MLPs or PLPs: Corporations without Corporate Taxes and with Fat Dividends

I'll call them MLPs just to be simple and because that was the original name. They are a very interesting asset class because of extremely favorable tax treatment and because they traditionally pay dividends that are large in comparison to the dividends of almost all publicly traded corporations.

The fat dividends are due to (1) tax rules that compel distributions of 90% of earnings and (2) depreciation rules make most of this dividend free of tax.

The purpose of this page is to collect some resources relevant to MLPs. They offer many opportunities for research since

There are many attractions to owning MLPs. In fact, when you first get into the game, it seems tempting to own ONLY MLPs. Still, eggs-all-in-one-basket-wise, that would not be the prudent thing to do --- though while the band keeps playing, you will be rolling in dough.

Here are some general resources:

MLP Primer from S&P

S&P MLP Index Fact Sheet

Research Magazine's 2006 Guide to MLPs

All About MLPs from the Dividend Detective

List of MLPs from Dividend Detective

MLP Goes Institutional

CEFs that Hold MLPs

The idea of a CEF of MLPs seems like an intrinsically bad idea, but that problem has never slowed down the CEF industry. It is true that paper work is reduced and you get more diversification than you might get from buying just a few individual issues, but you pay a lot for these modest benefits. In addition to the CEF fees, you lose the tax benefits of direct ownership of MLPs --- which is one of the main reasons for their existence.

Moreover, there are not hugely many MLPs to choose from, and the turn-over in the CEFs is very modest, say about 6% per year. Thus, if you think the CEF investment managers do bring some analytical skill to the table, there is no reason not just to piggyback. Here is a list of the MLP CEFs:

Energy Income & Growth (FEN)
Fiduciary/Claymore MLP (FMO)
Kayne Anderson Energy Total (KYE)
Tortoise Energy (TYY)
Tortoise Energy Infrastructure (TYG)
BlackRock Global E&R (BGR)
Kayne Anderson MLP (KYN)

Among these Tortoise Capital Advisors may have the most genuine, specialized knowledge of the area. For piggybacking, their CEFs would be my first port of call.

Also, take a look at the web resources of Eagle Global Advisors. On their MLP FAQ they calmly observe "In summary, MLPs must offer higher expected returns for the level of risk in order to attract a limited pool of potential investors away from traditional asset classes."

I appreciate the sentiment, but if we know anything about financial assets it is that "must" rarely applies, if ever, applies.

Personally, I would think that the big reasons that MLPs typically offer a superior Sharpe ratio is to account for the investor's anxiety that the general partners might put their hand too often into the cookie jar.

TYG Form NQ for Q3 2008.

What Can Go Wrong?

It is just good sense to worry about the master partner somehow ripping off the limited partners. This would be a shortsighted thing to do, but history teaches us that rich guys in a jam can be as shortsighted as moles.

Here are some ideas that can be used to mitigate this risk:

You might also worry about changes in the tax law. There is nothing on the table in the US right now, but Canada did make radical changes to its treatment of production MLPs, so it can happen. Personally, I put my faith in the traditionally close bond between the U.S. Congress and energy lobbyists. Also, any changes in the law will be discussed for months (or years) before any action.

What is Scheduled to Go Wrong?

The logical frame work the MLPs is that it provides an economically efficient way to monetize the value of the revenue stream of a wasting asset, such as a pool of oil. This is the reason for the favorable tax treatment.

Although the tax code could have ruled differently, the same logic really does apply to pipelines. A pipeline to a gas field that runs dry has no value, so pipelines are also wasting assets.

Now, the nice twist to this theory is that there is a kind of Moore's law that seems to apply to hydrocarbon recovery. Science keeps finding ways to squeeze more oil and gas out of old fields, or to get new production out of nearby property that was once thought to be uneconomical. The bottom line is that although there is some depreciation, the actually observed rate of depreciation has typically been much less than that suggested by a straight line calculation of "proven reserves less production."

Note: The preceding paragraph, was written when oil was $140/bl and there did seem to be a Moore's Law of Oil. This law can almost work in reverse if the price of oil or declines substantially . With oil at $35/bl, production from some reserves may be "shut in" and the pipelines that serve such reserves will simply become empty and rust. This is a very bad thing for your MLP.

Thus, we find a useful role for fundamental analysis. In general you should be willing to pay up for pipelines that are genuinely "mid-stream" and you should make sure you are compensated for the risk of "collection" pipelines that may be part of an MLP. The risks to a genuinely "mid-stream" MLP are mainly the operational and agency risks, coupled with some risk (or reward) due to the demand for oil and gas.

Invitation to Research

The time series properties for MLPs would make nice material for final projects in 434 or 956. You'll probably want to focus on weekly returns, and a key connection you'll want to make is the dependence either on (1) the underlying asset, say natural gas (2) competition from fixed income alternatives --- say Muni's, TIPs, or other bonds, and (3) the relation to the overall market.

Historically, most MLPs do not seem to have been very sensitive to the price of the underlying commodity, but one should not count on this holding at the extreme ranges of the commodity price. Some more refined understanding of this relationship would be quite welcome.

You might be tempted to consider fancier things like pairs trades between the MLPs, but keep in mind that they are very expensive to short, if you can short them at all. For the short side of the trade, you will probably have to use CEFs, but because of the expense ratio this could be a bonus. Still, even there you have the big dividends to cover. These are off-set by the big dividends (and tax breaks!) on the underlying. MLPs are also thinly traded, so a short-squeeze is always a risk.

Comment Fall '08: You can use CRISP data through the end of 2007, but some of the fun takes place in 2008 so you may have to do some work "by hand." Even if you decide not to use 2008 data, you should look at what happened on Oct. 10. It seems like a day of major "mispricing" for the whole sector, if you believe in that sort of thing.

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