Dividend Investing Ideas Center
Have you ever wished for the safety of bonds, but the return potential...
I’ve been a big fan of master limited partnerships (MLPs) for quite a while now. The tax structure is designed as a “pass-through” entity in which sponsoring firms (the general partner) can place certain assets into the MLP and realize big tax savings. Retail investors buying units in the MLP benefit from large tax-deferred cash distributions, often in the 5-7% range.
Given the recent few years of zero-percent interest rates, it’s no wonder why MLPs have been an income seeker’s best friend.
But in all this fury to gain yield, the sector has changed quite a bit from the early days. Often touted as “bond proxies” or not “subject to commodity pricing risk”, many investors have been recently duped into thinking that all MLPs are the same.
The truth is that they are not.
Recent dividend cuts at several big name MLPs, like Linn Energy Liquid error: internal, or slowdowns in dividend growth—such as Kinder Morgan’s (KMI ) recent stutter steps—highlight just how the sector has changed.
Changes to the tax code back in the 1980’s, during the last oil boom, allowed for pipeline firms to be structured as partnerships to stimulate construction of much-needed energy infrastructure. The revamped tax code specified that only businesses whose “income and gains [are] derived from the exploration, development, mining or production, processing, refining, transportation or the marketing of any mineral or natural resources” could qualify.
Now, that is still a broad definition and mandate for what constitutes an MLP, but for many years, the vast bulk of them—less a few coal mines and timber firms—were pipeline firms. This is why many market participants think that all MLPs act as toll-roads and collect cash flows from the volume of material in their pipes.
In recent years, perhaps due to the high tax rate in the U.S. and investor’s clamoring for yield, many companies have expanded on the definition of what can be in an MLP. Many firms have petitioned the IRS to receive private letter rulings. These rulings basically allow firms to maneuver their way into creating MLPs resulting in a surge in the number of MLPs in recent years. There are now over 130 MLPs on the market.
Surprisingly, most aren’t typical toll-road pipeline firms. In recent years, new MLPs launched include coking coal facilities SunCoke Energy Partners LP Liquid error: internal, chemical operations Westlake Chemical Partners LP (WLKP ) and fertilizer plants CVR Partners LP Liquid error: internal. The problem is that many of these firms have cash flows that vary based directly on commodity pricing and demand. Investors drawn into the sector because of the high tax-advantaged yield have the potential to get burned without even knowing it.
The effects of the low energy and other commodity price environment are starting to be felt. We’ve already seen big dividend cuts from popular MLPs. Previously mentioned LINE and its sister stock LinnCo Liquid error: internal slashed their payouts down to zero as the MLP (which produces shale energy) was forced to deal with high debts and low oil prices. Oil rig MLP Seadrill Partners LLC Liquid error: internal now yields a monster 22% as investors estimate that a dividend cut is in the cards. Similarly, energy services MLP Emerge Energy Services LP yields 47% as a cut is almost guaranteed. And it’s not just the “weird” MLPs that could burn investors these days—some of the “bread-n-butter” ones have been hurting as well.
As they’ve grown, many pipeline firms have diversified away from just moving crude oil and natural gas into processing the fuels. Previously mentioned *KMI*’s latest earnings show that commodity pricing for natural gas and profits from processing can crimp returns. Kinder actually decreased its estimates for its dividend growth next year because of the weakness in this unit. Natural gas superstar *ONEOK’*s Liquid error: internal current coverage ratio, or the amount of extra cash used to pay its dividend, is less than its payout. This is all due to weakness in its processing division.
The lesson in all of this is that MLPs are not bond proxies, nor are they just toll-roads. And that is OK but investors need to release this before they pull the trigger on the income-oriented investments. As the sector continues to evolve and change, potentially less-and-less MLPs will focus on the world of simply moving crude oil and natural gas.
Under that framework, investors need to really analyze a potential MLP investment and ask questions. How does it get its money? What percentage of it is commodity-based? Is it in an industry that could see higher regulation later on? The idea is not to get drawn into the high yield.
The alternative is going the index or broad route. There are plenty of MLP-focused ETFs and funds available that own a wide swath of sector. While the yields may not be super high, you’re still able to collect a 7-9% dividend from many of these funds. For example, the Alerian MLP Index ETF (AMLP ) yields 9.1%.
Ultimately, MLPs are still great investments in the long term, but finding the good ones is about to get a whole lot murkier.
Image courtesy of Stuart Miles at FreeDigitalPhotos.net