MLPs Are Not Utilities – They’re Traps

For some reason, I get a lot of unsolicited mail.  Maybe because it’s because I’m a registered investment adviser. But I am registered because I manage a hedge fund and am required to register by law, not because I advise individual clients.  Nonetheless, firms that cater to individual investors like to send me their solicitations.  But I really wish they would leave me alone.

Most of their mail enrages me because it is designed to lead investors to slaughter.

I recently told an investment relations person from the business development company Prospect Capital Corp. (PSEC) that I would report him to the SEC if he kept soliciting me to buy his company’s stock.  PSEC is a troubled BDC that pays egregious and unjustified fees to its management and should be avoided by investors at all costs.  After some back-and-forth, the guy finally got the message.  I believe, by the way, that PSEC is under investigation by regulators, and its stock is down sharply over the last year.

Then I received a “White Paper” from a firm called Miller Howard Investments entitled “Are MLPs and Midstream Companies Still Like ‘Utilities Without Walls’?” and it really made me angry. The firm, Miller Howard, obviously led a lot of its clients to invest in MLPs and is now trying to justify what was catastrophically bad advice.

I responded to this unsolicited email by telling the sender that comparing MLPS to utilities was highly misleading and the only thing that was white about his paper was that it resembled toilet paper!

And I’m still furious.

Here’s why MLPs are a huge, hidden trap for investors.

There’s No Such Thing As A Free Lunch

MLPs were one of the ways that investors were supposed to generate income in a world where central banks drove interest rates to zero and destroyed bonds as an asset class.  And for a while, they accomplished that goal.  But like many investment products that promise high returns with low risk, they turned out to offer a free lunch in a world where free lunches don’t exist.  Now investors feel like they’ve been hit over the head by a 2-by-4 as they’ve watched years of income go up in smoke while the principal value of their MLPs have dropped by 50% or more.  The Alerian MLP ETF has dropped from $17.19 to $9.89 year over year.

MLPs were part of the great reach for risk (and yield) that former Federal Reserve Chairman Ben Bernanke thought would stimulate economic growth and help the U.S. economy recover from the financial crisis and the Great Recession of 2008-2009.  Unfortunately, Mr. Bernanke’s solution didn’t work as planned; in fact, it worked in precisely the opposite way.

Rather than promote economic growth, zero interest rates created the biggest debt bubble in history.  And much of this debt was incurred in the energy industry, which is home to the MLPs that attracted investors and ended up blowing up in their faces.

Now the investment advisers who convinced their clients to invest in these products are scrambling to justify what proved to be very bad advice. (Hence that atrocious “White Paper.”)

Don’t Be Fooled – High Income Always Means High Risk

The “White Paper” I received makes a series of intellectually false comparisons between MLPs and utilities in a devious effort to convince investors that MLPs will rebound in value.  It focuses on midstream MLPs, which are companies like Kinder Morgan (which is not an MLP) that engage in the transportation, processing and storage of oil and gas rather than the exploration and production of energy.  Midstream companies were supposed to be insulated from the collapse in oil prices, yet their stock prices were decimated along with the rest of the industry.

The “White Paper” makes all of the familiar arguments about the supposed strengths of midstream businesses:  they provide essential services to the oil and gas industry and they have durable revenues.  But it tries to make the case that midstream MLPs are in the same category of safe investments as utilities. It points out that like midstream MLPs, utilities have seen sharp sell-offs in the past and have recovered.

But the comparison is completely bogus because the problem with MLPs is not just their substance but their form.

In terms of their substance, MLPs were designed to pay out high income streams in a tax advantaged manner. The tax advantages come from the fact that they are structured as partnerships, which allows them to pass through both income and deductions that shelter that income from their partners.  But there is no such thing as a free lunch in economics or investments.  High income means high risk.

Because they pay out all of their income, MLPs need to look elsewhere for capital to expand and maintain their businesses. So naturally they end up borrowing a lot of money or selling additional partnership units that dilute existing holders.  Since no business can expand indefinitely, when energy prices collapsed, energy MLPs collapsed with them, including those involved in the business of transporting oil and gas.

In terms of their form, the MLP structure has hidden traps for investors that they are now just learning about.

One hidden trap is the potential for investors to get hit with taxable income at the same time they are getting smashed with losses. As a partnership, a financially stressed MLP that restructures its debt in a transaction that reduces the face amount of the debt will produce “debt forgiveness” income for the partners without producing any income to pay for it.  This means that in addition to the loss in value of their investment, MLP holders will get a bill from the IRS for their share of the debt that was written off.  Talk about adding insult to injury – that isn’t something that happens when you invest in a utility!

When Kinder Morgan announced in 2015 that it was cutting its dividend by 70%, it was a knockout punch to the midstream and MLP industries that were already badly battered. Kinder Morgan is considered the 900-pound gorilla of the midstream energy companies. Despite the fact that it had built up $40 billion of debt while its stock price was plunging by 70% between April 2015 and January 2016, the company swore it would never cut its dividend.SMIBut eventually reality trumped corporate doublespeak and the company had no choice if it wanted to survive.  The dividend reduction shattered the myth that midstream companies could ignore the fact that their customers were facing existential threats to their businesses.Kinder Morgan has also built up an enormous amount of debt, which forced it to cut its distributions to unit holders in order to insure it could continue to make its interest payments and meet its other obligations.  If Kinder Morgan had to cut its dividend, the outlook for other midstream MLPs was dire.

Don’t listen to shady investment firms that are trying to justify their bad decisions by sucking you into MLPs. They are not utilities. They’re not even useful.

Thanks. I just had to get that off my chest.


Michael Lewitt

14 Responses to “MLPs Are Not Utilities – They’re Traps”

  1. Your candor is refreshing. Another trap of these MLP’s are the complications when preparing your tax returns – a nightmare. No thank you. Never again. The peddlers never talk about this. I don’t need any audit triggers.

  2. Master Limited Partnerships:
    Fellows in the office from Warton and Penn state laughed at me for not investing in these cash cows. My very early analysis was that they had feet of clay. Just too much debt even years ago when they were and maybe today still popular. By not following their advice I might have lost all of those high dividends… but by sticking to my not wise analysis according to associates, I did not lose income. I think I came out ahead in the long run. When all else fails, read the financials. I never did feel comfortable with any of the MLS’s financials. Yes, at tax time it is inconvenient, but as I saw it, most were too leveraged. Sorry you guys lost all that cash. Next time read the financials.

  3. Other issues that are problems to these entities is that when the upstream producer stops extracting oil or gas is that there is nothing flowing through the toll bridge. You can’t generate income when there is no economic activity that you rely upon!

    Another way that they are not utilities is their returns are not guaranteed by government, like the returns for a utility. This lack of income supports is what doomed some of these assets. They also don’t always have someone else that can provide the product to fill in the gaps. I know that’s not a great analogy, but this is spur-of-the-moment writing.

    Related to the lack of being able to retain earnings, the entities are not able to maintain their assets very well without this. This greatly increases their true cost of capital, since they have to borrow or sell units at a regular rate. If they do not expand, then they are do not always have their assets in the areas where they can earn the best return. This can result in having to depend upon just a few producers to maintain their infrastructure.

    Related to the debt forgiveness issue: Not only does the partnership receive a benefit that is passed to the unit-holders, it receives that benefit without cash. Therefore, the benefit that the unit-holder receives is phantom, since there is no money received to help pay for the increase in tax. The unit-holder is shafted by a big tax bill and no money to pay it with!

    I could expand upon these and other issues, but they might be too scary. And we can expect many of these exact scenarios to unfold before we see an upturn in the fortunes for these businesses.

  4. I just want to say Thank You! I just started reading your Sure Money. It is Fascinating and very helpful. I am always looking for safe income and MLPS are looking a bit to dicey at this time. Thanks for your Thoughts on them !

  5. I normally do not comment Unruh… but !!! MLPs versus physical GOLD !!! MLP is a legal entity created by government legislation. Physical gold is a centuries old metal recognized as a safe storage of wealth in good and bad times and a hedge against FIAT money printing. Gold does not file bankruptcy or borrow against itself like a MLP to pay high dividends, which may result if bankruptcy proceedings.

  6. I have recently retired and have been looking into the investment world as an interest and some passive income, but I can see already it’s a whole minefield and that you could lose your shirt, thanks Michael for your very interesting and informative info

  7. Just because SOME MLPs are debt laden and present a poor value proposition, doesn’t mean ALL MLP’s can be painted with the same brush. You have to do a little digging, but when the majority of take-or-pay customers have strong credit ratings, the risk is mitigated substantially.

  8. An MLP is a legal entity that owns a business. Like a corporation. Like stock of a corporation, MLP partnership units should be valued based on the value of the business. Also, generally the same business is more valuable if owned by a MLP, than if owned by a corporation because the MLP pays no income tax, only the investor does, while with a corporation both the investor and corporation pay tax.
    Midstream MLPs are down sharply. In the past when this occurred ( the 2008 crash and in 2001(?) when Enron went bust) it proved to be a very good time to invest in MLPs. MLPs, like REITs, tend to have a limited investor pool, and in sell offs tend to go down much more than justified.
    So the real question is this time different. Will MLPs come back very strong, as they have after prior sell offs. And if this time is different, why. The Utilities paper attempted to provide an answer, namely that this time is not different and MLPs will come back strong from the current sell off. Rather than be angry, you should devote some thought to why this time is different? And note, with KMI notice the stock went up after the dividend cut. That is because no one is really valuing MLPs based on yield, but instead on EV/EBITDA (which is one reason you get such high yields and why high yields). And after the dividend cut, the EBITDA was the same for KMI.

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