Master limited partnerships (MLPs) are known for paying attractive yields, but 24.2% is extraordinarily high, even for this category of investments. So, when a member called up asking how Northern Tier Energy L.P. (NTI) could have such a high indicated yield, I was admittedly perplexed. High yields reflect high risk, but the financial ratios and earnings trend did not point to a firm that is struggling to stay afloat.
Being the inquisitive type, I did some reading. Specifically, I went to the Securities and Exchange Commission’s (SEC) EDGAR database and called up the firm’s S-1 filing. (The S-1 is the prospectus required by the SEC prior to a company completing its initial public offering (IPO). As revisions are made prior to the IPO, updated versions will be filed under the title “S-1/A.”) What I found out was that NTI is not your typical MLP.
The majority of MLPs engage in the transport and storage of energy products. They operate pipelines and terminals. Since pipelines are federally regulated, the distributions of these partnerships are viewed as being relatively reliable (but not guaranteed). There are a small group of MLPs that primarily operate refineries instead: Northern Tier Energy, Alon USA Partners L.P. (ALDW), Calumet Specialty Products Partners (CLMT) and CVR Refining L.P. (CVRR). Refineries profit from the difference between crude oil and refined products, such as gasoline. This difference impacts the distributions these four MLPs pay relative to the income stream you would receive from a “typical” MLP.
The wider the spread between crude oil and refined products, the more profitable refiners are. The narrower the spread, the less profitable refiners are. Refining margins are notoriously volatile, which is why companies that primarily operate refineries often trade with comparatively lower multiples. Investors are uncertain about the future profitability and want to be compensated for this uncertainty.
Since MLPs are pass-through corporations, distributions for NTI, ALDW, CLMT and CVRR will vary with the size of the spread. Calumet’s distributions have ranged from a low of $1.81 to a high of $2.43 during the six-year period of 2007 through 2012. NTI directly cautioned investors in its S-1 filing that “unitholders will have direct exposure to fluctuations in the amount of cash generated by our business” and “quarterly distributions, if any, will not be stable and will vary from quarter to quarter.” CVRR warned at the start of its S-1 filing, “We will not have a minimum quarterly distribution or employ structures intended to consistently maintain or increase distributions over time.” In other words, there is the potential for a feast or famine scenario to exist when it comes to distributions with these types of MLPs.
Obviously, if you can predict the direction of refining spreads, there is money to be made here. But that is tough even for seasoned oilmen to do. Then there is the issue that NTI, ALDW and CVRR have very limited histories as publicly traded partnerships. NTI completed its initial public offering last July, ALDW started trading last November and CVRR went public two weeks ago. We simply do not know how badly their prices will be affected if distributions fall significantly or are not issued. So, by buying into any of these partnerships, you are taking the chance that you will get enough in distributions to offset a potentially significant future drop in their unit price. (MLPs issue units, instead of shares like corporations offer.)
And none of this discussion encompasses the tax complications of investing in MLPs. So, while there is a higher yield to be captured, you need to tread carefully and make sure you fully understand what you invest in. If these investments seem too complicated or risky, don’t hesitate to walk away from them. Staying within your sphere of knowledge and competency will reduce your risk—a concept that is unfortunately often overlooked in the quest for higher returns.
View original at: AAII Investor Update E-Newsletter
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