Should You Invest in MLPs?

Note: This article is part of Morningstar's November 2015 Income Investing Week special report.

The average oil and gas master-limited-partnership fund has been pumping mud this year along with the rest of the energy sector. But if you're investing for income, MLPs may offer plenty--if you choose the right ones.

The average energy limited-partnership fund has plunged 26.69% this year, as of this writing, and 10.69% in the past month alone. The obvious reason for this antigusher is the collapse in oil prices since September 2014, when West Texas intermediate crude (the type produced in the U.S.) peaked at $110.62 a barrel. Crude was selling at $42.24 on Nov. 12--a 62% decline.

But oil prices might not be the best explanation for the funds' poor showing. Let's start by looking at what energy MLPs are. As their name implies, MLPs are limited-partnership units, rather than common stock. Unlike traditional limited partnerships, MLP units sell on stock exchanges, which makes them far easier to sell than traditional limited partnerships.

The big appeal for investors, however, is that MLPs must distribute nearly all of their earnings to unit holders. The average MLP fund yields 6.4%, far more than the 2.32% available from 10-year Treasury notes or the 2.2% dividend yield on the S&P 500.

Most MLPs concentrate on oil and gas pipelines, the area that analysts call "midstream." (Upstream, in energy parlance, are energy and production companies; downstream are refiners, processors, and marketers of crude-oil products.) What's peculiar about the sell-off in energy MLPs is that pipeline companies make their money primarily from the volume of oil and gas they carry, rather than the price of the oil and gas that runs through their pipes.

Despite the huge drop in oil prices, U.S. oil production has increased 5.5% in the 12 months ended August 2015, according to the latest data from the Energy Information Administration. Natural gas production is up 7.2%. "Sentiment begins to drive prices in periods like this, rather than sober analytics," says Brian Watson, comanager of Oppenheimer SteelPath MLP Alpha MLPAX.

Of course, sentiment is one reason MLP shares rose so high in the first place. Yield-starved investors saw MLPs as a good way to get an income boost as the Federal Reserve's zero-interest-rate policy dragged on. The Morningstar Category saw an estimated net new cash flow of $586.1 million in 2010; by 2014, that ramped up to $11.9 billion.

As investor interest grew, the stocks became more expensive, and yields fell. In the case of

Worries about production drops aren't unfounded, although Watson notes that gasoline production generally stays relatively stable, even in recessionary periods, as does natural gas. "As long as people need it, the industry is going to supply it," he says.

But some investors worry that lower oil and natural gas prices mean it could be more difficult for pipeline companies to raise capital for new projects, Watson says. Others worry that the drop in oil prices augurs slower economic growth ahead, which could mean generally lower stock prices.

Some pipeline MLPs could be just as volatile as their cousins in the energy exploration and production market, warns Josh Peters, editor of Morningstar DividendInvestor. "If you're in the business of running pipes out to the wellhead and gathering gas or gathering crude oil, you may be charging fees per gallon of crude or per thousand cubic feet of gas, but if there's no drilling, there's no well, there's no gas, there's no fee," Peters says. "The closer you are to the consumer, the more consistent the demand will be."

And that decision should depend on a hard look at how secure an MLP's distributions are. While demand for oil and gas may be reasonably steady, new production can take away business from existing pipelines. Case in point: Boardwalk Pipeline Partners BWP, an MLP with pipelines stretching from Texas and Louisiana to Ohio and Indiana, slashed its payout by 81% last year. Competition from nearby Marcellus gas fields in Pennsylvania hurt their contract renewals and forced the payout reduction.

You can get an idea of how safe an MLP's payout is by looking at its distribution ratio, which essentially tells you how much of the MLP's available cash is doled out to unit holders. If the ratio is less than 1.0, the company's distribution is at risk, and it may be borrowing to make its payouts. "Cash-distribution coverage levels are getting tighter with some firms unable to reach 1.0 times coverage, including

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Because of their structure and the wonders of the corporate tax code, individual MLPs allow you to defer taxes on your dividends virtually indefinitely, provided you're willing to put up with the paperwork of K-1 forms at tax time. For most investors, MLP distributions are treated as a return of capital, rather than dividend income. Your distributions reduce your cost basis, and when your basis hits zero, distributions are taxed as long-term capital gains.

Bear in mind, however, that MLPs can be problematic in tax-deferred savings accounts, such as individual retirement accounts. For one thing, owning an MLP in an IRA won't make them any more tax-advantaged. Also, MLPs sometimes throw off unrelated business taxable income, or UBTI, and if that's more than $1,000 in an IRA, it will be taxed at 39.6%. Finally, if you're investing in a traditional IRA, your shares will be taxed at your ordinary income tax rate.

You should also think twice about investing in an MLP fund. While funds let you dodge the K-1 forms that individual MLPs must issue, MLP funds have significant tax complications of their own. For one thing, owning a fund eliminates the tax deferral that you get when you buy individual MLPs.

Another problem: Funds that invest more than 25% of their assets in MLPs are taxed as C-corporations. Rather than dole out capital gains distributions at the end of each year, as garden-variety mutual funds do, MLP funds have to set aside part of their earnings for taxes, which creates a significant drag on their performance and ability to pay out distributions in a bull market. On the other hand, it can use its losses in a bear market to reduce its tax liability.

What this means for you: In a bull market, a fund will lag the index when it has exhausted its tax losses--called "tax assets," from the fund's point of view. "All else being equal, an investor who is bullish on the MLP space would prefer to own an MLP index fund with a greater tax asset as a percentage of the fund's total assets," says Jay Jacobs, director of research at Global X.

Don't forget that adding an MLP fund or individual MLPs to your portfolio will increase your exposure to the energy sector, which currently has all the appeal of a wood-burning battery charger.

John Waggoner is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.