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Mastering the MLP Domain


MLPs have handily trounced both the Dow Jones Industrial Average and S&P 500 Index since the start of the millennium. But there's a hornet's nest of hidden costs the investor has to consider.

Master limited partnerships provide method of participating in new forms of extraction including shale and natural gas. Renewable sources such as sun and wind will soon be added to the mix if Democrat Senator Chris Coons, of Delaware, has his way. In June, Coons introduced the MLP Parity Act, a bipartisan bill aimed at amending a tax code quirk that currently prohibits the industry from investing in such "inexhaustible" energy assets.

Buyer Beware

These positives aside, MLP investing is now an increasingly crowded trade and performance has suffered of late after several stellar years. Investors shouldn't be blind to risk while chasing rewards. In particular, many of the new higher-yielding MLPs are less tied to traditional assets, and have many market mavens espying a bubble about to burst. While interest rates currently stand at once-in-a-lifetime lows, the law of gravity hasn't been entirely upended and they are destined to increase eventually. In these scenarios, yield-based investments inevitably suffer.

Asset depletion always needs to be taken into account when natural resources are involved. Also, the partnership structure leaves individual holders somewhat exposed should any issues arise at the parent company. Volatile capital markets, which represent a key source of funding, could dry up, as investors in 2008 painfully learned.

Acts of both God (a Katrina-style hurricane) and government (more fiddling from Congress on the Keystone Pipeline) are other considerations for investors to keep in mind.

While MLPs often employ hedging strategies to counter constantly shifting commodity prices, these techniques aren't infallible. For instance, 2012 has seen natural gas prices plunge to 10-year troughs, dimming prospects at companies exposed to the sector -- although with industry rig counts having subsequently fallen to their lowest level since 1989, a rebound may already be at hand.

Perhaps the biggest issue overhanging MLPs are future changes to the tax status they currently enjoy. Blame Canada. The October 31, 2006 decision of our northern neighbors to tax their similarly high yielding income trusts -- known ever after as the "Halloween Massacre" -- remains a spooky specter stateside some six years later.

Faced with structural deficits as far as the eye can see, Capitol Hill continues to mull an overhaul of the tax code including ending the present preferential treatment enjoyed by "pass-through" entities like MLPs. The likelihood remains that legislators will act gingerly if at all, especially in an election year and up against army of AARP retirees unwilling to accept any threat to their fixed income.

Still, the mere possibility of revamping current "carried interest" legislation had Blackstone head Stephen Schwarzman threatening to emigrate to France and comparing Obama to Adolf Hitler. Regardless of who wins in November, we likely haven't heard the last of this issue.

The Master

This weekend, The Master, a movie called "confounding" by one critic and centering on a mysterious cult-like organization, broke box office revenue records for a film in limited release. Master limited partnerships can appear equally impenetrable from the outside, yet offer a similar shot at big bucks. Investors must make sure they perform ample due diligence and are aware of all risks.
No positions in stocks mentioned.
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