This play on an oil price surge offers investors an attractive yield — but a lot of complexity

Published Tue, Jul 19 20223:32 PM EDTUpdated Tue, Jul 19 20226:03 PM EDT

Income-hungry investors hoping to scoop up attractive yields and a fresh play on this year's rising oil prices are setting their sights on a different corner of the energy market . Master limited partnerships offer investors a way to capitalize on the exploration, transport and processing of natural resources, including oil and gas. So-called MLPs are attractive because they offer yields that can exceed 7%. They've also experienced strong gains this year on higher energy prices. Indeed, the S & P 500's energy sector is up about 30% in 2022, but it has risen a mere 0.9% in July. At first blush, MLPs are familiar to equity investors: They have tickers and trade like stocks. But that's where the similarities end. "These are really partnership interests, and that creates some opportunities from a cash flow standpoint, but complexity from a tax standpoint," said Tim Steffen, a certified public accountant and director of tax planning at Baird. Here's what you should know about master limited partnerships before you invest in them. Complex structure, strong performance MLPs have general partners who run the day-to-day operations of the business, which can include pipelines for transporting oil and gas. The limited partners — investors — purchase interests in the partnership and provide it with capital. Limited partners collect income distributions from the business. "The assets that MLPs can hold, including pipelines and storage, tend to be very long lived, so what that means is that you end up with a higher quality asset," said Stephen Ellis, energy and utilities strategist at Morningstar. What investors find intriguing is the partnership's tax structure. The MLPs themselves aren't subject to federal income taxes, but the limited partners owe taxes on the income distributed to them. This differs from the way income is taxed to shareholders in a C-corporation, in which a business is on the hook for corporate income taxes and shareholders pay taxes on dividends received. This preferential tax treatment allows MLPs to offer attractive yields. For instance, Enterprise Products Partners (EPD) , which processes and transports natural gas, is offering a yield of 7.5%, according to FactSet. Its year-to-date performance is up 15.1%. Magellan Midstream Partners (MMP) , is up 8.4% in 2022, and it's offering yields of 8.2%, per FactSet. See below for a table of 10 energy MLPs and their performance in 2022 via Morningstar Direct and FactSet. Prices are current as of Tuesday's market close. "We project low-to-mid-single digit EBITDA growth for MLPs/midstream energy over the next 3-5 years," John Devir, Pimco managing director and portfolio manager, head of Americas credit research, said in an email. "Combined with the current yield of 7.84% (Alerian MLP Index), we believe MLPs offer an attractive total return potential of low-double digits." MLPs are also poised to continue to perform well, even as the Federal Reserve raises rates to tamp down the highest inflation in roughly four decades. "In a scenario where the Fed continues to raise interest rates beyond current expectations, which results in a stagflationary environment, we expect energy prices to remain structurally higher given ongoing global supply issues which could lead MLPs to outperform the broader equity market," Devir said. The assets aren't immune to recession risk, however. "MLPs have historically underperformed during periods of slowing growth," said Devir. "However, the macro environment today looks different than past cycles where global energy markets are very tight, reinvestment in energy production remains low and energy sector balance sheets are better positioned to withstand an economic slowdown." Investors should also be aware that MLPs are highly correlated to commodities, so fluctuations in the price of oil, for example, will affect them. Tax headaches Though investors love the prospect of additional income from their MLPs, they will likely encounter complexity around tax time. Investors can expect to receive a Schedule K-1 from the partnership, showing their share of the income from the business that year. The problem investors run into is that they can't file their personal tax returns until they receive the K-1 — which partnerships may not send until mid-March. This could mean that investors will need to ask for an extension when they file their taxes. Another stumbling block for investors comes down to where they hold these MLPs: Are they in taxable brokerage accounts or tax-deferred retirement accounts, such as an individual retirement account? "Owning MLPs or other partnerships in an IRA can trigger a tax liability," said Baird's Steffen. This is known as unrelated business taxable income, and the IRA itself would have to file a tax return. Instead, buying a mutual fund or an ETF with a basket of MLPs might be the way to go for investors hoping to avoid tax complexity, he said. "Understand what you're buying," said Steffen. "Don't just be lured in because oil has done so well this year."