The old adage “if it’s too good to be true, it probably is” rings true when it comes to many Master Limited Partnerships (MLP) in the energy sector. You can separate the wheat from the chaff based on how big the dividend yields are.
These partnerships were set up to pay investors a fat juicy dividend based on the proceeds from the sale of energy…but as it turns out, many are paying you back with your own money!
These MLPs became very popular after the market crash in 2008 as interest rates plunged and the energy boom began to take off. Now, don’t get me wrong, some of these MLPs are totally legitimate and I’ll tell you how to spot the good ones. But, many are nothing short of ponzi schemes that are destined to fail.
MLPs are vehicles that have the same characteristics of limited partnerships, but they trade on public exchanges. So, you get the flow through benefits of income without the liabilities associated with the company. To qualify, these partnerships have to payout 90% of their income generated from qualified sources to the shareholders. This is where it gets a little dicey.
Qualifies sources in oil and gas sector should mean they generate income from sales of the energy or pipeline revenue just as a real estate investment trust should be paying you dividends from funds generated from operations.
But, what’s really happening in many cases – the ones that are yielding 12% or 15% is that these funds are being generated through a combination of transactions, mainly acquisitions of more companies and the issuance of more shares to the public. So, what’s really happening is that on paper these companies are telling you they are generating cash from oil and gas while in reality what they are doing is issuing a bunch of stock, taking that cash and buying dividends in the form of other companies or through hedging contracts on future production or just by paying out the proceeds of the stock sales. But this does not lead to a reliable source of future income as energy prices constantly fluctuate good acquisitions are not always available. Anyway you look at it, the returns are not coming from pure energy production or pipeline revenue.
The companies that are paying you out from the “right” and legitimate sources are paying you returns in the low single digits. Earlier this year several MLP stocks took it on the chin when the SEC started asking questions about accounting practices.
The way you can tell which MLP is legitimate and which one is the product of wishful thinking is to look at the sources of income. If those sources are purely from energy production and sales – they are legit. If they are a combination of acquisitions, energy sales, the futures market and from stock sales, stay away! When you see the big fat juicy yields that some of these are offering, ask yourself why and how that is possible. In a world of super low interest rates, anything offering you 12% yields from natural gas or oil production should be suspect. It’s just too good to be true!
To your wealth,