Pipelines of Profits:
Beating the Market with Master Limited Partnerships (MLPs)

The day before Thanksgiving in 1996, Rich Kinder left his post at Enron. He was disappointed that Kenneth Lay had passed him over for the job of CEO. Soon after, an old college buddy, Bill Morgan, approached Kinder with a business proposition.

Morgan had just bought some assets that Enron had no use for -- a couple of small pipeline systems and a coal terminal. He needed someone like Kinder to run the business. Kinder agreed, and the partnership was christened Kinder Morgan Inc. in February 1997.

Seven months later, Kinder had doubled the company's market capitalization to nearly half a billion dollars by watching costs and shipping more volume through the pipelines. Today, Kinder Morgan Energy Partners (NYSE: KMP) is a $13 billion business, operating 38,000 miles of pipeline and roughly 155 terminals throughout the U.S.

Master limited partnerships (MLPs) had already been around for decades, but it took someone like Rich Kinder to transform this asset class from a passive holding company into a dynamic investment vehicle.

In the mid-1990s, Kinder Morgan was one of only a handful of master limited partnerships, which together totaled roughly $2 billion in market capitalization. Today, there are dozens of actively traded MLPs with a total market cap of roughly $100 billion. And in this special report, we will let you know the exclusive names and symbols of many of these MLPs throwing off enormous dividend yields for income investors. 

(1.)  What Makes MLPs Attractive

To understand why master limited partnerships have become so popular, it helps to have a better understanding of what they are. An MLP is a publicly traded limited partnership. Shares of ownership are referred to as units. MLPs generally operate the pipelines and infrastructure used to transport petroleum and natural gas around the United States.

Unlike a corporation, a master limited partnership is considered to be the aggregate of its partners rather than a separate entity. However, the most distinguishing characteristic of MLPs is that they combine the tax advantages of a partnership with the liquidity of a publicly traded stock.

MLPs allow for pass-through income, meaning that they are not subject to corporate income taxes. The fact that master limited partnerships are not subject to income tax means that more cash is available for distributions than would be available had the company incorporated. 

But why have MLPs gained in popularity so quickly? It may have something to do with their enticing yields. Or maybe it's their exceptional track record for raising dividends an average of +8-9% a year for the past ten years that has endeared them to income investors. Of course, it could always be the solid gains seen by MLPs over the past decade.

Master limited partnerships have steadily churned out double-digit gains, despite volatile commodity prices. In 2007, MLPs delivered average total returns of +12.7%, handily beating the S&P 500's total return of +5.5%. In fact, this group of about five dozen securities, represented by the benchmark Alerian MLP Index, has returned an astounding +16.5% per year between 1997-2007. And the best news of all is you can still find attractively priced MLPs with rich yields. 

Safety and Growth -- A Rare Mix
Like real estate investment trusts (REITs), MLPs pay out most of their cash flow to shareholders. As a result, the group carries an average yield of about 6.5% -- more than three times the puny sub-2% yield offered by the average stock in the S&P 500 Index.

But their healthy yields aren't even their main attraction. Rather, it's the rare mix of safety and growth that make MLPs a must-have asset class for your income portfolio.

Most MLPs process and ship oil and gas, so it's only natural to think they would be affected by commodity prices. But the reality is far different -- their cash flows depend primarily on product volumes, not commodity prices. As a result, they offer some of the most stable distributions around. 

MLPs that own interstate pipelines enjoy even safer revenue from government-regulated rates. The rates they can charge may vary depending on where their pipelines are located, but one thing is for sure -- their rates are not pegged to commodity prices. Kinder Morgan operates the longest petroleum products pipeline system in the U.S. and gets the same amount to ship a barrel of gasoline whether oil prices are $35 or $120 a barrel. 

But with most of the profits going to shareholders, what will drive this sector's growth in the months and years ahead? Most MLPs make money by delivering natural gas and petroleum products to the market. The more pipelines, gathering systems, tanks, barges, or royalty interests they own, the more cash flow they can generate. 

Their key to growth is buying or building the infrastructure that will ramp up their product capacity. And this group has been doing just that. The five largest MLPs will likely spend over $15 billion on development projects over the next three years.

Furthermore, U.S. energy demand is expected to grow a steady +1% annually for the next 20 years, just as it has over the past 20 years. As a result, energy MLPs should continue to see plenty of demand for their services and provide investors a growing income stream for years to come.

(2.) Other Features of MLPs

Some energy-related MLPs deliver more predictable earnings and dividends than others. Pipeline operators usually generate stable income, but growth tends to be constrained by government regulation on rates. Propane distributors generally offer more upside potential than pipelines, but their rates aren't regulated, and warm winters or cool summers could affect demand for their product. However, such risk factors are generally short-term aberrations.

Oil and gas leaseholders can provide a mix of high yields and high capital gains. Although these firms are more exposed to oil and gas price fluctuations, in today's environment of increased commodity prices, even the most risk-averse investor should consider them.

Growing Institutional Interest
You know an industry is getting hot when major financial institutions start piling into it. For years, MLPs were owned almost exclusively by individual investors. Institutional investors held less than 5% of these securities.

Now that's changing, and institutions are homing in on this once overlooked sector. A few years ago, mutual funds were given the green light to hold more MLPs in their portfolios. Congress passed a law allowing funds to hold up to 25% of their assets in MLPs, whereas previously MLPs could account for no more than 10% of their assets.

Closed-end funds have been quick to the scene. Institutional investors like Kayne Anderson and Fiduciary have invested billions over the past few years to develop several new closed-end funds dedicated to master limited partnerships.

And more funds are about to come to market. In the summer of 2006, two financial giants, Citigroup (NYSE: C) and Alerian, each launched their own MLP indices. These benchmark indices are likely precursors for new funds that will be hunting for MLP investments. As more and more institutional money chases this small group of stocks, the buying pressure should send share prices higher.

No Investment is Risk-Free
The main threat to MLPs is an economic slowdown, which could reduce transportation volumes and demand for their services. While this could affect MLPs in the short-term, the long-term picture is still bright. As mentioned earlier, the Energy Information Agency is projecting energy demand will continue increasing. U.S. energy demand is expected to grow at an average annual clip of about +1% over the next two decades, approximately what it has over the previous two.

And while regulated pipeline operators offer stable cash flows, if competition increases, payments to investors could decrease. Regulated pipelines receive a tariff indexed to inflation. These payments also build in a +10-12% return for the operator. That said, the tariffs represent the top rate a company can charge its customers for shipping oil and gas. When competition heats up, companies will offer their services below the going rate.

One other thing to watch for are interest rates. MLPs generate stable cash flow whether interest rates move up or down. However, just like every other income-paying asset class, MLPs compete directly with lower-risk fixed-income investments. If lower-risk bonds offer equally-attractive returns, then investors will rotate money out of higher-risk MLPs and into lower-risk bonds.

Taxes are Complex, but Funds Can Help
Most MLP distributions are comprised of about 20% net income and 80% return of capital (which is really just an allowance for depletion or depreciation). The income portion is generally taxed at your ordinary income tax rate.

You don't pay taxes on the return of capital portion until you sell the security, making MLPs ideal for long-term investors. Return of capital distributions lead to a reduction in your cost basis. For example, if you pay $50 a share for an MLP and receive a $5 return of capital distribution this year, then the cost basis of your shares will decline to $45. Say you sell the shares next year at $55 a share. You will be taxed at your ordinary income tax rate on the $10 in capital gains ($55 less $45).

If the owner of the security passes away, the reduced cost basis is stepped up to the current share price. That makes MLPs good for estate planning purposes, since they don't trigger a tax liability for your estate.

There is one glitch with MLPs, however. Individual MLPs aren't suitable for individual retirement or other tax-deferred accounts because they generate a type of income called "unrelated business taxable income," or UBTI. If your retirement account earns more than $1,000 of this income, then you'll end up paying taxes on it. As a result, you probably want to hold MLPs in a taxable (regular brokerage) account.

You can skirt around the UBTI issue by opting for a closed-end fund that invests in MLPs, such as the Kayne Anderson Energy Total Return Fund (NYSE: KYE). These funds handle the complexities of K-1 tax forms, Schedule E: Supplemental Income and Loss, and out-of-state returns that may need to be filed for individual MLP securities.

These funds don't throw off unrelated business taxable income. They generate dividend income that is reported on a simple 1099 form, instead of the somewhat more complex K-1 form used by an individual MLP. They also offer the benefits of holding a basket of MLPs with diverse income sources, but you do need to be careful -- management expenses can be much higher than with other funds. Although management fees take a bite out of returns, thanks to their tax and diversification benefits, MLP funds remain an excellent choice for many investors.

(3.)  Available Master Limited Partnerships

MLPs are as varied as the resources they bring to market. However, they generally fall into four main groups: pipeline carriers, propane distributors, coal leaseholders, and oil and gas leaseholders. Below you will find a list of many of the largest MLPs available . . .