Looking Under the MLP Hood

Maybe it’s because we’re so close to Halloween, but we can’t help but be drawn to the carnage in the MLP space. Recently, investors’ multi-year treat has turned into a trick as of late. How spooky has it become?  Well, after nearly quadrupling investors’ money from April of 2009 through April of 2014, the Alerian MLP index has been cut in half (-45% if including the dividends), leaving a salty and sweet Halloween predicament left in investors mouths of what to do with these uber-popular investments. Should you run for the hills now that you’ve realized they can lose half their value over a very short period, or stay the course seeing as how they’ve still more than doubled your money and continue to crank out healthy dividends?

(Disclaimer: Past performance is not necessarily indicative of future results)
Chart courtesy: Alerian

Just what is an MLP?

To back up a bit, MLP stands for Master Limited Partnerships, and they are generally used in the energy industry as a way to raise capital for drilling and pipeline projects and the like. You can think of it as a mutual fund which invests in private oil and gas deals instead of public stocks.

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But their defining characteristic isn’t necessarily the energy sector exposure, it’s their big fat yields, which Forbes explains:

Created by tax code changes in the late 1980s, MLPs first drew significant investor attention in mid 1990s as tax-advantaged vehicles for holding real assets. Significantly, unlike C-corporations, there is no stockpiling of earnings as MLPs typically distribute 90% of income to partners. MLPs are also like LLCs in that they are pass-throughs: partners [aka Unit Holders or investors] are taxed on their share of the MLPs income [which can be deferred in certain instances], but there is no tax at the corporate level.

….in addition they promise a minimum quarterly distribution (MQD) amount.

Add all that up and you get one of the highest yielding investment areas in the zero-bound interest rate environment we’ve been in since 2009. Here’s Alerian’s nifty graph showing just how much bigger the yield on their MLP index ($AMZ) is than other popular investments.

(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: Alerian

That high yield made MLPs a go-to recommendation for advisors around the country. The quick sell was along the lines of the following “equity research” by Wachovia (hey, they’re not around anymore to get upset about it..)

“MLPs provide an attractive value proposition, in our view, with high cuirrent and tax-deferred income, and visible distribution growth. Given median yields of 6%-8% and a long-term sustaninable distribution growth rate of 4-6%, MLPs should be able to deliver low double digit total returns, annually, in our view, all else being equal. Investors also benefit from lower risk, as measured by beta, and a partially tax-deferred distribution. The MLP value proposition is underpinned by the sector’s growing role in providing the backbone of U.S. energy infrastructure to deliver natural gas, crude oil, and refined products to a growing domestic market.”

Basically – buy these MLP things, you’ll yield 6% to 8% a year and get all the upside from the energy sector. And what wasn’t to like, they were doing it on both ends – paying the yield and appreciating in price.  And it wasn’t like there was any danger of energy prices crashing…. No wonder these things were growing like gangbusters – pushing up to a market cap of around $600 Billion in the middle of 2014.

(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: Alerian

Great, until they’re not?

This was all fine and dandy until the big sell off in oil prices and resulting mini-collapse of the energy sector’s profits. Here’s the side of MLPs that wasn’t in the brochure, showing just how painful it’s been for different types of energy sector MLPs over the past year.

(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: Financial Advisor IQ

Just as we’ve seen in nearly every other asset class, this one didn’t act very different when the energy sector’s back was against the wall, selling off right alongside energy stocks  and oil prices ($XLE –30%, $USO –59%, $AMZ –32% past 18months). While we saw worldwide correlations go to one in the global financial crisis, we’re now seeing energy sector correlations go to one in an energy price crisis. Just look at the ‘diversified’ category above – oops.  As our friend Dana Lyons pointed out via Twitter – no amount of dividend is going to make you comfortable with some of those big losing numbers.

In the running for worst (unleveraged, non-vol) ETF of the year: Global X MLP $MLPA: off -38% in 2015 pic.twitter.com/U8ZYB7xmUq

— Dana Lyons (@JLyonsFundMgmt) September 29, 2015

Said another way, four years of pretty 7% dividends and steady growth in price can be wiped out in a few short months – making this more than just about the yield. You have to worry about how they are going to pay that yield.

Buy the Dip?

Credit Suisse seemed to have called a short term bottom in August when they upgraded the whole MLP sector, something Mr. (right about half the time) Jim Cramer jumped on. Per CNBC:

“Just last week, Credit Suisse upgraded the entire group and pointed out that the average MLP sports a 7.8 percent yield.

Additionally, Credit Suisse noted that when MLPs rebound, they do so dramatically. Since the financial crisis, Cramer stated that the MLP stocks have typically provided a 40 percent return in the first eight months after they bottom. However, first the stocks need to stop going lower.

But others are looking to hedge their bets some, cautioning against the highest yielding MLPs – which might be the very ones attracting investors to the space. Andy Kapyrin, a partner at RegentAtlantic in Morristown, N.J says that just like most investment sectors out there, there are outliers and the enticing yields are often the ones that could experience the biggest drawdown.

Kapyrin thinks the subsectors holding up best this year will prove to be the “steady Eddies” of MLPs going forward. But he’s worried that with oil prices still in flux, partnerships offering the juiciest yields are likelier to surprise shareholders by significantly lowering their distributions when prices do regain their footing.

“We’re warning our clients to be cautious about any MLP yielding more than 8%,” Kapyrin says. It’s always risky “reaching for yield” with these partnerships, he adds, but the risks are “especially pronounced now that volatility is running so high.”

What’s interesting is Cramer suggests staying away from MLPs with commodity price exposure, which seems like saying stay away from Dentists who mess with your mouth, but he clears it up some:

In Cramer’s playbook of rules in the current environment, he emphasized to own the MLPs with the least commodity price exposure, such as the pipeline plays. Pipelines tend to operate like a utility, changing a fee based on the volume of oil or gas that it transports. Thus, it has less of a direct connection to the actual price of oil.”

We’ll echo those sentiments some and say MLPs probably aren’t the best way to play a bounce in Oil prices (here’s 6 ways to do that), as gains in energy prices aren’t the same as gains in energy company prices.

At the end of the day – Josh Brown has a theory which goes something like ‘the market will try and cause pain to the maximum amount of people it can’ – and you don’t have to look a lot further than the hundreds of billions in MLPs to find a good candidate for max pain infliction.  Whether that pain continues or the MLP good times will continue is yet to be seen. But consider that MLPs popularity may have been one of the factors that led to the huge supplies in Crude Oil, which eventually drove prices down. The more MLPs and more assets in MLPs, the more drilling, exploration, distribution, and refining that can be done, meaning more supply and lower prices. Maybe an MLP shakeout is what’s needed to drive prices back up, in a crazy chicken or the egg investment scenario, where the key to making money is first losing a lot of it…

What’s really needed is a trend following overlay in the energy markets to complement an MLP, going short Crude Oil at each break lower in case it’s a massive trend lower like we saw in 2014. Just so happens we know some people who do just that… give us a ring for details (312-870-1500).  For now – we’ll keep watching the pleasantly scary show that is MLPs with increased interest.