A way to make money from energy trends

Pennsylvania's Marcellus Shale isn't quite the equivalent of Saudi Arabia and oil. But it is an extremely promising natural-gas investment play. So how can investors capitalize on a potential energy boom in Pennsylvania and beyond?

Master limited partnerships (MLPs) are one vehicle. Or you can buy shares of public companies drilling these gas-rich shale deposits in Marcellus, which Terry Engelder of Pennsylvania State University estimates is part of the largest onshore natural-gas basin in America.

MLPs became popular back in the 1980s, but fell out of favor when the price of oil dropped to nearly $10 a barrel (ah, sweet memory!). With oil prices rising rapidly amid turmoil in the Middle East, natural gas now looks more attractive. And some consumers are rethinking nuclear power after Japan's earthquake created the threat of a reactor disaster.

MLPs typically offer annual yields of 5 percent to 7 percent with historically low tax rates. That's because MLPs must distribute 90 percent of their earnings, known as return of capital. But there are pitfalls, such as shifting tax rules. Higher interest rates could be around the corner, meaning MLPs would borrow money at a higher cost. Gov. Corbett has promised he would not tax natural-gas production in the state - at least for now.

So how do MLPs make money for investors? They collect fees for storing and transporting energy, and generally provide stable returns, usually on a quarterly, dividend-style basis. Over the last 15 years, MLPs have yielded about 4 percent more than the U.S. 10-year Treasury bond and 2.2 percent more than domestic REITs, according to a January 2011 white paper written by Wells Fargo Family Wealth analyst Thomas J. Raymond.

Note there are both ETFs (exchange-traded funds) and ETNs (exchange-traded notes) that hold these energy partnerships, but the difference in tax consequences between the two structures are significant. When MLPs rally, the differences between these products become very apparent.

The ETF structure has an edge: Since MLPs give out cash distributions, they are treated as return of capital, according to Fidelity, the brokerage firm. The ETN structure is taxed as ordinary income, at a much higher rate. Also, the ETF trades like a stock, while the ETN is technically debt.

Both the Alerian MLP ETF (symbol: AMLP) and the UBS E-TRACS Alerian MLP Infrastructure ETN (symbol: MLPI) aim to track a benchmark group of these vehicles, known as the Alerian MLP Infrastructure Index. The JPMorgan Alerian MLP Index exchange-traded note (symbol: AMJ) is another new ETN in the space, and Credit Suisse launched the Cushing 30 MLP Index ETN.

Be aware: These products can be very different. Discuss the structures with your broker or financial adviser before purchasing. ETNs, for example, are usually more suitable for investors with tax-exempt or tax-deferred accounts. And come tax time, MLPs generate a tax form called a K-1, which often arrives late and can force you to file for an extension.

MLPs can be classified roughly into three categories: upstream MLPs focus on finding and extracting energy sources; midstream MLPs store, refine, and transport energy; and downstream MLPs distribute energy to end users, such as a gas station or utility. The most common model today is the mid-stream MLP, which operates as a toll-taker. Energy companies pay a usage fee in order to transport product through MLP-owned pipelines. Mid-stream companies' fortunes are tied to energy demand, not prices. These MLPs can theoretically turn a profit whether oil is at $30 a barrel or $150 a barrel.

There are also publicly traded companies cashing in on natural gas in Marcellus. Among them are Chesapeake Energy, Range Resources, Anadarko Petroleum, Cabot Oil & Gas, Consol Energy Inc., EOG Resources, EQT Corp., Talisman Energy, Ultra Petroleum and ExxonMobil. (For updates on drilling plans, check out Shaleblog.com at http://shaleblog.com.)

Some argue that MLPs are overpriced despite the juicy yields. Jason Pride, Glenmede's director of investment strategy, advises clients to steer clear of MLPs at the moment. Large-caps stocks, he notes, yield 6.6 percent now and 6.2 percent over the last 50 years, while MLPs yield 6.4 percent currently and 7.7 percent over the last 50 years. "MLPs are overvalued, while large-cap stocks are undervalued," Pride says.

Chip Cobb of Bryn Mawr Trust, on the other hand, says MLP income is consistent and "better than municipal bonds and investment-grade corporate bonds on an after-tax basis." His firm owns Enterprise Products Partners, Kinder Morgan, and Buckeye Partners. He reiterates that clients shouldn't own them in retirement accounts because of the tax complexities.

Tom Cameron, former head of the Philadelphia Stock Exchange, now portfolio manager of the Rising Dividend Fund, personally owns MLPs that consistently raise dividends, among them Linn Energy, NuStar Energy, Williams Partners, and Enbridge Energy Partners L.P. Says Cameron, now in his 80s: "I probably have 80 percent of my own money in these partnerships."