Master Limited Partnerships: Dark Clouds Ahead?

Includes: EPD, LNGG
by: Reel Ken

Master Limited Partnerships remind me of an artichoke. You need to peel away the outer part if you really want to get to the heart of the matter. I would like to focus on some factors that come into play in determining their potential for future price appreciation.

Over the last several years, equities in general and MLPs in particular have enjoyed a significant run-up. MLPs and the broader equity indexes have been reasonably correlated with the MLPs showing outsized returns. Recently the MLPs have started to show weakness, but this is most likely a result of their association with the energy sector, which has also shown relative weakness.

I think it's time to discuss some problems that I see within the MLP universe. The logical starting place is to look at some of the factors that have led to their share price appreciation.

1. Aggressive marketing as "Tax Shelters". Though in-depth analysis belies this myth, investors have been biting on the "spin".

2. Launching of MLP ETFs. ETFs are a popular and convenient way to invest in the underlying security and create an automatic demand for shares. They "mask" the K-1 issues and make it simpler to purchase. When an investor purchases the ETF, the ETF then buys shares in the MLPs. This drives the underlying MLP share price upward.

3. A low-yield environment increases investor demand for yield. MLP distributions are routinely characterized as dividends and appear quite attractive. Though these distributions are really a return of capital, a yield hungry public has been leaping without looking.

4. MLPs are energy-sector related, yet their concentration on mid-stream infrastructure is seen as a more reliable and safer play in the sector. This appeals to many investors looking for more safety.

Let's look at some of the factors that may come into play in the future that are likely to minimize the effect these factors have had on share price appreciation.

1. Realization that the tax sheltered aspects are illusionary. This trend has already started, though it is still prevalent. Investors have switched to ETNs and ETFs to bypass K-1's and other tax complexities. This is critical, as we will soon see.

2. As interest rates start to move up, it will negatively affect the MLP. First, investors may choose other income producing assets. We see this phenomenon in other high yield sectors, such as utilities.

Additionally, MLPs constantly need access to capital to continue to grow. As interest rates rise, their costs rise and their margins shrink. If they issue shares to raise capital, well, there is asset dilution. This problem is unlikely to arise until interest rates move up, but it is worth keeping on your "radar".

3. Launching of ETNs vs. ETFs. This is a very big problem as ETNs, by their very nature, do not buy any securities but just track an index. This is very different from an ETF, where new money is put to use through direct purchases in the securities comprising the fund.

Though it is not disclosed anywhere, the ETN issuer typically trades derivatives (calls, puts, etc) which would allow them to completely hedge their upside exposure with zero risk and next to no capital expenditure. Their tracking fee (85 basis points) pays for the hedging costs. The ETN issuer doesn't worry about downside exposure because the bulk of the money is invested somewhere else. If the index goes down, they can actually show a profit.

By completely hedging the position, the ETN issuer can now use the investor capital in any way it pleases. The result is that much of the money invested by the public does not go into the sector which would otherwise have increased the share value of the MLPs.

This creates a problem for the MLP investor, as it draws money away from the sector. Imagine if all the investor monies went into an MLP ETN. No-one would be buying actual shares and the sector would collapse.

Though this is extreme, as more investors move towards ETNs, instead of individual MLPs, the share price of MLPs will not show a level of price appreciation consistent with the money that is, in theory, allocated to them. Several more ETNs are due to launch soon, so the problem will likely be exacerbated.

Conclusion: What I've tried to outline here are some risks that I see as specific to MLPs. In the immediate, short term, MLPs are likely to mimic the energy sector in general and the risks are probably no greater than the market risks associated with this sector.

On the other hand, the MLP investor should be aware that there are some sleeping lions out there. I am most concerned about the increased flow of investor dollars to ETNs and their potentially adverse long term effect on the MLPs themselves.

The reader should take this information into account in determining if they think MLPs can continue to show the price appreciation that we have become accustomed to.

Disclosure: I am long EPD, LINE.