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Despite conservation efforts, the U.S.'s existing energy infrastructure just can't keep up with our ever-increasing thirst for energy. By 2030, Americans will require an estimated 131.2 quadrillion BTUs of energy - up 33% from 2005. We need repairs, upgrades and expansions, and we need them fast.

Many investors have already started piling into energy infrastructure, looking for ways to tap into its inevitable market surge. But the best play may be one you've never even heard of: the master limited partnership (MLP).

MLPs are limited partnerships, specializing in mineral and natural resource development, that can be traded on securities exchanges. Investors buy and sell MLP "units" just like shares of stock, but instead of receiving dividends, "unit holders" get cash distributions typical of a partnership structure.

Poorly understood and often overlooked, MLPs are the Rodney Dangerfield of asset classes: Even after 20 years, they still can't get no respect. But as interest in infrastructure swells, their combination of liquidity and tax efficiency - not to mention their historically high returns - make MLPs a promising way for investors to jump into the coming energy infrastructure boom.

MLPs: A Different Kind of Partnership

Established by Congress in the 1980s, MLPs were originally developed to spur investment in energy and natural resource projects. According to the Revenue Act of 1987, only companies engaged in "the exploration, production, mining, processing, refining, marketing or transportation" of mineral and natural resources may use this structure.[1]

Today, there are about 100 MLPs, more than 75% of which are energy infrastructure companies. These partnerships run a variety of business - including pipelines, refineries, processing plants and more - for a range of natural resources: oil, coal, propane, natural gas, timber - even "alternative" fuels like ethanol and biodiesel.

Because most MLPs own physical assets that operate independently of the commodities transported, processed or refined, the income of these companies depends less on energy prices and more on energy demand. And since demand is much less volatile than pricing, MLP income remains relatively stable even when energy prices go haywire. So unit holders usually see a steady, predictable increase in their cash distributions.

MLPs offer other advantages, too, including:

  • Consistently high yields that outperform other assets.
    In the past, the average current yield of MLPs has ranged anywhere from 7-10%, and currently it hovers above 8%, according to industry leader Kayne Anderson Capital Advisors.

    That's not to say MLPs were immune to last year's market implosion-they weren't. But historically, they have outperformed other asset classes, such as stocks; between 1998 and 2007, MLPs beat the S&P 500 seven out of 10 years.
  • Low correlation to other asset classes.
    Historically, MLPs have only weakly correlated with other assets, making them a good diversification tool.

MLP Correlations With Other Asset Classes

Asset

2007

July 2007-July 2008

3-Year

5-Year

S&P 500

0.43

0.43

0.43

0.40

Natural Gas

0.02

0.10

0.13

0.14

Crude Oil

0.26

0.34

0.31

0.31

10-Yr. Treasury

0.24

0.36

0.19

0.07

Utilities

0.36

0.29

0.41

0.40

REITs

0.35

0.21

0.30

0.32

Corporate Bonds

0.03

-0.01

0.00

-0.07

Data: Wachovia

Of course, in 2008, correlations between all asset classes skyrocketed, including MLPs. But history suggests this rise may be short term, and as the markets settle down, MLPs may adjust back into their historical patterns.

  • A partnership's tax benefits.
    Because MLPs are partnerships and not corporations, their income is pass-through, which means it's not subject to "double taxation" from corporate income tax. Therefore, more cash is available for unit holder distributions (which, by law, must consist of the company's entire cash flow after operational, maintenance and debt expenditures are met).

    What's more, due to the way limited partnerships work, as much as 90% of those taxes are deferred until the unit is sold - a nice perk for investors thinking long term.

Of course, MLPs do have their drawbacks. For institutional investors, they're an administrative headache, and even individual investors may run into some paperwork-related problems. In addition, holding MLPs in an IRA or other tax-deferred account could potentially set off an obscure tax known as the unrelated business taxable income, which is why some funds, such as endowments, avoid MLPs altogether.


MLPs In 2008, And Beyond

Like almost all other asset classes, MLPs nose-dived in 2008. The Alerian MLP Index, the sector's benchmark, lost 41.5% of its value last year, and as of March 2, 2009, it was 48% below its peak.

In part, MLPs suffered so greatly because of the credit squeeze. Since MLPs pay out most of their profits in unit holder distributions, they must rely heavily on loans to finance any growth initiatives. When lenders pulled back, the companies ran into cash shortages.

In addition, hedge funds loaded up on MLPs in good times, only to dump them once the market tanked. And due to the administrative obstacles mentioned above, institutional investors were largely prevented from scooping them up.

But MLP fundamentals appear to remain strong. "Cash-motivated, fearful selling powered several selling waves in the Alerian MLP Index," said Elliott Gue in a February 25, 2009 article for Personal Finance. "This presents investors with a great opportunity to buy into a sector that's been hit mainly by cash-motivated selling pressure, not a deterioration in fundamentals."

Accessing MLPs

Investors can access MLPs in many ways. Those looking for broad exposure can check out the Alerian BearLinx MLP Select Index ETN (NYSE: BSR), which tracks the Alerian MLP Index, or play a number of closed-end funds investing solely in MLPs, such as:

  • Kayne Anderson MLP Investment Company (NYSE: KYN)
  • Tortoise Energy Infrastructure Corporation (NYSE: TYG)
  • Fiduciary/Claymore MLP Opportunity Fund (NYSE: FMO)
  • Energy Income and Growth Fund (NYSE: FEN)
  • Tortoise Energy Capital Corporation (NYSE: TYY)

You can also invest in the companies directly. In general, larger MLPs that have steadily increased their distribution payouts are safer bets than smaller ones or exploration/production companies, which are more dependent on commodity prices than other MLPs. Some players include:

  • Kinder Morgan Energy Partners (NYSE: KMP), the largest transporter of natural gas in Texas, the Midwest and the Rockies; and North America's biggest carbon dioxide supplier
  • Energy Transfer Partners (NYSE: ETP), which operates about 17,000 miles of U.S. pipelines and handles 20% of the country's natural gas needs
  • Enterprise Products Partners (NYSE: EPD), which operates 35,000 miles of natural gas, natural-gas liquids and crude oil pipelines
  • TEPPCO Partners (NYSE: TPP), which runs a range of U.S. natural resource businesses, including pipelines, gathering systems, marine transports and storage
  • NuStar Energy (NYSE: NS), which runs 8,500 miles of pipeline, 85 terminal facilities, four crude oil storage tanks and two asphalt refineries

Although MLPs do have some drawbacks, their high yields and tax efficiency make them a promising play, especially as the market recovers. As the demand for new and upgraded energy infrastructure in America grows, so too may the MLP - and it's likely this erstwhile Rodney Dangerfield will finally get the respect from investors it deserves.

Endnote:

1. A handful of real estate MLPs still exist, which formed before the rules were tightened in the late 1980s.

Further Reading:

Source: MLPs: Profits in the Pipelines?