“Blind luck” is how Jack Johns characterized his 16 percent profit on something he read about on the Internet called Master Limited Partnerships. Johns, a retired postal worker from Rincon, Georgia, said he sold his MLP investments within a year because he realized he didn’t really know what he’d bought.
“I always assumed when I got to this stage of my life, I’d be investing in Treasury bills and insured certificates of deposit,” said Johns, 65. Because of the Federal Reserve’s record-low interest rates, Johns said he sought higher returns in riskier assets. “MLPs fit into that category,” he said.
MLPs are more popular than ever. They’re tax-exempt, publicly traded companies that own pipelines, storage tanks and other cash-generating energy infrastructure and give practically all their income to investors. In 2013, there were a record 21 initial public offerings valued at $8.8 billion and an all-time high of more than $11.9 billion flowed into funds investing in MLPs, according to Morningstar Inc.
The surge of investment is the second time around for MLPs, which also exploded in popularity in the 1980s before Congress limited their tax-exempt status to partnerships dealing in natural resources. In the 1990s, regulators won settlements against brokers such as Prudential Securities Inc. and PaineWebber Inc. for allegedly understating the risks of MLPs. The companies neither admitted nor denied any wrongdoing.
Today, critics are raising warnings about growing dangers even while retirees like Johns are piling in. Almost unanimously bullish commentaries, such as the reports Johns found online, have attracted droves of individuals to a trade even some professionals have said they don’t understand. MLP values have risen with the unprecedented U.S. energy boom, a pace that will be difficult to sustain as production from shale drilling slows.
“We’ve been through a remarkable period where it works really well and the returns have been great,” said Bobby Tudor, chairman and chief executive officer of Tudor, Pickering, Holt & Co., a Houston-based investment bank catering to energy companies. “It just strikes us that it’s likely to be harder going forward than easier.”
Because they distribute income to investors, MLPs rely on borrowing and selling shares, or units, to grow. Wall Street banks love MLPs because they earn fees on those transactions, said Kevin Kaiser, an analyst at Stamford, Connecticut-based research company Hedgeye Risk Management LLC.
In the past year, bank fees for MLP deals totaled $890.3 million, led by Barclays Plc with $126.7 million, Citigroup Inc. with $96.7 million, and JPMorgan Chase & Co. with $78.2 million, data compiled by Bloomberg show.
“MLPs are Wall Street’s dream,” Kaiser said in a phone interview. “They’re fee machines.”
Marc Hazelton, a spokesman for Barclays, Rob Julavits, a Citigroup spokesman, and Tasha Pelio, a spokeswoman for JPMorgan, declined to comment.
Growth attained by issuing debt and equity becomes a problem if the companies lose investors’ confidence, said Douglas Johnston, managing partner at Quantalysis LLC, an investment research firm in Huntington, New York.
“It’s a bit of a gimmick,” Johnston said. “Retail investors bid the product up. MLPs can then issue more equity to fund the distribution and growth. It works until it doesn’t work.”
For Boardwalk Pipeline Partners LP (BWP), it stopped working on Feb. 10, when the eight-year-old Houston-based company cut its payout to investors and shares dropped 46 percent, the biggest decline ever. CEO Stan Horton, in a conference call to 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. Joe Hollier, a spokesman for Boardwalk, declined to comment.
“Retail investors need to be very careful about buying on their own because it’s easy not to know what you’re buying,” said Evan Welch, chief investment officer at Boxborough, Massachusetts-based Antaeus Wealth Advisors LLC, which oversees $285 million. “I find them difficult to understand, and with anything I don’t understand I’m a little cautious.”
MLPs have been profitable for most shareholders. The Standard & Poor’s MLP Index returned 28 percent annually the past five years, compared with 22 percent for the S&P 500 Index of U.S. stocks. The number of MLPs almost doubled in the past four years and their combined market value has surged past $500 billion, more than Apple Inc. (AAPL), data compiled by Bloomberg show.
“We’re undergoing a renaissance in oil and gas production in the U.S., and that means all of a sudden you need the highways and infrastructure,” said Stephen Maresca, a New York-based Morgan Stanley analyst. “These companies are absolutely the critical assets of the U.S. energy infrastructure.”
Individual investors own about 65 percent of MLPs, according to estimates by Wells Fargo Securities LLC. Many of them were attracted by analysts from banks, brokerages and research companies who predict that 93 of 114 MLPs, or 82 percent, will rise in value in the next year, according to data compiled by Bloomberg. All but five MLPs are recommended by the majority of the analysts who cover them, data show.
“At the top, everybody’s a believer,” said Tim Gramatovich, who helps manage $800 million as chief investment officer of Santa Barbara, California-based Peritus Asset Management LLC. “The question we’re all asking is how do we blow ourselves up next.” MLPs are “the next great investment debacle,” he said.
Johns, the retired postal employee, read about MLPs online and listened to conference calls when companies announced earnings. He ended up putting $50,000, or 8 percent of his savings, into MLP shares through his online brokerage account with Vanguard Group Inc. The biggest MLP brokers are KCG Holdings Inc., UBS Investment Bank, Credit Suisse Group AG, the Merrill Lynch unit of Bank of America Corp. and Citigroup Global Markets, which handle a combined 59 percent of MLP trading, according to data compiled by Bloomberg.
Johns said he made about $8,000 within a year.
Some of the skepticism is driven by the madcap pace of the U.S. energy boom. New methods of sucking oil from shale have fueled a 47 percent increase in U.S. production since 2011, the steepest rise in history, and will boost output to a 28-year high this year, according to the Energy Information Administration of the U.S. Department of Energy. Natural gas output is already the highest ever and growing. All that oil and gas needs infrastructure supplied by MLPs.
Yet, production from shale drilling, which bores horizontally into rock deep under the earth’s surface, declines faster than crude from traditional vertical wells. Output falls by 60 to 70 percent in just the first year, according to Austin, Texas-based Drillinginfo Inc. By comparison, traditional wells take two years to fall by 55 percent before flattening out.
The first MLP was formed in 1981 when Apache Oil Co. rolled up private drilling funds and offered them to investors as publicly traded “units.” Its success drew a slew of companies to try out the new structure. By 1987, there were more than 100 new MLPs established, according to law firm Latham & Watkins LLP. The Boston Celtics, La Quinta Motor Inns and Sahara Casinos were among the companies that became MLPs to cut taxes.
Congress took notice. Concerned about losing tax revenue as corporations turned into MLPs, lawmakers restricted them in 1987, leaving an exception for businesses based on natural resources.
The exemption will deprive the tax collector of about $6.7 billion in the five years ending in 2017, Congress’ Joint Committee on Taxation estimated last year. A proposal in Congress would expand MLPs to cover renewable energy.
MLPs that borrow money and sell additional shares to grow, as opposed to those that simply distribute income from existing infrastructure, were first created in 1997, when Richard Kinder left his job as second-in-command at Enron Corp. and took the company’s pipeline business with him, according to Kinder Morgan Inc.’s website.
Today, Kinder Morgan Energy Partners LP (KMP) and related companies have a combined market value of more than $80 billion. Kinder Morgan Energy’s shares have increased in value more than 10-fold since 1997, four times the rise of the S&P 500. Richard Kinder’s wealth is valued at $8.8 billion, making him the 50th-richest American, according to the Bloomberg Billionaires Index.
Investors accuse the Kinder Morgan management company of taking an unfair share of MLP income for itself. A class-action lawsuit, filed Feb. 5 in Delaware Chancery Court, alleges that Kinder Morgan’s management borrowed money, issued shares and diverted maintenance spending to inflate its payout.
Kinder Morgan asked a judge to dismiss the lawsuit. The Houston-based company said it spends enough to maintain its assets and its safety record beats industry averages. “Given our access to capital and tremendous asset footprint, we are extremely well-positioned to take advantage of changes in the energy landscape,” the company said in a statement responding to questions from Bloomberg News.
The lawsuit turns on how Kinder Morgan accounted for upkeep on its 80,000-mile pipeline network. According to formulas used by Kinder Morgan and other MLPs, maintenance work is subtracted from income and leaves less for quarterly payments to investors; money spent on expansion by building or acquiring new pipes doesn’t.
In Kinder Morgan’s case, according to the 39-page complaint, maintenance costs were misclassified as growth spending, allowing the company to keep investor payments at unsustainable levels and increasing the amounts management could pay itself.
“The vast majority of these expenditures are captured in operating expenses,” the company said in the statement. “The classification difference does not make any difference to the bottom line.”
Richard Kinder said he’s bought 1 million more shares of the partnership since September. “You sell, I’ll buy, and we see who comes out best in the long run,” he said on a Jan. 15 conference call with analysts and investors. The company declined to make Kinder available for an interview.
MLPs are expanding into industries that may pose new dangers for investors. Historically, the partnerships have been pipeline companies. Demand for higher-yielding investments is encouraging energy companies and private-equity firms that have qualifying assets -- sometimes called “MLP-able” -- to spin them off. So MLPs are branching out into offshore drilling, oil refineries, shipping and other businesses.
Some can be volatile because they directly depend on the price of oil and gas. That means their payouts may vary more than those of the traditional MLPs that investors are accustomed to, said Chris Eades, a managing director of New York-based ClearBridge Investments LLC, who oversees MLP mutual funds.
MLPs use unique financial metrics defined by the companies themselves. The nonstandard accounting has caught the attention of the U.S. Securities and Exchange Commission, Julie Hilt Hannink, head of energy research at New York-based CFRA, an accounting adviser, said in an interview. Linn Energy LLC (LINE), an oil- and gas-drilling MLP, disclosed an SEC inquiry into its accounting last year. The inquiry is ongoing, Clay Jeansonne, a Linn spokesman, said in an e-mail. SEC spokesman John Nester declined to comment.
MLPs don’t pay corporate income tax and are required by law to draw at least 90 percent of their revenue from natural resources such as oil and gas. Unlike real estate investment trusts, or REITs, MLPs don’t have to distribute all available cash. Still, that’s usually their policy.
In most MLPs, managers have discretion to determine how much cash to distribute to shareholders. Some companies distribute more cash than they take in, according to Jim Cunnane, a managing director of Advisory Research Inc. in St. Louis who oversees $4.5 billion in MLP investments. While that rarely happened five years ago, it’s becoming more common, he said.
“People are pushing the risk profile in today’s environment,” Cunnane said in an interview. “There are going to be winners and losers, and this is a red flag.”
A sense that something could go wrong was what led Johns, the retired postal worker, to decide MLPs weren’t for him, even after his 16 percent gain.
“A lot of people in them think they understand, but they really don’t,” Johns said. “I just thought they just weren’t as safe as you might think.”
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