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How MLPs Can Help Investors Tap Into the Booming Energy Industry

Meg Handley

Dramatic growth in domestic production of crude oil and natural gas thanks to massive shale plays throughout the nation has opened up a host of opportunities for investors looking to capitalize on the newly invigorated industry.

But getting in on the rising tide of the energy industry doesn't mean you have to expose your portfolio to a ton of the volatility risk that's traditionally associated with investing in commodities. According to experts, Master Limited Partnerships (MLPs) can give investors access to the booming energy industry and current income they're looking for, without adding layers of risk and volatility.

"It's very clear that the U.S. energy industry undergoing a renaissance as we've learned how to tap shale gas and shale oil," says Jason Stevens, a midstream analyst at Morningstar. "MLPs are installing the plumbing for that boom, and they offer investors a more stable way to play the energy boom than to go out and directly invest in exploration and production companies."

But many investors might not be familiar with MLPs, and it's important to know what you're getting into when you invest in these types of companies. Here's a look at how to integrate MLPs into your portfolio:

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What Is An MLP?

An MLP is a publicly traded company that qualifies as a non-taxable business entity because it derives at least 90 percent of its income from energy-related activities such as the transport, storage, processing, refining, marketing, exploration, production, and mining of natural resources.

"Just think about what's going on in the Marcellus," says Greg Reid, managing director of Salient Partners and president and CEO of Salient's MLP business, referring to the massive deposit of natural gas discovered in Pennsylvania. "How do they get all those raw materials into New York from Pennsylvania? How do you transport all that if they don't have all the pipelines? Then they use rail, and build pipelines later. That's where opportunity is."

While MLPs trade on a stock exchange like traditional corporations, they have a different structure--when you buy an MLP, you actually become a limited partner, or unitholder, rather than a shareholder.

That impacts how MLPs handle taxes. The MLP itself is not subject to corporate taxes. Instead, MLP unitholders are responsible for their individual portions of the MLP's income, gains, losses, and deductions. While complex, this structure eliminates the double taxation generally applied to corporations.

"It's messier from a tax standpoint," Reid admits, cautioning that MLPs should be looked at as a long-term investment because frequently buying and selling MLPs can create more tax complexities. That's why these types of investments are mainly suited for taxable accounts, and should not be purchased in IRAs or 401(k)s. If you generate more than $1,000 in income from these MLPs in those types of accounts, it could create a messy tax liability and a paperwork nightmare.

Still, the competitive yields MLPs offer relative to other asset classes are making them increasingly attractive to all kinds of investors.

Why Should I Consider an MLP?

In today's low-yield environment, MLPs offer significantly more potential than many other investments. Although as a group, they've underperformed the benchmark Standard & Poor's 500 Index, their long-term returns (over three, five, and 10 years) dwarf most other asset classes, even REITs.

As a group, MLPs yield around 6 to 8 percent a year. Add on a 5 percent projected yearly growth in distributions, and investors are suddenly looking at 11 to 13 percent total return annually.

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"The growth opportunity is as good as I've ever seen it," says Brian Watson, director of research and portfolio manager for Oppenheimer SteelPath. "We all kind of thought we were going to run out of oil and gas, but now it's become a really lucrative space."

Watson likes Enterprise Products Partners (symbol:EPD) because it has a very diverse footprint in the industry. From pipelines to natural gas liquids processing, the company has "enviable new growth projects" to look forward to, Watson says. "This is a name that's providing potential," he adds. "It's a risk-reward balance--it's a company that's got a bulletproof underlying business, that provides decent growth in a low-risk way."

Reid also has a couple of favorites in the MLP space, which currently boasts around 90 members with a total market capitalization of more than $300 billion. Targa Resources (TRGP) is one promising MLP Reid has his eye on, and not just because it's yielding around 7.6 percent.

"It's really cheap and it's going to grow a lot," Reid says. "They did an acquisition and their stock fell, but they're still getting projected returns in the 13 to 15 percent range." Another favorite of Reid's is William's Partners (WPZ), a pipeline company that's been beaten up a bit this year.

What Are the Risks?

According to Stevens, the specter of massive tax-code reform is the main risk when it comes to MLPs. Currently, the asset class enjoys a structure that allows it to avoid paying corporate taxes and instead pass through the income--and taxes--to unitholders. If that structure is invalidated, MLPs could starting having to pay taxes on their income, which would reduce the cash distributed to unitholders and drive down the stock price.

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Another byproduct of its structure that could impact investors is that because MLPs do not retain earnings, there's no "bucket" to finance growth projects. That means MLPs constantly have to come to the market to raise new capital. If markets are down and an MLP can't access the capital it needs, the growth part of the total return equation would suffer, Stevens says.

"If you take growth off the table, total return prospects aren't as good and stock prices would quickly reflect that," he adds.

Finally, though they are billed as a way to dampen the commodity risk associated with investing directly in the oil and gas production industry, MLPs don't protect investors from everything. Like any investment, those interested in entering the MLP space should do their homework, and find out exactly what sectors of the energy industry the MLP operates in.

"Don't assume MLPs have no commodity price risk at all," Watson says. "Some names are taking a fair amount and some aren't, so it's important to know what you're getting into."

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