Let’s get back to basics and answer one of the enduring questions on this site: What is an MLP?  In a nutshell, a Master Limited Partnership (MLP) is a legally recognized way of structuring a business (similar to a general partnership).  Typically an MLP consists of a General Partner (GP) that runs the business and several Limited Partners (LPs) that have invested capital in the business.  To qualify as an MLP a business must make 90% of its income from natural resources or real estate.

Best of Both Worlds

MLPs bring together some of the best parts of partnerships & corporations. Like a corporation, shares of an LP (called “units”) can be bought and sold on exchanges like stocks. Further, MLPs pay quarterly cash distributions similar to stock dividends to investors. However, like a regular partnership, they enjoy certain tax benefits that corporations do not. Specifically, earnings are only taxed once (when the MLP distributes earnings to LP unitholders) instead of being taxed also at the “entity” level like corporations. In addition, most taxes are deferred until the units are actually sold.

Energy MLPs

The majority of master limited partnerships today operate in the midstream energy sector.  This includes pipelines which carry natural gas and other petroleum products from the source to markets where it is needed.  These pipelines bill customers to transport the natural gas or oil, and as such are not as impacted by fluctuations in commodity prices.  In addition, government regulations help MLPs hedge against the cost of inflation by allowing them to account for this in their billing rates.

The Natural Gas Boom

With the advent of new technology that allows for the economical extraction of natural gas from shale deposits – the US is on the brink of a natural gas revolution.  The increased reserves of domestic gas will help reduce our dependence on foreign oil supplies and help drive economic growth.

The Shale Gas Boom
Master Limited Partnership investors are well positioned to benefit from the unfolding shale gas boom in the US. America’s gas reserves are now estimated to be over 30 trillion cubic meters, which could meet consumption demand for almost 100 years. As more gas flows through pipelines, infrastructure MLPs see an increase in revenues from government regulated fees. In turn, investors also benefit as the master limited partnership raises distributions paid to unit holders.

Environmental Advantages
The shale gas surplus has also had positive environmental effects. As prices have fallen, gas has become a more viable alternative to coal for power generation. This has led to a significant decline in the use of coal-fired power plants (which emit a variety of toxic pollutants). In fact, according to The Economist, America has seen greenhouse gas emissions fall by 450m tons over the last 5 years (the largest decline worldwide).

A Changing Energy Market
In the US, natural gas is rapidly changing the dynamics of the energy market. Advances in the technology of extracting shale gas have greatly increased estimates of domestic gas reserves. As a result, the US is able to generate power at lower cost and decrease its reliance on foreign oil.

Cheaper and Cleaner
Rising supply has caused prices to fall to a 10 year low. However, advances in technology have also allowed for cleaner gas power generation (up to a 50% decrease in carbon dioxide emissions). In fact, gas now accounts for 25% of generation vs. 20% in 2006, while coal is expected to fall to only 36% (a 60 year low) in 2012.

What it means for MLP Investors
Since infrastructure MLPs rely heavily on a “toll road” model, increased demand for gas means increased revenue. As more gas flows through pipelines it is reasonable to expect distributions to unit holders to grow over time. Bottom line: the future for MLPs looks pretty good.

Further proof that natural gas infrastructure remains at the forefront of the US energy market – Kinder Morgan announced it is buying El Paso Energy for a whopping $21 Billion in cash and stock.  This will make Kinder Morgan, Inc. the largest pipeline operator (and fourth-biggest energy company) in the US.  This is a huge move for KM, as they will be able to better leverage shale gas plays with this new network of pipelines.

The investment site SeekingAlpha.com has an excellent article on how natural gas liquids (NGLs) are changing the global energy landscape, and how this can impact MLPs. I have included the link below.

US NGLs Could Reshape Global Economy

Arguably the biggest advantage of investing in MLPs is the favorable tax structure these businesses enjoy. MLPs are partnerships which pass through the majority of earnings from the business to investors in the form of quarterly cash distributions. Sounds like a dividend, right? Exactly – distributions are very similar to dividends.

Dividends Take a Double Tax Hit

So what’s the difference? Investors in a public company that pays dividends pay taxes twice. That’s right: twice. They are taxed once at the corporate level when the company pays taxes, then again when they pay taxes on dividends they receive. Ouch. Sounds like uncle Sam fares pretty well in that situation.

Distributions Avoid Double Taxation

Investors in MLPs, on the other hand, pay taxes only once on the cash distributions they receive from the partnership. Because the partnership’s goal is to pass on most of its earnings to unitholders, it is not taxed at the “corporate” level. This amounts to what is essentially a tax efficient “shield” for MLP investors.  Given that the rate of tax on stock dividends will likely rocket to almost 40% in 2013, this makes MLP distributions look pretty attractive moving forward.

We haven’t posted in quite a while (that trend will change – I promise), so I thought I’d give a brief update on the state of the MLP universe for our readers.  While the US economy remains a bit shaky, the bottom line is that MLPs have continued to grow over the long term.  They are also well positioned to benefit from changes that are occurring in the oil and gas space.

MLP Investment Continues to Grow

Investment in MLPs continues to grow over time. In fact, the Alerian MLP index hit a historical high of 390.02 in April of this year. That translates into a very robust 5-year annual return of roughly 17%. While the index is currently hovering around 349, this still represents tremendous long term growth (especially given the current economic climate).

The Future is Unconventional Reserves

But the bigger story here is the continued long term potential for growth in the MLP space. Unconventional oil and gas reserves are the future of domestic energy in the United States. New technologies for extracting oil and gas from shale will drive demand for infrastructure (namely pipelines). In fact, INGAA analysts estimate over $200 billion in new natural gas infrastructure will be built by 2035. That means big returns for MLP investors moving forward.

Exchange Traded  Funds (ETFs) have recently grown in popularity due to their flexibility and favorable fee structures.  As a result, ETFs are now emerging as options for investors in the MLP space.  The NAPTP has a useful and comprehensive list of MLPs and MLP ETFs posted on its website which you may find helpful.

Canadian Royalty Trusts or “CanRoys” are similar in structure and tax treatment to master limited partnerships in the US.  Like MLPs, they typically have high yields and are exempt from paying taxes at the corporate level.  Unfortunately for investors, the Canadian government has decided to put an end to the corporate tax exemption in 2011 (in order to capture more tax revenues).  This could boost interest in the US MLP space as investors look for the same tax treatment in other existing investments.

As we saw in our last post, Distributable Cash Flow is the amount of cash an MLP could pay out to investors in a given period.  However, a well managed business balances future cash requirements with giving investors a return on investment today.  As a result, not all DCF is paid out to unitholders – some is retained to fund expansion or to ensure that the partnership does not have to reduce distributions in the future.

As an investor, this is what we want – a business which generates more cash than required to provide investors a solid ROI. We can measure this with a metric called the “Coverage Ratio”:

In general, we want DCF to be about 1.2 times the amount of the actual cash distribution.  In other words, DCF should be about 120% of distributions.