Not so long ago, master limited partnerships (MLPs) were the darlings of energy investors.
It's easy to see why: They paid high dividends, employed reliable, transparent business models, and they even enjoyed some unique tax advantages.
They were simply one of the very best energy investments you could make.
Then the oil and natural gas bear started. This once red-hot class of shares froze over like a Siberian winter - quickly and brutally.
But as it turns out, that fall was only temporary. A select few MLPs are about to come roaring back in a big way, and I'm going to show you how to play them...
Why These Plays Were Extremely Profitable
Now, my Energy Advantage subscribers have received several midstream service provider recommendations from me over the years.
In large part, I made these high-profit recommendations on the basis of the unique "tollkeeper" position provided to MLPs. While a few of these gravitated upstream to include field operations or downstream to emphasize processing and distribution, they most often would include holdings primarily comprised of pipeline, storage, terminal, gathering, initial processing, and similar midstream service assets in both crude oil and natural gas.
For regular investors, however, there were initially some healthy twofold benefits.The MLP business model itself was what initially drove the development of these holdings. This corporate structure has the advantage of eliminating a corporate tax level and moving all tax implications from corporate profits and losses directly to the personal tax returns of the general partners.
First, the underlying partnerships provided some heady upside at the outset. That enhanced the overall value of the assembled assets, but gave no immediate profit to holders of common stock (i.e., regular investors), at least, until the second benefit hit.
Once the general partners decided to spin off a portion of the MLP to retail investment, usually making up to 80% of the holding available for common trade and retaining 20% for the original partners, things began moving noticeably.
Not only would the combined assets in the MLP holding tend to enhance the common stock value now trading on the secondary market, but there was another attractive plus...
This Sparked an MLP Feeding Frenzy
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By moving up to 80% of the holdings' value to the open market, the same amount of the aggregate profits had to be transferred as well. For investors, that translated into an enhanced dividend well above market or even sector averages.
Such a double-whammy promptly translated into a feeding frenzy that only ended when several factors collided.
One was the collapse in crude oil and natural gas prices. The oil price crash was a result of OPEC's decision (recently reversed) to defend market share instead of price. Gas prices, on the other hand, fell because of continuing excess U.S. shale and tight gas production.
Another factor came from what the production surplus did to one of the main advantages MLPs had for investors.
Given their "tollkeeper" position, MLPs profit from two main income streams: transporting production from fields to end users (refineries and gas process centers) and using pipelines for storage.
Interestingly, that's why so much of new pipeline construction is actually adding loops to existing networks - providing more storage capacity - rather than making new connections.
But when the surplus of oil and gas in the market is both depressing prices and maximizing storage availability, MLP prospects decline. And when that lasts for a long time, as was the case until recently in both oil and natural gas, that puts a dent in MLP stock returns.
Third, and perhaps least noticeable, has been the manner of MLP asset expansion. Most of these holdings do not have, or are legally prevented from, access to debt or significant lines of credit. That means enhancing the asset base (and thereby the returns to general partners) is done through continuing waves of acquisitions.
Yet at some point, the need to expand ends up creating a situation in which assets are added at costs exceeding their market valuation. This is the ultimate reason why the biggest MLP the world has ever seen - Kinder Morgan (KMI) - threw in the towel and dissolved into three conventional corporations.
This is how the MLP business model became altogether too expensive.
Since that move, MLPs and other midstream holdings have become more focused on structure.
As a result, the size of the holdings have become less important than the quality and positioning of the assets themselves.
And it's this last fact that's been absolutely critical to the comeback of certain MLPs.
Here's a Great MLP Play
Once the pricing of oil and gas improves, the midstream companies with what I call "trigger point" assets - assets at the most important interconnections of the midstream process - will benefit first. And that will mean investors owning the shares of those companies will experience a pop as well.
Now, this environment is not one where a rising tide will lift all boats. Instead, on this playing field, you need to move on the best-positioned players, as my Energy Advantage readers have just done.
Now, I can't give away my most recent Energy Advantage recommendation. It has extreme profit potential, and sharing it wouldn't be fair to my paid subscribers.
But Money Morning Members can get the broadest possible exposure to this favored subset of MLPs with the JPMorgan Alerian MLP ETN (NYSE Arca: AMJ). This holding has given Energy Advantage more than 18% in gains since April 2016, and it's set to deliver even more gains as the price of oil and gas slowly improves over the coming year.
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About the Author
Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.