Oil and gas Master Limited Partnerships are being touted as the answer to investor woes.
MLPs aren't inherently bad, but can represent significant risks to long-term investors.
Investing only in MLPs limits portfolio diversification, heightening risk.
Even as part of a portfolio, MLPs aren't necessarily optimal for diversification or as a tax strategy.
Being bullish on energy right now is great, but make sure it's in the right way.
Though the 2008-2009 bear market has now passed, a touch of fear remains in most investors—some are even wondering whether long-term stock investing is a bust. There must be a better way, right? Inevitably, alternative investments will pop up and claim they're the next, best thing—oil and gas Master Limited Partnerships (MLPs) are one recent example getting a lot of attention. Such things aren't inherently bad and can be useful in very specific circumstances, but often they present significant risks and hidden pitfalls to long-term investors.
Just what the heck is an MLP? MLPs are publicly traded limited partnerships. Specifically, they tend to be tied to oil and gas transportation and storage (which makes up the majority of the market). This is known as the cash flow heavy, "midstream" segment of the energy market. MLPs are marketed as the perfect hybrid between a Limited Partnership (LP) and a publicly traded company: They're exempt from US federal income taxes, yet they're supposedly as liquid as public shares—and on that basis a lot of folks see value in them as a tax haven. Even better, MLPs are required to pay quarterly minimum distributions to shareholders (but investors still must pay income taxes on the distributions when the shares are sold).
But MLPs are no panacea. MLPs don't provide good diversification. Since most are heavily concentrated in oil and gas transportation, a problem in that industry could severely impact returns. And just like any regular corporation, MLPs can go bankrupt—but unlike a regular corporation, because they must pay out most of their profits each quarter, they often fund growth with leverage. Additionally, many MLPs are cobbled together in a way that's complicated and limits transparency—investors must carefully determine exactly how a particular MLP does business before buying in.
But it's like a stock, right? If the investment's not up to snuff, just get rid of it. Well, maybe. Although MLPs are marketed as being as liquid as stocks, that might not always be the case. Just because MLPs are publicly traded doesn't mean they're easily sold—just more easily than pure Limited Partnerships. That's generally a far cry from stocks, which rank among the most liquid of all asset classes. Considering not many investors are familiar with MLPs and that other sales restrictions may apply—depending on the MLP—true liquidity could prove illusory. John Maynard Keynes famously called investors' preference for liquidity a "fetish." Well, call it an obsession if you like, but the ability to freely trade assets is well worth consideration in our view.
It's not wrong to be bullish on Energy stocks right now—in fact, it's a good thing if done right and without too much exposure to the wrong areas or overconcentration within a larger, well diversified portfolio. As always, among the largest considerations for long-term investments is to achieve desired growth in the context of proper risk control—e.g., diversification, benchmarking, and so on. For many long-term investors, there are simpler, safer methods than MLPs to achieve ample exposure to outsized Energy sectors returns—generally it can be as simple as owning the right mix and proportion of Energy stocks themselves.
Also, due to constant cash flow requirements, MLP payouts are mostly based on transportation and storage contracts, which have a very different profile than other energy companies such as exploration and production, integrated oil, refiners, and so on. While transport and storage companies have relatively stable businesses, they also generally don't participate in the gains E&P companies post in boom times.
So, if MLPs aren't optimal for getting appropriate Energy exposure in a portfolio, investors might think of MLPs as great tax vehicles. But if taxes are the only concern, surely there are better ways to go about it than owning part of an oil transport company.
MLPs are an example of capital markets evolution and innovation. That's a great thing. Just be sure the "new" thing is the optimal thing for your investing needs before diving in.
For more information on the energy sector, visit the Fisher Investments on Energy website.