In yesterday’s issue of ETR, I talked about Master Limited Partnerships (MLPs). These companies take an entirely different approach than most in the oil and gas sector.

They don’t explore or drill for oil or gas. They don’t buy or sell it either.

They just move oil or gas from point A to point B or process and store it.

It doesn’t matter to the MLPs what oil or gas is selling for. Their income is tied to the volume of oil or gas that flows through their pipelines, not to the price of the commodity.

It’s a very lucrative business model.

What makes MLPs unique in the investing world is how that income is passed back to you.

By owning an MLP, you get quarterly payments similar to stock dividends. They’re called “distributions,” and they offer unusually high yields. Most range between 4% and 7%. Compare that to the S&P 500’s average dividend yield of 1.71%, and you can see why MLPs are so attractive.

And with MLPs, you can also realize share price appreciation. Just look at what one company did compared to the S&P 500 from 2002 to early this year:

MLPs offer a rare combination of both high yield and growth.

So if you are thinking about adding a few MLPs to your portfolio, what should you look for?

Here are a few criteria:

Commodity sensitivity: Some MLPs have direct exposure to commodity prices. They get a share of the profits if the price of the oil or gas they are storing or moving goes up. You want to avoid these MLPs. Instead, you want MLPs with as little indirect exposure as possible. Here’s an example of what I mean by indirect exposure: If oil or gas prices drop too low and a driller that uses an MLP’s pipeline goes out of business, the MLP would see a drop in volume as a result… and that could hurt its income.

Cash distribution outlook: You want to own MLPs with a history of steady and/or increasing distributions. A search on Yahoo Finance will give you this information. Just punch in an MLP’s ticker symbol, click “historical prices,” then select “dividends only.” Make sure the MLP hasn’t stopped payments in the past and that distributions haven’t dropped.

Organic growth: Most MLPs grow through acquisitions. But you can’t count on that. You want to own MLPs with strong organic growth too. These are the MLPs with opportunities to grow as new oil and gas fields are discovered.

Cash distribution coverage ratio: This ratio measures the ability of an MLP to continue making distribution payments from its cash flow — and the higher the ratio is, the better. A ratio above 1.3 is best.

Debt rate: Since we are likely entering a rising interest rate environment, you want to own MLPs with as much fixed rate debt, as opposed to floating rate debt, as possible. With floating rate debt, payments will slowly rise, eating into profits.

Asset diversification: This one is obvious. An MLP that is solely reliant on natural gas from one location is more risky than a diversified MLP with multiple business lines.

And now, given those criteria, here’s a short list of MLPs that you should consider owning:

BPL Buckeye Partners LP
BWP Boardwalk Pipeline Partners LP
MMP Magellan Midstream Partners LP
OKS ONEOK Partners LP
SEP Spectra Energy Partners LP

All of these companies have a yield above 5%, at least a 5% earnings-per-share growth rate over the next five years, a P/E (price-to-earnings) ratio below the sector average, and a positive return on equity.

One more thing: Be sure to speak with your financial advisor or accountant before investing in MLPs. Because of their specific tax status, you may not want to hold them in certain types of investment accounts.

[Ed. Note: For more exciting investments ideas from Christian, sign up for his Trend Trader portfolio in the Liberty Street League newsletter.]