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.

The acronyms ‘MLP’ and ‘PTP’ are frequently used interchangeably, but there is a subtle difference.  A Master Limited Partnership (MLP) is technically just a business structure legally recognized in the tax code (it is not necessarily a publicly traded entity).  A Publicly Traded Partnership (PTP) is any partnership that is publicly traded like a stock (not necessarily an MLP).

I often get asked about benchmarks for gauging MLP performance (similar to the S&P 500 for the broader equity market).  The de facto standard is the Alerian MLP Index which tracks 50 of the largest master limited partnerships in the energy industry.  Performance data is available under the NYSE ticker AMZ and AMZX (tracks combined price and yield).  You can view data for the MLP index on Yahoo! Finance by entering ‘^AMZ’ in the ‘get quotes’ box.

As investors become increasingly aware of the higher yields offered by MLPs, financial institutions are pushing to offer more in the way of investment options.  Exchange Traded Funds (ETFs) are the latest investment vehicle to be offered in this space.  As reported by ETFtrends.com, two funds filed with the SEC in June to offer MLP ETFs:  ALPS Advisors and Van Eck Global.