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Those of us who have been investing in high dividend paying stocks have done very well this year. The high payers in my portfolio have been split between financial preferred stocks and Master Limited Partnerships (MLP). I examined preferred stocks in an earlier article. This article examines MLPs.

MLPs are set up as limited partnerships that sell portions of the company (called units) on stock exchanges. As such, the MLP itself doesn't pay income taxes, but each year unit holders receive a statement that shows their share of earned income (form K-1). It's been my experience that most K-1's show little or no income (and many show negative income). Thus, I've paid very little income tax on the MLP units I've owned.

The vast majority of MLPs are in the energy industry. Traditionally, MLPs' assets were the pipelines used to carry oil and natural gas from the well to the refiners, and they were called "midstream" MLPs (oil goes from the well (upstream) through the pipelines (midstream) to the refineries and gas stations (downstream)). In the past few years, many MLPs have gone public for companies whose assets are the wells themselves. These companies are referred to as upstream MLPs.

MLPs make distributions based on their Distributable Cash Flow (DCF). Most investors, including me, think of these distributions as dividends, but you will always see MLPs report on distributions, not dividends. Thus, when buying MLPs it's good to have the following conversions in mind:

Stock speak

MLP speak

Shares

Units

Dividends

Distributions

Earnings

Distributable Cash Flow (DCF)

Earnings per share

DCF per unit

With this background in mind, we can examine the good, the bad, and the ugly of MLPs.

The Good

  • High distributions - MLPs tend to pay very high distributions, especially upstream MLPs. My favorite MLPs and their current distributions are:

BreitBurn Energy (NASDAQ:BBEP)

9.8%

Linn Energy (NASDAQ:LINE)

7.3%

QR Energy (NYSE:QRE)

10.3%

Vanguard Natural Resources (NASDAQ:VNR)

8.3%

  • Increasing distributions - It is very common for MLPs to raise their distributions annually, and many raise the distributions more frequently than that. This practice is so common that any MLP that does not raise distributions regularly is viewed harshly. All of MLPs shown above have raised their distributions recently, and they have stated or implied that they intend to keep doing so.

  • Capital Appreciation - MLP units are often very cheap when they first come public. As distributions increase, the unit values can appreciate significantly. LINE is a great example. I first bought units in LINE, on October 7, 2009, at $22 as part of a secondary. At that time, the distribution was $0.63 per quarter ($2.52 per year), making the annual yield 11.4%. A few hours later the price had returned to its $25 value from the day before. A year later, LINE had increased the distribution and the price was around $35. Thus, units bought around the time of the secondary increased by 50% in a year (40% capital appreciation ($35/$25) plus a 10% distribution (2.52/25)).

  • Tax Advantages - As noted above, cash received from an MLP each year is very lightly taxed.

  • Hedging - Without hedging, revenues from many of the upstream MLPs would vary significantly as the price of oil and/or natural gas changes. Therefore, MLPs work hard to have much or all of their production hedged so that revenues and distributions will remain stable or will continue to increase even when the price of these energy components drops. Thus, when choosing to invest in an MLP, it is important to review their hedging strategy and effectiveness. Normally, MLPs show their hedging in a table, such as the one below from a recent BBEP presentation:

(click to enlarge)

  • Commodity price arbitrage - As explained below, unit prices move up and down with oil and gas prices, even though they really shouldn't. Investors who understand this can buy more units when prices are low and sell some back when prices are high. In this way, they receive a lower overall basis when owning the same average amount of units.
  • Industry concentration - Almost all MLPs are in the energy industry. Therefore, prices for all MLPs tend to move with each other.

  • Unit price is linked to oil and gas prices - Midstream MLPs' revenues have little or no relation to the price of oil/ gas. Hedging also eliminates most or all of the relationship between revenues and oil/gas prices for the upstream MLPs. Nevertheless, unit prices still move with the commodity prices, and by a much larger amount than can be justified by the change in revenues resulting from the commodity price change.

  • Frequent secondary offerings - The MLP business requires constant expansion to increase distributions, and this means that the companies continually need capital when pipelines and/or land becomes available. The companies often sell more units to get this capital, diluting the value of existing units. For example, BBEP sold 10,000,000 units on 9/6/12 at $18.51. The day before, the closing price was $19.28. The closing price the next day dropped 3.3% to $18.65.

  • Seeing a price drop like this isn't pleasant if you own the units (I consoled myself by thinking "secondary's happen"). On the other hand, this presents a great opportunity to start a position or add to it. Fortunately, the unit price after a secondary will normally return to its previous level after a few days, or even a few hours. However, sometimes the unit price stays depressed for much longer.

The Ugly

  • Interest rate sensitivity - Eventually, general interest rates will increase, and then the value of high dividend stocks of all kinds, including MLPs, will drop. It should be noted that when interest rates are at today's very low levels, it may take a while for the prices of MLPs to drop significantly. I have not seen a lot of unit price drops relating to interest rates in the last few years since interest rates have been extremely low. However, I have no doubt that the day will come when interest rates will increase and unit prices for all the MLPs will drop at once. When I see this happening, I will have to think hard about whether I should continue to own these MLPs. There will be a rush to the exits, and I'll have to be careful as I think that day is coming closer.

  • Hedge fund ownership - Hedge funds own a large percentage of the total units of many of the MLPs. When things get rocky, the MLP unit prices can drop very quickly, even if the source of the trouble has little or no effect on the MLP's business. Returning to LINE, on August 1, 2011, the unit price was $40.21. Then the fear of a European debt crisis hit and a week later the price had dropped over 20% to $31.91. I believe this occurred, at least in part, because hedge funds sold first and asked questions later. Fortunately, the price returned to $35.58 the next day, and to $37.86 within four days after that, but that first week of August was frightening. The other MLPs behaved similarly and some of them were worse!

The bottom line is that MLP ownership has been very profitable in this low interest rate environment, and it is very likely to remain so for some time. However, you need to be aware that there are serious risks in this area. You will need to be able to hold on during those rocky times. In addition, when interest rates return to normal levels, the suitability and amount of these investments in your portfolio needs to be re-examined.

Source: High Yielding Upstream MLPs: The Good, The Bad, And The Ugly