Jack Johns, a retired postal worker in Rincon, Ga., put $50,000 into master limited partnerships in 2013 after reading about them on the Internet. Even though the bet paid off—he earned about $8,000 in less than a year—he sold his holdings because he realized he didn’t understand them. “I think it was just blind luck,” he says of his 16 percent return.
Johns, 65, is just one of thousands of individual investors pouring money into MLPs—tax-exempt, publicly traded companies that own pipelines, storage tanks, and other cash-generating energy infrastructure and give practically all their income to shareholders in the form of distributions. That’s a big part of their appeal: With bond yields at historic lows, MLPs yielded an average 6.7 percent over the past 12 months, according to data compiled by Bloomberg. Along with buying MLP stocks, last year investors put more than $11.9 billion into mutual and exchange-traded funds (ETFs) investing in MLPs, according to Morningstar.
So far they’ve been rewarded. The Standard & Poor’s MLP Index returned 28 percent annually over the past five years, compared with 22 percent for the broader 500-stock index. Professionals warn that many MLP shareholders, such as Johns, may not understand what they’ve gotten into. “Retail investors need to be very careful about buying on their own, because it’s easy not to know what you’re buying,” says Evan Welch, chief investment officer at Antaeus Wealth Advisors in Boxborough, Mass. MLPs are structured differently from typical corporations and operate in a highly technical industry. Some financial advisers say they also use management incentive payments that encourage executives to take on more debt. “I find them difficult to understand,” Welch says. “And with anything I don’t understand, I’m a little cautious.”
The unprecedented U.S. energy boom has propelled MLPs upward. New methods of extracting oil from shale, such as hydraulic fracturing and horizontal drilling, have spurred a 47 percent increase in U.S. production since 2011 and will boost output to a 28-year high in 2014, according to the U.S. Department of Energy. Natural gas output is already the highest ever and growing. All that oil and gas needs the infrastructure supplied by MLPs.
Yet production from shale drilling declines faster than that of crude from traditional wells. Output falls by 60 percent to 70 percent in just the first year, according to research firm Drillinginfo. “We’ve been through a remarkable period where it works really well and the returns have been great,” says Bobby Tudor, chief executive officer of Tudor, Pickering, Holt, a Houston-based investment bank catering to energy companies. “It just strikes us that it’s likely to be harder going forward than easier.”
Wall Street is urging investors to keep buying. Analysts predict that 93 of the 114 MLPs in existence will rise in value in the next year, according to data compiled by Bloomberg, and all but five MLPs are recommended by the majority of the analysts who cover them. “At the top, everybody’s a believer,” says Timothy Gramatovich, chief investment officer of Peritus Asset Management in Santa Barbara, Calif., who does not count himself as one. MLPs are “the next great investment debacle,” he warns.
Wall Street has another reason to love MLPs. Because they distribute most income to investors, to grow they need to borrow money or issue new shares, and banks earn fees on those transactions—$890.3 million in 2013, data compiled by Bloomberg show. “MLPs are Wall Street’s dream,” says Kevin Kaiser, an analyst at research firm Hedgeye Risk Management. “They’re fee machines.”
An example of what can go wrong occurred on Feb. 10, when Boardwalk Pipeline Partners (BWP), an eight-year-old Houston-based company, cut its payout to investors and its shares dropped 46 percent. CEO Stanley Horton, in a conference call with analysts and investors, attributed the cut to declining income from the partnership’s pipelines. The company’s market value has dropped by $2.8 billion since the announcement, to $3.1 billion.
Such risks are what made Johns, the retired postal worker, decide to take his profits and get out of MLPs. “A lot of people in them think they understand, but they really don’t,” Johns says. “They just weren’t as safe as you might think.”