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Profit From Energy’s Middlemen

November 13, 2012 – by Richard Band

With the U.S. poised to overtake Saudi Arabia’s oil production by 2020 and to become energy self-sufficient by 2030, energy truly is in the spotlight, and pipeline MLPs like Kinder Morgan Energy Partners (NYSE:KMP) and Enbridge Energy Partners (NYSE:EEP) are seeing dollar signs ahead.

These “middlemen” make money regardless of fluctuating commodity prices, and their tax-advantaged status means they’re not going to tumble off the fiscal cliff. But better yet — there’s a way to take advantage of them without dealing with the tax headache MLPs can bring.

MLPs that operate pipelines or other “heavy metal” businesses generate cash flow well above their reported earnings. The reason: Depreciation — which is deducted in computing an MLP’s earnings — is a bookkeeping entry that doesn’t actually reduce consumer cash. As a result, the part of your quarterly distributions that exceeds reported earnings escapes current taxes.

Eventually, when you sell your MLP units, the government will tax those deferred amounts as ordinary income. Also, if you hold your units long enough for the cumulative deferrals to equal the units’ original cost (maybe 10 to 13 years), you can’t defer tax on any subsequent distributions.

MLP Tax Status is Here to Stay

MLPs are likely to survive the fiscal cliff negotiations under way in Washington because most or all of an MLP’s cash distributions escape current income tax, thanks to depreciation deductions. Politicians probably won’t mess with MLPs’ tax status because:

  1. The loss of revenue to the Treasury is relatively small, and
  2. As mentioned, MLPs support the growth of America’s domestic energy industry.

Politicians won’t want to kill this golden goose.

I would focus on the names with the strongest balance sheets and operating records, since we’re in a period of slow economic growth that could easily tip into recession. These “blue chips” of the industry — like Kinder Morgan and Enbridge — generally carry lower cash yields (5%-7%) than the riskier MLP plays. I would hold off on MLP turnaround stories until it becomes apparent that the economy is accelerating again.

The one sticking point is that you’re limited to $1,000 of unrelated business taxable income (MLP dividends) in an IRA. I don’t recommend holding MLPs in a tax-sheltered account for that reason. MLPs also create extra paperwork at tax time. If you can navigate these complexities, though, you’ll be rewarded with a going-in yield that easily exceeds that of any Treasury bond.

Another Kind of Middleman

If you do want to play pipeline MLPs in your IRA, there’s a way around those complications. Kinder Morgan Management (NYSE:KMR) pays quarterly distributions in stock — shares of KMP — rather than cash, and carries an implied yield of 6.8%. There’s no tax due until you sell. I also like Enbridge Energy Management (NYSE:EEQ), which has the same tax features as KMR, but is growing a little more slowly. Current implied yield is 7.3%.

Since they generate zero taxable income, both of these vehicles are suitable for IRAs.  Because of tax complications, traditional MLPs should be held outside an IRA (i.e., in a taxable account).

Richard Band’s Profitable Investing advisory service helps retirement savers outperform the market without losing a minute of sleep along the way. His straightforward style and low-risk “value” approach has won seven “Best Financial Advisory” awards from the Newsletter and Electronic Publishers Foundation.