Nervous About MLPs

Last week (ending March 13), stock markets had an enormous rally. The Alerian MLP Index shot up from 168 at the beginning to close the week at 185. In addition, all high yield securities participated. The Dow Jones REIT Index jumped 20% while junk funds were up but with lesser gains.

MLPs have outpaced the Dow this year. The MLP index is up YTD, even if the year is handicapped by starting it after January 2 when MLPs had an unusually large advance. At the same time, Dow is down sharply. Going forward, MLPs will probably be affected by the strength (or lack of strength) in the stock markets, especially high yield sectors. My take is that, on balance, government massive spending will not be positive.

In April, MLPs will report earnings, set distributions and give guidance. I have a nervous feeling about what MLPs will have to say. They all have massive capital projects which are key to favorable taxes on distributions. So far their businesses (flows through the pipelines) have been strong. But even their businesses may feel a pinch from the weak economy. It's always difficult to properly assess results because they do not calculate or report distributable cash flows, however they report earnings. Distributable cash flow (per unit) is used to set the distribution rate.

Investors with long term time horizons will be attracted to MLPs because of the unusually high yields. The Alerian MLP Index yields 11.3%, a massive 840 basis point spread over the 10 year Treasury bond yield. Such a spread is unprecedented (other than when the index recently dipped below 185). In the past, the rule of thumb was that a 200 basis point yield spread was to be expected. A 3-400 point spread was thought of as a signal for buying. Not any more. All high yield securities have enormous spreads, rewards needed in this credit crisis.

MLPs will probably follow the lead of the markets, especially high yield stocks. These securities are watching government efforts to fix financial institutions. When Citigroup (C) is selling for less than $2 a share (a price which could not be imagined a few months ago) and with the tremendous mess surrounding AIG, it is difficult to have encouraging thoughts about emerging from the credit crisis quickly.

Comments

[Edit or perish:]

Nothing of substance, just emotional ramblings apparently based on the author's "feelings" or possibly a gift of clairvoyance.

He probably picks horses at the track based on his nervous feelings and other inside information available only to him & his hair piece.


"MY TAKE is that, on balance..."

"I have a NERVOUS FEELING about what MLPs will have to say."

"MLPs WILL PROBABLY follow ..."

"Going forward, MLPs WILL PROBABLY be affected ..."

Mar 17 07:27 AM

[saluki65:]

Most invesotrsare nervous but there isno explanation as to why. Disappointing you would publish this. I would have been better off bottom line if I had put more into MLP's the last few years.

Mar 17 08:54 AM

[John Polomny:]

The commodity markets are bottoming due to the massive money pump going on worldwide. In addition the North American rig count is down over 50% in the last year so nat gas is heading higher not lower. Although the price of oil and gas do not necessarily influence the pipeline MLP's, for them its more about volumes, the positive sentiment should lift prices.

Mar 17 09:50 AM

[MattZN:]

With all due respect, the author clearly does not know anything about MLPs. MLPs have never followed the general market. The predominant energy MLPs are exposed to Oil prices in varying degrees, which correlate with Natural Gas (NG) and Natural Gas Liquid (NGL) prices. MLPs have varying levels of exposure to commodities prices depending on their business. Pipeline operators tend to have much lower commodities and economic exposure then drillers, for example. Natural Gas, in particular, is a resource which cannot build supply anywhere near as quickly as it destroys it, because NG wells tend to spike and drop-off significantly within a year (unlike Oil wells).

MLP pricing comes down to how solid their distribution is and the types of distribution growth expected from the completion of CapEx projects (in normal times). The distribution is mandated by the MLP structure... it isn't like a normal company where the board of directors can just cut it off willy nilly. The distribution is based on DCF (Distributable Cash Flow) and can be modeled fairly well even in these tough economic times, which means the fear driving the general market has much less of an effect on the MLP space.

When fear (or more likely forced selling) in the general market DOES effect the MLP space it tends to be viewed as an enormous opportunity for those of us who like the space.

-Matt

Mar 17 12:41 PM

[material guy:]

MLPs are required to pay out a large proportion of their earnings to owners in order to qualify for their favorable tax treatment. Since they can't retain earnings, most MLPs use leverage to grow. Therefore, lack of liquid bond and credit markets crimps their business, in some cases forcing managements to scramble to finance their equity share of projects already under way. The leverage and increased uncertainty over future payouts are the main risks here.

Mar 17 12:41 PM

[Skip Olinger:]

I will reiterate what has been said above, this is not a well thought out piece and lacks facts and statistics to back it up. In short, this was a waist of time to read. By the way, if you actually read the quarterly press releases, many of the MLP's show the reconciliation from net income to EBITDA and then to distributable cash flow. Try a little research sometime.

Follow up to MATT:
Thanks for the insight on NG wells depleting faster than oil wells. I need to research that further.
There are 3 general types of MLP's: E&P and gathering companies tied to the price of commodities (hedging really matters here), pipeline companies that make a toll on throughput and propane distributors (tied to seasonal demand and to some extent their ability to hedge prices). Toll companies should be the safest and least volatile to energy prices. As I understand it, it is harder to shut off a gas well when prices are low than it is an oil well. Therefore, in most markets, a long haul pipeline will still get throughput and thus revenues. In theory this should make their distribution stream more stable. Look, if I could get my portfolio to grow at 10% a year, I'd be a happy man. So looking at Energy Transfer and Enterprise Products, I get temped here.

Best,
Skip

Mar 17 02:12 PM

[yellowhoard:]

As long as the dems control everything, I would be very uncomfortable hiding in the "safety" of an MLP. They are looking to tax everything. Especially income from "evil" energy providers.

Mar 17 03:03 PM

[lotsobuck:]

Did your dog eat your homework?

Mar 17 05:01 PM

[MattZN:]

MLPs do not use leverage to grow. Perhaps you are thinking of trusts or closed-end-funds or similar businesses which purchase MLP assets and use leverage to purchase more. The MLPs themselves are not typically leveraged. MLPs (as with all energy companies) DO use hedges against their work product to smooth pricing bumps. The crash in oil prices was a HUGE bump that tested the mettle of many MLPs hedging strategies. Most survived just fine though the ones exposed to Oil prices the most saw a huge drop in their unit pricing on the open market - back down to pre-oil-boom levels so not all that fun for someone who bought in at the top, but actually not the end of the world for long-time investors who had been reaping the distribution for the last decade.

MLPs can be thought of as having two major components: There is the infrastructure they already own which is bringing in current income, and there is the infrastructure they are currently building which will bring in new income in the future.

When a MLP wishes to build new infrastructure, called CapEx spending, it finances the infrastructure in numerous ways. A MLP may do a unit offering, a cost-sharing deal with other interested parties, offer debt, use a bank line of credit, etc. Large projects such as pipelines can cost hundreds of millions to billions of dollars to construct. These are NOT tiny projects.

A MLP building, say, a new pipeline typically lines up interested parties on both ends of the pipeline in a process which can take a year or longer. Once lined up the project enters the next stage where the interested parties provide contract guarantees (for example, production or consumption volume guarantees) for a period of time (e.g. 5 years). These guarantee a certain amount of volume flow in the pipeline and thus guarantee a large chunk of the revenue used to repay the cost of the project. The MLP uses these guarantees to garner interest from its unit holders, new investors, potential buyers of debt, etc, all to finance the project. The entire project is not necessarily financed all at once.

The market price of a MLP depends on a combination of expected revenue from ongoing operations and future revenue from CapEx projects when they are completed. In the current market certain events can also create issues, such as a MLP not being able to meet debt covenants to maintain its bank line of credit or other debt used to finance new projects. Because many of these are multi-year projects it's not good to have to stop the build half way through. Between October and February MLP prices were seriously depressed with rampant speculation that they would have trouble with debt covenants and financing ongoing projects. The speculation turned out to be largely incorrect as most MLPs really had no trouble. Some have, though. There was a spectacular flame-out of a small MLP. The bigger ones, such as KMP, had no trouble at all.

In anycase, that's it in a nutshell. I do own a bunch of these things. I own the actual MLPs, not the trusts or closed-end-style funds. My recommendation to anyone looking into this space for the first time, to avoid shooting yourself in the foot from being blinded by the confusingly large yields is to go with pipeline companies with large market caps (typically in the 8-12% yield range at current-day prices).

-Matt

Mar 17 09:39 PM

[January Thaw:]

And if you want to think ahead, take a look at what each one is doing!
i.e. MMP taking advantage of the biofuel sentament with a proposed pipeline just for ethanol...Each MLP is very different from another.
You have to get to know these guys, and you'll love 'em

Mar 17 10:55 PM

[mark joseph:]

I wonder if this article is a response to response comments (mine included) to Mr. Morris's article "the new dividend aristocrats"
( seekingalpha.com/artic... ). In those comments the point was made that MLP's were a far better investment for dividend or yield than standard high yielding equities.

Mr. Morris is "nervous"? Welcome to the rodeo.

We are all nervous. Cockiness is a vice these days and all investments are mortal, including cash.

This all been said, all Mr. Morris saying, "buy MLP's!" without meaning to. He seems to be saying MLP's are too good to be true. Insanely high yields, tax deferred, energy distribution and capital appreciation all combined to make anyone ask "why doesn't everyone buy these?

A few points.

- First of all, slowly but surely, everyone is buying them hence the upward mobility of the BSR chart (MLP ETN). MLP's are an tiny sliver of the total market and are invisible to the naked eye of most investors. The stock market, most of it's 200 years, has pursued dividends first with Cap appreciation as a kicker or icing. For 20-25 years that changed. We are going back to that focus on yield and investors are seeking out the best tools. I have been shocked at how many "experts" I have talked or corresponded with (including Bill Fleckenstein and Warren Brussee) that do not even know what an MLP is.

-Ownership in MLP's has very little institutional presence (under 10%) but it is growing at 1% a year. That 1% is an historical number and was established before the S&P caved. It is likely much higher now with miles to run. The case can easily be made that institutional investment will be going up substantially as institutional money managers, who enjoy their employment, will abandon the pure capital appreciation game, and seek the best yield opportunities like MLP's.

- Yields indicate strength with MLP's!! We have all been programmed so well that high yield equals high risk. In a standard equity market a high yield often means management is drinking salt water to quench their thirst. To the contrary, with an MLP the dividend can ONLY go up if earnings rise, simple as that. They are required to put 90% of earnings back to the partners.

- All MLP's are not the same. Simple rules are #1: debt must be five times earnings or LESS. I like to find 3 times or better. #2 : Stick to pipelines be they move gasoline, crude, Nat Gas, Diesel. Stay away from trusts, storage MLP's etc. CPNO, TPP, KMP, JPS are all solid MLP's. There are plenty more.

-Taxes on MLP's are better than good. All taxes are tax deferred on yields, essentially meaning that they are tax free if you never sell. If you do sell you will be taxed at cap gains rates as distributions are looked at as a return of capital, not a standard dividend. If you are worried about the sunset provision on taxes not being renewed by dems (fair concern) MLP's are far better than standard equity dividends as they will go up from only 15% to 20% vs. up to 42% (or higher if they raise taxes above pre tax bill rates) on typical dividends as they will be taxed at standard income rates.

- Again, stick to pipelines only (move diesel, gas, crude, gas... see symbols above) as trusts and storage MLP's are risky , if not shady. Storage is subject to energy commodity prices. Pipelines have thousands of different multiyear contracts and get paid mailbox money for users to have access to pipes.

-Inflation protection? Not totally, but MLP's will re-price their contracts as they expire each year and new contracts to reflect inflated cost's etc. Allowing a buffer to avoid inflation wipe out of yields.

As we have learned the hard way, no investment is a panacea but MLP's are as close as we can be an ideal investment and still make money. I would rather be down the road and prefer to direct traffic during Lemming's MLP rush hour than be part of it.

I do own many of these and have for a a year and a half. I sold all standard equities Oct. 5 and channeled even more dollars into these as I felt they would likely be contrarian to the market downward chart. So far, so good.

For what it is worth,

Mark Joseph

Mar 18 04:24 PM

[dave mckay:]

Mark Joseph, I'm confused. None of those MLP's you listed have debt 5 times earnings or less. The only one I could find that meets that criteria is MMP. JPS is a closed end mutual fund, so I think you have a typo on that one.

Mar 24 03:54 PM

[mark joseph:]

Dave, I am sorry for my lack of clarification. the ratio of 5 to 1 is long term, debt of the previous year to ebit of the following year. In other words long term debt of 2007 would apply to ebit of 2008. This is the result of the MLP's load up their debt for earning gains a year later.

In a good MLP you will see a long historical rhythm to the growth pattern based on this ratio. If they are all over the place from year to year I would be concerned regardless of ratio.

As these are investments you do want to stay in for some time, due to taxes, one has to feel comfortable with the managements history.

And yes, JPS was a typo. I own it but not sure I would suggest it.

Thanks,

Mark


On Mar 24 03:54 PM dave mckay wrote:

> Mark Joseph, I'm confused. None of those MLP's you listed have debt
> 5 times earnings or less. The only one I could find that meets that
> criteria is MMP. JPS is a closed end mutual fund, so I think you
> have a typo on that one.

Mar 25 02:24 AM

[mark joseph:]

ave, I am sorry for my lack of clarification. the ratio of 5 to 1 is long term, debt of the previous year to ebit of the following year. In other words long term debt of 2007 would apply to ebit of 2008. This is the result of the MLP's load up their debt for earning gains a year later.

In a good MLP you will see a long historical rhythm to the growth pattern based on this ratio. If they are all over the place from year to year I would be concerned regardless of ratio.

As these are investments you do want to stay in for some time, due to taxes, one has to feel comfortable with the managements history.

And yes, JPS was a typo. I own it but not sure I would suggest it.

Thanks,

Mark

Mar 25 02:26 AM

[dave mckay:]

Thanks Mark,

What do you think of MMP? How about NS? These two seem to have the best looking charts out of the pipeline MLP's. BTW, I am very familiar with JPS. I don't own it, I own PDT instead and like it much more than JPS, mostly due to the fact that it has a lot less financial related preferreds in it.

Mar 25 04:25 PM

[Mary@NAPTP:]

Matt's comments get it right--and I would just like to add that Material Guy is also wrong when he says that MLPs have to pay out a large portion of their earnings to keep their favorable (i.e., partnership) tax treatment. MLPs' tax treatment depends on the kind of income they earn, not on how much of it they pay out (see section 7704 of the tax code if you want the full details). They pay out most of their cash flow because that's what gets people to invest in them and what they're set up to do, but they could stop paying distributions altogether (and some have in times of financial distress) and their tax treatment would remain the same.

Mar 27 10:26 PM

[mark joseph:]

Dave,

I own about 17-20 of these and mmp is included. I have to admit, though, that I use an MLP advisor on these as they certainly are not all the same.

I am curious if anyone has a take as to how a high inflation might effect these? I have heard two different takes. I will assume that high inflation, today, will be accompanied by high energy prices.

Any thoughts from the crowd?

Apr 06 04:58 AM