Yields on ten-year US Treasury notes are currently hovering around 4.5 percent. Meanwhile, the Philadelphia Utility Index yields just 3.5 percent and the Bloomberg REIT index just 5.0 percent. Utilities, REITs and bonds are the go-to sectors for investors looking for income, but none are offering high yields right now.

Fortunately, the energy sector offers an alternative. Publicly traded master limited partnerships (MLPs) can hand investors high tax-advantaged yields, outstanding growth opportunities and relatively low exposure to volatile oil and gas prices. MLPs are traded right on the major US exchanges just like common stocks. And the better-placed MLPS offer annual distribution growth (payout increases) of 5 to 10 percent on top of yields between 6 and 8 percent.

Better still, changes to the US tax code are allowing mutual funds and other institutional investors to more freely buy MLPs. This is a whole new class of investor, previously shut out of the group. As this institutional capital begins to find its way into MLPs, the buying pressure will push up prices for the best-placed partnerships.

In short, the bull market in MLPs is just getting started and this is my top slow-but-steady income idea for the next few years.

An MLP Primer

MLPs are partnerships that trade directly on the major exchanges just like common stocks. Most of the MLPs I follow trade on the New York Stock Exchange and can be purchased easily through any discount or full-service broker at the same commissions you'd pay to buy any stock. Just like common stocks, MLPs offer limited liability for unitholders (shareholders). That means that you're not responsible for any charges or losses beyond your investment in the MLP.

MLPs raise capital by issuing units--the rough equivalent of shares in a common stock--and are permitted by US law to own certain specific types of assets. Pipelines, gas processing facilities, coal properties and production platforms are just four of the most common assets owned in MLPs.

Most MLPs are owned jointly by one or many general partners (GP) and limited partners (the unitholders). The GP is responsible for the day-to-day operation and management of the MLP's assets. The GP makes all decisions related to acquisitions of new assets and sales of existing assets. Normally, the GP also owns a small stake in the MLP and receives what's known as an incentive distribution for managing the partnership's assets. Incentive distributions are, in almost all cases, based on a pre-set tiered system--the more money the GP generates to pay out to unitholders, the higher their take of those cash flows. The idea is that this incentivizes the GP to make more distributable cash for unitholders--the more they make for the LP, the more they get to keep as an incentive distribution.

Some GPs are themselves publicly traded partnerships. But in most cases, the GP is a normal corporation; some of the largest firms in the energy business such as Williams, Teekay Shipping and Valero act as GPs for publicly traded MLPs.

When you buy an MLP you become an LP unitholder. This entitles you to no control or voting rights over the operation of the MLPs assets; you can, of course, sell your MLP units at any time just as with a common stock. However, you do have ownership rights over the majority of those assets and receive regular distributions of cash from the partnership.

The New Era of MLPs

The real beauty of MLPs lies not just with yield but also with total return. As I mentioned above, MLPs are likely to offer 5 to 10 percent annualized increases in payouts coupled with yields of 6 to 8 percent over the next few years.

A perfect example of this total return phenomenon is my income portfolio holding, Enterprise Products Partners LP (NYSE:EPD). This particular MLP has boosted its distributions at an annualized rate of just less than 10.5 percent over the past five years. Five years ago, the annualized distribution was around $1.10 per unit; now, that distribution has grown to about $1.63, an increase of roughly 50 percent. Enterprise has pushed through a long series of steady quarterly payout hikes.

In addition, the MLP itself has appreciated significantly. The combination of steadily rising distributions coupled with capital appreciation has resulted in some impressive performance.

And this performance isn't just a product of the bull market in oil and natural gas prices that began in 2002-03. Consider, in particular, that Enterprise performed well even in the midst of the 2001-02 recession and during the massive pullback in energy prices in 2001. In fact, during the big natural gas bear market of 2001, Enterprise hiked its distribution by more than 13 percent. That's testament to just how isolated this MLP is from volatile gas and crude prices.

MLPs, even ignoring their tax advantages, have to be considered at least as attractive for income-seeking investors as bonds, utilities or REITs. MLPs, as a group, offer not only high dividends but also the potential for growth in distributions and capital appreciation.

I also see some near-term growth catalysts for the MLP space. Perhaps the most important is an overlooked change to the US tax code that opens up MLPs for more institutional investment. Specifically, mutual funds must derive 90 percent of their income from certain qualified sources to qualify as “regulated investment companies.” Until 2004, this did not include MLPs. Funds could place no more than 10 percent of their respective total assets in MLPs.

The American Jobs Creation Act of 2004 (the “Act”) changed all that. The Act specifically allows funds to put up to a quarter of their assets into MLPs provided a single MLP accounts for no more than 10 percent of total assets!

To date, MLPs have been mainly a retail investor's game. Because institutions were effectively barred from owning these publicly traded partnerships, the MLPs did not benefit from the huge quantity of institutional money that's been looking for high yield plays. Changes to the tax law will mean that institutional money begins to gradually move into the sector alongside retail cash.

That will undoubtedly push the MLPs higher!

Despite this tailwind for the MLP class at large, it's a mistake to suppose that all MLPs are equally attractive. It's also a big mistake to simply troll through the group looking for the MLPs paying out the highest yields.

Before I add an MLP to The Energy Strategist income portfolio I look for two key traits: potential for distribution growth and relatively low commodity price risk. When it comes to distribution growth, the key is to look for MLPs that will see strong organic growth from their existing assets or have the potential to acquire new assets and boost cash flows. Some of my favorite MLPs are levered to coal.

The Coal MLPs

Coal MLPs do not actually mine or produce coal; these companies simply lease out their land to miners like Peabody Energy (NYSE:BTU) and Arch Coal (NYSE:ACI), earning a royalty fee in the process.

Coal is far from a dead energy source. Not only is power produced from coal far cheaper than natural gas-fired but it’s not as polluting as you may think. Specifically, the use of low-sulphur coal can cut sulphur dioxide emissions from coal-fired plants by as much as 80 to 90 percent.

The US is blessed with considerable domestic reserves of coal, some of the largest and highest quality reserves anywhere in the world. The most extensive reserves of low-sulphur coal are located in the Powder River Basin (PRB) in the Western US. The PRB is the key growth market for the low-sulphur coal that coal-fired power plants need to meet increasingly strict pollution guidelines.

One of my MLP portfolio holdings, Natural Resource Partners (NYSE:NRP) has reserves in the PRB region, as well as considerable reserves of primarily low-sulphur coal in Appalachia. Hot demand for coal spells rising royalty fees for coal MLPs and, of course, rising distributions for unitholders. Natural Resource Partners recent distribution hike was its eight quarterly hike in a row, and brings the yield to just shy of 5 percent.

Coal MLPs do have some commodity risk: If coal prices were to drop precipitously, royalty revenues would likely fall, hitting distributions. But I just don’t see that happening any time soon. Peabody Energy, the largest coal mining company in the US, recently reported in its quarterly earnings conference call that 15 to 20 major plants nationwide have less than 15 days of coal supply on hand. And a handful of those have less than five days’ supply in their coal yards. This is drastically below the comfort level. Normally, 50 or more days of coal supply are kept on hand this time of year. There is a very real risk that there’ll actually be a shortage of coal in the Northeast this winter if it’s a cold season.

This scarcity has driven a 150 percent increase in low-sulphur coal prices in 2005 alone. And coal prices and coal-related stocks barely felt the recent correction that swept across the energy space. I see coal as a far more defensive market at this time than either oil or natural gas and the coal MLPs are a great way to play the trend and generate significant income.

It’s undeniable. Coal is one of the best bets to maximize our returns in the coming year. And worldwide trends show no signs of letting up on this increased demand. Which means, of course, that the current tightening of supply may be here to stay. That fact alone leads me to consider coal to be the MOST PROFITABLE long-term play that the energy world has to offer.

© 2005 Elliott H. Gue
Editorial Archive

There’s a lot more to the story than what I’ve outlined here. The demand for coal will continue to rise steadily due to certain developments in the oil industry that still aren’t finding space in the mainstream press. My new report THE SAUDI MIRAGE--available absolutely FREE--discusses these developments in detail. Read it at: http://www.energystrategist.com/novtel