Master limited partnerships (MLP) have been around for almost three decades–Apache Oil Company, the first such partnership, launched in 1981–but these forbearers differed greatly from the modern-day incarnation. Though intended to facilitate investment in the energy industry, early MLPs gravitated toward exploration and production but also engaged in a wide range of other businesses.

By the end of 1986, there were 34 MLPs that operated outside the oil and gas industry, including offerings involved in restaurants, nursing homes, cable television and mortgage banking.

But many investors learned the hard way that cyclical businesses didn’t necessarily lend themselves to the MLP structure; the worst offerings failed to generate sufficient cash to support their high, tax-advantaged yields.

The modern MLP traces its roots back to the Tax Reform Act of 1986 and the Revenue Act of 1987, which required master limited partnerships to generate at least 90 percent of their income from “qualified” sources–many of which were related to natural resources.

Over the past year energy-focused MLPs have become more popular for the very same reasons as in the mid-1980s: high yields and tax advantages.

A Compelling Case

Yield chasers have long flocked to MLPs. An article in the March 19, 1987, edition of the Wall Street Journal noted that “in order to be competitive” an MLP needed to offer a 9 to 10 percent yield.

Today, MLPs are an attractive alternative to a frothy bond market, where spreads on high-yield issues appear insufficient to compensate for underlying risks. And whereas the average stock in the S&P 500 offered a dividend yield of just less than 2 percent at the end of the first quarter, the Alerian MLP Index yielded roughly 7 percent.   

MLPs also offer significant tax advantages. As pass-through entities, MLPs don’t pay federal income taxes at the corporate level. They spread this responsibility among unitholders.

This tax relief is a huge advantage when these firms compete with traditional corporations for acquisitions–one way in which MLPs grow their distributions. And investors avoid the double taxation to which corporate dividends are subject. (The government taxes corporation’s earnings as well as the dividend payments received by individual investors).

Better yet, the Internal Revenue Service generally treats 80 to 90 percent of the distribution investors receive as a return of capital, limiting current tax liability. Rather, the amount paid is subtracted from the cost basis; taxes are due as a long-term capital gain when you sell your position.

In other words, 80 to 90 percent of the distribution you receive from an MLP is tax-deferred. The remaining piece of each distribution is taxed at normal income tax rates, not the special dividend tax rate. But the piece taxed at full income tax rates is only 10 to 20 percent of the total distribution–a substantial deferred-tax shield.

The group will become even more attractive in 2011, when the top rate on dividends will increase from 15 percent to 20 percent in the best case or nearly 40 percent in the worst case.

The Dangers of Nearsightedness

High yields and tax advantages are a compelling proposition at a time when many investors are seeking to recover losses suffered during the financial crisis and market implosion and cowering in fear before the prospect of higher taxes.

Speculation that the Obama administration would eliminate MLPs’ tax advantages are farfetched but remain a major concern for some enervated investors.

Legislative efforts to crack down on tax loopholes enjoyed by investment firms organized as MLPs also have many investors worried that the tax advantages enjoyed by energy-focused partnerships could also be at risk.

Elliott H. Gue, editor of The Energy Strategist and co-editor of MLP Profits, addressed these concerns definitively in the Jan. 2, 2010, issue of Personal Finance Weekly, Don’t Get Carried Away. But some investors began to fret once again after Senate Finance Committee Chairman Max Baucus and House Ways and Means Committee Chairman Sander Levin unveiled the legislative text of The American Jobs and Closing Tax Loopholes Act (HR 4213).

This revenue-raising proposal, which has the support of the Obama administration, applies only to the taxation of “carried interest” paid out to fund managers as compensation for their services. Depending on how the partnership earned this carried interest, it could be taxed as long-term capital gains rather than ordinary income; the bill would tax this compensation at the higher, ordinary income rate.

Rest assured: This is a non-issue for investors in energy MLPs–the carried interest income they generate isn’t capital gains and has always been taxed at ordinary income tax rates. Investors concerned that this marks lawmakers’ first foray into eliminating the tax advantages associated with MLPs should note that in 2008 Congress expanded the definition of qualified income sources to include biofuels. That the current proposal before Congress doesn’t specifically address energy MLPs likewise suggests that lawmakers understand the key role these partnerships play in developing and maintaining the country’s energy infrastructure.

And all too often investors focus on a partnership’s yield, rather than its underlying business. This shortsightedness is hardly a new problem. Writing for the Wall Street Journal back in March 1987, Barbara Donnelly noted, “Investors are focusing too much on yield, ignoring whether the underlying business can really support such high payouts.”

This folly is alive and well. Consider the case of the formerly high-yielding K-Sea Transportation Partners LP (NYSE: KSP), which Elliott highlighted in the Nov. 11, 2009, issue of this publication:

Thanks to its sky-high yield, K-Sea was a popular MLP; Roger Conrad and I, were often asked for an opinion on the stock. Many were surprised–some were openly hostile–when we noted that we’ve had it rated a “Sell” since we started the service in May…

But there were already myriad signs of trouble ahead for K-Sea earlier this year. The main problem is that K-Sea owns a significant number of single-hull tanker vessels; these vessels are legally required to retire from service no later than the end of 2014. Single hull vessels have a difficult time getting long-term contracts for work, and companies needing tanker barge capacity are willing to pay far lower rates for single-hulls.

In the company’s fiscal fourth quarter conference call back in August, K-Sea noted that it had nine single-hull barges go off long-term contracts in fiscal year 2009. These long-term contracts provided attractive economics, but once the ships came off contract they needed to be sold, scrapped or simply contracted under far less lucrative terms.

At the time of its fiscal fourth-quarter call, K-Sea noted that it owned another 16 single-hulls under soon-to-expire contracts; the loss of this stream of revenue remained a significant risk. K-Sea noted that because of contract expirations only around 60 percent of its barges would be contracted by the middle of calendar year 2010…

These were all signs of trouble for single- and double-hull ships coming off contracts and called into question K-Sea’s ability to replace revenue from the 40 percent of its capacity not under contract by the middle of next year…

The end result: K-Sea slashed its quarterly payout to $0.45, and the stock halved in value overnight. With the current yield based on the lowered dividend near 16 percent, there’s still lingering concern that the MLP will be forced to cut its payout even further.

Eyes on the Prize

The moral of the story: There’s more to MLPs than tax advantages and high yields. Though the group’s fundamentals often receive shorter shrift, a number of emerging trends suggest that energy-focused MLPs are poised to outperform.

For one, many of our favorite names have taken advantage of the low cost of debt and equity capital to shore up their balance sheets, pay down near-term debt and make acquisitions that will be accretive to cash flow.

Equally important, hydraulic fracturing, horizontal drilling and a host of other advances have enabled producers of oil and natural gas to extract these commodities from shale deposits across the US. Increased production from these fields requires a build-out of related infrastructure to process, store and distribute the output. And because some of these fields–most notably the Marcellus Shale–are located in areas not usually associated with hydrocarbon production, the infrastructure needs are acute.

Energy-focused MLPs are itching to fill this void. In recent weeks two of the biggest names in the Alerian MLP Index announced exciting expansion plans in key unconventional plays.

Enterprise Products Partners LP (NYSE: EPD) signed a letter of intent with a major producer in the Eagle Ford Shale, a deposit that contains crude oil as well as natural gas. Enterprise will build a 140-mile crude oil pipeline that will connect Karnes County, TX to its existing system. The deal also includes a seven-year natural gas processing and transport agreement that will necessitate expansion of existing infrastructure.

Meanwhile, Kinder Morgan Energy Partners LP (NYSE: KMP) announced that it bought a 50 percent stake in Petrohawk Energy Corp’s (NYSE: HK) natural gas gathering and treating business in the Haynesville Shale, a deposit in Louisiana and east Texas that produces prolific quantities of natural gas.

In a recent research report Standard & Poor’s Rating Service sounded the alarm that production from some shale plays could fail to meet volume expectations of some midstream operators. Although this risk is difficult to quantify, investors can hedge their bets by focusing on midstream MLPs that line up guaranteed contracts before breaking ground on new pipeline projects.

And remember the lessons of the 1980s: Forget the yield–instead focus on the underlying fundamentals of each MLP in your portfolio.

MLP Masters

Looking for more information on which high-yielding MLPs have the strongest fundamentals? On June 16 Roger Conrad and Elliott Gue will host an audio conference to discuss our favorite MLPs and the tax advantages these securities offer. Attendees will not only be able to ask us any questions they might have about MLPs, but they’ll also receive a three-month free trial of MLP Profits. Sign up today!