Physical ownership of oil and gas assets is usually structured as a Master Limited Partnership or an MLP and this entity structure is oftentimes extended to other commodities like precious metals, minerals etc. But we don’t like them and here is why.
- They are products that are usually sold and not bought. Nobody that we know off wakes up in the morning and says “You know honey, today I am going to buy an MLP”. It just usually does not happen. You would never hear about it until you talk to a guy working in the brokerage industry who makes his living selling MLPs. We are always weary when there are products that exist to be sold rather than products that people need to buy. So it fails the first smell test.
- You need to understand the whole point of these things. Investing in an MLP means that you are buying an oil well. You know what an oil well is a la Mark Twain…It’s a hole in the ground with a wire on top. You have to recognize that these things are highly speculative. Is there going to be oil or gas down there and will the promoters be able to extract it in a cost-effective way. That is the big bet. The expectation is that there will be enough oil or gas down there that could be sold for big profits which will allow the MLP to distribute income along the way. Those promises don’t always work out. One recent example, Boardwalk Pipeline Partners. Back in February of this year, they slashed the income they were sending investors by 81% and the stock fell 50%. That does not sound to us as a safe and reasonable investment specifically when they are touted as a guaranteed fixed-income replacement.
- And when they pay that money to you, they are doing it out of cash flow but in order to generate that cash flow, these entities incur huge debts in the process which means that they have to be able to sell that oil for far more than they were expecting. In other words, the price of oil has to rise in order for them to be able to generate the income necessary to be able to pay off the debt they incurred in the process of extracting that oil. One of the issues we have at the moment with oil prices (and value of other commodities as well) dropping is the ability for these outfits to remain financially viable. And if these concerns arise after you invest in them, guess what, they become illiquid. MLPs are thinly traded and sometimes don’t trade at all which means you could find it very, very difficult to sell your investments.
- Then there is this tax complexity. Have you ever heard of a K-1, one of the most despicable tax documents you would ever have to file? Most folks, when they own a mutual fund or a stock or a bond, they get from their brokerage firm what’s called a 1099 and this document is a simple, straightforward document, about a third of a page long. That just tells you the amount of interest or dividends you earned during the year. No fuss, no muss. But you don’t get a 1099 when you invest in an MLP; you get a K-1. These things can be dozens of pages long. We have seen people spend hundreds of dollars in fees just to have an accountant figure out how to transfer the information from a K-1 onto 1040. They also create UBTI (unrelated business taxable income) and if you are investing in an MLP inside your IRA, you could be creating a double-tax problem. That is why we advise our clients that if you are going to make the unfortunate decision to own an MLP, never do it inside of an IRA. Estimating your cost basis and being able to differentiate between return of capital versus the income you received could make record keeping a nightmare.
- Finally, there is the cost of owning these things. Just two words, mind-bogglingly expensive. One example of an MLP fund, the Alerian MLP ETF has an expense ratio of almost 8.5%. That’s the annual cost of owning these things. These products have to generate 8.5% in profits for you just to break even. That does not strike us as a great deal. And the way a lot of these partnership agreements are structured, the general partner, that’s the producer, the promoter of these things who is drilling for oil in the ground split the income in a way that might overtly benefit them instead of you, the shareholder.
In short, you are dealing with management risk, you have very limited rights as a shareholder, you have virtually no say in what’s going on, you have high concentration risk, interest rate risk, and you have the risk of product substitution because hey, you own a commodity producing investment and the demand for that commodity is dictated by its price and if there are competing alternatives in the marketplace, look out below. Have you seen what is happening with coal recently? Sudden nobody wants to buy coal.
So for all these reasons, we prefer to stay the heck away because there are always simpler, easier ways to invest.