Capture the Boom in U.S. Oil with MLP ETFs

December 5th at 2:49pm by Tom Lydon

The surge in unconventional oil production will help the U.S. become the largest oil producer in the world. Investors can capitalize on the oil boom through master limited partnership exchange traded funds that track the growing infrastructure network needed to accommodate increasing oil output.

MLPs are businesses that engage in energy infrastructure activities, including the processing, storage and transportation of minerals and natural resources. While MLPs are associated with the energy sector, they have a low correlation to energy prices, along with the broader equities markets, as the assets act like a toll-road in the nation’s energy infrastructure. [What is an ETF? — Part 30: Master Limited Partnerships]

According to the INGAA Foundation, North America will have to invest $251 billion in related infrastructure to keep up with new oil and natural gas discoveries, writes Mary Lyman for The Energy Collective. MLP businesses are expected to invest $25 billion this year to meet the growing shale oil production across the U.S. [Capitalize on the U.S. Oil Boom with Yield-Generating MLP ETFs]

The growth in the MLP marketplace is tied to growing demand for energy and its availability from newly developed sources. Consequently, the asset provides a reliable income source as companies participate in the country’s energy infrastructure.

As a partnership, MLPs act as a pass-through entity where the company’s income or losses pass through to individual owners of the partnership. Most investors enjoy MLPs because of the investment’s attractive quarterly cash distributions.

MLPs are particularly attractive for fixed-income investors since MLPs are required under their partnership agreements to distribute all available operating cash flow each quarter, which produces a reliable stream of income.

MLP ETFs that hold more than 25% of their portfolio in MLPs are structured as C-Corporations in order to track an underlying MLP-related index. Due to the C-Corporation structure, they must pay corporate income tax on distributions before passing them to investors. Consequently, MLP ETFs may incur higher fees that would cut into overall performance, leading to an underperformance compared to the underlying benchmark. [MLP ETFs Try to Address Tax Headaches]

The MLP exchange traded notes, like the UBS ETRACS Alerian MLP Infrastructure ETN (NYSEArca: MLPI), have outperformed MLP-related ETFs, such as the Alerian MP ETF (NYSEArca: AMLP).  As an unsecured debt instrument that replicates the return of the MLP index, the ETN vehicle is not subject to the double-taxation effects associated with a C-Corporation. ETNs, though, are subject to credit risk of the underwriting bank or issuer.

In an attempt to skirt the tax problems, newer MLP-related ETFs limit MLP holdings to 25% of the total portfolio. For instance, First Trust introduced the actively managed First Trust North American Energy Infrastructure Fund (NYSEArca: EMLP), the first RIC-compliant MLP product, limits MLP holdings to 25% and includes other energy infrastructure firms with similar characteristics to MLPs. Additionally, the newer Global X MLP & Energy Infrastructure ETF (NYSEArca: MLPX) and he Alerian Energy Infrastructure ETF (NYSEArca: ENFR) to also limit holdings of MLPs [How MLP ETF Structures Affect Yields and Returns]

For more information on master limited partnerships, visit our MLPs category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.