Master Limited Partnerships (MLPs) are essential vehicles for energy investors; there’s a reason we currently hold nine MLPs in our model portfolios—actually, two main reasons.

One reason is that MLPs allow some energy companies to structure themselves in a way that attracts conservative, long-term investors rather than speculators—that is, as income investments rather than capital-gains plays leveraged on commodity prices.

Note that MLPs are limited by law to companies that generate at least 90 percent of their income from a limited list of “qualified” businesses, many of them related to energy or resources.

Congress intended MLPs as a way to expand the pool of capital for investments in exploration & production, midstream and other energy sectors. From an investment standpoint, MLPs help diversify the energy sector, providing a range of risk and income profiles in the energy patch.

Just Passing Through

Of course, the second and most important reason that MLPs are attractive is that they provide tax-advantaged income. MLPs don’t pay corporate income tax; instead, they pass profits on directly to unit holders (shareholders) in the form of quarterly distributions. That’s why they’re known as “pass-through” entities. This arrangement avoids the so-called “double taxation” of corporate income and dividends that affect traditional corporations and their shareholders.

Here’s where it gets interesting: those distributions aren’t fully taxed either. Because of depreciation allowance, 80 percent to 90 percent of the distribution is considered a “return of capital” and thus not taxable at the time your receive it. Instead, they reduce the cost basis of your investment in the MLP. When you sell your MLP units, your capital gain may be larger (or the loss will be smaller).

The rest of the distribution—typically 10 percent to 20 percent—is taxed at normal income tax rates. But being able to defer the rest of the tax until you sell the investment is an enormous advantage, as you can reinvest it and generate compound returns that could more than pay for the eventual tax.

For example, let’s say you own units of an MLP that you bought for $50 a share. You receive $5 in annual distribution payments, $4.50 of which is considered a return of capital. So the cost basis on the MLP would drop to $45.50 ($50 minus $4.50), and you would owe zero tax on that $4.50. The remaining 50 cents of the distribution would be taxable at your income tax rate.

When you finally sell the units or the cost basis drops to zero dollars, a portion of the capital gains are taxed at the special long-term capital gains tax rate. The remainder will be taxed at your normal income tax rate.

Keep in mind that MLPs are most advantageous when held for long periods, because you get more time to compound the tax-deferred income. But because many of them have high yields, they can be attractive sources of income even if held for a relatively short time.

Cream of the Crop

Over the past two decades, the investable universe of publicly traded MLPs has expanded in number and type. From oil and gas producers to tanker companies to pipeline operators, almost every subsector of the energy sector is now represented by at least a dozen MLPs.

Our portfolio holdings represent those that best combine high-quality assets, reliable income, financial stability, competitive advantage and relatively high yields (in most cases) with attractive valuation relative to discounted cash flow and/or peer valuations.

Here’s a closer look at our two Growth Portfolio MLP holdings and one of our Conservative Portfolio MLPs; we’ll review the rest of our recommended MLPs in the next issue.

Eagle Rock Energy Partners LP (NSDQ: EROC) is primarily an “upstream” company involved in the production of crude oil, natural gas, and natural gas liquids (NGL), in Texas, southern Alabama and Oklahoma. The company’s gathering and processing business consists of about 8,000 miles of gathering pipelines in the Texas Panhandle, East Texas, Louisiana, South Texas and the Gulf of Mexico. The MLP’s pipelines connect individual wells to processing facilities and to the US interstate pipeline network. The firm also owns 21 gas processing plants that separate propane and ethane from raw natural gas.

The MLP has been somewhat hurt this year by weak gas and NGL prices, resulting in flat distributions for the past two quarters. But the pain has been mitigated by hedging and so-called “keep-whole” contracts that maintain price floors for its services. About 74 percent of its exposure to natural gas prices in 2013 is hedged. In any case, natural gas itself accounts for only about 10 percent of cash flows.

Earlier this year, Eagle Rock Energy Partners acquired BP’s midstream assets in the Texas Panhandle and agreed to a strategic partnership in which it is the exclusive gathering and processing partner for the energy giant in the Texas Panhandle; this agreement should provide some stability to cash flows in the coming years.

Despite a tepid year, Eagle Rock is an attractive MLP with solid oil and midstream gas assets in some of America’s most productive regions; the MLP currently yields a whopping 10.8 percent and has good long-term growth prospects. Buy Eagle Rock Energy Partners below 12.

Mid-Con Energy Partners LP (NSCQ: MCEP) is a growth-oriented MLP whose unit price has dropped enough to generate a yield near double digits – a great one-two punch for almost any kind of investor who can stand some volatility.

The MLP is nearly a pure play on oil, as crude oil accounts for about 96 percent of the firm’s reserves – about 10 million barrels of in the Midcontinent region, much of it in Oklahoma and Colorado. Most of the MLP’s reserves are established plays with little drilling risk and easy-to-predict production decline rates.

Mid-Con Energy Partners specializes in water-flooding, an enhanced recovery technique that involves injecting large volumes of water into a mature field to restore well pressure and bolster output. With excellent production trends and a history of smart hedging strategies, Mid-Con Energy is not highly vulnerable to weakness in crude-oil prices.

The MLP is increasing production at a high rate; in the third quarter, average production rose 10 percent sequentially to 1913 barrels of oil equivalent per day. At the same time, it has good access to capital and a pipeline of potential acquisitions and joint ventures that hold out good hope for long-term growth. The firm’s general partner, private-equity outfit Yorkville Partners, has a good record of investing in oil- and gas-producing properties, including some that could benefit from water-flood technology.

Note that management reviews Mid-Con Energy Partners’ distribution policy every third quarter, so the payout will likely increase once a year rather than each quarter. The MLP currently yields a handsome 9.8 percent. Buy Mid-Con Energy Partners under 26.50.

Kinder Morgan Energy Partners LP (NYSE: KMP) is the largest pipeline transportation and energy storage companies in North America, with an attractive portfolio of high-performing pipelines and other midstream assets, most of which generate reliable cash flow backed by long-term contracts.

Earlier this year, Kinder closed on its $37 billion acquisition of pipeline giant El Paso Energy Corp., which greatly boosted its distribution assets. The company now boasts 75,000 miles of pipeline and more than 180 terminals.

As such, Kinder Morgan is benefiting from rapidly rising demand for natural gas, driven mainly by the low price of natural gas – which in turn has been caused by the glut of gas resulting from enormous investments in hydraulic fracking. The power-generation industry, one of the major buyers of natural gas, is also shifting rapidly away from coal toward gas for environmental reasons.

Put these trends together and you see dramatic numbers like a 47 percent increase in gas throughput for Kinder Morgan’s southeastern gas pipeline system this year alone. And higher throughput means higher fees and cash flows for the MLP. Growth also will come from continued expansion throughout North America. As we reported last week, the MLP recently signed a 25-year contract to transport natural gas from the US to Mexico, including a new 60-mile pipeline in Arizona to serve Mexico.

Kinder Morgan has never cut its distribution and has raised its payout for 15 straight years. With a current yield of 6.4 percent and excellent prospects for continued distribution increases, we consider Kinder a bargain now. Buy Kinder Morgan Energy Partners LP below 82.