Master limited partnerships risks are increasingly in focus by dividend investors as energy prices remain depressed. The sector has attracted income investors thanks to its relatively high dividend yields, historically stable cash flows, and perceived protection from swings in commodity prices.
However, with many energy master limited partnerships down over 30% in 2015, it’s time for investors to seriously revisit the topic of master limited partnerships risks. We identified a handful of the biggest risks facing master limited partnerships (MLPs) below.
In addition to understanding MLPs unique corporate, legal, and tax structures, which we covered in our article, “What is a Master Limited Partnership?”, remaining aware of the risks facing the industry is extremely important. With that said, let’s dive into the biggest master limited partnerships risks.
Master Limited Partnerships Risks
1. MLPs have underperformed significantly in the past and risk oversupply resulting from “free” money.
As seen below, energy MLPs turned in terrible performance from 1981 through 1995, trailing the market by over 13% per year while recording much higher volatility. Many of the original energy and real estate MLPs left the market due to challenging economic conditions.
The tax advantages and higher yields of MLPs do not guarantee their future total return performance, and MLPs are coming off of an extremely strong performance run from 1996-2013 in which they nearly doubled the market’s annualized return. It’s easy for investors to forget about master limited partnerships risks during bull markets.
This table shows the performance of energy MLPs relative to US stocks and bonds from 1981 through 2013. MLPs underperformed US stocks by nearly 3% per year with higher price volatility.
Energy infrastructure has been a booming business. As seen below, courtesy of the Wall Street Journal, MLPs raised substantial capital in IPOs and follow-on stock offerings over the past five years, and MLP mutual funds and ETFs enjoyed massive inflows until earlier this year:
Source: Wall Street Journal
Looking even further back highlights how extreme the past decade has been for MLPs. With low interest rates, yield-starved investors, rising oil & gas production, and new shale plays emerging by the day to drive infrastructure needs, it’s no surprise that there was a record number of MLP IPOs over the last five years:
Source: Latham & Watkins LLP
The following chart from Deutsche Bank further highlights the major jump in MLPs over the last decade, with the number of MLPs nearly tripling from 2005 through 2015:
Source: Bloomberg, Deutsche Bank
Investing is part art, part science. The “art” investors would look at this data and suggest that the decade long run MLPs have enjoyed is a sign they are possibly overvalued and ready for a pullback, perhaps like the one we have experienced already in 2015.
These investors express concern that the amount of “free money” (i.e. infrastructure investments were easily financed by investors hungry for yield) thrown at the energy industry for this long has created a distortion that is just now beginning to correct. Perhaps many of the wells drilled by exploration and production companies over the last five years will prove to be uneconomic, reducing the need for pipeline infrastructure that was put in place in those regions.
In other words, there could be too much pipeline capacity chasing falling production in many shale basins that were once booming. Distressed exploration and production companies are announcing more cost cuts and layoffs by the day. Renegotiating their existing contracts with MLPs at lower rates is a logical action to help them survive.
Despite the near-term gloom, MLP bulls believe that new low cost extraction technologies such as fracking will result in rising energy production and demand for more energy infrastructure in North America over the long term, providing a long runway for MLPs to remain quality income investments. Only time will tell.
2. Dependence on capital markets for cash distribution growth.
While MLPs are not required to distribute most of their cash flow by law, almost all of their partnership agreements call for all “available cash on hand” to be distributed to unitholders. With no income tax at the partnership level and almost all cash being paid out, it’s no wonder why MLPs offer such high dividend yields.
However, these benefits come at a cost. Unlike blue chip dividend stocks and dividend aristocrats, which increase their dividends primarily as a result of earnings growth, most MLPs need to borrow money or issue new units to continue growing their distributable cash flows.
When times were good, MLPs enjoyed easy access to capital because they almost looked like bonds with their stable cash flows and clear returns. Their high yields were also an easy sell to yield-starved investors.
Sentiment has clearly changed with the plunge in oil prices, which threatens to reduce the volume of fuel running through pipelines. Paying out almost all of your cash flow and straining your balance sheet in this environment could prove to be dangerous.
To further complicate things, calculating a payout ratio is a bit of an art with MLPs. Companies list their coverage ratio, which measures how much distributable cash flow the business generates compared to what it pays out. Distributable cash flow is defined as net earnings plus depreciation, minus maintenance capital expenditures. A coverage ratio of 1.0x indicates that the company is paying out all of its distributable cash flow. Higher ratios are better.
The complicating factor is that the company makes critical assumptions about its “maintenance capital expenditures” to calculate distributable cash flow. There is no standard definition of maintenance capex between firms, and with long-lived assets such as pipelines, maintenance capex is even harder to define.
Using the traditional definition of free cash flow to calculate MLPs’ free cash flow payout, the safety of distributions appears less certain and more dependent on capital markets. Of the 139 MLPs in our database, 41 recorded negative free cash flow and 39 paid out cash distributions greater than all of the free cash flow generated over the trailing 12 months.
The return MLPs will achieve on their growth capex is less certain in today’s depressed oil price environment. If MLPs cut back on growth spending, cash distributions will take a hit and possibly cause investors to re-rate the space even lower. There are many moving parts here, so it’s hard to say what could realistically happen. However, negative free cash flow, heavy dependence on capital markets, energy production volumes that could be peaking (at least in the near term), and distributable cash flows that could be frozen or reduced are reasons to do all of your homework before investing in MLPs.
3. High debt loads increase financing risk and make the asset class more sensitive to rising rates.
Most MLPs maintain substantial debt loads and, should interest rates start to rise, could see their cost of capital increase. If capital markets were to freeze up again like they did in 2008, MLPs would likely display significant volatility, just like they did during the financial crisis. This would be less of a concern if the energy market backdrop was more favorable, but almost all exploration and production companies (i.e. MLPs’ customers) and banks (MLPs’ financiers) are cutting back activity and lending.
4. Take-or-pay or other contracts don’t guarantee safety during a commodity price slump.
Many income investors like MLPs because of the perceived safety provided by take-or-pay contracts (e.g. customers pay for renting space in a pipeline regardless of whether they use it or not) and fee-based cash flow (based on volume, not price).
However, when oil & gas prices plunge and remain low like they have over the past year, there is only so much weaker producers can do to honor their contracts with energy MLPs. Some are unable to meet the agreements, have to renegotiate, or go bankrupt. Chesapeake Energy (CHK) noted such actions in September (see slides 19 and 20).
With US oil production starting to decline in response to lower oil prices, more investors are also questioning the ability of MLPs to keep up their steady growth of cash distribution payouts, which has been a key input in valuing MLPs. The following chart shows US oil production by month. You can see it is flattening out and starting to edge lower since the summer.
5. Distribution growth is dependent upon favorable regulation.
MLPs are highly regulated businesses. For example, many pipelines are regulated by the Federal Energy Regulatory Commission (FERC), which has the ability to set rates. Any change in regulations by the FERC could significantly impact cash flows and the rate of an MLP’s distribution growth.
The FERC’s job is to ensure that companies charge “just and reasonable” fees and that exploration and production companies have fair access to transport products. Rates are usually set on a cost-of-service basis, factoring in capital and maintenance costs to keep the infrastructure running.
While regulations have generally been a good thing for MLPs by providing clear returns on their infrastructure investments, they are a major uncontrollable factor the businesses depend on. For now, there doesn’t seem to be risk here but we are not sure how the FERC would respond (if at all) to more exploration and production companies renegotiating contracts or ceasing production.
6. Organizational and financial complexity requires an extra level of research and understanding.
An academic study of 119 MLP contractual agreements found that partnerships with agreements unfavorable to investors tend to have higher proportions of insider equity ownership compared to those with agreements more protective of investors. It’s very important to understand the agreements in place for the MLPs you are considering investing in because you most likely will not have voting rights.
Investors need to thoroughly understand an MLP’s “incentive distribution rights,” which provide the general partner running the MLP with a disproportionate share of the cash flow as cash distributions increase. When times are good and production volumes are growing, investors don’t mind these clauses. However, when growth slows, investors are less willing to provide an MLP with shares upon realizing its high cost of capital because of the incentive distribution rights.
An MLP’s organizational and legal structure should also be thoroughly reviewed before investing. Many of these investments are “too hard” for us to get comfortable with.
7. Investing primarily in MLPs can decrease the benefits of portfolio diversification.
This risk should come as no surprise. The majority of MLPs are exposed to the energy sector, so a portfolio that is overweight MLPs will be overweight energy. As we have observed this year, some MLPs have embedded commodity price risk and remain sensitive to the financial health of major players in the sector.
8. Change in the tax code could hurt the performance of all MLPs.
Dividend investors should also be aware of potential legislative risk against the industry. Tax reform and deficit reduction are two hot topics, and many presidential candidates have proposed altering income tax rates, capital gains, dividend rates, and the treatment of pass-through entities.
MLPs operating outside of real estate and natural resources industries have the greatest amount of regulatory risk. For example, AllianceBernstein (AB) and Blackstone Group (BX) operate in the financial sector and use the MLP structure solely as a tax shield. The government seems more likely to scrutinize these companies and consider disallowing their favorable tax treatment.
Booms and busts can take place over very long periods of time. Energy MLPs have performed extremely well for nearly 20 years and benefited from easy financing and investors’ appetite for yield over the last five years. The fallout in energy prices is waking up income investors to the embedded commodity price risk in many of these stocks that were otherwise generating stable cash flows. If sustained low oil prices erode demand for infrastructure, the long-term growth profile of MLPs could significantly decrease.
There will be a fantastic time, perhaps not too far off, when the MLP industry offers an extremely attractive risk/reward ratio. However, we could see many distribution cuts and even greater investor pessimism first due to the duration and magnitude of the boom leading up to 2015’s weakness. US oil production has only just started declining as well.
We do not own any MLPs in our Conservative Retirees dividend portfolio given our concerns over distribution cuts and the energy shakeout, but we will continue to watch the space closely. In a future piece, we will review the different types of MLPs and how to analyze them. Investors living off dividends in retirement will hopefully find this analysis to be especially useful.