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?

In short, MLPs are publicly traded investment partnerships. MLPs have unit holders, and not shareholders, and are targeted toward the energy sector (primarily oil and gas), and trade on major exchanges such as the New York Stock Exchange, or Nasdaq.

For Canadians, MLPs are akin to their former Energy Income Trusts, as both can send most of their income—with almost no taxes—to unit holders.

Energy-related MLPs have one critical legal threshold to clear: In order for a partnership to qualify as one, the partnership must get 90% of its cash flows from commodities (usually oil and gas).

MLPs merge the tax benefits of a traditional limited partnership with the liquidity of a publicly traded company. The MLP doesn’t pay taxes from the profit. Instead, the money is only taxed when the partnership’s unit-holders receive their cash distributions.

And yes, MLPs are growing.

According to industry figures, over the past 10 years, MLP market cap growth has grown from $25 billion to $350 billion. MLPs own oil and gas pipelines, transportation and processing, refining, and storage sectors.

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.

Let's look at one key benchmark, the Alerian MLP Index (AMZ).

Since December 31, 2007, the index has returned 66.6% for investors, with about 32% of that from capital gains. Compare that to the S&P 500, where returns slid by 1.55% over the same time frame.

2012 was no exception: over its first six months, MLPs kept up the pace, outperforming all major investment indexes.

QUICK FACTS

 

There’s lots to love about MLPs:

• They combine the income-producing benefits of bonds with the capital appreciation advantages of stocks – and combine them into one energy investment that has outpaced every other leading investment benchmark in 11 of the last 12 years.
• On top of that performance, factor in a tax element that wipes clean 80%-to-90% of your tax burden on that investment.
• Combine that performance with an oil and gas industry investment that, historically, makes money no matter what commodity prices are doing.

That’s where MLPs may just may change the way you look at investing, altogether... especially in the more conservative part of your portfolio.

They are particularly engaging in a tepid economy, where finding oil and gas investments with reduced downside risk and returns that beat average dividend stocks is no easy task.

Can MLPs be a game-changer for you? Sure – if you know the lay of the land, and if you know how to play them right.

Here are some key points on MLPs:

1. How long have MLPs been around?

While the first MLP, Apache Oil Company, was formed in 1981, the investment vehicle really gained momentum in 1986, via the Tax Reform Act, and in 1987, via the Revenue Act. Both pieces of legislation stated that as long as 90% of MLP revenues originated from natural resources related to the exploration, development land ownership, and investment gains and losses, they would be considered “established” MLP structures.

Later in the decade, MLPs morphed into midstream ownership entities that owned assets that transported, refined and stored oil and gas products. That “asset ownership” feature helped MLPs reduce their exposure to volatile oil and gas prices, and provided a steady and reliable cash flow for MLP investors.

Historically, investors have been drawn to MLPs for two significant reasons:

• Income generation -- In volatile markets, where high investment risk is par for the course, income-generation is a priority.
• Tax benefits – Since master limited partnerships are considered legal, qualified partnerships by the I.R.S., unit holders earn more income – but pay less tax on that income.

MLPs have taken a pivotal, even leadership role in getting energy to U.S. consumers. They generally trade at a higher valuation than regular corporations (the industry calls those “C-corps”) and can therefore raise money for big projects more cheaply than them.

As owners of the storage facilities and pipelines needed to transport oil, gas and other commodities from the refineries to consumers, MLPs are ideally positioned to benefit from rising energy demand.

2. How are MLPs structured?

MLPs are generally structured with a General Partner (GP) acting as management, and the Limited Partners (LP) providing the capital.

• MLPs can have one or more General Partners, who can have a 2% ownership stake in the partnership.
• MLPs can have thousands of Limited Partners (known as unit holders) who own publicly traded units. Limited Partners play no role in the management of the partnership, and are eligible for quarterly cash distributions.

Most MLPs have a tiered-hierarchy, with a General Partner at the top of the organization, and are tasked to manage the MLP on behalf of unit-holders. Typically, General Partners have a 2% interest in the MLP, while the participation rate varies for individual Limited Partners, and they are tasked with providing financial capital, and benefit from investment gains from the partnership.

Unlike stocks, MLP partners own “units" of the partnership, and the number of units owned represents a Limited Partner’s stake in the partnership. Typically, Limited Partners look for two investment results from MLPs – strong yield and solid growth. In both areas historically, investors have often been rewarded handsomely.

Operationally, MLPs offer investors the following benefits:

• As a partnership, MLPs aren’t taxed like corporations. That “pass through” structure means unit holders aren’t “double-taxed” on dividends they receive. For the partnership, that tax structure means a lower cost of capital, thus giving MLPs a big advantage in generating more assets.
• MLP’s unique tax structure allows for more money to funnel to investors. And since MLPs are publicly traded, that enables MLPs to gain access to a wider ranger of investors.

3. How Can Individual Investors Get Going With MLPs?

Historically, MLPs were only available to the public as individual investments, but in recent years they’ve become available as closed-end funds and exchange-traded funds, and are now widely available on financial exchanges.

Some of the most widely traded individual MPs include:

• Kinder Morgan Energy Partners (KMP)
• Enterprise Products Partners (EPD)
• Magellan Midstream Partners (MMP)
• Linn Energy Corp (LINE)

The most prominent exchange-traded fund is the Alerian MLP (AMLP), which holds over $4.4 billion in net assets. The Alerian ETF invests at least 90% of total assets in its underlying index, the Alerian MLP Infrastructure Index.

Note that individual MLP investors based in the U.S. generally must file a unique IRS tax form annually, called a K-1 form. It’s advisable to consult a professional tax specialist before filing the K-1 form. Canadians can buy MLPs but may be subject to a withholding tax by the U.S. government—again, check with a financial advisor.

4. How do MLPs offer energy investors special tax advantages?

Master Limited Partnerships earned a unique benefit from the Tax Reform Act of 1986, as it largely exempted MLP investors from corporate taxes. Investors may look to real estate investment trusts (REITs) as a blueprint. Like REITs, MLPs are considered pass-through entities by Congress and by the Internal Revenue Service. In that regard, any profits or losses are “passed along” to MLP unit-holders, who pay any associated taxes at their individual, ordinary income tax rate.

Due to what accountants refer to as “depreciation allowances," MLP investors may receive up to 80% to 90% of investment distributions without paying immediate taxes on the income, thus providing an ample tax deferral advantage for investors.

*Non-U.S. residents get hit with a 35% withholding tax by Uncle Sam. There is paperwork to ensure there’s not double taxation on what you do receive.

5. What are the major risks associated with MLPs?

MLPs do present some risk. For example . . .

• Commodity risk: MLP returns can be impacted if there is a slide in oil and gas exploration and production due to gyrating energy prices.
• Correlation risk: This just means that MLPs go up and down with the market and with commodity prices more now than ever before.
• Liquidity risk: MLPs don’t always offer the same easy liquidity prominent with stocks, mutual funds, and exchange traded funds. Of course, you have to throw in the regular volatility of the oil and gas industry, macro events, changes in legislation etc—which aren’t always good for the oil and gas industry.

6. Outlook for MLPs going forward

Energy-related master limited partnerships are positioned positive for substantial investment growth over the next few years.

You see, a lot of MLPs transport energy, and as more oil and gas are produced by the U.S., it has go somewhere—and the oil and gas transport services MLPs provide is influenced energy volume, not price. And there’s a strong argument that the lower oil and gas prices go, the more demand there will be for it.

Put another way, pipeline-oriented MLPs are paid to move oil and gas, no matter if it’s priced at $100 or $25 per barrel.

That’s a big advantage for MLP unit holders, who already enjoy some of the best investment returns on the global financial markets over the past 25 years.

More and more investors are becoming aware of that fact. Before you pour cash into an MLP, take these tips with you first:

More on Master Limited Partnerships

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. Repeat: 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 a 14.5% 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 to 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.

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That wraps up our MLP investing primer. If you like what you just read, I encourage you to sign up for my weekly Free Alerts emails, in which I share my research on specific oil and gas stocks, plus actionable tips you can use right away for your own energy portfolio. Simply enter your email in the box on the right to get started.

Keith Schaefer, Publisher

Oil & Gas Investments Bulletin

DISCLOSURE: I own none of the stocks mentioned in this report; I do own other MLPs in the Oil & Gas Investments Bulletin portfolio, not stated here.

About Oil & Gas Investments Bulletin

Keith Schaefer, Editor and Publisher of Oil & Gas Investments Bulletin, writes on oil and natural gas markets - and stocks - in a simple, easy to read manner. He uses research reports and trade magazines, interviews industry experts and executives to identify trends in the oil and gas industry - and writes about them in a public blog. He then finds investments that make money based on that information. Company information is shared only with Oil & Gas Investments subscribers in the Bulletin - they see what he’s buying, when he buys it, and why.

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