What Are Master Limited Partnerships (MLPs)?

Many energy companies have assets that generate a consistent income over time. For instance, a natural gas pipeline will transport a predictable amount of gas through it each year, generating very stable revenues. These stable revenues often lead to a distribution of earnings to shareholders in the form of a dividend. Unfortunately, investors are double taxed when standard corporations issue dividends – once when the company earns the revenue (corporate income tax) and once when the dividends are paid out (personal income tax).

Master limited partnerships (MLPs) solve this problem by eliminating double taxation for revenues derived from qualified sources – as determined by the U.S. Internal Revenue Service. These sources include almost all activities associated with the production, processing or transportation of oil, natural gas and coal assets in the U.S. [for more MLP news and analysis subscribe to our free newsletter].

How Do MLPs Work for Investors

Master limited partnerships are formed around assets that generate at least 90% of their revenues from the aforementioned qualifying activities. Once implemented, MLPs pay their investors through required quarterly distributions in a schedule that is agreed upon by the limited partners (investors) and general partner (manager of the asset).

The general partner typically begins with a small stake in the asset – usually around 2% or so – but is provided incentive distributions from net income after quarterly distributions. Most general partners are paid on a sliding scale based on cash flow, which also influences limited partners’ cash distributions, thereby aligning both of their interests [see also 13 High-Yielding Commodities For 2013].

When it comes to taxing these distributions, the MLP itself avoids corporate income tax at both the state and federal levels. Investors, on the other hand, face relatively complex tax implications. Most of the time, investors are taxed at their individual marginal rate, but they may record any depreciation on their own tax forms to reduce liability.

Benefits of Investing in MLPs

MLPs have become a popular investment vehicle for companies, because it enables them to access capital markets with a reduced tax burden. For the general partner, selling MLPs to investors raises funding necessary to complete large infrastructure projects at a lower cost of capital, thanks to the lack of a corporate income tax.

For investors, MLPs have become an attractive source of “dividend” payments for income investors, even though they are treated as income distributions taxed at the marginal rate. Many MLP distributions range between 6% and 8% or more in very stable quarterly payments that grow 5% to 10% annually, all backed by predictable energy assets.

Finally, many MLPs benefit from increase energy flow (e.g. through pipelines), but hedge their commodity risk with derivatives. As a result, these MLPs enable investors to gain exposure to the energy industry without necessarily increasing exposure to volatile commodity prices, while also paying out a consistent yield via quarterly distributions [see also Keystone XL Pipeline: The Good, Bad And Ugly].

Investing in MLPs Using ETFs and ETNs

There are many different MLPs traded on U.S. stock exchanges, including several different exchange-traded funds (ETFs) and exchange-traded notes (ETNs). But, these products are unlike many other exchange-traded products (ETPs) in the market, meaning investors should carefully consider a number of different factors before investing in them.

For instance, traditional funds registered under the Investment Company Act of 1940 are forbidden from holding more than 25% of their portfolio in MLPs. As a result, closed-end funds (CEFs) and now ETFs structure them as C-Corporations, meaning that distributions are taxed at the corporate level before being passed on to shareholders [see also MLPs: CEFs, ETPs, or Mutual Funds?].

Meanwhile, ETNs differ in that they simply promise to pay the return of an index instead of necessarily holding the index, thereby providing synthetic exposure. The distributions paid by these funds are taxed as ordinary income, since they’re interest payments rather than return on capital.

The most popular ETFs and ETNs include:

• JPMorgan Alerian Index ETN (AMJ)
• ALPS Alerian MLP ETF (AMLP)
• UBS E-TRACS Alerian MLP Infrastructure ETN (MLPI)
• Credit Suisse Cushing 30 MLP Index ETN (MLPN)
• Yorkville High Income MLP ETF (YMLP)

Notably, in early 2013, Global X launched a new ETF in the sector covering 25 small cap junior players in the space, called the Global X Junior MLP ETF (MLPJ), offering a very attractive yield.

Investing Directly in MLP Equities

Investors can also invest in MLPs directly, instead of purchasing ETFs or ETNs. As discussed earlier, there are certain tax implications to doing this, but the benefit includes more specific exposure to particular companies. According to Dividend.com, there are just over 100 different publicly traded MLPs for investors to choose.

Some examples of popular MLPs include:

• Energy Transfer Partners LP (ETP): An intrastate transportation and storage, midstream and retail propane operator, with a 7.65% yield and $14.04 billion market capitalization.
• Natural Resource Partners LP (NRP): An owner of coal reserves in the three top U.S. coal producing regions, as well as the Gulf Coast region, with a 9.92% yield and a $2.35 billion market capitalization.
• Terra Nitrogen Company LP (TNH): A producer and holder of nitrogen fertilizer products, with a 6.99% yield and a $4.51 billion market capitalization.
• Teekay Offshore Partners LP (TOO): A transporter of offshore oil production via marine environments, with a 7.33% yield and a $2.24 billion market capitalization.
• Suburban Propane Partners LP (SPH): A U.S. marketer and distributor of propane, fuel oil and refined fuel products, with an 8.08% yield and a $2.41 billion market capitalization.

The Bottom Line

When researching MLPs, it’s important to consider individual subgroups instead of lumping them into the same basket, including everything from diversified operators to those specializing in niches like sea transportation. Each of these subsectors has unique dynamics that include energy prices, spot rates, and even weather conditions.

In the end, the safest plays tend to be the companies that are involved in stable businesses with high barriers to entry, like natural gas pipeline transportation.

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Disclosure: No positions at time of writing.