Oil & Gas MLPs Why Such Sell-Off?

You already know about my concerns around higher-yielding stocks. When a company offers a yield of over 5-6% (especially in today’s market with low-interest rates), you must take a minute to understand why. There is no free lunch in finance. Should you aim at higher yield? Yes, but not to a point where you increase the risk to your portfolio. We have designed the DSR dividend safety score to help prevent most dividend cuts in your portfolio. Many companies rated “2” cut their dividend in the past 2 years. One sector including many of them are Energy MLP’s. I know they are praised by income-seeking investors and this is why I want to highlight this industry. First, let’s do a recap of what they are.

 

What are MLP’s?

MLPs were formed in the U.S. in the early 1980’s. They are publicly traded partnerships. Back then, there were much higher top marginal tax rates than there are currently so investors were particularly interested in tax-advantaged businesses. The MLP structure allowed businesses to spin off portions of their assets in a very tax-advantaged situation and allowed individual investors to benefit as well. But the structure was so attractive in terms of taxation, that practically every business would want to be an MLP, and so in 1987, the government restricted which kinds of businesses can exist as MLPs.

The structure of MLPs can vary to some extent, but the basic structure is this: There exists a General Partner (GP), that consists of the management team, and Limited Partners (LPs), that contribute capital. Often the entity that holds the GP also holds some LP units.

Limited Partners contribute capital by buying units of the MLP. (They are called units rather than shares). These LP units can then be traded on a stock exchange. In return, the LPs receive distributions from the operations, which are similar to dividends.

The GP often has Incentive Distribution Rights (IDRs) that are set forth in the founding of the partnership. The IDRs give the GP a ton of incentive to raise the distribution overtime for the units that the LPs hold. These partnerships, therefore, are specifically designed for distribution growth.

This is what we have seen on the market in the past few years: a bunch of MLPs raising their distribution month after month while seeing their stock value disappearing faster than Nutella in a house filled with teenagers. All those MLPs offer incredible yields (many of them over 10%). Income seeking investors went after them thinking they found their golden egg hen. Unfortunately, the hen is about to kill itself leaving you with no more shiny eggs.

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Disclaimer: I do not hold shares of MMP.

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