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Master limited partnerships were established by the Tax Act of 1986 to permit investors to earn high, tax-deferred cash returns through investments in specified assets. There are many types of MLPs now, including coal, shipping, amusement parks, and timber, but the largest subset of MLPs comprises companies that produce, process, transport, and store oil and natural gas products.  As income vehicles, MLPs compete with real estate investment trusts, high-yielding stocks, and bonds. The Alerian Index, which tracks the 50 largest energy MLPs, was recently yielding 5.9%, down from over 8% in October 2009, as investors have pushed prices up in their search for higher-yielding securities. (The average REIT now yields around 4.5%).

Energy Master Limited Partnerships are engaged in the transportation, storage, processing, and marketing of natural gas and other natural resources. At least 90% of an MLP’s profits must be derived from these specific activities for it to be designated under this structure. Units of MLPs trade much like ordinary common shares on a public exchange, and by purchasing units, investors become limited partners in the business, which entitles them to periodic cash distributions from the partnership. However, investors are also subject to certain tax considerations, which can be quite different than those levied on ordinary stockholders. Since in the MLP structure, the company does not pay any corporate level taxes, most of the tax burden falls on the individual unit holders. One way for investors to think about this is to imagine that they are running their own businesses. The tax burden is proportional to do the individual investor’s share in the MLP’s profits. Typically during the first quarter of the year, the investor receives a K-1 form that specifies what his or her tax obligation will be.

Penn Virginia Natural Resource Partners (PVR) is a publicly traded natural resource partnership, with healthy growth in distributable cash flow and an attractive property assortment.  Although, master Limited Partnerships, just by their very nature, must offer a high payout, there are additional reasons for liking Penn Virginia Resource Partners.  First, the company has fairly diverse coal reserves located in the Central Appalachian Basin (Eastern Kentucky and Virginia), Northern Appalachian Basin (West Virginia), the Illinois Basin, and the San Juan Basin (New Mexico). Together these properties reportedly have over 800 million tons of proven coal reserves.  At current production rates (around 35 million tons of coal a year), we figure the company has at least 20 years of reserves. Moreover, the partnership occasionally purchases additional properties, which can be quite profitable given the attractive rates of return and relatively low cost of capital.

PVR does not actually engage in any coal mining operations, but rather leases the properties to third-part operators, who then pay the company a royalty. The attractive thing about this business model is that PVR gets to sidestep the heavy capital investments and cumbersome regulations required of the industry. And since around 50% of electricity produced in the United States is still generated from coal-fired electric plants, we do not think this commodity will be losing its luster anytime soon.

Even more enticing, is the company’s other business, which is the natural gas midstream segment. The business makes money mostly from gas processing contracts with natural gas producers. This unit also markets third-party natural gas and sells it into various pipeline systems within several states. Though the coal royalty business is a relatively safe and stable performer, the midstream unit provides good diversification benefits and acts as somewhat of a natural hedge against it.

So with solid returns, generous cash-flow distributions, and a well-balanced business model, we think Penn Virginia Resource Partners is a company worth looking further into. Moreover, by purchasing units of a natural resource Master Limited Partnership, investors gain a direct exposure to an expanding sector of the U.S. economy, while taking advantage of the characteristics unique to the MLP structure. Also, of note is the fact that this investment certainly beats many other low-yielding assets by a wide margin and provides a nice passive cash-flow stream.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.