In a previous article (Outrageous Opportunities in Upstream MLPs), I discussed high-yield opportunities in upstream MLPs, comparing them to Canadian Royalty Trusts (Canroys). Even after recovering from recent lows, both sectors feature tantalizingly high distributions:
Master Limited Partnership
- Breitburn Energy Partners (BBEP) - 8.7%
- Constellation Energy Partners (CEP) - 13%
- Enervest Energy Partners (NASDAQ:EVEP) - 8.6%
- Linn Energy (LINE) - 11.2%
Canadian Royalty Trusts
- Enerplus Resources Fund (NYSE:ERF) - 11.3%
- Harvest Energy Trust (HTE) - 16%
- Pennwest Energy Trust (NYSE:PWE) - 13.5%
- Pengrowth (NYSE:PGH) - 14.9%
If you believe at all in the Efficient Markets Hypothesis, you’ll want to know what risks induce the market to place such high yield premiums on these stocks. Here’s a look at a few of the key risks.
MLPs and Canroys both have serious, but different tax risks. The market has undoubtedly discounted the Canadian 2011 trust tax changes and many Canroys have accumulated tax pools, which will delay the bite of the increased taxes for several years. But ultimately, the benefits of the current trust structure will be lost. Moreover, the risk of increased provincial levees and royalties still looms. Canadian national and provincial governments have shown a propensity to extract every cent they can from resource companies. Raising taxes on companies with substantial foreign ownership is a pretty easy political move.
Although MLPs pay mostly tax-deferred distributions, that satus could be lost. The IRS or FERC could change an individual company’s status or Congress could inadvertently destroy all MLPs while attempting to make private equity partners "pay their fair share." Pipeline MLP holders may recall how a 1995 FERC ruling temporarily reduced MLP prices by nearly 20% in a single day. Another risk stems from the unpredictability of MLP income passthroughs. For example, Teppco (TPP) passed through very little taxable income in 2006, but socked many unitholders with taxable ordinary income that exceeded the distributions paid in 2007.
Most Canroys hedge about half their production one or two years out; upstream MLPs tend to hedge 70% to 100% of their production as much as five years out. General inflation or a gold-rush environment in the oilfield is bad news for these companies, because it means higher labor, lease, and equipment costs that may not be completely offset by higher revenue. A glance at classified ads in Edmonton, AB or Pinedale, WY, suggests the gold rush is on right now. MLPs will suffer more from this because of their higher hedging percentages. At this point, a slump in oil and gas demand and a commensurate decline in oilfield costs might actually help them.
Distributable Cash Flow
Both Canroys and upstream MLPs rely heavily on financing to maintain and grow distributable cash flow. Current credit conditions and the cool reception to recent MLP equity offerings have constrained these companies. Acquisitions have ground to a halt and several Canroys have reduced distributions in order to maintain capital expenditures. The best bets in these sectors are the companies that show good potential for organic growth and whose distributable cash flow easily covers current distributions. Look out for companies that borrow to make distributions.
Exchange rates have a mixed effect on the various Canroys. Ceteris paribas, a stronger Loonie increases the U.S. Dollar value of their shares and distributions. However, because Canroy costs are Loonie denominated while their revenue is mostly U.S. dollar denominated, it squeezes their margins. A few Canroys, such as HTE, have hedged exchange rates to ameliorate this effect. To further complicate matters, many Canroys have U.S. dollar-denominated debt and interest payments. Pengrowth realized a $40 million exchange rate gain on their debt just in the third quarter of 2007. In short, some of these stocks will suffer from a stronger Loonie while some may actually benefit.
Lehman Brothers owns substantial stakes in nearly every upstream MLP -- more than 10% in several cases. If circumstances force Lehman to dump those units, it might present great buying opportunities for holders with new money and a long term perspective, but really stressful times for current unitholders.
Should I Buy?
If you are comfortable with these risks and you think the market has fully discounted them, many of these companies present compelling values. They can help diversify a portfolio nicely since their correlation to the overall equities market is fairly low.
For my own portfolio, I hold Baytex Energy Trust (NYSE:BTE) and Enerplus Resources Fund (ERF) but favor the MLPs for new purchases. While I believe the market may have priced MLPs efficiently for institutions and short-term holders, it does not fully value their significant tax advantages to very long term holders. Moreover, each dollar invested in an MLP generally buys you more net proved reserves.
Before you buy, consult a knowledgeable tax advisor to gain a complete understanding of MLP tax implications. Expect that you’ll have to pay an advisor extra to prepare your taxes.
Disclosure: Author holds positions in the stocks mentioned