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Here’s How to Play America’s Energy Boom

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The Exchange

By Roger Whitney

For years, the United States was known for being the world's largest energy-consuming nation, with imports from abroad making up for its inability to produce enough fuels for its appetite. Now, the U.S. is entering an energy renaissance, one that's leading to a marked shift in that position.

The International Energy Agency recently predicted America's oil production will exceed Saudi Arabia's output by 2017, and three years after that, it's expected to be a net natural gas exporter. Major oil finds in California, North Dakota, Texas and Pennsylvania have already put the country on a course toward energy independence, and even more energy fields have yet to be proved out. Developing these new resources and the infrastructure to transport, process and deliver this energy could take decades. Along the way, the biggest benefactor may well be master limited partnerships, or MLPs.

MLPs build, own and operate the pipelines, barges, railcars and storage tanks to deliver natural resources, and the opportunity in front of them is potentially massive. In February, U.S. News & World Report quoted an investor who estimated that more than $300 billon of new infrastructure development is needed within the next decade to accommodate the energy boon. For some time, this wasn't widely recognized -- Warren Buffett bought railroad Burlington Northern Santa Fe for $26 billion a few years ago partly for this reason -- but that's changing.

As individual investors begin to hear more about MLPs, and the need for what they provide expands, here are a few keys to keep in mind about their unique business structure.

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Income pass-throughs

Publicly traded master limited partnerships avoid taxation at the corporate level and pass through net income, operating expenses and deductions, such as depreciation, to individual shareholders. In turn, investors file a K-1 with the IRS to account for their income interests. Typically, only 20% to 30% of annual distributions are taxable in the year they are received due to depreciation deductions. That can make tax reporting cumbersome, which has limited, until recently, institutions and individuals from owning them.

For the 10 years ended March 31, 2013, the industry-tracking Alerian MLP Index has returned an average of 17.8% a year with a distribution yield of 5.7%. In comparison, the S&P 500 has an average return of 8.5% with a yield of 2.2% over the same period. Not only is the yield attractive on an absolute basis, it's grown on average of 7% annually.

This impressive past performance is what's been attracting investor attention -- the total market capitalization for MLPs has grown from $25 billion in 2001 to over $440 billion this year. The attractive and growing yields of MLPs offer a natural inflation hedge and could be a good component to a diversified portfolio.

They should not, however, be considered a bond alternative -- MLPs are better suited to be part of your equity or alternative asset allocation.

A definite need exists for infrastructure, and it likely will be built regardless of the state of the economy. In many areas, such as the Bakken field in North Dakota, energy output far exceeds our current transportation capacity. That lack of capacity has caused price distortions that will need to be resolved, and it makes MLPs particularly interesting as a source of income and growth in an uncertain economy.

Understanding the risks

The temptation with an emerging security or market is to dub it the next big thing. MLPs are not that. A potential investor has to know the not-insignificant risks of putting money into the space. Among them: Building pipelines and storage facilities isn’t cheap, and MLPs have an ongoing need to raise funds via debt or share offerings.

What that means is any interruption in their ability to access capital can lead to a disappointing performance. For instance, in 2008, when development projects were delayed due to disruptions in the capital markets, the Alerian MLP Index lost 36.9%. Clearly, this isn't a bond alternative.

Rising interest rates are another worry. Higher rates create headwinds for MLPs as the cost of capital increases and the yields on competing investments become more attractive. For over a decade, MLPs have enjoyed a very low cost of capital. If rates rise, and that may be in the offing, their cost of capital increases, as well. That could slow distribution growth.

MLPs can act like yield-spread investments in the short-term. Should rates rise slowly, these risks should be reasonable, but if they do so quickly, share prices could react with a rapid move to the downside.

Another important risk to monitor is the ability of an individual MLP to support and grow its distribution rate. MLPs must carefully manage their infrastructure utilization, expansion and cash flow. A poor or aggressive operator can establish an attractive distribution rate, yet not be able to sustain it. When an MLP cuts distributions, you’ll likely see investors flee.

If you're considering individual securities, your evaluation would be similar to studying a stock. Look for solid operators with a record of sustaining and growing distributions, starting your research with strong, large operators that have broad analyst coverage. Two examples are Enterprise Products Partners and Plains All American Pipeline. Each has well-diversified holdings, a consistent history of increasing distributions and a strong coverage ratio for their payouts.

Be very cautious of closed-end funds (CEF) that invest in MLPs. Most MLP-specific CEFs use leverage to enhance the distributions paid to shareholders, typically 20% to 30%. This means that for every $1 of assets in the fund, they buy $1.30 worth of securities, increasing the yield the CEF can pay out. If prices are stable or rising, it's great. But during market downturns, this can magnify the inherent risks of investing in MLPs, adding a significant amount of price risk to an asset class that's already highly levered. If rates rise fast, these funds could experience significant downside pressures.

For most individual investors, an exchanged-traded fund or actively managed fund may be the best option. If you are investing in an IRA or taxable account but would like to avoid the tax hassles of "unrelated business taxable income (UBTI)" and K-1 reporting, several managed options are out there. The largest and oldest exchange traded fund is the Alerian MLP ETF (AMLP). It's not alone anymore, as this list of popular options shows.

Should you prefer an actively managed fund that has the benefit of reinvesting distributions, the largest MLP manager is Oppenheimer's recently purchased Steelpath Capital Management.

Roger Whitney, CFP, CIMA, CPWA, co-founded WWK Wealth Advisors, a Registered Investment Advisor, in Fort Worth, Texas. He has specialized in investment management and planning for 23 years.

Some WWK clients may hold long positions in Enterprise Products Partners and Steelpath funds.