Upstream energy companies are increasingly deploying an old investment vehicle -- uncommon for oil and gas drillers -- to increase the value of their assets and lure new investors into energy.

Master limited partnerships (MLPs) have a financial leg-up over traditional corporations because their profits aren't taxed until they are distributed to the MLPs' "unit-holders." When a corporation takes existing assets and spins them off into a separate MLP, the value of those assets immediately increases because the future cash generated by the assets will be taxed at a significantly lower rate than before.

Energy MLPs tend to invest in dependable, long-life assets that generate steady cash flows, such as pipelines or oil fields with long reservoir life spans. The vehicle has long been used by midstream energy players, such as pipeline and storage companies. Their distributions to investors can be so reliable that MLPs often resemble fixed-income investments more than stock investments.

Kinder Morgan Energy Partners ( KMP) is perhaps the most well-known of energy MLPs. Kinder operates an enormous network of oil and gas pipelines and terminals. Rather than owning the fuel in its pipes, the company charges customers transmission fees, which are easy to forecast.

This model has allowed the company to steadily increase its distribution payments to unit holders over time. The value of Kinder's units has increased nearly 1,000% since the company was formed in 1992.

Recently, upstream energy companies have been testing the MLP waters. So far, six are operating in the U.S., including Linn Energy ( LINE), Atlas Energy Resources ( ATN) and Constellation Energy Partners ( CEP). Encore Acquisition ( EAC) is currently in the registration phase. Exco Resources ( XCO) and Whiting Petroleum ( WLL) have also shown interest. Dan Pickering, president of Pickering Energy Partners, says there may be 10 to 15 new MLPs now in various stages of development.

Looking back on the history of energy MLPs, one can see that they haven't always been the safe and secure investment that people think they are. Energy MLPs have already experienced one boom and bust cycle. This happened in the 1980s, when commodity prices collapsed and profit distributions from MLPs screeched to a halt.

Michael Davis, managing director at Pickering Energy Partners, says today's environment is becoming eerily reminiscent of the last MLP boom period. The six existing upstream energy MLPs have seen tremendous success from soaring commodity prices. Other companies are taking notice and want in on the action.

However, commodity price risk may be less relevant today than it was in the 1980s, according to Barbara Shook, Houston bureau chief of Energy Intelligence. Today's financial markets are considerably more advanced than they were in the 1980s, providing MLPs with numerous tools to hedge against unexpected swings in the price of oil and gas.

MLPs are also at risk of rising interest rates. Since MLPs typically offer consistent yields to investors, any increase in interest rates would drive investors to bonds and likely reduce demand for MLP units.

Kinder Morgan Partners
(KMP)
Source: Bigcharts.com

Because assets immediately increase in value once they are dropped into an MLP vehicle, partnerships are encouraged to keep acquiring assets well after they are created. This appetite grows stronger when a corporation plugs "incentive distribution rights" into an MLP's bylaws. These rights allow the general partner of an MLP to take an increasing share of income distributions as the partnership's asset base grows.

Incentive distribution rights can generate an enormous conflict of interest between an MLP's general partner and its unit-holders, says Davis. When an MLP is being encouraged to take large risks and consistently acquire more assets, its motivation could run counter to those of unit holders seeking steady yields and reliable, low-risk dividends.

Merrill Lynch recently lowered the ratings of four midstream MLP general partners. In a research note, Merrill analysts said that "current GP valuations assume significant acquisition activity at each underlying MLP and this expectation for acquisition activity for midstream energy MLPs may be misguided." If upstream energy companies continue to clamor for more MLPs, the same overvaluation scenario could soon affect them as well.

Additionally, the major aspect of MLPs that makes them so popular with investors is drawing them into the political crosshairs. After Canadian resource companies fled corporate-level taxation by forming royalty trusts, the Canadian government wrote legislation mandating that royalty trusts will be liable for traditional taxes as of the year 2011.

Grant Hofer, energy analyst at UBS, believes that many Canadian resource companies will defect to the U.S. and form MLPs, rather than stick around and pay a greater share of their income to the government. However, some analysts think that the U.S. government is also hungry for this lost tax revenue stream and may soon follow Canada's lead and close the tax "loophole" for MLPs.

The U.S. Senate Finance Committee is now crafting a bill that would do just that for MLPs that provide fee-based financial services. Although the language of the bill explicitly excludes natural resource MLPs from the new taxation, many analysts believe that it is only a matter of time before political goodwill turns against energy MLPs. At a time when some energy firms are making record profits off of high commodity prices, resentment against "tax breaks" for oil companies is clearly rising.

Getting in on an energy MLP can be extremely rewarding for individual investors. However, it is important that investors not be blinded by an MLP's impressive income distributions and asset valuations. Investors should actively monitor these investments to make sure that an MLP's risks match investors' expectations.

Although MLPs may look like secure bets at first glance, they could potentially be as risky as equity investments in the upstream energy space.

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