Many investors blindly seeking high income have been steered into a complex hybrid security known as a master limited partnership or MLP. They are limited partnership units that trade on an exchange (which improves liquidity). They are regularly sold with the promise of annual yields of 5% to 7% (some of it, they claim, is tax-free). Their yields look very attractive when compared to less than 1% at your bank. So, how do they do it. Let’s use an oil exploration and development MLP as an example (hugely simplified).
When oil is profitable, a portion of the limited partners (your) distribution is the net income of the wells (less a percentage for the general partner). That may only be 1 or 2% of the share price. The rest of the distribution comes from the value of the oil being pumped out of the in the form of things like depreciation. Remember, oil is a depleting asset - it will eventually run out.
So the bulk of your perceived income isn’t really income, it’s the return of the money you sunk into the wells. Yes, the return of principal is not taxed, but it causes the cost basis of your shares to decline. You will possibly face capital gains taxes later when you sell.
In some cases, there may not be much left to sell because the wells’ oil or gas depletion can also cause the value of your shares to fall. So, after the eventual decline in the value of the wells, even in a rising energy price environment, your net return will probably be less than the 5% to 7% promised
What might happen to oil and gas MLPs in a market with falling oil prices? A few months ago, many would have called such a scenario unlikely, but it has happened. With oil over $100 a barrel, it wasn’t hard to meet MLP investors high-income expectations. With crude down about 40%, those big distributions are threatened, particularly if prices remain low.
So far, most MLPs have maintained their high distributions, but the stock markets are showing some concern about their future. In the past week, several MLPs, which had recently traded with a 5% distribution, have suffered share price declines that pushed yields to 15% or more.
Any time the very efficient stock markets price a security to yield double digits, it shows just how dire the situation is for those securities. There is serious fear that many oil and gas MLPs are in trouble.
Those who own MLP shares should be concerned and now face the potential for large losses. There is no way to know what the future holds, but my message is not for current owners, but for everyone who is tempted by high-yield promises in the future. High returns always mean high risk, not matter what the salespeople say.
If you’d like to learn more about Master Limited Partnerships, read this Vanguard White Paper.