HardAssetsInvestor

Written by Lara Crigger  |

December 18, 2009

Elliott Gue: How Investors Can Play Energy MLPs

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The editor of MLP Profits shares his outlook on where this overlooked asset class is headed in 2010. 

• The benefits of MLPs in a portfolio 
• Which sectors he has his eye on right now
• Is there more upside for 2010? 

 

Master limited partnerships (MLPs), or exchange-traded limited partnerships, are an income investor's dream. Offering steady, high yields that average around 7-8 percent, these companies tend to operate in the most stable and reliable sectors of the energy industry, such as pipelines, which makes them relatively immune to oil shocks or other commodity price swings.

Haven't heard of them? It's time to brush up, says Elliott Gue, editor of the MLP Profits newsletter. Editor of The Energy Strategist and a widely recognized energy expert, Mr. Gue knows his MLPs. He writes and speaks about the asset class often, and has been interviewed by Clean Skies TV, CNBC, Bloomberg TV, Barron's, Forbes and the Washington Post.

Recently, HAI Associate Editor Lara Crigger sat down with Mr. Gue to discuss this often overlooked asset class, including the headaches of K-1 forms, why he has his eye on gathering and processing companies, and where he thinks energy MLPs will go in 2010.

 

Lara Crigger, associate editor, HardAssetsInvestor.com (Crigger): What benefits can energy MLPS offer investors?

Elliot Gue, editor, MLP Profits (Gue): One obvious benefit is very high yields; the average MLP offers somewhere between 7-8 percent. Some of them even offer yields over 10 percent.

They're also taxed differently, since they pay out distributions, not dividends. An MLP is a publicly traded partnership, not a corporation. As a result, these companies are not subject to corporate tax, which in the United States is among the highest in the world. Instead of being taxed at the corporate level, the partnership just passes through all of the income that they earn to the unit holders (who are basically the shareholders).

This is reported on a K-1 form, and the disadvantage of that is that it does add some complexity around tax time. But still, the benefit is that, typically, a large portion of the income that you receive is technically a return of capital, which reduces your cost basis in the MLP and is not immediately taxable. In many cases, you can actually defer your taxation on an MLP for many, many years.

Crigger: So given these benefits, why do you think MLPs haven't really caught on yet with investors?

Gue: Well, there's the tax issue I just mentioned. K-1 forms are very common, but a lot of taxpayers have never seen them, and it does add a little time in terms of record-keeping and filling out your tax return. (Although, if you use a tax accountant, that's not really a problem.)

Really, the K-1 forms from 15-20 years ago were pretty awful, but they've simplified things quite a bit since then. But I think a lot of investors remember the old format, and they're still a little scared of them. But most of the MLPs nowadays allow you to download the information from your K-1 directly into a tax program like Turbo Tax. So it's a lot easier than it used to be.

The other thing is that MLPs do tend to be smaller companies. That's not universally true; some like Enterprise Products Partners (NYSE: EPD) and Kinder Morgan (NYSE: KMP) are huge. But they tend to be companies involved more in the midstream energy business, which is basically pipelines, storage facilities and tankers. So it's a little more under-the-radar business than your typical energy firm.

Crigger: What criteria should investors use to judge a good MLP from a bad one? What characteristics should they look for?

Gue: Well, one key thing to keep in mind is that the whole point of this structure is to generate distributions. A normal energy company, like an exploration company, is looking to book new reserves and grow their production. But an energy MLP is typically looking to generate a reliable, steady stream of cash flow that it can then use to pay out those distributions reliably over time.

There really are a number of different classes of MLP, so the first thing to look at is: What business are they involved in? As I mentioned before, more than 85 percent of them are involved in the midstream energy business, but that's actually a more varied business than people give it credit for.

For example, pipelines - that's a very steady business, typically, especially interstate pipelines. Basically a company that owns a pipeline is not paid based on the value of the natural gas or oil that moves through that pipeline; it's paid based on the volume. Therefore, those revenues are very steady, regardless of commodity prices.

But there are some businesses that carry a little more commodity sensitivity, and that's the thing to keep an eye on. One of them is what's known as gathering and processing.