Will MLPs Go Extinct?

In their search for income-producing investments, investors have turned over every rock to find the perfect combination of hefty payouts and safety. Many have ended up in a once-obscure niche of the energy industry, through investment vehicles known as master limited partnerships.

But as Washington struggles with huge budget deficits, investors worry that MLPs' unique tax benefits could go away. With precedent for similar action, could the window of opportunity for smart investing in MLPs close forever?

Why MLPs matter
Master limited partnerships let companies in the natural resources industry structure their businesses to achieve tax advantages over ordinary corporations. The legal partnership structure allows income to flow through the business entity without incurring tax at the corporate level, leaving more for investors to collect through distributions of cash flow. Even better, because much of the money that MLPs produce doesn't count as taxable income, thanks to factors such as depreciation and depletion, investors benefit by receiving a great deal of cash that isn't immediately subject to taxation.

The MLP structure can produce some extremely attractive dividend yields. Currently, Cheniere Energy Partners (ASE: CQP) and Inergy (NYS: NRGY) yield more than 10%, while several others, including Terra Nitrogen (NYS: TNH) and Energy Transfer Partners (NYS: ETP) , offer payouts in the 8% range.

But with the federal government starving for tax revenue, any investment that produces a favorable tax result like this immediately becomes suspect. The government should eventually get its fair share from MLPs when investors sell out and deal with provisions that recapture the benefits of depreciation and other tax breaks. But the lag time between the benefits that investors enjoy, and when the IRS gets its due, is a thorn in the government's side.

Blame Canada
The precedent for changing the taxation of MLPs comes from our neighbors to the north. A similarly tax-favored investment called the Canadian royalty trust became very popular in the early 2000s as rising energy prices melded with blowout dividend yields. Yet the popularity of so-called Canroys became their downfall. In 2006, the Canadian government started a five-year clock to eliminate the favorable tax status that they enjoyed. Canroys weren't forced to dissolve, but those that continued operating had to convert to ordinary corporate status by the beginning of 2011, facing the same tax rules as other regular corporations. Some, such as Precision Drilling (NYS: PDS) , ended up eliminating their dividend payouts entirely.

But the endgame for most Canroys should actually give MLP investors some hope. Companies like Pengrowth Energy (NYS: PGH) and Penn West Petroleum (NYS: PWE) may no longer have their status as royalty trusts, but they still have very attractive dividend yields. Moreover, they still offer investors what they want: exposure to rising energy prices and growing production trends. Sure, shareholders don't enjoy quite as much of the benefit as they did under the former tax rules, but at least for now, just about everyone has emerged a winner.

Is the U.S. different?
In addition, MLP investors can take some solace from the fact that no one in the federal government seems in any hurry to discourage domestic energy production, especially given its role in producing jobs. Shale-rich North Dakota has the lowest unemployment rate of any state, so putting any sort of curb on energy companies right now will produce a lot of resistance from job-hungry Americans.

More importantly, though, it doesn't really matter whether MLPs retain their tax benefits in the long run. Investors will inevitably take a short-term hit if the tax-favored status of MLPs goes away, but with so much money coming out of the energy industry, any major pullback would likely present a buying opportunity for long-term investors.

Right now, you have to watch what's going on in Washington very closely in order to protect your investments. But in the case of master limited partnerships, even if the worst happens, it could still turn out all right for your portfolio.

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At the time thisarticle was published

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