Independent Investment Advice Blog

Oil in a MLP in a CEF is Risk Cubed: Independent Financial Advice

Posted by Don Martin on Mon, Jan 14, 2013 @ 12:45 PM


Are Energy Master Limited Partnerships held in a Closed End Fund Too Risky?


    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.

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   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.

Tax aware investing




Tags: independent financial advice, MLP's, Closed End funds

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Donald Martin, CFP®

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Donald Martin is a NAPFA-Registered Fee-Only financial planner and investment advisor.