Fool me once, shame on you; fool me twice, shame on me. Fool me a third, a fourth, and a fifth time, I should not only be ashamed, I should have my head examined.
I’m ashamed to admit it; I endured an investing phase where my head was in need of serious examining. I would get fooled, and I would return to get fooled again. I refer to my master limited partnership (MLP) phase.
As every income investor is aware (and has been aware for the past decade), income is tough to conjure in a market where short-term interest rates are measured in basis points and long-term rates are counted using half the digits on one hand. Meaningful income ̶ income that compensates for consumer-price inflation and time ̶ is found only at the wobbly end of the risk continuum.
Few income sources wobble more than the income offered by master limited partnerships (MLPs) ̶ pass-through entities focused primarily on energy and natural resource production. The thought sprang to mind after a High Yield Wealth subscriber sought my opinion on Energy Transfer Partners (NYSE: ETP), a huge natural-gas pipeline and storage partnership.
An Enticing Concept
The MLP narrative is oh-so enticing: Pay no federal income taxes if you generate at least 90% of your income from qualifying sources: the production, processing, storage, and transport of natural resources (usually oil and natural gas). All those untaxed earnings ramp up the income possibilities.
Incentives further ramp up the possibilities. The partnership agreement typically states that the MLP distribution must comprise all available cash flow, less a reserve determined by the general partner (the MLP’s management team). What’s more, the general partner is motivated to keep reserves low. The higher the quarterly distributions paid to limited partners (the unitholders), the higher the management fee paid to the general partner.
What can possibly go wrong? In short, everything, and everything goes wrong more than income investors know.
Yes, it’s 75-degree San Diego days as long as the price of the commodity behind the MLP remains elevated. It never does. Commodity prices are, and always will be, volatile.
Oil that trades at $100/barrel one year will trade at $40/barrel the next. And as so many MLPs have proven, as the price of the commodity goes, so goes the income and the distribution to unitholders. And as the distribution goes, so goes unit value, because all the value resides in the distribution.
The examples are as numerous as they are depressing.
Calumet Specialty Products LP (NASDAQ: CLMT), a refiner and specialty lubricants manufacturer, continually increased its quarterly distributions from 2011 through early 2013. As the MLP distribution rose, so, too, rose the unit price, doubling to $40 from $20.
But then came 2013 and lower refining margins. The quarterly distribution ceased to grow. The unit price began to drift lower. Refining margins continued to contract, as did the distributable cash flow — the cash that covers the distribution. The MLP distribution was eliminated in early 2016, and so was about 80% of Calumet’s unit value.
Flotsam and jetsam are found all through the MLP energy flow. Former high-yield exploration darlings Breitburn Energy and Linn Energy LLC are bankrupt; distributionless Mid-Con Energy Partners (NASDAQ: MCEP) and EV Energy Partners (NASDAQ: EVEP) hang by a thread.
Pipeline giant Kinder Morgan (NYSE: KMI), the originator and exemplar of the MLP model, abandoned the model and its high-yield distribution. It’s now organized as a regular C-corporation. Yes, Kinder Morgan pays corporate taxes now, but it also keeps something in the till for the inevitable rainy day.
An MLP Distribution Cut
Over the past year, I’ve purged the High Yield Wealth recommendation list of all MLPs, except one. Call it melancholy longing or thick-headedness, perhaps both spring eternal, but I retain one MLP — a downstream partnership focused on fuel-marketing. It’s a legacy holdover, but one on the shortest of leashes.
As for our inquiring subscriber and my thoughts on Energy Transfer Partners?
ETP was a High Yield Wealth recommendation before I threw in the towel back in November. It had become obvious to me that ETP was struggling to support its high-yield distribution, which was being maintained through the good grace of the general partners, who were deferring their incentive drawing rights (money to them) and using the money to support the distribution.
It’s a good thing I threw when I did. ETP announced it would cut its quarterly distribution by half two weeks ago. When the MLP distribution cut was announced, ETP units lost 40% of their value. Yes, its units still yield 9.4% after the distribution cut, but I suspect that more cuts are on the way. A distribution cut is like a good potato chip . . . you can’t have just one.