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Before You Invest in Oil & Gas Master Limited Partnerships

The chase for yield has investors asking lots of questions about MLPs — Master Limited Partnerships. Today’s editorial is an 8-point checklist every investor should know before adding MLPs to their portfolios, and comes from guest editor Brian O’Connell.

by +Keith Schaefer

Can you afford to miss out on an investment opportunity that has returned 66% to investors over the past five years – and has beaten every major market index in 11 of the past 12 years?

That’s the promise, and the potential of Master Limited Partnerships (MLPs), an energy investor’s answer to a long-unanswered question – how can I get income and growth appreciation out of a single investment – and earn a big tax break in the bargain?

When it comes to MLPs, the positives have outweighed the negatives, but that doesn’t mean you should jump in eyes closed and head first.

Before you pour cash into an MLP, take these tips with you first:

Master Limited Partnerships Defined

By and large, master limited partnerships are just that – limited partnerships that happen to be highly liquid, and tradable on U.S. stock exchanges, just like traditional stocks.

Instead of shares, MLP’s offer investors “units,” and payouts aren’t called dividends, they’re called “distributions.” In essence, MLPs offer the tax advantages of limited partnerships with the asset growth benefit associated with common stocks.

Tax-wise, MLPs are treated differently from stocks and bonds, and are generally treated more favorably by the Internal Revenue Service. Taxes are paid by MLP unit-holders, on a pass-through basis.

That means MLPs, unlike common stocks, don’t face double taxation on distribution payouts to investors.  However, non Americans (like Canadians, eh) do face double taxation—there is a withholding tax by Uncle Sam and they are not part of the Canada US tax treaty.  All MLP investors should check with their tax accountants.

The vast majority of MLPs invest in midstream oil and gas companies, primarily in the pipeline, storage and distribution sectors.

Why MLP’s?

Master Limited Partnerships are often referred to as an “investor’s dream.” Why? Because some MLPs really do make that true – at least from a historical sense.

Statistically, MLPs offer…

Historical yields of up to 10%

From 2002 to 2012, MLP’s outperformed the Standard & Poor’s 500 Index by a whopping 291%.

In the past five-years, the Alerian MLP Index has returned of 66.6% to investors, approximately 32% of that return coming from price appreciation. Conversely, the S&P 500 fell 1.55% over the same time period.

MLPs have averaged a14.5% annual rate of return over the past 10 years.

In 2012, 78% of MLPs actually raised their distributions.

Due to depreciation, up to 90% of MLP distributions are tax-free until you unload the investment. It’s not unheard of for MLP investors to go 10 years before they pay a dime in taxes.

Demand for Oil Drives MLP Growth

There’s no sure thing on Wall Street, but MLPs may be as close as a “sure thing” as possible. Since MLPs generally invest in relatively stable midstream energy companies – think pipelines, storage tanks, and oil and gas terminals – investors benefit from high demand for the services those midstream oil and gas companies provide. In other words, it doesn’t matter where the price of oil stands – $150 or $75 – as long as global consumers use oil and gas, MLPs benefit from that steady demand.

Bear Market Benefits

Master limited partnerships have proven resilient against down stock market cycles. In the immediate aftermath of the economic collapse of 2008, 39 of 50 MLPs actually raised their distributions to investors to, on average, 10%. In addition, as MLP’s invest in “high demand” midstream oil and gas companies, MLP’s provide investors with stable, reliable.

Ups and Downs

While MLP’s do offer stable, dependable yield growth, significant tax advantages, the tax situation is complicated, and you may need to bring in a tax advisor to handle the MLP portion of your investment/tax portfolio. In addition, exposure to small-cap oil and gas stocks – a common investment for MLPs – can lead to higher-than-normal volatility.

Not All MLPs Are Created Equal

Some master limited partnerships are riskier than others. For example, larger pipeline MLPs are relatively stable – they generate a steady cash flow, as they’re not significantly impacted by oil and gas prices. Larger pipelines are also difficult to replace, making them more valuable for MLP investors.

That’s not the case for smaller pipelines that move natural gas from processing plants to suppliers. Since natural gas is more vulnerable to commodity price fluctuations, MLP investors should proceed with caution when it comes to evaluating various MLP investments.

Midstream Demand

According to the Interstate Natural Gas Association of America both the U.Ss and Canada will shell out an estimated $84 billion to build new midstream oil and gas platforms, pipelines, storage tanks, and other necessary infrastructure that meets the needs of skyrocketing domestic energy production.

That demand will generate big revenues to MLPs, who are expected to provide that entire infrastructure. In turn, those revenues should fatten up distributions, and boost MLP performance for years – and maybe even decades to come.

SEC Regulated

MLPs are exactly the product of the Wild, Wild West. In fact, the U.S. Security and Exchange Commission regulates MLPs, just like it regulates stocks. As a result, MLPs must file annual and quarterly reports, and keep investors apprised of any changes to its business model, and any developments that may impact the MLP. In addition, MLPs must also comply with the accounting requirements mandated by Sarbanes-Oxley.

Why Investors Are Flocking To Energy MLPs

What are the top reasons why regular, everyday investors are so attracted to MLP’s? Here are four big reasons why:

1. The high level of current income – MLPs offer steady, reliable yields, and steady, reliable distribution payouts. That makes it perfect for income-minded investors, especially retirees.

2. The growth element – As MLPs are essentially operating companies, which means they can buy companies and grow dynamically, MLPs are high-growth vehicles. The “perfect storm” of current income, distribution yields, and growth dynamics fuel the type of double-digit investment returns that MLP investors have enjoyed for years.

3. Low correlations – MLPs traditionally have low correlations with the U.S. equities market, and are largely immune from price volatility of crude oil.

4. Tax advantaged – MLPs offer investors extremely favorable tax treatment, allowing investors to keep more of their partnership profits, and keeping more cash out of the clutches of Uncle Sam.

Why Do So Many Investors Overlook MLPs?

Historically, master limited partnerships have been a relatively small asset class. Even as recently as 2000, there were only about 16 energy-related MLPs available for investor access.

Today, there are over 100 energy MLPs, and the largely positive investment returns have earned the notice of the financial media, of financial advisors, and finally, of investors. Now, MLPs are morphing from an asset option for the rich and powerful, to a broadened investment category open to investors of all financial categories.

Make no mistake, MLPs aren’t a secret anymore. For energy investors, that increased visibility is good news, and it may just be an opportunity of a lifetime for savvy investors.

- Brian O’Connell, guest editor

 



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