Rev Up Your Portfolio With Energy MLPs

Energy-related master limited partnerships have been remarkably consistent performers. They outpaced Standard & Poor’s 500-stock index every year from 2000 through 2011. Although the streak ended in 2012, MLPs didn’t go down in flames. Rather, these investments, which trade like stocks but avoid paying income taxes on their earnings, returned 4.8% on average, compared with 16.0% for the S&P 500.

Strong early-year gains dissipated in late 2012 on fears that Congress might require MLPs to reorganize as corporations. That would have chopped the amount of cash available for shareholder distributions. But the New Year’s Eve agreement to avert the fiscal cliff did no such dirty deed. Indeed, analysts who follow the partnerships believe that the threat of an overhaul is gone because the $500 million or so in additional revenues that Uncle Sam would collect yearly is relatively trivial.

Rapid Rebound

MLP shares have quickly regained their vigor. Year-to-date, the Alerian index of 50 energy MLPs, which gather, transport, refine, store and sell oil and natural gas, showed a total return of 14.0% (all prices and returns are through March 7). The index’s current yield is 6.0%, 4.1 percentage points more than the yield of ten-year Treasury bonds. Going back to 1999, the gap between MLP and Treasury yields has averaged 3.4 percentage points.

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Publicly traded partnerships, which own an ever-growing share of America’s energy infrastructure, have bold expansion plans, greased by super-cheap capital. In fact, a big infusion of capital last year may have also contributed to the late-2012 swoon; a record $26 billion worth of new shares were sold, both by established partnerships and by 13 firms issuing stock for the first time. The new shares add more than 10% to the category’s total stock market value and threaten to seriously dilute future earnings and dividends unless the partnerships can find profitable projects for the new money.

The sector’s prospects look favorable. Darren Schuringa, who invests in MLPs for Yorkville Capital Management, in New York City, predicts that distributions will climb 8% this year, up from 6% growth the past few years. That implies that MLP investors could earn another 10% to 15% this year, bringing total returns for 2013 to about 25%. Yes, that’s big-time bullish. But with the U.S. deep into an oil-and-gas boom, I think solid additional gains are achievable.

If you own blue-chip MLPs, stand firm. If you want to invest new money in the sector, skip the dozens of mutual funds, closed-end funds, and exchange-traded funds and notes that track MLPs. They have high expenses and, because of the odd rules of partnership taxation, pay taxes that other kinds of mutual funds don’t have to pay. That hurts returns.

You’re better off buying individual MLPs, despite the burden of wading through partnership K-1 forms when you prepare your taxes. I recommend such leaders as Enterprise Products Partners (symbol EPD, $57, 4.6%), Kinder Morgan (KMP, $85, 6.1%), Magellan Midstream (MMP, $49, 4.1%) and Plains All American Pipeline (PAA, $54, 4.2%).

If you want to speculate a bit, check out a couple of the MLPs that went public last year. Some advisers worry that the new MLPs’ operations may not yet be well diversified. But you can combine the stability of the energy-distribution business with the growth prospects of a real estate investment trust by investing in newly public MLPs that supply and operate highway fuel plazas and convenience stores. Worth a look are Lehigh Gas (LGP, $21, 5.6%), which operates in the Northeast, and Northern Tier Energy (NTI, $31, 16%), which operates in Minnesota and nearby states. An off-the-charts yield of 16% is usually a danger sign, but even if Northern Tier shares dropped 10%, you’d still earn a respectable 6%.