Demand is growing for master limited partnerships, thanks to the increasing use of natural gas, 6% yields and proposed legislation to expand their use for renewable energy projects.

Master limited partnerships are business partnerships, often listed on a U.S. stock exchange. Limited partners generally invest in a partnership run by someone else, typically a "general partner." However, unlike an investor in stocks, limited partners have no voting rights. Plus, a limited partner, also known as the "unit holder," generally pays fees to general partners out of distributions.

Master limited partnerships are attractive because they avoid the double taxation of publicly traded corporate dividends. They also pass depreciation and expenses through to investors. Some 80% of the distribution of income may be considered a return of capital. And those distributions can cushion master limited partnership price declines in down markets.

"The broader outlook for the [MLP] asset class remains strong," says James Cunnane Jr., co-manager of the closed-end Nuveen Energy MLP Total Return Fund. "We believe the fundamental strength of the domestic energy story." Master limited partnership returns, he predicts, will average 8% to 10% annually over the long term.

The big news is that bipartisan legislation, proposed by Senators Chris Coons (D., Del.) and Jerry Morgan, (R., Kan.), seeks to expand the use of master limited partnerships from fossil fuel-based energy projects to renewable energy products. The tax benefits of master limited partnership profits, which are taxed at the partnership level instead of at the corporate tax level, should increase renewable energy investments. And hydraulic fracturing of natural gas and new extraction methods have been lowering production costs while increasing supplies.

As of midyear 2012, master limited partnerships were in the red after a collapse in natural gas prices and a drop in crude oil prices. Over the shorter term, they are vulnerable because of their strong correlation to the price of oil.

The Alerian MLP Index was down 8% for the year as of June, according to Alerian, the Dallas-based data company that publishes it. But for the year ended in June, that same index outperformed the S&P 500 index-10% versus 8.50%. Over the past five years ended in June, the Alerian index has grown at a 12% annual rate, compared with the piddling 2% annual return of the S&P 500.
Many master limited partnerships in energy pipelines and storage have been hailed for tax-advantaged income, quarterly dividends and attractive performance.

But these investments come with a number of risks. When interest rates rise, master limited partnership prices typically drop. Distributions are not guaranteed. Investors may have no power to remove bad management. Bad news about energy, the sector of many master limited partnerships, may hurt prices. Debt-burdened partnerships could have a tough time borrowing. Limited partners may have to foot the bill for higher interest rates.

A partnership may depend upon negotiated land leases for energy pipelines. Meanwhile, tax laws could change next year, wiping out tax advantages.

In addition, clients still may owe taxes, which can prove quite complex because they must get K-1 statements rather than 1099 tax forms. Investors with a master limited partnership in a retirement savings account still may owe Uncle Sam for unrelated business taxable income.

One way around this potential tax headache is to invest in master limited partnership exchange-traded notes, exchange-traded funds and closed-end funds, structured as C corporations. With these investments, clients get a 1099 and can invest in an IRA without those complex tax consequences.

Financial research shows that master limited partnerships can be a good diversifier. They have low correlations to stocks, bonds and REITs. For example, over the past 15 years ended in February, according to Morningstar Inc., Chicago, the Alerian MLP index had a monthly 0.36 correlation to stocks, 0.39 to utility stocks and REITs and just a 0.05 correlation to bonds.

In addition, the Alerian MLP Index has outperformed REITs, utility stocks and the S&P 500 over the past decade.

Morningstar's back-tested research also shows that a portfolio with a 10% allocation to master limited partnerships, and the rest split among large- and small-cap U.S. stocks, international and emerging market stocks, as well as bonds and commodities, grew at an annual rate of 8.6% over that 15-year period. By contrast, the portfolio without the master limited partnership allocation grew at a 7.6% annual rate. The portfolio with the master limited partnership also registered a higher risk-adjusted rate of return as measured by the Sharpe ratio.

A portfolio with a 10% allocation to master limited partnerships also outperformed the risk-adjusted return of a portfolio with, instead, a 10% allocation to REITs.

Past performance, however, is no indication of future results. This year, to date, the Alerian MLP index has underperformed REITs, bonds and utility stocks because of the collapse of natural gas prices and drop in cost of oil.

"Master limited partnerships are well worth it," says Dennis Melchior, financial advisor with UBS Price Wealth Management in Palm Beach, Fla. "They have low correlations to other assets, and partnership prices are depressed. Master limited partnerships can provide good income and good exposure to energy resources."

Like REITs, master limited partnerships pay out most of their earnings to investors. As a result, Melchior says he can increase client cash flow by adding both to a portfolio comprising a bond ladder and dividend-paying stocks.

Master limited partnerships he recommends for non-IRA accounts include Energy Transfer Partners, a natural gas company that extracts, distributes and stores gas; Enterprise Product Partners, an oil and gas company that extracts gas and crude oil (it also refines and produces petrochemicals); and MarkWest Energy Partners, which, together with its subsidiaries, gathers, processes and transports natural gas.

Two master limited partnership exchange-traded funds he recommends for IRAs include the exchange-traded Steel Path MLP Alpha and Cushing MLP Premier. Investors report the income on the 1099 tax form.

To avoid master limited partnership tax headaches, Morningstar suggests the Alps Alerian MLP ETF. Among closed-end funds, it recommends the Cushing MLP Total Return Fund, Kayne Anderson Energy Development and ClearBridge Energy MLP.

Analysts say good oil and gas company fundamentals should benefit the majority of energy stocks and master limited partnerships over the long term while coal consumption declines. Oil and gas drilling and production spending is expected to increase about 15% by year's end 2015, according to Spears & Associates, Tulsa, Okla.

It is also a favorable political environment for master limited partnerships. At year-end 2011, a report by Fitch Ratings said master limited partnerships were "well positioned against economic regulatory risk, and the sector should generate stable operating performance and financial strength in the natural gas pipelines, crude oil and refined products pipeline."

Fitch says master limited partnerships with limited commodity price exposure, manageable ongoing capital expenditures and modest leverage generally exhibit stronger credit profiles. The credit ratings for larger scale master limited partnerships are clustered at the lower end of the investment-grade spectrum ("BBB-"/"BBB"), reflecting a strong incentive to maintain capital market access. Below-investment-grade master limited partnerships may take steps to improve their credit profiles by increasing the scale of their operations and lowering commodity risk.

The way Fitch sees it, North American gas prices should remain low this year because of the lower-cost production of shale gas and the record high levels of gas in storage heading into the winter heating season. But low natural gas prices could prompt increased demand because of coal-to-gas switching for power generation. There should also be moderate demand for refined oil products.

James DiGeorgia, analyst and publisher of the Gold and Energy Advisor (at GoldandEnergyAdvisor.com), says he favors oil and gas companies with lower oil-to-gas production ratios than in the past. Many of these companies are undervalued. But their production is hedged and profitable. Energy companies that gather and process natural gas, however, can be more exposed to commodity price movements than pipeline companies.

Published reports indicate that when the commodity market went bust earlier in the decade, some master limited partnerships in the business of gathering and processing natural gas cut their distributions.        

"Natural gas has always been considered a bridge energy alternative," Di Georgia says. "Most energy companies are focusing on oil and natural gas liquids. There is a trend of more government agencies, including public transportation and some corporations, converting their fleets to use compressed natural gas. The natural gas industry is working with utilities companies to convert home natural gas to fuel natural gas vehicles."

Cunnane, of Nuveen, says that there will be a continued need for the development of natural gas infrastructure. But these projects are expected to deliver lower investment returns. As a result, he prefers to focus on crude oil companies because of continued strong worldwide demand.

"In this environment, we favor those MLPs with exposure to crude oil and natural gas liquids, which are priced off of crude oil," he says. "MLP sectors with this exposure include G&P, upstream, midstream oil, diversified natural gas and marine transportation."
The largest holdings in his fund include Plains All American, Kinder Morgan, Energy Transfer, Enbridge Energy Partners and Enterprise Products.

The outlook is good, but there is no free lunch. Experts have warned that as limited partners, clients could wind up footing some unexpected bills, such as each partnership's state and local taxes.

With fewer than 100 publicly traded master limited partnerships, the units could prove tough to sell. Master limited partnerships lost about 50% from mid-2006 through mid-2008, according to the Alerian MLP index.

Be advised that exchange-traded MLP funds could get hit hard during a financial collapse because of tracking errors and illiquidity, which makes it difficult for market makers to keep the stock price and asset value of the funds in sync. Exchange-traded notes are debt obligations-exposing investors to counterparty risk if the banks default.

In June, J.P. Morgan announced that it had capped the new issuance of its J.P. Morgan Alerian MLP Index ETN (exchange-traded note) at $4.7 billion. It is the second cap, based on published reports, that the big bank put on the fund this year amid its large trading losses and risk in the credit markets. As a result of the cap, the note began trading like a closed-end fund with the share price trading at a premium to the asset value of the note.

Ike Ikokwu, a Cumming, Ga.-based CPA and financial planner, says that advisors who want to invest in master limited partnerships should look for companies with a strong history of earnings growth, earnings distributions, strong balance sheets and access to capital-liquidity that can allow them to continue their growth plans. MLPs with strong balance sheets are likely buyers if the industry consolidates.

But Ikokwu typically does not invest in master limited partnerships. He prefers to put clients in separately managed, well-diversified accounts. If his clients want to invest outside of these accounts in a master limited partnership for income, he likes Kinder Morgan Energy Partners, a pipeline transportation and energy storage company. He favors alternative income investment opportunities that don't have the same problems of losing specific tax benefits master limited partnerships afford when held in retirement accounts. Plus, he favors those that can produce high-single-digit or low-double-digit annual returns.

"Considering that the managers create various income and alternative portfolios with similar types of assets, the goal of adding an income-producing asset, whether through limited partnerships or alternative investments, can and is achieved [by separately managed accounts]."