Posted by Don Martin on Mon, Feb 25, 2013 @ 03:46 PM
Will you hit an oil gusher in energy MLP’s?
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Master Limited Partnerships (MLP’s) are not nearly as good as they may appear to be. Their big fame comes from the tax-free status as a flow-through entity and the tax deferral of the annual distributions. This alleged tax benefit coupled with high yields during a time of ultra-low interest rates makes MLP’s appear attractive, but they are not any better than a generic traditional oil company that is a “C” corporation. MLP’s are limited by law to the energy or real estate industry; the real estate industry prefers not to use them.
MLP’s pay no corporate income tax because they are a partnership, so they are called a flow-through entity, like an “S” corporation or an unincorporated small business. The partnership unit (share) owners still pay tax on the distributions they get, however these are often 80% tax deferred because of depreciation. This creates a myth that MLP’s are better. The problem with distributions is that they are subject to recapture at ordinary tax rates when the units are sold. Since ordinary tax rates are higher than dividend taxes then MLP’s can cost their unit owners more tax over the long run.
Another myth is that since MLP’s, as a business entity, pay no tax they should be compared to a “C” corporation that pays 35% corporate tax. However a large multinational “C” corporation may have half or even all of its income sheltered in foreign subsidiaries and brought home only during special “tax holidays”. Thus a “C” corporation may not have a significant tax disadvantage over an MLP.
If one assumes the typical multinational “C” corporation has an effective corporate tax rate of 17% and that an affluent owner of MLP units is in the top 39.6% personal tax bracket, then, when including tax on recapture of depreciation, (which is taxed at a 19.6% higher rate than dividends for high income people) the C corporation shareowner’s total comprehensive tax cost (both by the entity and by personal 1040 taxes) is roughly even with the MLP unit owner’s tax cost. This assumes that MLP units are eventually sold, triggering recapture tax. If someone kept his units until death then basis is stepped up, thus avoiding depreciation recapture tax. Since investment themes often burn out every decade or so then investors may find it difficult to hold on to unwanted MLPs for 40 years until they die.
The risk of an oil MLP versus a giant “C” corporation oil company is that the “C” corporation is a hugely diversified company with lots of flexibility, by contrast the little MLP has to flush out most of its cash every year so it runs the risk of having no cash and no ability to get a good loan during a crisis. A traditional “C” corporation is much safer way to invest in the oil and gas industry.
Both the MLP and C corporation are taking a chance that Congress could change the tax code and destroy their tax benefits. Thus neither should be seen as a magic windfall tax savings vehicle.
The difference between MLP versus a “C” corporation is that a “C” corporation pays out 40% of earnings (about 2% of the stock price) and retains the rest (about 3%). Hopefully the management doesn’t lose the retained earning with reckless gambles and instead makes money with the retained earnings. If the reinvested funds produce a decent return the total after-tax return from the two entities should not be that different once the taxes at the 1040 level are counted. An MLP might pay a 5% distribution yearly versus a “C” corporation would pay a 2% dividend. To a yield starved retiree the MLP yield with its alleged 80% tax-free distribution looks incredibly attractive, but that is a myth.
There is a theory that the bigger the dividend, the more trustworthy the investment. I think this is only true if the stock is a volatile growth company that never pays dividends when compared to a typical company with a 2% dividend. It is not true when the extremes of a 5% or greater yield (distribution) are offered to entice investors. A company with a very high PE ratio can’t afford a 2% dividend so that is why companies that pay less than 2% may be high risk, but a company that has to seduce you with a huge 5% or more payout (at the risk of using up all its spare cash) is also a high risk situation. So don’t let the high dividend theory fool you into respecting MLP’s high distribution as a sign of good health.
Investors who own MLP’s need to hire a tax professional to assist in filing various state income returns where the MLP operates. This cost may significantly lower the rate of return for small investment accounts. All investors should avoid holding MLP’s in a retirement account because of the Unrelated Business Income Tax penalty (UBIT). A 401k would be hurt by investing in MLP's since the tax code has penalties for UBIT, so employers don't offer them in a 401k.
I have written an article “Are high return assets a trap?”
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Jan 14, 2013 @ 02:45 PM
Are Energy Master Limited Partnerships held in a Closed End Fund Too Risky?
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Investors searching for yield can allegedly get 6% to 9% yield in some Closed-End mutual funds (CEF’s) that hold Master Limited Partnerships (MLP’s), but these are very risky. The yields may be unsustainable. CEF’s that hold MLP’s lose the tax benefit of MLP’s. They often use leverage which means in a downturn they may need to sell assets to reduce debt to meet margin calls, leading to a vicious cycle of forced sales leading to more falling prices. They may have little or no track record in a risky, volatile industry. CEF’s have the premium/discount problem where buyers who buy when the discount is less than 7% incur a risk that the discount could widen to 20% thus creating a loss even if the Net Asset Value (NAV) was stable. CEF’s have the problem that the IPO underwriter’s fee is paid by those who buy during the IPO and the underwriter may prop up the market price for a few months after the IPO. The biggest risk of an MLP is that it is used by a narrow type of business venture such as pipelines or storage that has the risk of an undiversified business in a very volatile sector of the volatile commodities industry and is thus more susceptible to economic downturns. The MLP’s only significant net tax savings over time is that there is no “C” corporation tax, so it is like owning an “S” corporation. However, this tax savings is lost if the MLP is owned by a mutual fund because a fund company may not own more than 25% of its assets in an MLP, so these MLP’s have to be structured a taxpaying corporation. The biggest problem is the economic problem that the business is undiversified and dependent on the volatile cycles of the energy industry. Also there is risk that the corporate level tax savings may merely be a form of compensation by the invisible hand of the market to make up for the business risks of an MLP, so the tax benefit and higher yield may not be that great on a risk-adjusted basis; it is a bit like the lure of high yield junk quality preferred stock (which is like junk bonds) issued by a overleveraged bank that owns a lot of risky loans. Such an “investment” is extremely risky, especially when the next recession comes. An old rule of thumb is that when an invest offers an alleged high yield that it must be similar to a junk bond in which case one must examine it for hidden and excessive risk and see if the contingent risk outweighs the benefit of the high yield. Investors in MLP’s or CEF’s need to have a high risk tolerance, which ironically means that retired people seeking to get a better current yield may need to avoid the risk of this asset class even though it would imply accepting a lower yield by investing in less risky assets. Investors who want to own MLP’s should hold them in a taxable account and they need tax sophistication including the willingness to pay a CPA to prepare state income returns for several different states where the MLP is located. There are tax problems, extra tax filings, and potential penalties for owning MLP’s in an IRA, depending on circumstances. Investors need to be emotionally prepared for a multi-year crash in the oil business while holding an undiversified business that is dependent on one narrow service such a geographically fixed pipeline. In 1982 oil crashed and the oil industry went in an extremely deep depression for several years, causing severe damage to the local economy of the oil producing regions such as Texas, Louisiana, Alaska, etc. The crash hurt people from all walks of life who lived in the oil region and did not merely hurt the oil industry. If you insist on owning this asset class then try to buy on a deep dip and diversify and limit your ownership to a small percentage of your total assets.
What if demand for oil shifts elsewhere or shifts to coal or to using train cars? This is now happening in the central U.S. where there are problems shipping oil from Canada and more oil being is loaded onto trains. Oil in Canada recently briefly experienced a 50% price cut due to some shipping problems and over production.
If one feels they want to invest in the oil industry a safer method would be to buy a diversified portfolio of the large and medium sized oil companies. They are a better risk than MLP’s because they have a diversified portfolio of business ventures rather than simple portfolio of fixed pipelines. Of course, if one feels the overall stock market is a bit too high then this might not be the time to buy any oil companies, as the oil industry tends to be more volatile than other industries. MLP’s can invest in other energy sources besides oil. MLP’s are similar to Real Estate Investment Trusts (REIT’s) because REIT’s have no corporate income tax and are limited to narrow field of real estate.
Buying the asset class of oil producers in an MLP and then having it held in a CEF is really three levels of risk cross multiplied against each other, or risk cubed (risk to the third power).
I have written an article “Are high return assets a trap?”
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Jun 12, 2012 @ 04:05 PM
What asset classes have returned over 10% annually?
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People wonder about investment asset classes that are rumored to return 10% or more annually while the rest of the market, like the SP500 index, returned roughly 4.14% annually over the past decade (or -0.92% annually over five years). This is the reult of examining 474 asset classes in Morningstar with a 10 year history out of 502 asset classes. Of these, the top 44 (about 9%) had annual returns at or above 10%. The winning asset classes were Emerging Markets stock, precious metals, energy (oil) and bonds. Also the Alerian MLP index (MLP = Master Limited Partnership which serves the oil industry) came in the top 9% with a 15.4% annualized return.
Assuming that the bond markets ability to produce more capital gains is very limited with bond prices so high and assuming that the commodities boom may be over then that implies the only asset class remaining that has done double digit returns is EM stock. But that asset class gets a lot of help from the (probably ended) commodities boom and from the U.S. Fed’s Quantitative Easing which stimulated the EM countries rather than the U.S. At some point the EM countries may find they can’t sell exports to over-indebted deleveraging Developed countries and the EM countries will incur a lower growth rate because the easy gains from the initial phases of rapid development have been exhausted. Future growth in EM countries will be at a slower pace because their professionals now cost almost the same as Developed countries. EM countries demographics are starting to become closer to that of the slow growing Developed countries.
What asset classes returned a minimum of ten percent annualized?
One asset class, REIT’s, came in exactly at an annualized return of 10% and some variations of REIT's came in at just under 10%. The ten year history was influenced by the fact that 2002 was a recession so asset prices were depressed then. A five year history shows only 16 asset classes, mostly bonds, precious metals and Thailand stocks that made at least a 10% annualized rate of return. Since the economy was at a high point five years ago and has spent three years recovering from the crash of 2009 it seems a five year comparison is more valid.
If oil, precious metals, and bonds are unlikely to repeat their past ability to produce significant capital gains then it seems those investments that claim to be able to provide a total return of double digit rates are not going to repeat that rate of return.
One thing that investors misunderstand is Master Limited Partnership units. These are rumored to produce lucrative rates of return. But I see no economic reason why they can beat the market. Other than tax benefits that they get for their owners these MLP’s do nothing special that can’t also be done by other businesses serving the demands of consumers. They exist to serve the oil companies providing pipelines or oilfields. If the oil companies suffer from a crash in oil the oil majors could renegotiate the MLP contracts and reduce the compensation to the MLP vendor. The MLP’s run outsized risks of investing in fixed assets like pipelines or oil wells and can’t diversify either geographically or into other industries. Their annual rate of return is probably 1% higher than it would be if they had to pay corporate income taxes, so there is risk that a tax law change could take that away, which happened in Canada. The oil industry has a bad reputation of boom and bust cycles, so MLP investors could be left holding onto a white elephant during the next down cycle for oil. The oil companies are not stupid. They offloaded heavy capital equipment projects onto naive retail investors who bought MLP’s, so these MLP owners shoulder the risk of being stuck with immobile, illiquid capital assets during an era when businesses need to be flexible, nimble and practice “just in time” manufacturing techniques. Yes, I am sure the “Peak Oil” theory (forecasting an increasing scarcity of oil) will be proven to be true, but the question is which decade will it come true? Will the oil industry suffer a repeat of the price declines of the 1990’s for a whole decade and then take another decade to begin to recover before peak oil becomes proven to be true in 2035? The extra theoretical profit from MLP’s seems risky and unsustainable. The Morningstar energy sector index came in at 12.82% annual return for the past ten years versus 15.4% for MLP’s. The extra profit could be attributed to investors taking on higher risk that may not be fully compensated for. And part of their historical profit was a run up in asset prices as investors scrambled to buy high yield assets, so total return was only partly due to the current income produced by the MLP’s. If the price of MLP shares stays flat and all investors get is the current yield these assets won’t perform as they have in the past. The shocking drop in natural gas prices and now in coal and oil shows nothing is reliable in the energy business.
The one asset class that I expect to produce a 10% annualized return are U.S. stocks, but only if investors wait to buy them during a crash at a good, low, fair price. Based on the PE10 theory U.S. equities need to drop to 900 for the SP index to be fairly priced. Further, they should be bought a discount so as to provide a margin of safety, so perhaps waiting to buy when they retest the low of March, 2009 would be good.
I wrote an article “Increasing results using risk aware investing”.
Investors should seek independent financial advice. 