What Lies Ahead For MLP ETFs?

new etfsTony Daltorio: One of the very best choices any investor can make when looking at master limited partnership (MLP) investments is going for those in the energy sector.

These MLPs offer investors both income and growth: Income through relatively high yields, and growth thanks to their involvement in America’s booming energy industry.

As Money Morning Global Investing & Income Strategist Robert Hsu told readers Aug. 15, a $2,500 stake in energy MLPs 10 years ago is worth $10,000 today – twice the return of the S&P 500.

That’s just the sector as a whole – that’s not even just investing in the sector’s best players.

For those unfamiliar with MLPs, here’s what you need to know about what these investments are – and why you can’t afford to leave them out of your portfolio.

Investing in MLPs

The first MLP investment started in 1981, with Apache Oil Co. Shortly after, other energy and real estate MLPs emerged. The goal was to raise capital from retail investors by offering an affordable and liquid security.

In 1987, Congress passed laws to clearly define MLP investments, which created the rules they operate under today.

To qualify as an MLP, a partnership must receive at least 90% of its income from qualifying sources. These sources include natural resource-related activities such as exploration and development, mining and production, processing, refining, storage, transportation, and marketing of a natural resource.

MLPs are traded on stock exchanges just like stocks. But instead of shares, you own units. And instead of dividends, you receive distributions.

Unlike with dividends, the majority of the income that unitholders receive is not taxed as income when received. Instead, it is considered as a reduction in the cost basis, creating a tax liability that is deferred until the units are sold.

Therefore, investing in MLPs for the long term can mean avoiding paying taxes on 80% to 90% of the distributions received.

Types of MLPs

MLPs span a wide range of sectors, like coal mining, shipping, and hotels, but more than 80% are involved in the oil and gas sector.

There are two main types of oil and gas MLP investments:

  • Upstream MLPs: Those upstream MLPs focus on the exploration and development of oil and gas properties. This makes them a bit more risky since they are directly exposed to the fluctuations in the commodity price. However, many of these MLPs have and operate mature oil and gas fields that have long reserve lives.
  • Midstream MLPs: The midstream segment includes the gathering, storing, transporting, and processing of oil and natural gas along with refined products. Many MLPs focus on transportation – in other words, pipelines. This is a very steady business and is the reason why MLPs are often called “toll road” businesses. Other MLPs in the sector may focus on storage and terminal facilities and processing of either oil or natural gas, which are also rather stable businesses.

The midstream is the MLP segment favored by Money Morning Global Energy Strategist Dr. Kent Moors.

What Lies Ahead for MLP Investments

With the shale boom rejuvenating the U.S. energy sector, MLP investments have been extremely profitable for investors. The total return of the broad-based Alerian MLP Index so far in 2013 is about 18.4%.

But it has been profitable for a while now. According to the Financial Times, the market capitalization of the MLP sector grew from just $8 billion in 1996 to about $480 billion today. And over the coming years, the MLP sector should grow into a trillion-dollar-plus asset class.

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