generate even more cash than they actually classify as income, meaning that they can disperse even more cash to their unitholders and keep them happy.

I’ve written about MLPs many times before, so this may all be a bit boring — but essentially, they are a way to get high current income and defer taxes on that income until you sell your units, since the fact that the dividends/distributions to unitholders are far higher than the partnership’s reported income means that you’re often getting a “return of capital” as most of your distribution, which just lowers your cost basis in the shares and means you end up paying capital gains taxes on that “return of capital” … but not until you sell the shares and register that gain, so you get to choose when to incur taxes (and I’m not a tax expert so don’t rely on me for the details of this, but I think that inherited MLP shares get a bump up in cost basis, so this is a popular investment among older investors in part as a way to efficiently pass along wealth to future generations without forgoing current income — do remember, I could easily be wrong on that point).

And yes, MLPs are generally probably not very well understood by most investors, so there is perhaps an opportunity for folks to get in on a sector that’s critical and profitable but somewhat small and not dominated by institutions (many institutions can’t own MLPs, and most mutual funds do not although they’re now technically allowed to), but it’s worth noting that MLPs generally trade like other yield-focused investments — they compete with bonds, high dividend stocks, and stuff like Real Estate Investment Trusts for the attention of income-focused investors, so the prices fluctuate in part due to yield expectations for those other sectors. Right now the yields on most investments are so absurdly low that it’s tough to say what’s fair — the REITs[11] and the utilities yield about 4-4.5% (or at least the averages of those, as measured by the big ETFs for those sectors), the ten year US Treasury bond or a 5-year CD yields a bit under 3%, and the closest thing to an index for MLPs (the JP Morgan Alerian Exchange Traded Note) yields about 5.5%. MLPs don’t historically seem to get to yield much less than that before the price falls to get the income levels back up, but we haven’t had many long-lasting low-interest-rate environments like this in the past, where 5 or 6% seems like a terrific yield.

And certainly MLPs have been probably by far the best thing to own for the last decade or so — the compounding high interest and the relative stability of their income stream have helped them to avoid the worst of the crashes (though they’ve had several downward spikes), and I wouldn’t argue with anyone who wanted to dedicate a portion of their portfolio to the sector.

So without further ado, which are the favored “A.O.P.” investments that Matt Badiali is pushing now? Here’s how he hints for us:

“Today, there are TWO A.O.P. businesses that stand head and shoulders above the rest—they regularly send out the biggest paychecks… and have superior streams of revenue.

“I’m very confident and pleased with the results these companies have had to offer investors. Take a look below, and you’ll find a brief description of what I really like about each one:

“A.O.P. Company #1: This Pennsylvania business owns and operates natural gas assets, including five natural gas processing facilities and over 4,000 miles of natural gas gathering pipelines.

“Although they’ve only been around for 3 years, this company has increased its distribution payouts by an incredible 457%.

“Since 2005, they’ve also increased their total revenues by 58% and cash distributions by around 200%.

“To qualify for the August 14, 2010 distribution check, you must enroll by August 3.”

Well, I don’t know how you get the “only been around for three years” and reconcile that with the “since 2005” numbers in the subsequent paragraph, but maybe they just made a little mistake on the dates — this MLP had only been around for three years in 2005, arguably (this entity was formed in 2001), but they have been in business under various names and corporate structures since the late 19th century … I think this first one must be Penn Virginia Resources (PVR), which does have the natural gas assets described in the tease but which is also has a second major business as an owner of coal[12] properties in Appalachia.

And oddly enough, when you think “Pennsylvania” and natural gas you probably think of the Marcellus Shale, which might get you excited about growth prospects for Penn Virginia … but in actuality, when it comes to natural gas they’re still mostly a Texas/Oklahoma company. That’s possibly going to gradually change over the next several years, since they have made deals with two different Marcellus producers to expand gathering systems in the area over the next several years, most notably a five-year deal with Range Resources that started just recently and that will have them spending a couple hundred million building out gathering pipes for some of Range’s acreage in Pennsylvania. They do think this will be accretive to “distributable cash flow” by next year, which means they shouldn’t have to cut the quarterly distribution to unitholders.

PVR is an interesting MLP, they own primarily gathering and midstream assets on the natural gas side (gathering is what it sounds like, small pipes that connect the wells to bigger pipelines for movement to refineries or storage; midstream is mostly refining and processing, and the separating of natural gas liquids[13]), which means they have to constantly analyze the production in their service areas and expand to new areas as (or if) the area where they’re “gathering” sees production declines, so it’s a bit more complicated than the MLPs who primarily own the big interstate pipelines that primarily, for example, move crude oil from the Gulf Coast to the Northeast.

And if you add on the coal business, you’d think that would provide some additional stability to earnings — you get, at least, more diversity of revenue. The coal business is basically just land ownership — the own the coal, but they don’t produce it, they just collect royalties, so it’s far smaller in terms of revenue than their natural gas business, but that revenue comes in with far higher margins because they don’t actually have to mine the coal.

But even given that, this MLP has an above-average yield, and unlike some MLPs they actually make enough in income to cover their distribution (it’s not just the distribution of depreciation). I haven’t looked at this one for my personal account in a long time, and I don’t want to downplay the relative risk of owning gathering systems in Texas and Oklahoma when fields might decline, but it is impressive that they have an above-average yield for the MLP space (just under 8%) — and like essentially all MLPs, they have been able to continue to increase the distribution amount, though not as aggressively as some. They’ve got a market cap of about a billion dollars, so they’re quite small compared to big guys like Kinder Morgan (KMP) and Enterprise Products Partners (EPD)[14] which are 20 times as large, but they also yield more (the big MLPs generally have yields in the low-6% range) and, since they are smaller, might arguably have more growth potential.

And there’s one more …

“AOP Company #2: This Houston firm is one of the largest A.O.P. businesses in the world. They own 49,100 of oil and gas pipeline throughout the continental U.S.

“If you bought 5,000 shares of this A.O.P. business soon after it first went public in 1998, you would have since collected over $90,000 in distribution payouts.

“You’d have received 47 distribution checks during that time and your initial $5,000 stake would now be worth $155,000 in capital gains. Combined, you’d have made $245,000.

“In order to ensure you receive the next distribution payout, which will likely be paid on August 13, you will want to purchase your shares prior to August 6, 2010.”

Well, what do you know — this one is one of the biggies I mentioned above, Enterprise Products Partners (EPD). I think this is actually the largest of the pipeline MLPs at the moment, their market cap is just under $25 billion, and they do pretty much everything that you think of for “traditional” MLPs — they own gas gathering systems, they own onshore and offshore pipelines for both gas and oil, they do midstream gas processing and marketing of the various products, they own storage facilities and terminals, and they even sell chemicals and feedstocks. So if you’re looking for one of the more diversified MLPs, it’s hard to argue with EPD.

While Enterprise is huge, they are also focused on growing — and growth for MLPs generally means either acquiring small pipeline operators, or building new (or expanding and extending old) gathering and transportation systems. EPD has done quite a bit of acquiring in the past, and they do seem focused on significant oil and gas growth areas, which I would always look for in an MLP to make sure they’ve got some potential to keep adding to their revenue base — in EPD’s case, the expansion focus seems largely to be the southern shale areas, primarily Barnett and Haynesville, and the big Eagle Ford Shale that has everyone excited in South Texas.

But as I said, the yield is not massive — EPD will earn you just a whisper over 6%, and that will eventually be taxable unless you try to finagle holding it in an IRA. And most people don’t recommend holding MLPs in IRAs since a lot of their value is in the tax deferral, which you get with an IRA anyway — as an aside, some MLPs will tell you that holding their units in a Roth IRA isn’t kosher, but I think that’s just for pipeline operators that are entirely FERC-regulated (I know that both Boardwalk Pipeline — which I own — and El Paso[15] Pipeline Partners are ineligible for Roth IRAs, but as far as I know that’s a FERC-specific issue in proving that tax is eventually paid on those distributions).

So there you have it — the two main A.O.P. investments that Badiali appears to be recommending in the MLP space this time around — and no, neither of these was on his list three or four years ago, if you’re curious about those “original” A.O.P. ideas you can always check out my older article here[16] (those four picks from 2006 or 2007 have generally done well, though as a group they’ve probably been similar to the average MLP performance — unless you picked these on downward spikes they’re wealth builders and powerful compounders, not usually rocket stocks), and of course under “related articles” below you’ll see several other MLP-oriented articles, these tend to come up at least once a month or so.

The only general thoughts I’d share as you get started in your research are to look at how the MLPs you like might grow (ie, these days that mostly means they’re either an acquirer, or they’re serving the hot new exploration areas in some way, like shale gas), and make sure they’re generating enough free cash (or EBITDA, depending how you want to measure — it doesn’t have to be actual accounting income) so they don’t have to cut the distribution if things get ugly for a year (as happened in late 2008, precipitating the dips in most of these stocks — and the disappearance of the weakest ones). You might also, if you’re looking more closely, check on how the company’s pipes are regulated and their services priced — many pipelines, especially larger ones, tend to have pricing agreements set by regulators, like other utilities, and they tend to be consistently busy, the smaller or more regional gathering systems may be unregulated and possibly more subject to pricing pressures from time to time.

And, of course, there’s always risk — just ask Enbridge Energy Partners (EEP)[17] about their major spill last week on the pipeline that transports Canadian oil to midwest refineries (though that’s of course quite minor compared to BP’s Gulf disaster, and didn’t seem to hit EEP’s unit price terribly hard, at least not yet).

Finally, I know I have lots of MLP-happy folks in the vast Stock Gumshoe readership, so feel free to share your thoughts about the best or worst MLPs out there, that’s why we’ve got the friendly little comment box below.

Full disclosure: as noted above, I do own shares of Boardwalk Pipeline Partners (BWP)[18], but do not currently own any other Master Limited Partnership units named above (or any others, actually). I will not trade in any mentioned shares for at least three days.

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