The Big (and Profitable) Changes in MLPs

From the Editor: Shares of MarkWest Energy Partners (NYSE: MWE) are up 63% since Kent recommended them in Energy Advantage. Genesis Energy LP (Nasdaq: GEL) is up 71%. But the MLP market is about to get much more interesting, according to Kent. That's why he's targeting the "clones" now...

From the tax advantages to their high-paying yields, it's hard to beat the returns of a Master Limited Partnership (MLP).

And the good news for us is that this market is about to heat up again, especially when it comes to energy-based MLPs.

You see, the shape and focus of these MLPs is changing fast and for the better - even though it hasn't drawn much attention outside of these pages quite yet.

However, don't expect all of this to remain under the radar for too much longer.

In fact, new "MLP clones" are beginning to emerge that are going to hand us some interesting investment options in the coming months.

For MLP investors, what is about to hit is really something quite new...

The Advantages of Master Limited Partnerships (MLPs)

Of course, MLPs have long been a particularly attractive partnership option.

And when a company decides to float a part of the partnership proceeds as an equity issuance, average retail investors are allowed to participate as well.

One of the advantages of this arrangement is that an MLP carries tax considerations that distinguish it from other limited partnerships. In an MLP, there are no corporate taxes paid, meaning that all profits are carried through to the individual tax returns of limited partners.

And when stock is issued on such a partnership it is tantamount to a percentage of the profits passing directly through to the shareholders. Usually that translates into a dividend that is much higher than market averages.

It sounds like a perfect arrangement. But there are considerations on the other side investors need to account for.

For instance, MLPs must have a physical asset base.

That is, they have to be structured around tangible facilities. That's why most are based on oil and gas pipelines.

Of course, there are some exceptions. My favorite outlier, about as non-oil and gas as you can get, is StoneMor Partners LP (NYSE: STON). StonMor is an MLP that manages cemeteries... and it pays a 9.5% yield!

As it stands, the problems for the dominant pipeline-based MLPs emerge in two ways.

First, during periods in which natural gas or crude oil prices are declining, the value of an MLP based on pipelines will also decline.

Since much of that network is actually used for storage rather than transit, MLPs usually benefit whether a producer needs to ship or store volume coming out of the ground. However, in times when storage capacity maxes out, MLPs will also suffer.

Second, the structure of assets comprising the base for the partnership is also important. Facilities in areas where production is declining or that contain older pipelines that require either refurbishment or replacement will cut into the profitability of an MLP.

After all, there is no pass through income flow if operators are not using the pipelines. Therefore, MLPs are not automatically profitable at all times.

Yet there is another reason why limited partners are attracted to them.

In addition to the advantage of no corporate taxes, there is the added attraction of significant tax write-offs on the underlying assets themselves. Owning a percentage of those assets (which every limited partner does in an MLP) allows for the proportional pass through of depreciations, capital incentives, and rollovers.

The partners, therefore, have reasons for sticking with an MLP even when profits decline. As for shareholders, they have to be more attentive to the market conditions.

A Whole New World for MLPs

The good news is there are some changes in MLPs that will provide additional options for the average investor. I have been tracking two that are particularly interesting. In each case, though, we are seeing an expansion of the assets utilized and the pass-through elements available.

The first change involves the assets comprising the base of the MLP. While the essential structure is not changing (and actually could not unless legislation is altered), I now expect a dual move on the asset side: expansion into the upstream and downstream from the current pipeline (or midstream) emphasis, and crossovers between energy sources.

With these changes, MLPs are showing up at the wellhead - upstream where the actual oil and gas comes out of the ground.

At the same time, holdings in initial processing and separation, refineries, and wholesale and retail distribution, along with terminal and underground storage facilities, are moving the focus downstream.

This new mix of assets increases the options for investors, allowing MLPs to "verticalize" more of the overall operations.

It also provides increasing access to multiple points of profitability. And here crossovers are going to revise MLPs significantly.

Of course, there have always been MLPs in energy sources other than oil and gas. Electricity production and distribution, for example, have been long represented in such partnerships, as have coal assets.

But now new partnerships are coming that will cut across energy types.

Expect to see the first versions, the first new "MLP clones," if you will, to emerge connecting natural gas assets with power production. Given the rapid transition from coal to gas as the generating fuel of choice, the "spark spread" (the difference between gas and electricity futures contract prices) will entice combinations of gas and electricity assets in the same MLP.

Similar crossovers will occur between coal and power facilities, liquefied natural gas (LNG) production and tanker fleets, and even transmission lines and emerging smart grid networks.

In each case, the new MLP will provide entry to asset elements that are actually working together in a continuous revenue or profit stream.

The second major advance is likely to be structures that allow for some pass through of the tax advantages currently reserved for the limited partners only. Now, stockholders are never going to achieve parity with the partners. The latter, after all, actually own the assets upon which the tax advantages are based.

Nonetheless, I expect to see MLP models that will augment dividends to shareholders by monetizing some of the write-offs currently enjoyed by the partners. There have even been some rumblings that the folks with big red noses, funny hats, oversized shoes, and undersized cars (i.e., the clowns of Congress) may even be considering a mandate in this direction.

All of which should hand us some interesting new ways to make some serious money.

I'll have much more on this as it develops.