Master Limited Partnerships: Pipe Dreams or Shark Jumpers?

|
 |  Includes: EPD, KMP, NS, OKS
by: MLP Trader

2011 is the 20th year that I have invested in Master Limited Partnerships. I started buying Teppco Partners, which is now (NYSE:EPD), and added others throughout the 90s: Northern Border Partners, now (NYSE:OKS), Kaneb Pipeline Partners, now (NYSE:NS), and so on. It has been a fabulous run, with total returns exceeding 1400%.

I think that great run is coming to an end. No, I’m not liquidating. Many of my holdings have zero cost basis, so the tax consequences are prohibitive. But I’m putting new money elsewhere and am advising others to do the same. I'm also hedging sporadically. Going forward, I expect very long-term returns to be positive, but modest. Along the way, there is likely to be a really bad-ass correction. Here’s why.
The Big Picture
MLPs are primarily income investments, so it makes sense to compare them to income investment benchmarks. Below is the yield for the largest MLP, Enterprise Products (EPD) over the last decade. You'll have to take my word that other large-cap MLPs look pretty similar. Not only is EPD’s yield at its lowest, its spread over Treasuries has hit new lows.

Click to enlarge
I’ll accept the argument that MLPs are not simple fixed income vehicles--they also sport substantial growth. For example, the compounded annual growth rate of EPD’s distribution has been excellent, oscillating between 5-10% for a long time. So, to be fair, let’s add that into the yield and re-calculate the spread.
Click to enlarge
Even this adjustment puts EPD near its highest valuation of all time (the flat distribution growth in 2004 was exceptional). So the bullish investment case for EPD (and other MLPs) relies either on the growth rate increasing dramatically or the supposition that MLPs have been chronically undervalued for a really long time.

The growth rate has indeed been boosted by the Oil/Natural gas price ratio reaching all-time highs and ethane demand blowing off the charts. EPD and many other MLPs make money from fractionation and selling Natural Gas Liquids [NGLs}; the margins for this are generally determined by Oil/Natural Gas ratios. But this is already baked in the current growth rate, so let’s consider the other possibility.
Have MLPs Been Chronically Undervalued?
I generally believe in efficient markets, so when someone claims that a lucrative investment class is undervalued--not for just a few hours or days--but for 20 years--I want a good explanation. There actually is one for most of this period. Until the “Jobs Creation Act” of 2004, institutions were effectively barred from owning MLPs. What’s more, there were a bunch of MLP scams in the 90s, where investors got badly swindled. With well-meaning folks like radio host Bob Brinker denouncing these scams on a regular basis, the well was poisoned for good MLPs, like Kinder Morgan (NYSE:KMP) and Teppco. Only individual investors could buy MLPs and they were scared off by the scams. Add to that the complications associated with owning MLPs in tax-deferred accounts, and you got an illiquid and inefficient market.
But institutions have now been in the MLP sector for over 6 years and numerous vehicles exist to own MLPs in tax-deferred accounts: i-shares, CEFs, ETNs, ETFs, and so on. Yet valuations are still at their peaks even within that time frame. The chronic undervaluation argument may be valid to 2004, but it’s not so convincing anymore. More likely, current valuations reflect some froth based on easy money fueling big leverage.
What I Heard in the Bar at the Old Greenwich Hyatt......
Having attended MLP conferences for years, I’ve been struck at the accelerating accretion of hedge funds in the space. The reps I’ve talked to admit they’re employing substantial leverage. Brokers like Interactive Brokers only charge around 1.25% on big margin balances, so the math is compelling: you borrow at 1.25% and collect 6% on an MLP. Works great until it doesn’t. As we'll see, when it doesn't, it really doesn't.
The MLP space is exceptional in its desperately thin volume. Many of the unit-holders are still ultra-long term investors like myself and the tax paperwork alone is a big deterrent to trading these companies. EPD is a $37 Billion company, but trades a paltry 1 million shares/day. By comparison, Marathon Oil, a C-corp with a $32 Billion market cap, trades around 7 million shares.
The upshot is that a fund with a tiny 0.1% stake in an MLP may need several days’ volume to liquidate. Combine the limited liquidity with the presence of numerous leveraged hedge funds in the space, along with leveraged Closed End Funds, leveraged individual investors-- and now--a leveraged ETF, and you have an incredibly volatile mix.
Don’t believe me? Let’s look at a halcyon day in January (the 20th) when the broad market barely moved. Here was a typical MLP on that day:

Click to enlarge

Nearly every MLP in the sector had an identical chart, many dropping over 5%, with nearly a day’s volume selling in an hour. Some didn't recover as well as CPNO. Was this just part of an oil or energy sector move? Stonemor Partners (NYSE:STON) answers that. STON's production may result in petroleum after a few million years. In the meantime, this MLP manages cemeteries and funeral homes, not fossil fuels. STON was down over 7% from the previous close with a decline over 10% in two days.

Click to enlarge

This bears the marks of a single leveraged holder executing a hamfisted liquidation. Similar MLP "flash crashes" have occurred a few times over the last few years. In several cases, big block orders (5-20% of the daily volume) actually hit the MLPs in alphabetical order! Other times, they occurred at precise 30 or 45 minute intervals (this lucrative opportunity hasn’t recurred for a while, otherwise I wouldn’t be telling you about it).
Now January 20 was a pretty calm market day, with no news affecting MLPs. I think it is only a harbinger of what could happen at the first whiff of margin rate increases or real negative news for the MLP sector (e.g. sloppily written “carried interest” taxation that inflicts collateral damage on MLPs). I’m guessing January 20 involved a single seller. If this sort of selling cascades to multiple leveraged sellers, it could get extremely nasty. Maybe enough to scare long-term investors out of the space. We saw this with the Lehman meltdown and there was a lot less leverage in the space at the time. If you really insist on buying MLPs right now, that's the sort of opportunity you should wait for.
What Happens When Inflation and Nominal Rates Rise?
So far, I've focused on the spread of MLP yields to Treasuries, without addressing the fact that Treasury yields are still pretty close to historic lows. There is a distinct possibility they will soar in the next few years. It's hard to imagine the spread to MLP yields narrowing even further, so MLP yields will need to go up as well.

Many MLPs do have some protection against an inflationary, high-rate environment. In particular MLPs operating FERC-regulated interstate pipelines are allowed to make PPI-adjusted rate increases. Also, MLPs that conduct fractionation and have "keep-whole" or "percentage of proceeds" contracts will enjoy increased revenue. But the past experience has been that the increased revenue can't boost distributions fast enough to keep pace with soaring bond yields. MLPs do better than other income investments in increasing-rate environments, but they still lag.

Have MLPs “Jumped the Shark?”
Given all this, it's worth asking if MLPs haven't “jumped the shark” with a 36% price gain in just the last 9 months, on top of a 50% gain in the previous year.

I use a tongue-in-cheek checklist to guess when an investment trend has jumped the shark. While it's not really serious, it did help me correctly time the sale of my dotcom company stock in 2000 and my house in 2006. Let’s try it on MLPs:
  • The phrases “new paradigm” or “new normal” is applied to it -- check
  • Valuation metrics used for the last decade (or century) are now deemed inapplicable -- check
  • Favorable article in Barron's -- check
  • Favorable articles in Kiplinger's, Money, and Smart Money Magazines -- check
  • Regular raves by a certain button-pressing CNBC host -- check
  • It gets pitched to me by a waiter, barber, shoeshine boy, etc. -- pending......
  • Cover story on Time or Newsweek -- pending.....
Once the last two items are checked, I’m out. Tax consequences be damned.

What to do
Seriously, I don't think the shark has been jumped yet. But I think the next ten years will yield much smaller gains than the last ten, and the sector has the potential for a really nasty downturn in the meantime.

I've been opportunistically hedging a small part of my MLP holdings. Unfortunately, it's not easy. Except for KMP, most MLPs have miniscule options volume. Writing calls on MLPs risks serious tax nuisances if the units get called away, so I don't recommend it. The inverse MLP ETF (NYSEARCA:MLPS) often trades fewer than 1000 shares a day. The best hedging method I can recommend is Single Stock Futures [SSFs]. These are available on KMP, EPD, and a few others. You will pay a pretty big premium, but you don't have premature call risk as you do with the options.

Disclosure: I am long EPD, OKS, LINE, ENP, KMR, EEQ, EVEP, NS.

Additional disclosure: I am short KMP Single Stock Futures