Of course, MLPs and royalty trusts aren't risk-free. As publicly traded vehicles tied to volatile commodity prices, their share prices got whacked when oil and gas prices tanked last year. According to IHS Herold, an energy research firm in Norwalk, Conn., U.S. royalty trusts as a group lost 20% and MLPs dropped 28.3% in 2008, while Canadian royalty trusts, a different animal from their American counterparts, sank 34.4%.
Yields have increased as unit prices have dropped, but a better gauge to look at is the sustainability of the distributions in the face of weak underlying commodity prices. Some investors favor MLPs because their cash flows stem from stable business activity based in fees-business such as the movement of oil and natural gas through pipelines, for instance-and such activities aren't hurt as much by fluctuations in raw material prices.
"I much prefer companies that are transporting oil and gas because the cash flows they throw off are generally consistent," says Josh Peters, an equity strategist at Morningstar who also edits the company's Dividend Investor newsletter. "When you're looking at yields of 8% to 11%, the yields are sustainable because you're getting a return on moving these assets around and that's not likely to change."
Some of Peters' favorite MLPs recently were Magellan Midstream Partners, Kinder Morgan Energy Partners and NuStar Energy. Magellan, formerly known as Williams Energy Partners, operates pipelines and storage terminals for refined petroleum and ammonia in the central U.S. The equity price tumbled 23.6% last year, but in 2009 it gained roughly 19% by mid-February, with a yield of 8%.
Kinder Morgan, which owns more than 25,000 miles of oil and natural gas pipeline, saw its equity price drop 9% last year before it rebounded more than 12% through mid-February. Its yield was more than 8%.
One of the reasons Peters likes NuStar Energy-a spin-off from refiner Valero Energy-is that it now has an asphalt refining business to go along with its oil pipeline operations. Its stock lost 16.4% last year but was recently up about 20% this year, and the yield was nearly 9%.
Quirky Considerations
MLPs, however, are not a good fit for retirement accounts such as 401(k)s and IRAs because the partnership income they throw off often exceeds the $1,000 that may be considered unrelated business taxable income-and then becomes, as the name implies, subject to tax. "That's part of the reason why they're not included in pensions," says Michael Ling, a certified financial planner at Berkeley Inc., a registered investment advisor in Boise, Idaho.
But Ling says closed-end funds such as the Energy Income & Growth fund-whose holdings include Magellan Midstream, Kinder Morgan and NuStar-give investors the same benefits as MLPs but without the tax consequences in the retirement accounts.
Also, not all MLP partnership units are equal. As distributions rise, the general partner often gets a disproportionate share of total distributions as an incentive. That's a turnoff for some, but not all.
"You can view it as a risk, but it's really a cost," says Troy Smith, the Raleigh planner. "It's not a problem if unit-holders are getting compensated enough."