Mastering This Investment Class

The Marcellus Shale gas formation has drawn a lot of attention in the past few years. It contains an estimated 500 trillion cubic feet of natural gas, and no fewer than 15 companies are drilling there.

But natural gas prices have fluctuated quite a bit for the last nine years. From a low of just over $2 per million Btu to a high of over $15 per million Btu in December of 2005.

When prices were scraping bottom in 2009, some drillers managed to hang on. But many were forced to close up shop.

Such is the risky nature of this business.

But what if you could invest in a group of companies that make money (and lots of it) no matter how low the price of natural gas or oil goes?

These companies don’t do any exploring. They don’t do any drilling. They don’t even buy or sell oil or natural gas. Nonetheless, they profit handsomely.

Take a look at the stock chart of one of these companies. Over the last nine years, it has gone up 150% while the S&P gained only 14%.

That’s impressive growth but it gets better. The company pays a 5.4% yield too!

You get both growth and income. A rare combination.

These companies are called Master Limited Partnerships or MLPs.

And they might be a good investment for you.

Why? Let’s start with the basics…

What Is an MLP?

MLPs are a special type of investment. They have limited partners and general partners. The limited partners are the investors, like you and me. The general partners are the ones who oversee the partnership’s day-to-day business. Typically, the limited partners hold a 98% ownership stake, while the general partners hold the other 2%.

MLPs get special tax treatment. They are not taxed at the corporate level. In return, they must distribute most of their cash flow — usually around 90% of it — to their limited partners every quarter.

Most MLPs operate in the energy sector. They own and operate the pipeline networks and terminals that process, store, or transport oil, natural gas, or other petrochemicals.

Generally, they don’t explore or drill for oil or gas. They don’t buy or sell those products either. They just move it from point A to point B and get paid for doing so.

Why Are MLPs Different Than Stocks and Bonds?

MLPs are similar to stocks in that they are easily traded on exchanges. They also offer investors growth potential and an often hefty yield.

But unlike stocks in this industry, their revenues don’t fluctuate with the price of oil and gas. That’s because their income is tied to the volume of oil or gas flowing through their pipelines, not to the price of the commodity.

That’s a huge benefit. It means they can chase growth in the oil and gas industry wherever it is. In the past, it was in ethanol. Currently, it is in shale gas. And, as I said, they get paid to move it through their pipelines no matter what the price is.

All of the estimates I have seen are for gas and oil use to continue to increase. That means volume increases for the pipeline MLPs. And that means more profits for them.

MLPs are often compared to bonds because of their yields. But yields on MLPs are higher than those of bonds. (With MLPs, they’re called distributions, not dividends.) Most MLP yields are between 4% and 7%. And right now, the average yield on an investment-grade bond is 4.71%. Plus, bonds can’t match the price growth of MLPs. And MLP yields can increase or decrease, whereas bond yields are fixed.

The MLPs you want to own, of course, are the ones that are going to increase their distributions.

I will show you how to identify those MLPs tomorrow. Meanwhile, let’s take a quick look at some of the additional benefits of MLPs…

The Benefits

  • Their pipelines can stay in service for decades with routine maintenance. This means low maintenance costs.
  • Territory overlap is limited, meaning very little competition.
  • As new oil and gas fields are found, huge expansion opportunities open up.
  • Pipelines that cross state lines are regulated at the federal level, and rates are tied to the Producer Price Index. The government makes sure that fees collected outpace inflation.

With inelastic demand, very high barriers to entry, little concern for price fluctuations, and high yields, it is easy to see why MLPs are an attractive investment.

Tomorrow, I will go into more detail on what to look for in an MLP… and recommend some MLPs worth owning.