Alternative Investing

How to master the tricks of energy investing

Ryan Ely, Special to
Bruce Forster | Stone | Getty Images

You may not know this, but the United States is already the largest natural gas producer in the world, according to the U.S. Energy Information Administration, and is estimated to produce more oil than Russia and Saudi Arabia in 2013.

The U.S. greatly reduced its dependence on foreign energy imports in a very short time. And with what seems to be ever-growing demand for the infrastructure necessary to harvest these resources, there is one particular asset class that has the market cornered: master limited partnerships (MLPs).

These niche operators of pipelines, refineries and storage facilities service the rapidly growing needs of the energy industry here in the U.S. and across North America. But even with this rapid expansion, the total market cap of the 50 largest MLPs combined is still smaller than the market cap of ExxonMobil alone.

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Furthermore, the unique tax structure of MLPs, although beneficial to both the company and individual investors, is complicated and can give investors a tax headache.

With all this said, here's what individual investors need to know about MLPs:

Master limited partnerships are publicly traded equities that you can buy and sell just like regular stocks. They enjoy preferred tax treatment, being exempt from corporate taxes. In order to be considered MLPs for tax purposes, however, these companies must derive at least 90 percent of revenue from activities related to the production, processing or transportation of oil, natural gas and coal.

MLPs are required to pass their profit, or income, on to investor as a "limited partner," or shareholder, in the company. Between a steady business model and the corporate tax exemption, the average dividend yield on MLPs is almost 6 percent. This makes them a great asset class for income-oriented investors.

One of the most common types of MLPs is what is considered a "midstream" MLP, a company that owns and operates pipelines used to transport oil and natural gas.

These MLPs operate their pipeline businesses like toll roads: They charge a fee to a company producing an underlying commodity to move that commodity from the drill site to a destination where it can be stored, refined, processed or sold. Fee-based, long-term contracts help midstream MLPs generate a consistent cash flow and return on the investment of having built the pipeline.

Furthermore, this model allows for distributions to be consistent and steadily increased. By and large, MLPs target an annual distribution growth rate in the mid-single digits.

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For income-oriented investors, midstream MLPs can offer a nice combination of growth, from the underlying business, and income, in the form of consistent and growing distributions.

MLPs also operate in what are known as the upstream (think "exploration") and downstream (think "gas stations and refineries") segments of the energy market. This is important to understand because although all MLPs have a similar structure, the downstream, upstream and midstream segments of the business are vastly different from a risk perspective.

Upstream and downstream MLPs generally have a harder time paying consistent dividends because their business models are not "toll road-based." Upstream MLPs have much more exposure to the wild price swings in the commodities markets, and downstream MLPs can be much more exposed to swings in demand for finished petroleum products.

These are generally not the ideal type of MLP for risk-averse, income-oriented investors, but they can offer great returns in the right environment.

All MLPs, regardless of type, issue K-1 forms to limited partners at the end of each year.

A K-1 is a tax document that shows your share of an MLP's income.

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K-1s can be confusing but, when utilized correctly, can help you keep upwards of 75 percent of your distribution, tax-deferred. That's because you actually end up applying your share of the MLP's depreciation to reducing your own cost basis. This allows you to avoid paying income tax on all of the distribution. If all that sounds too confusing, here's some good news: You can access MLPs in several other ways, none of which involve K-1 forms.

These include mutual funds, exchange-traded funds (ETFs), closed-end funds and exchange-traded notes (ETNs). You won't have to worry about K-1s with any of these options, but they do vary in their strategies. Mutual funds and ETFs, for example, actually own the underlying MLPs.

Closed-end funds are unique in that, in addition to owning the underlying MLPs, they also employ leverage (or, borrowing money to buy more shares) to enhance return and yield. Remember, however, that leverage works both ways—so be careful what you wish for: A correction in the MLP market is bound to have an amplified effect on such closed-end funds.

ETNs, meanwhile, are debt instruments issued by banks that promise to deliver you the performance of the underlying index. They are a low-cost way to access the space, but make sure you're comfortable with the credit risk of the issuer.

—Ryan Ely is an investment advisor with Capital Investment Advisors, a fee-only registered investment advisor based in Atlanta. Ely is a member of its Investment Committee and provides research on the energy sector, specifically master limited partnerships and exploration and production companies. He is also the executive producer of "Money Matters with Wes Moss," a weekly radio talk show in Atlanta.