It is difficult to be a holder of energy stocks as the price of oil drops day after day, seemingly without bottom. This article will explore why, nevertheless, it may make sense in the MLP space.
WHAT ARE MLPs?
A Master Limited Partnership is a company organized as a partnership. Instead of paying corporate income taxes, it passes through most of its profits to its partners who are taxed thereon, but only to the extent that they are not treated as returns of capital. Generally, most of a year's distributions are treated as ROCs.
Many investors think that this means they are like muni bonds. This is wrong. MLPs' distributions are tax deferred, not tax exempt. The tax comes due if and when you sell your shares, and then the cumulative prior income is treated as ordinary income, not dividend income. The tax deferral feature is not important unless you plan to hold for a very long time.
Most MLPs are in the energy sector, which is normally divided into "upstream" (companies actually drilling for oil and gas), "midstream" (those providing services to the industry, like pipelines, storage facilities, etc.), and "downstream" (refiners of crude into something usable).
Upstream MLPs are the most volatile investments, since their revenues depend on the price of oil, although most hedge a large position of their anticipated future production.
Midstream MLPs typically earn most of their revenue on a fee basis, so they are not as leveraged to the price of the commodity. Of course their volume of business can decline if commodity prices fall far enough. However, while growth in demand may slow, it is unusual for total demand to actually decline in an economy whose energy requirements just grow and grow. Efficiency gains can only do so much.
MLPs are all U.S. based, so that they are less impacted by upheavals in geopolitics and global markets. There are Canadian Income Trusts, which are similar. However, I will only cover U.S. equities here.
I started my study at the beginning of 2006, for reasons I will explain below. Here are high and low spot prices for West Texas Intermediate (WTI), the price that the average investor hears quoted in the press and on CNBC:
|Nov, 2014||74||-33% decline|
As you can see, the current decline in oil prices is not unusual. It is the sixth decline of 25% or more in the past nine years. Of course, the media needs to have drama to keep us tuned in or reading, so they have hyped this one just like the previous five.
Is the current price the bottom? No one can say for sure. What is sure is that momentum selling, like momentum buying, is almost always overdone.
MLP SHARE PRICES
The stocks of MLPs are traded like ordinary stocks on the major U.S. exchanges. Because they pass through most of their untaxed profits in the form of distributions to shareholders, they offer higher yields to investors than ordinary tax-paying companies. This makes them appealing to retail investors, especially retirees, seeking high current incomes to live on.
Retired retail investors are also the most prone to panic when markets decline. It is fine earning 6% or more, but not when your stock starts dropping. A flight to "safety" during market declines in energy prices causes retail investors to dump their MLP holdings along with everything else, thereby throwing out the proverbial baby with the bath water.
Below are long-term charts for three popular MLPs. As you can see, Linn Energy (LINE) has been extremely volatile, Kinder Morgan (NYSE:KMP) less so, and Enterprise Products (NYSE:EPD) pretty steady except during the financial meltdown of 2008 that brought all investments to their knees. These charts are fairly typical for MLPs over this period.
MLPs provide steady income one can live on, while maintaining and increasing value over the long term, despite wild short-term price volatility.
I looked at the actual distribution history of 10 of the largest MLPs: Enbridge Energy (NYSE:EEP), Enterprise Products, Energy Transfer (NYSE:ETP), Kinder Morgan, Linn Energy, Magellan Midstream (NYSE:MMP), MarkWest (NYSE:MWE), ONEOK (OKS), Plains All American (NYSE:PAA), and Williams (NYSE:WPZ).
I began in 2006 in order to include the fracking revolution, and I wanted to include Linn Energy since it only began trading on 1/17/06. Going back further would only have improved results, so using a nine-year history will make my point.
Here are the actual results of a $10,000 investment made in each at the beginning of 2006:
$11,071 means an average annual return of 11.1% on one's initial total investment of $100,000.
Note the consistency from year to year for all companies. Although several of these companies got "into difficulties" during the period, and despite the wild swings in energy prices, the financial crisis, etc., MLP managements did what they had to in order to maintain distributions. They could not always raise them as shareholders expected, but cuts were avoided. Obviously, if an investor is counting on these distributions in order to meet expenses, this is critical.
Of course, if an investor gets his distributions but the value of his shares drops, he has not actually benefited, since in effect he has merely consumed his capital.
How would a $10,000 investment in each MLP have fared over the past nine years, including the oil price crashes of 2006, 2008, 2010, 2011, 2012, and the current one?
In other words, despite all the wild swings, nine-year appreciation equaled 90.2% or a compounded average annual rate of 7.4% per year. That is on top of the 11.1% distribution yield.
Note that I assumed distributions were spent, not reinvested, as is usual in such analyses. Reinvesting distributions would have made the results even more impressive. Realistically, MLP investors typically invest because they want income to spend, not reinvest.
These returns did carry a high cost in terms of peace of mind. One has to be willing to hold through some terrible storms and serious diminutions of one's total account value. The case of Linn Energy is instructive.
If you had purchased 447.43 shares of LINE at the close on its first trading day (1/1/06) for $10,000, you would have seen a quick 12.5% drop by mid February, hardly an auspicious start. (I chose the closing price to buy since buying a new issue on the open would not have been likely, while using the average of the high and low prices for the day would have produced a slightly more favorable result).
After the initial drop, shares did not recover to their initial price and stayed there until late July. After that, they rose steadily as distributions increased, ending the year with your account showing a lovely 43% gain. You would have felt like a very smart investor indeed. A 43% gain, plus increasing distributions. Life was good.
Your shares had increased another 18% by July of 2007, just prior to the price of oil cracking. No doubt you were telling your friends to buy Linn Energy. When oil cracked, LINE plunged to $20.86 by year end, and didn't reach bottom until $18.88 on 2/15/08. Your sensational unrealized gain had turned into a 16% unrealized loss. And this was before the really bad stuff happened!
LINN shares rallied and you were back in the black to the tune of 14% by June 24 of 2008. Oil was on a tear. Distributions were going up. You could mention Linn again as a high yielder to your friends.
Then, of course, came the crisis. Oil peaked in July and everything crashed when financial markets imploded in the fall. LINN hit a low of $11.20 on December 5th. LINN's shares in your capital account were now down almost exactly 50%. Of course, almost everything seemed to be down 50% in that dismal period, so perhaps at least you had shared suffering with friends to comfort you.
But a curious thing happened. Although oil did not hit bottom for over two months, and the S&P did not reach its low until springtime, LINN rallied. It also kept paying distributions throughout all this chaotic period when brokers were advising clients to keep cash at home in case banks failed.
By August of 2009, your LINN shares were back in the black and, mirabile dictu, by year end you again had an unrealized profit of 25%! Distributions had not been raised in 2008, but neither had they been cut.
Oil peaked in May of 2010, and your LINN shares were quickly back to breakeven, as they suffered along with other producers. By year end, however, they were back to $37.49 and your unrealized gains were 68%! Quite a ride!
2011 was less exciting, despite another plunge in oil prices. However, the distribution increased by nearly 6%. 2012 saw another oil price crash, but again LINN's hit was only temporary. Distributions again increased. By the fall, LINN was becoming a real darling of high-yield investors who couldn't distinguish between an oil rig and an oil rag. They hedged their future production (whatever that meant), and that meant that everything would be fine. LINN hit a high closing price of $42.52 on 11/1/12. Your unrealized profits would have been 90%.
In 2013, things weren't fine. A hedge fund, assisted by Barron's, accused Linn of accounting improprieties. The stock dropped sharply. Linn countered. The shares rallied. The hedge fund raised new issues. The shares went back down. All this was an attempt by short sellers to scuttle a proposed merger between Linn and Berry Petroleum, a move Wall Street had acclaimed as brilliant. Rumors flew back and forth. Trading volume exploded.
On July 1, the SEC announced an "informal" investigation into Linn's activities and practices. It was unclear what exactly was meant, how long it would take, or how the Berry merger would be affected. Volume exploded from 7 million shares the four days before the announcement to 88 million the four days after. Jim Cramer on CNBC (who had been bullish) shouted (his normal tone) that everyone should sell, because "where there is smoke there is fire". He might as well have poured gasoline on the fire. The stock plummeted. Your unrealized capital gains were gone.
The SEC eventually cleared Linn of doing anything wrong, and the Berry merger subsequently went through (although on terms less favorable to Linn), but a cloud has lingered over the stock. Those who could not stand the heat, closed out their positions. Having once been burned, they are reluctant to re-enter.
As for Linn, 2014 has been a year in which they have executed well. Distributions have not been increased, since they are busy absorbing the Berry organization. Wall Street has praised their moving around their portfolio to shed unwanted assets and acquire more desirable ones, and the company's CEO was honored with an award as Oil Executive of the Year. They are still hedging, but they no longer enjoy the relative immunity to oil prices in the mind of the average retail investor. Sadly (for its investors) LINN stock is almost exactly where it was when it went public in January of 2006. It has always bounced back before, and it may again. But for shareholders it has been a roller coaster ride, exhilarating for traders perhaps, but not for those seeking a peaceful retirement.
However, my point in narrating this long story is to indicate that even under the worst of conditions, including a well-coordinated attack by short sellers in 2013, this MLP has managed to well reward long-term investors, despite the absence of meaningful capital gains. Amid all the turmoil, no distribution payment was eliminated or reduced over nine years.
The story for the other nine MLPs in the study is more upbeat. All turned in high cash distributions, plus large capital gains. The point here is that even with a difficult story similar to Linn's, MLPs as a group have amply rewarded investors. If you plan to invest in MLPs, diversify. Don't pick just one or two. There are several excellent advisory services that will help you sort through potentially stronger ones.
WHAT CAN GO WRONG?
There are always surprises in investing. Most are negative. Stocks become overvalued, or over-leveraged, or underperform. Things blow up, literally. Hedges turn out to be less protection than expected. Governments interfere. What were once the Flavors of the Month are suddenly shunned. You can't predict most of these things.
Any reasonable person must ask, what can go wrong that I can anticipate? The results above are all in the past. We have all heard the sickeningly repeated mantra that past results are no guarantee of the future. So, I ask myself the following questions about continuing to pursue a strategy that has worked so well for so long. What could go wrong?
1. If I focus only on pipeline MLPs, how do I know the demand will continue? The answer is that there is an enormous projected need for pipelines across the U.S. as we ramp up production from shale to the point where the US once again is the world's leading energy producer.
2. What about the environmental restrictions? Much of the environmental hoopla surrounding the Keystone pipeline is political posturing. There is already a massive network of pipeline infrastructure across the country. Crude oil and natural gas will be moved from wells to refineries one way or another, and moving it by truck or train actually has greater environmental risk than moving it by pipeline. Those who think we can solve all our energy needs by wind and solar are dreaming. More pipelines will be built because they are needed.
3. Couldn't the government screw things up? Always. However, eventually even the densest politicians will come to see that energy is one of the main drivers of economic growth. Pipelines are the key piece of infrastructure of the energy sector.
4. Will all pipeline MLPs prosper? No. There is always the potential that some grow too big to continue their previous growth rates. Financing all the construction could become an issue. However, pipelines can often secure long-term contracts before they need financing, making the presentations to lenders a lot easier to sell.
5. Suppose energy prices continue to plunge and don't recover as predicted? As Bertrand Russell once warned, what shouldn't be possible has no influence on what actually happens. I once invested in a real estate fund with a man of excellent reputation who said that since World War II his firm had missed some dividend payments, but never lost a dime of any customer's principal. Underwriting was stringent and low ratios of loan to value assured. When the crash of 2008 occurred, he committed suicide. To date I have recovered only about $.15 on each dollar that I had invested. It was an expensive lesson.
Oil prices "shouldn't" go below $70, but home prices shouldn't have declined as much as they did. There are, however, good reasons to be more sanguine about oil. For one thing, the oil-producing companies outside the U.S. need a much higher price to balance their budgets and keep their masses quiet. They can always cut production in order to move prices up. They don't want to live on their FX reserves for very long. Long-term projections are always suspect, but it is widely thought that the current supply glut will not continue for more than a few months. In energy, it is the margin between supply and demand that determines price more than anything else. Longer term, the world will again be scrambling for more oil, not less.
6. What happens to an MLP's share price if a distribution is cut? Of course it has happened, and the result is usually disastrous. In 2014 BWP cut its quarterly distribution from $.53 to $.10. The next day volume spiked from 750K to 43 MM shares and the shares dropped from $24 to $13. Three months earlier, they had been at $30, so the cut was not entirely a surprise, the cause being that most of their revenue was affected by commodity prices. (It has since recovered, but only to $17). Note that if the top company in my table above had had a 50% cut in every year after the first, the reduction in total distributions would only have been about $8,000, and there would still have been a rise from year to year, with an average yield of 9%.
The important question about distribution cuts is do they arise from temporary factors or from excessive debt, production problems, or other conditions that may be long lasting?
7. What happens if interest rates go up? Won't high-yielding MLPs become less attractive as other interest-sensitive alternatives become more competitive? Surprisingly, the belief that MLPs suffer when interest rates rise is a myth. Here is a list showing results for the Alerian MLP Index compared to Telephone Utilities and also the 10 Year Note Index.
|Alerian Index||Telephone Utilities||10-Year Note (TNX)|
That should put that myth to rest. Source: Energy and Income Advisor
8. Suppose you get into MLPs just as they are about to go down? Paying too much is the bane of all investors. My solution is to sell put options when I would prefer to pay less, but that is more complicated than anything that the average investor wants to become involved with. A possible criticism of the analysis I presented above is that I picked an optimal time to start in 2006.
To check this, I looked at starting earlier, but it actually improved results. MLPs have been going strong for a lot longer than nine years. However, suppose I started later, when prices had already climbed? To test this was easy. I simply assumed the same start date but "paid" 20% more for everything. The result was:
Adding to this a distribution yield of 9.2% (rather than 11.1%) still produces a terrific return of 16.6% per year.
9. If MLPs are volatile, and volatility = risk, then aren't MLPs too risky for seniors? First of all, the idea that volatility = risk is one that brokerage houses have embraced, because it simplifies discussions with clients. I think of risk as the likelihood of permanently losing most of your capital. With MLPs this risk seems smaller than with more speculative stocks that don't even pay dividends. Second, the returns on MLPs suggest that the reward/risk ratio is much superior to other investments with comparable yields.
10. What about fracking and the shale revolution? Doesn't that signal a whole new ball game? The returns generated above occurred during the explosive growth of fracking. While the jury is still out on the long-term growth of shale production (due to high well depletion rates), in the short term many worry that lower oil and gas prices will inhibit shale drilling.
The average shale project is thought to have a breakeven price of just under $80/bbl. Costs of drilling are high but coming down, aided by relentless technical breakthroughs such as pad drilling. Therefore, while low oil and gas prices may cause cancellation of some new projects, shale production will not suddenly collapse.
The dispersion of shale means that there will be a long term need for more pipelines to bring crude to refineries economically. This is why pipeline MLPs particularly are so exciting as long-term investments. Slackening demand for pipelines is not a likely problem. Of more concern is the amount of capital needed to finance their building. Fortunately, interest rates are expected to stay relatively low for an extended period, even though they are likely to rise from current low levels.
11. Aren't there good arguments that the world simply cannot afford higher oil prices and grow, while energy companies cannot afford to keep production at the levels needed if prices are too low? The answer is yes to both points, but my personal belief that there is likely an equilibrium price around $90-$100 for WTI where consumers will find a way to pay and producers will find a way to earn a satisfactory profit. Energy powers economic growth. Faced with a choice of growth or stagnation, the ingenuity of man is a wondrous thing.
There are no sure things in investing, unless you have inside information or are otherwise breaking the law. I believe MLPs will continue to offer a good ratio of reward to risk, although the volatility may be more than many can tolerate. It is best to diversify among them, not overpay for any, and also not chase only the highest yielding stocks or put all one's funds into one sector. As with many investments, the best time to buy is often when there is blood in the streets. Courage!
Disclosure: I currently have positions in nine of the 10 stocks mentioned in the article. (Not MMP)