A big energy investing myth that crushed investors
By Eric Rosenbaum
When Kinder Morgan (NYSE: KMI) made the decision to cut its dividend by 75 percent this week , it represented more than just a pain for investors in the pipeline company, and more than just another sign that the oil collapse continues to cause more casualties.
It went public in a private equity-backed IPO in 2011, then went on a buying spree that including the acquisition of El Paso for $38 billion, becoming one of the largest midstream — oil and gas pipeline — players in North America. In August 2014, all of its various entities were combined in a $70 billion transaction, a deal under which it abandoned the MLP structure, a decision that shocked some energy industry watchers, given how closely it was associated with the concept.
Assets under management in MLPs in 2007 were $100 billion; by 2014 that had quintupled to $500 billion.
But the stock plummets this year in MLPs — including a 60 percent dive for Kinder Morgan, which has brought its market cap down to $35 billion — culminated in Kinder Morgan’s dividend slashing and show that some of the arguments used to sell investors on MLPs were more myth than reality.
Even as oil prices collapsed, MLP backers said that the “toll road” economics of MLPs, which have long-term delivery contracts with exploration and production companies, would insulate them from pricing pressure. With the party now over, it’s left a wide wake of investors who went searching for high yields in the MLP space but are now sitting on year-to-date losses of 25 percent and up, and dividend cuts likely looming on the horizon.
“The pitch with these companies was that they are not susceptible to prices of energy, that they are ‘toll booths,’ pass-through businesses that don’t have to worry about oil prices going up and down or being volatile. They’re like bonds,” said Josh Brown, CEO of Ritholtz Wealth Management, on CNBC on Wednesday. “They are not like bonds, and they are not toll booths. They are highly susceptible. The entire pitch is out the window,” Brown said.
Brown, who writes “The Reformed Broker” blog, said that energy MLPs are even more susceptible to something worse than oil prices: financial conditions. “They have a ton of debt and need to roll it constantly, and they cannot grow [shareholder] distributions and payouts unless they can continue to do that [access credit], and when that market closes off to them and commodities free fall, these can’t act like bonds,” Brown explained.
“By virtue of paying out a significant portion of cash flow each quarter, most MLPs are dependent on capital markets access to fund organic growth projects and acquisitions. If access to equity and debt financing is limited, then growth isas well, and valuations will come down,” said Maria Halmo, director of research at MLP research and index company Alerian.
Investors have chased energy MLPs because of the high-yields at a time of unprecedented low interest rates from the Federal Reserve, but Brown advised investors to learn the lesson that “you’re not getting 8 percent yield when Treasurys are 2 percent, unless you’re taking four times the amount of risk.”
By one industry account, 70 percent of MLP accounts are held by retail investors.
“There were some investors who bought the story too wholeheartedly,” said Nick Einhorn, vice president of Renaissance Capital, an IPO watchdog and manager of IPO-Focused ETFs.
One way in which investors accessed the high yields was through MLP ETFs.
- Alerian MLP ETF (NYSE Arca: AMLP): $6 billion
- JPMorgan Alerian MLP ETN (NYSE Arca: AMJ): $3 billion
- ETRACS Alerian MLP Infrastructure ETN (NYSE Arca: MLPI): $1.5 billion
- First Trust North American Energy Infrastructure ETF (NYSE Arca: EMLP): $828 million
- Barclays iPath S&P MLP (NYSE Arca: IMLP)ETN (NYSE Arca: IMLP): $300 million
- Credit Suisse Cushing 30 MLP ETN (NYSE Arca: CSCB): $400 million
(Source: ETF.com, through Dec. 8, includes exchange-traded notes)
“In typical investor fashion, there was a lot of yield-hungry money chasing the strong returns of MLPs,” said Peter Lazaroff, director of investment research at Plancorp. “Just as investors hurried into a high-flying asset class, many of those same investors are exiting in response to poor performance without an understanding of the underlying fundamentals that drive MLP returns and volatility,” he said.
Lazaroff said any investor who was surprised by MLPs’ susceptibility to volatility or the fact that they are equity-like investments and not some sort of bond replacement “were poorly informed.” He added that a great deal of the investing public, and unfortunately many financial advisors, never really understood the relevant mechanics of MLP investing.
MLP experts contend that the midstream is being unfairly punished for the woes at the level of the upstream — exploration and production — part of the oil and gas business. But others say that argument, while reflecting the fact that there are various levels of risk within MLP companies based on their position in the upstream to downstream chain, only goes so far in explaining the selloff.
“The days of the entire sector rising because people want yield are over,” Brown said on CNBC. “And lots of wealth management people are getting a huge wake-up call.”
Officials at ALPS, the distributor for the Alerian MLP, the largest MLP ETF, did not return calls for comment.
- Alerian MLP ETF (NYSE Arca: AMLP): -37 percent
- JPMorgan Alerian MLP ETN (NYSE Arca: AMJ): -45 percent
- ETRACS Alerian MLP Infrastructure ETN (NYSE Arca: MLPI): -45 percent
- First Trust North American Energy Infrastructure ETF (NYSE Arca: EMLP): -29 percent
- Barclays iPath S&P MLP (NYSE Arca: IMLP)ETN (NYSE Arca: IMLP): -44 percent
- Credit Suisse Cushing 30 MLP ETN (NYSE Arca: CSCB): -47 percent
(Source: ETF.com, through Dec. 8, includes exchange-traded notes)
It’s too late for investors who chased yield in the sector to get out unscathed, but professional investors and advisors are wondering whether now is the time to look for bargains in the MLP sector.
Kinder Morgan, after announcing its dividend cut, rebounded 7 percent on Wednesday. That may lead other pipeline companies to consider a move they never would have contemplated, since many investors bought their shares for the yield. But if dividends throughout the sector are slashed, that will mean more pain for MLP shares before any relief rally. And other, recent dividend cuts from MLPs did not lead to a relief rally, as in Kinder’s case.
“Kinder Morgan is cutting dividends preemptively in anticipation of the lower volume outlook, and other MLPs may follow suit,” wrote Tom Lydon, the editor and publisher of ETF Trends, in an email. “Given the uncertainty in the energy space and the prospects of dividend cuts, MLP ETFs may experience greater volatility, and dividend-minded investors who are typically more conservative in nature may find the added risk unappealing,” he said.
Einhorn said yields in the space can range from 6 percent to as much as 25 percent, and so investors should expect dividend cuts, and while they’ve been reluctant to look at lowering dividends, the companies need to keep their lenders satisfied or their credit limits might get cut.
“Investors have to be selective and do a lot of work. You can’t just say MLP X has a Y percent yield and looks fine,” Einhorn said. “They all have different risk profiles. It’s like junk bond investing. … Lots of money to be made if you can adequately assess risks, but for several years there was lots of money to be made if an investor just threw money at companies.”
Lazaroff said that the “toll road” economics story remains true for many MLPs that focus entirely on the midstream portion of the energy supply chain, but like all investments, valuation is key. “The MLP sector saw incredible multiple expansion as investors hurried into the asset class on the basis of high yield and strong past performance,” he said.
Lydon said if investors did not understand this before, they need to now: As so-called energy toll road operators, MLPs rely on volume of transported goods and are less sensitive to crude oil prices, but MLPs are not completely immune to falling prices.
“With crude oil at near seven-year lows, the industry is at risk of energy producers cutting back on production — an environment of persistently low oil prices would eventually lead to U.S. producers finding it too costly to keep pumping oil, which would mean MLPs would suffer from lower volumes transported,” Lydon said via email.
“I’ve never looked at MLPs for our fund before, but now I’m looking,” Stephen Weiss, chief investment officer and managing partner of Short Hills Capital Partners, told CNBC on Wednesday. “I don’t think I will buy until they do what Kinder did and I see how the market reacts.”
Brown didn’t disagree with the idea that there’s bound to be some opportunities, but he said that the phenomenon of long-lived contracts written years ago at a certain level of energy prices will roll off and there will be a huge difference in cash flows and coverage ratios for debt. He said companies will claim they have a guarantee that a customer has to take oil or pay instead, but those [contracts] roll off, too, and the E&Ps have holes in balance sheets.
Early December is also the peak of tax-loss selling season, and with an average return of -42 percent in oil and gas pipeline companies, MLPs make good tax-loss candidates. “At these levels, tax-loss selling, along with closed-end fund deleveraging (both impossible to quantify), can only add to downward pressure,” said Halmo.
As retail investors flee, institutional investors with patience may be willing to buy MLPs at current multiples, given the size of yields. “The MLP recovery will be dependent on a fundamental recovery in commodity prices. Investors who are adding to positions at these levels are doing so despite the lack of a near-term catalyst,” Halmo said.
But for many retail investors, “The defensive characteristics that these ETFs were supposed to provide, because they were toll roads, no longer holds true. These have not proved to be the safe stocks investors had expected them to be,” said Todd Rosenbluth, head of mutual fund and ETF research at S&P Capital IQ.
Lydon added that the rising-interest-rate environment could make riskier MLPs less appealing as an income-producing asset.
“An investment in MLPs remains an investment in the build-out of North American energy infrastructure over the next several decades,” Halmo said.
In the immediate future, according to Brown, “There’s lots of pain still to come.”