Energy MLPs: Taking a Closer Look After the Oil Bust

In March 2015, Sunoco spun off its logistics business to form Sunoco Logistics Partners. Sunoco's motivation was to "unlock" the value of low-volatility assets that were perceived as underpriced by the stock market. Hess has publicly stated that they plan a similar MLP spin-off.

But the MLP structure can be complex and some partnerships end up being squeezed by large payments they make to the sponsoring corporation that serves as the General Partner. The payments are meant to encourage the company's management to keep paying out more to investors, but can become a financial burden on the partnership as it tries to grow. 

Kinder Morgan, an industry leader and pioneer in popularizing the MLP structure, last year did an about-face by consolidating its three MLPs back into the parent corporation. Kinder Morgan's three MLPs were making high payments back to the general partner, payments that lowered the yield on the MLPs and hindered their stock market value.  Kinder Morgan's rationale was to simplify a structure that was becoming difficult to manage, provide greater dividend growth and visibility and obtain a lower cost of capital to pursue expansion opportunities. 

Williams Companies, another major industry player, announced a similar consolidation in mid-May following the same rationale as Kinder Morgan. Analysts are expecting more simplification deals, and say the Williams merger likely won't be the last. A smaller midstream company, Crestwood Equity Partners LP, has already unveiled a $3.5 billion merger to simplify its structure by taking a master-limited partnership back in-house.

Investment Vehicles

Taxes are a prominent consideration when selecting the type of vehicle to use when investing in MLPs.

Separately Managed Accounts

Direct ownership of MLPs in an SMA is on its face the simplest way to invest. With an SMA structure, the investor receives the full tax benefits of MLP ownership, namely tax-deferred distributions and avoidance of taxation at the partnership level.

For many investors, however, the complexity of the partnership structure creates personal tax complications.  Each MLP issues annual K-1 tax forms, which often arrive late in the tax season. MLPs also create complications if owned in 401ks and IRAs.

Mutual Funds and Exchange Traded Funds

Mutual funds and ETFs have similar tax and regulatory issues related to MLP ownership.

Mutual funds and ETFs are effectively limited to owning no more than 25% of their portfolio in MLPs.  Holding greater than 25% of the fund/ETFs in MLPs would negate the tax status of the vehicle, forcing the fund or ETF to be taxed as a C-corporation rather than a registered investment company. This means paying corporate taxes at the fund level before passing income along to fund shareholders. This corporate tax cuts into the yield and returns of the fund. 

Maintaining less than 25% invested in MLPs avoids this double-taxation issue, but has a dilution disadvantage for investors. With only 25% in MLPs, the fund manager must invest the remainder of the portfolio in other assets such as stocks of energy corporations. These other stocks may offer similar sector exposure as MLPs, but likely lack the high yields and investment characteristics that make MLPs attractive to investors in the first place.

Exchange Traded Notes

Exchange traded notes (ETN) are fixed income instruments designed to reproduce the returns and yields of an MLP index, but without holding any of the underlying index holdings. The ETN structure offers several advantages over competing investment vehicles. There is no 25% MLP maximum to contend with.  Tax consequences are equally simple; the fund company issues a Form 1099 for the income.

ETNs have disadvantages.  All of the income from this debt instrument is taxed as ordinary income, with none of the deferral benefits of actual MLP ownership.  As with any debt instrument, there is default risk.

Outlook and Recommendation

We believe that MLPs offer investors advantages that are not available from other investments and represent a good long term holding. We recommend MLPs as part of a diversified portfolio for income-focused investors, based on their income payouts, potential for capital appreciation and inflation-hedging characteristics.

The debate between active and passive management is as vigorous in the MLP asset class is in most asset classes. We see the virtues of both arguments, but are wary of active management in the MLP asset class. Much of the best recent performance among individual MLPs has come from deal-related activity, which is notoriously difficult to predict. Some of the worst performers have been pressured by financial stress caused by macroeconomic factors, also not easy to reliably anticipate. The MLP universe isn't particularly large, which we think makes it difficult for an investor to gain a sustainable edge.

For the majority of clients, we recommend a passive ETN approach. The yields are sufficiently high and the taxes extremely straightforward. Also, performance is unhindered by added layers of taxes.

We considered raising our allocation to MLPs after the reversal of fortune they experienced in recent months. We've continued to hold MLPs, but haven't raised our allocation because of the risks we see for the asset class.  Because MLPs are required to pay out the vast majority of their earnings, they have to borrow to fund growth. Consequently, MLPs are dually vulnerable to rising interest rates, affected by increasing cost of capital as well as competition from fixed income investments that become more attractive competitors in a more normalized interest rate environment. 

Though we are in the camp of rates staying "lower longer," we recognize the risk of being complacent about the interest rate outlook. Another cautionary factor keeping us from raising our allocation to MLPs is their reliance on the capital markets for funding. Again, although our base case is for markets to "grind" higher and for liquidity to remain available, we consider there to be an elevated risk for a market reversal. A severe reversal could impair access to liquidity for MLPs.