WASHINGTON, March 18, 2018: For quite some time, we’ve been investing in Master Limited Partnerships. Usually known by the abbreviation MLP, these investments, in the main, are the oil and gas version of Real Estate Investment Trusts (REITs).
This past week, however, MLPs got hit, and hit hard, by a selling tsunami. This was set off by an unfavorable ruling by the Federal Energy Regulatory Commission (FERC). We’ll get to that in a minute. But first, we need to understand what an MLP is and how it works for investors.
What’s an MLP?
To oversimplify, both MLPs and REITs are legally structured so that investors in their shares – known as “units” – receive at least 90 percent of net earnings. Called “distributions,” these are essentially dividends under another name.
In return for their apparent generosity, MLPs and REITs get favorable tax treatment for handing out all that cash to its investors each year. To make a long story short, when things work out for these entities (which they sometimes do not), happiness reigns in the boardroom and in the hearts of their income seeking investors.
Again, we’re oversimplifying. But the bottom line is that for much of the time, MLPs and REITs are great investments for those in search of reliable income and not too worried about capital gains.
Most MLPs today are holding companies that own and invest in oil and gas pipelines. This insulates them somewhat from the often-violent fluctuations in the pricing of the fossil fuels their pipelines transport. An MLP’s earnings are more stable, however, as the oil and gas companies that contract with them to move their products essentially pay rent for this service.
These “rental” agreements, like real estate rentals, are contracted for x period of time, so they remain stable throughout that period. Thus, MLP income from each contract is not directly pegged to the going price for the fuels they transport.
Downsides to an MLP investment
There are a few downsides to investing in MLPs.
- If oil and/or gas prices take a hit or become unstable, less product may flow through each MLP pipeline, potentially leading toward less profitable new contracts.
- Instead of 1099s, investors get K-1 forms annually for each MLP that they own. Should you own several of these MLPs are in your portfolio, this blizzard of K-1s can lead to significantly increased paperwork when it comes to filing that annual 1040.
- If you, as an investor, earn over a certain total of distributions from MLP investments you own, and if you hold these MLPs in an IRA account (often a good idea, BTW), you could still get taxed on some of those distributions.
- Should U.S. business hit a prolonged downtown, a given MLP may have to cut or even eliminate that big distribution for a given period of time.
- The pricing of MLP units (shares) can be surprisingly volatile, depending on the oil and gas business as well as unexpected events.
This last bullet item is what happened to MLPs last week, causing this entire investment class to take a big hit.
Why did MLP investments take a big hit on March 15?
Without much warning, the FERC disallowed a longtime corporate MLP tax break the industry thought to be sacrosanct.
In short, FERC disallowed a special tax allowance that many MLPs have routinely used for years. A recent article in Seeking Alpha explains.
“[O]n March 15th… the entire MLP sector took it on the chin in response to a notable policy revision from the Federal Energy Regulatory Commission. More specifically, the FERC published a press release stating that it will no longer allow MLPs that operate interstate pipelines to recover an income tax allowance in the calculation of their cost of service rate agreements.”
Given the over-all panicky mood of stocks since that nasty February correction, investors promptly unloaded MLP shares en masse. Many of these “forced sales” were not a very good move. The reason why? A number of MLPs don’t use the somewhat arcane tax allowance cited by Seeking Alpha.
Did all MLPPs get hurt by the FERC decision?
Seeking Alpha notes that one MLP that doesn’t use the service rate tax break is Energy Transfer Partners (symbol: ETP). It’s a longtime favorite of ours. The per share (unit) price of ETP hit a 52-week peak of $24.71 roughly a year ago. But the per share price has been sinking ever since. That’s largely due to this MLPs complex structure. Speculation that oil prices are bound to sink very soon doesn’t help either.
However, ETP got smacked around last week like all the other MLPs. ETP shares promptly cratered to a 52-week low of $15.06 mid-week. Shares have since recovered somewhat, closing at $16.97 on Friday.
Paying a quarterly dividend (distribution) of $0.565 per share, the current yield for ETP is a whopping 13.32 percent. As outrageously high as this is, it looks sustainable. That’s because the recent panic hit to ETP shares was, as we’ve just explained, entirely unwarranted.
ETP tells it like it is
The Seeking Alpha piece offers ETP’s explanation of the issue. (Note that italics and bold text are via Seeking Alpha.)
“Energy Transfer Partners, L.P. is aware of revisions the Federal Energy Regulatory Commission (“FERC”) is proposing to its 2005 Policy Statement for Recovery of Income Tax Costs, which if adopted after a public comment period, would no longer allow interstate pipelines owned by master limited partnerships to recover an income tax allowance in the cost of service. These revisions are not expected to have a material impact to ETP’s earnings and cash flow. Many of ETP’s rates are set pursuant to negotiated rate arrangements or rate settlements that it believes would not be subject to adjustment, or would be limited in terms of adjustment. In addition, many of its current transportation services are provided at discounted rates that are below maximum tariff rates, many of which it believes would not be impacted by a change in the maximum tariff rate.”
Source: Energy Transfer Partners.
What to do in today’s volatile market environment
If ETP’s share price remains subdued or lower on Monday, we plan to open a position in this issue. In light of the recent market conditions, and given current headline risks, a 13.32 percent yield looks great for now. That’s reason enough to establish a new position.
In addition, we may re-enter the MLP related ETF position we just dumped midweek, given the uncertainty in this sector. That’s AMLP, an ETF that owns an aggregate of major MLP shares. It pays a smaller dividend than you can get from higher-paying MLP investments. That’s due in part to management fees we think are a bit high.
On the other hand, since it’s diversified, it tends to be more stable than individual MLPs. And, there’s an added plus. AMLP files all those K-1s as part of its management fee so you don’t have to.
Elsewhere in our portfolios, we are slowly raising cash by selling a few clear losers while also garnering some gains. We suspect the fog won’t clear from U.S. markets for the foreseeable future, so caution is still the watchword here. We were, quite frankly, blindsided by the violence of the February correction. So readjusting our portfolios and raising cash seems to be the prudent thing to do for now.