There are two ways to own limited partner stakes in Kinder Morgan Partners (NYSE:KMP):
- KMP units: these are conventional MLP units which generate quarterly cash distributions. KMP unit holders receive K-1 forms each year. KMP units may be subject to Unrelated Business Income Tax (UBIT) if held in tax-deferred accounts.
- Kinder Morgan Management (NYSE:KMR) shares: KMR shares are known as I-shares. They are pari passu with KMP units, with the only real difference being that distributions are paid in additional shares rather than cash. KMR shares can be more tax efficient and are well suited for tax-deferred accounts. KMR shareholders do not receive K-1 forms.
In theory, KMP units should trade on par with KMR shares. Even if you prefer a cash payout, you can hold KMR and simply sell the paid-out units for the cash. However, for reasons that evade most MLP experts and Kinder Morgan insiders, KMP trades at a consistently large premium to KMR. Over the last 12 months that premium has ranged from $5 to $13.
This is all the more puzzling since the only other MLP I-shares available - Enbridge Energy (NYSE:EEQ) - track the corresponding MLP units (Embridge Energy Partners) (NYSE:EEP) very closely. In fact, EEP and EEQ rarely trade more than a percent or two apart and EEQ sometimes trades at a premium to EEP.
Kinder Morgan management has emphasized in several conference calls and presentations that they think the KMR-KMP spread should not exist. In fact, company insiders have largely favored KMR over KMP for their own purchases. At least two major brokerage firms have higher ratings for KMR than for KMP. Why buy KMP when you can buy Kinder Morgan at a 12% discount with KMR shares?
The KMP-KMR spread presents some promising trading opportunities. We know that it "should" eventually converge on 0 and that it has declined over time. Moreover, it exhibits a consistent cyclicality around distribution dates. This is apparent from a chart of the KMP-KMR spread:
In general, the KMP-KMR spread has declined over the last two years in both percentage and absolute terms (the anomalous dip around January 2011 was caused by speculation that Kinder Morgan might act to eliminate the spread). The yellow arrows show the declines in the spread from the day before ex-dividend to several days afterward. On average, the spread has dropped over $3 within 10 trading days of the ex-date.
If the chart pattern continues, the trade is to go long KMR and short KMP on - or around - the ex-dividend date. From there, you can either bet on the long-term decline of the spread, or close a short-term trade within a week or two of the ex-dividend date. KMP puts are relatively cheap, so they can be used for this strategy.