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It's no secret that energy master limited partnerships (MLPs) have been all the rage lately. With bond yields at record lows, this high-yielding asset class has witnessed a surge of new investors. Several oil and gas pipeline companies in this space have been especially popular.
But while these seemingly foolproof investments have yield seekers drooling, there are some serious risks investors need to be aware of.
The allure of the MLP asset class
Pipeline MLPs are publicly traded firms that store and transport oil and natural gas. Their structure as limited partnerships provides investors with two major advantages: substantial quarterly dividends (aka distributions) and deferred taxes on returns. Further boosting their appeal is their ability to bypass corporate taxes and distribute all profits to partners and investors.
The beauty of their business model is that they make money on volume, and are much less susceptible to fluctuations in oil and gas prices. Think of them as toll road operators that get paid based on how many cars are on the highway. As long as they have oil or natural gas flowing through their pipelines, revenues should keep booming.
Seems like a fail-safe business model, right? It very well may be, especially if you're a long-term investor, but there are still some major risks to consider.
All that glitters ain't gold
Because of the overwhelming optimism regarding this space, a tremendous amount of money has poured in recently. Last year, the Alerian MLP ETF had the fourth-highest net inflows of any U.S. ETF. But unfortunately, this flood of new money seeking outsized returns tends to be accompanied by heightened volatility. Since many of these investors are simply seeking short-term gains, any news perceived as negative can sometimes lead to an outsized decline in share price.
For example, in January, an analyst on CNBC's Fast Money suggested that Kinder Morgan Energy Partners (NYSE: KMP ) , one of the largest and most popular pipeline companies, was overbought. The stock plunged almost immediately, recording a 4% loss at its intraday low. So if you find it hard to stomach sharp ups and downs, this sector may not be right for you.
Tax-related risks (and a loophole to avoid them)
Despite MLPs' envious ability to completely avoid corporate taxes, tax implications for individual investors aren't so cut and dry. For one, MLPs only defer taxes, they don't cancel them. So if you plan on holding the stock for a long time, you can reap the advantage of years of compounded, tax-deferred income from high dividends. But when you finally sell your shares, the taxman will have his hand out.
Another hassle is the tax paperwork, which can get messy. Unlike the simple Form 1099 you have to fill out for most income distributions, MLP tax returns require filling out a Schedule K-1, which requires multiple entries on your federal return. In addition, the IRS won't let you have your cake and eat it too because MLPs can't be placed inside a tax-deferred retirement account.
However, there is a loophole.
Instead of investing in individual MLPs, you can avoid some of these issues through MLP ETFs, which allow you to fill out the simpler 1099 form, instead of having to file individual K-1s for all your holdings. And even better, you can stiff the taxman not once, but twice, because you can place one tax-deferred product (the ETF) inside another tax-deferred account (your IRA). How do you like them apples, Uncle Sam?
Another risk for MLPs is their ability to raise capital. Since they're required to distribute the bulk of their income to investors, they often have very little cash left over to fund growth. As such, they rely on raising equity and debt in the capital markets. If we find ourselves in another credit crunch, like the one we saw in 2008 and 2009, some of the less creditworthy MLPs could be in trouble.
What to look for when choosing individual MLPs
Despite these risks, there's no denying that these companies stand to benefit from forward-looking trends in energy infrastructure. When selecting individual MLPs for your portfolio, look for steady distribution growth, not just eye-popping yields. If you come across a yield of 10% or above, ask yourself: Is the distribution sustainable?
Well-capitalized, large-cap MLPs with stable cash flows are probably your safest bet. Enterprise Products Partners (NYSE: EPD ) and Plains All American Pipeline (NYSE: PAA ) are two I'd recommend looking into, as they appear particularly well-positioned to ride out the energy infrastructure build-out.
If you like the idea of capitalizing on long-term trends in energy, two other companies worth looking into are Clean Energy Fuels (Nasdaq: CLNE ) and Westport Innovations (Nasdaq: WPRT ) . Westport is creating new technology for engines to run on natural gas, while Clean Energy is developing a national network of natural gas fueling stations. With domestic supply plentiful, natural gas will almost certainly play a bigger role as an alternative fuel for vehicles in coming years. These first movers are banking on it.
While energy is certainly a promising sector, there are other companies out there paying consistently high dividends with even less risk. Many of them are high-quality businesses that have been around for decades, making themselves and their shareholders a ton of money. To find out the names of nine such companies, check out this special report from The Motley Fool: "Secure Your Future With 9 Rock-Solid Dividend Stocks." It's totally free but won't be around forever, so click here and get your copy today.