caution2-stockphotoIt’s a tough life for income investors these days, with interest rates so low and the stock market so high.

Consequently, some investors have turned to master limited partnerships (MLPs) in the energy sector, hoping to find a solution to their problems. After all, dividend yields for MLPs are occasionally stretching towards double digits.

But investors should beware: In most cases, the assets in these partnerships will be fully lucrative for just a few years, meaning their dividends represent a return of capital. Thus, you can boost your retirement income through them – but only if you don’t expect to live very long.

A Good Idea, in Theory

At its most basic, an MLP is a company traded in public markets that gets the investment benefits of a public company along with the tax benefits of a limited partnership.

[ad#Google Adsense 336×280-IA]Therefore, income isn’t taxed at the company level; instead, it’s passed through to shareholders.

This structure is restricted to certain businesses, including real estate and energy. And in order to qualify, at least 90% of the business’ cash flow must be passed through to shareholders.

One important point for individual investors: Since MLP income isn’t taxed at the corporate level, MLP dividends don’t qualify for the dividend tax relief introduced in 2003.

Thus, instead of the dividend tax rate of 20%, they’re taxed at full income tax rates, up to 39.6% at the federal level (plus state tax). This makes MLP dividend income considerably less attractive than dividend income from ordinary domestic corporations.

MLPs are generally structured to include a stream of running income out of which a dividend can be paid and where the need for further capital investment is limited. The archetypal MLP is an energy pipeline system and, in principle, such an asset can pay high dividends for many years without ever running out of money.

But the problem with MLPs is that the assets underlying them generally have a finite lifespan. A pipeline, for example, can operate for decades provided it’s properly maintained… but eventually, it must be replaced.

The other typical MLP asset, a set of producing oilfields, is even more likely to see production slow markedly after a decade or so, and it could end altogether after 20 years.

These Aren’t the Answers You’re Looking For

We can see how this works by examining two existing MLPs, VOC Energy Trust (VOC) and MV Oil Trust (MVO).

Both companies own fixed portfolios of producing oil wells, and both have nice yields – 10.5% for VOC and 11.8% for MVO. Additionally, both appear to have earnings that fully cover the cost of dividends paid, which can be a real problem in the MLP area.

However, both companies’ properties have finite lives that are predicted to run out around or before 2030. Consequently, they’re both declining assets, being worth essentially zero when the oil runs out.

Not surprisingly, their share prices reflect this information. For example, from 2012 until today (a strong run for the stock market), MVO shares are down from around $40 to $26. Not much use getting a juicy 11% dividend yield if you lose a third of your capital in two years in a bull market, is there?

What’s more, the dividend yield is fully taxable, whereas the capital loss is long term and, therefore, deductible at only 20%.

Now, some companies attempt to get around this by buying other properties in the MLP, thereby expanding production and perpetuating the MLP. Buying distressed properties at the bottom of the market can work nicely, but in today’s bubble market, purchase prices are high. With nearly all of the MLP’s cash flow being paid out in dividends, purchases must be financed by dilutive new equity offerings or by debt.

And because of modern accounting standards, companies buying assets at a high price must write off much of the purchase price as soon as the auditors determine that the value has declined. This generally results in a massive earnings loss for that year, although, by MLP law, the dividend can still be paid.

For instance, let’s look at Breitburn Energy Partners (BBEP) and Linn Energy, LLC (LINE). BBEP and LINE have both been aggressively buying new properties and issuing new equity and debt to fund the purchases. Both are now quite highly leveraged, but offer nice yields – 9.4%, in both cases.

However, BBEP reported a loss of $0.16 per share in 2013, and LINE reported a large loss of $2.15 per share, so both dividends are being paid out of capital. And with share prices being well supported by the dividend yield, both companies are trading well above book value – 1.5 times book in the case of BBEP and two times book in the case of LINE.

In all four of these cases, the sustainability of the dividend looks to be in doubt. In the case of VOC and MVO, the oil will eventually run out. Meanwhile, BBEP and LINE will eventually run out of capital if they continue writing it off after acquisitions and not reporting earnings.

Of course, if the price of oil zooms to $200, all four companies would benefit, as their assets would be worth double the current amount (though BBEP and LINE would report losses on their derivatives positions because they hedge the value of their output in forwards markets). That being said, oil prices seem pretty unlikely to double, except possibly in a short-term “spike” like we saw in 2008, when prices briefly reached $147 per barrel before collapsing to $30.

Bottom line: At this point, MLPs don’t look like the answer to income investors’ problems. If you insist on one, though, you’re better off in pipeline MLPs, like Enterprise Products Partners (EPD). But even these have been bid up to very high prices. EPD, for example, is yielding just 3.8% and trading at 4.8 times book value. Since even pipelines have a finite life, these, too, are no bargain.

Good investing,

Martin Hutchinson

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Source: Wall Street Daily