The Securities Litigation Expert Blog

Master Limited Partnership Bubble Now Well Documented

Posted by Jack Duval

Feb 21, 2013 3:05:00 AM

This blog post continues our expert analysis of complex investments and their regulation.

Two new reports are out documenting the bubble in shale gas and shale oil.  The first is "Shale and Wall Street" by Deborah Rogers and is published by the Energy Policy Forum.  (EPF)  The second is "Drill, Baby, Drill" by J. David Hughes and is published by the Post Carbon Institute.  (PCI)

The crux of these reports is that a bubble has formed due to: massive over-investment in shale gas extraction, heroic assumptions about shale gas and oil reserves, rapidly declining extraction rates, complex investment products used to finance the exploration, a flurry of Wall Street activity which generated large transactional fees for Broker-Dealers, and a wholesale lack of transparency.

Sounds a lot like the sub-prime bubble.

Our previous coverage of the MLP bubble can be found here, here, and here.

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Topics: Master Limited Partnerships, MLP, FINRA, shale oil, Energy Policy Forum, bubble, litigation, Senior Investors, investments, Master Limited Partnership, sub-prime, natural gas, shale gas, Compliance, Post Carbon Institute, Complexity

Master Limited Parternship Warning from Morningstar

Posted by Jack Duval

Nov 12, 2012 3:36:40 AM

Morningstar has issued a research note warning investors about the ALPS Alerian MLP ETF (AMLP).  (Morningstar)  The reason?  Hot money is flowing into this ETF because the industry giant, JPMorgan Alerian MLP Index ETN (AMJ), has hit its $5 billion asset limit and stopped creating new units.  This means AMJ is now a closed-end fund and that shares will fluctuate above and below NAV.

Here's what Morningstar has to say about why an ETF structure (as opposed to an ETN structure) is bad for MLPs:

 However, AMLP is not the right vehicle for the majority of investors, and it represents one of the rare cases when buying the ETF structure makes very little sense.

Legally MLPs can make up only 25% of a portfolio registered under the Investment Company Act of 1940. Most mutual funds and ETFs are structured this way. To get around this issue, AMLP is actually structured as a corporation that pays income tax: Before return is passed on to the investor, it must be taxed at the corporate level. Although AMLP's prospectus expense ratio is 0.85%, its gross expense ratio (which accounts for these tax liabilities) is almost 5% as of September. As a result, AMLP has lagged its index significantly. Over the past year AMLP lagged by 10%, and since inception it trailed by a shocking 40%. The upside? When MLPs are down, AMLP declines less because it can reverse some of the deferred tax liabilities it has accrued. For all but the most risk-averse yet desperate-for-yield investors, this downside protection is not enough to make up for the fund's structural issues...

Because of legislation forbidding open-end funds from owning more than 25% of their portfolio in MLPs, AMLP is structured as a C-corporation and pays income tax at the corporate level. Any taxable income from the underlying MLPs is an annual tax liability, and upon the sale of the portfolio's shares they must also pay up at the corporate level. AMLP accounts for these tax liabilities in the NAV, meaning that the total return of the fund can and does trail the index by massive amounts.

Thus the C-Corporation structure eliminates the deferred tax structure inherent in a MLP and pays the taxes along the way.  By Morningstar's calculation, this comes to about 5 percent per year, and causes serious underperformance against the index.


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Topics: Master Limited Partnerships, MLP, AMJ, investments, Master Limited Partnership, Morningstar, natural gas, ETF, ETN, Alerian, AMLP

Moody's Master Limited Partner Research

Posted by Jack Duval

Nov 11, 2012 2:27:36 AM

Moody's has come out with research on Oil and Gas bond covenants and has come to the conclusion that MLPs offer the least investor protection.  (Finanzen)

"Our review of bonds issued between January 2011 and October 2012 showed that those of US midstream limited partnerships have the worst covenant quality," says Andrew Brooks, Moody's Vice President and co-author of the report, "Midstream MLP Covenants Offer Least Investor Protection; E&Ps Near US Average." "Investor protection is weakest in the areas of restricted payments and liens subordination, reflecting these firms' focus on high shareholder distributions and externally financed growth."

The Moody's research can be found here.  (You'll need a subscription or $550.)

The MLP focus on paying out earnings leaves those firms in a perpetual refinance cycle.  That is, they cannot self-fund because they distribute their earnings to their investors.  This is the paradox and the Achilles Heel of MLPs.  The very thing that makes them attractive to yield-starved investors is what makes them vulnerable to sharp (and pro-cyclical) declines.

See our previous coverage on MLPs here, here, here, here, and here.

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Topics: Master Limited Partnerships, MLP, Moody's, investments, Master Limited Partnership, natural gas, Oil and Gas

The Bubble in Yield Plays Continues to Grow

Posted by Jack Duval

Oct 29, 2012 3:33:29 AM

Nathaniel Popper, reporting in the New York Times, has a good piece on how individual investors are plowing into junk bonds just as they are getting more risky.  (NYT)  This continues the trend of yield chasing we have documented with our coverage of Energy plays in Master Limited Partnerships here.

The scenario is simple, the Fed has cut interest rates to near zero and intends to keep them there for the foreseeable future, while at the same time the baby boom generation is retiring at an accelerating pace.  These retirees need income but don't want the risk of equities.  Unfortunately, they are running right into the teeth of the bubble forming in risky income plays.  Like all bubbles, it will end badly.

Here are some highlights from the article:

  • Junk bond issuance has reached record levels this year

  • The average credit rating of companies issuing junk bonds has declined

  • The proceeds of many of these offerings are not going to operations, but to cash out private equity funds

  • Retail investors added $2.1 billion in the first three weeks of October, while institutional investors sold $256 million over the same time period

  • Retail investors added $22 billion to junk bond funds this year compared to $8.3 billion in all of 2011

  • LBOs are back in vogue

  • More and more junk bonds are issued that allow the borrowers to skip interest payments

For those of you who have been around for a while, this all sounds like the years leading up to the collapse of the junk bond market in the early 1990's.  (PIK bonds anyone?)

Key takeaways for investors and industry participants:

  • Investors should beware of the increasing risk in these yield plays, both from an investment cycle and individual investment perspective;

  • Compliance/supervisory officers should beware of seemingly high allocations to fixed income that are actually invested in speculative or aggressive high yield bonds or other risky income investments; and make sure the accounts are coded for such investments and that the advisor and investor are both fully aware of the risks

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Topics: chasing yield, Master Limited Partnerships, junk bonds, MLP, investments, LBO, Nathaniel Popper, risk, Compliance, private equity, NYT

Shale Gas Pain Continues

Posted by Jack Duval

Oct 27, 2012 4:19:43 AM

Clifford Krauss and Eric Lipton continue the excellent New York Times coverage of the shale gas boom and bust.  (NYT) There are some fascinating revelations in the article:

1.  The drilling companies were forced under contract to keep drilling, even as the price of natural gas collapsed:

The land that the natural gas companies had leased, in most cases, came with “use it or lose it” clauses that required them to start drilling within three years and begin paying royalties to the landowners or lose the leases... and as with so many other shale gas players, Chesapeake struck so many complicated financial deals that it couldn’t stop ramping up the gas factory.

“At least half and probably two-thirds or three-quarters of our gas drilling is what I would call involuntary,” Mr. McClendon (of Chesapeake) acknowledged at one point.

2.  Valuing gas producers off of known reserves incintivized more drilling even it it was already unprofitable to pull it out of the ground:
The industry was also driven to keep drilling because of the perverse way that Wall Street values oil and gas companies. Analysts rate drillers on their so-called proven reserves, an estimate of how much oil and gas they have in the ground. Simply by drilling a single well, they could then count as part of their reserves nearby future well sites. In this case, higher reserves generally led to a higher stock price, even though some of the companies were losing money each quarter and piling up billions of dollars in debt.

It appears that the pain for drilling companies will continue for some time.

In separate news, investors in Ohio's Utica shale formation should beware that drillers succeeded in getting legislation passed that requires only annual disclosures about well extraction rates and volumes, as opposed to the quarterly reporting required in almost every other state.  (Reuters)

By this spring, a new energy bill being crafted by lawmakers initially included a clause that would have allowed regulators to publicly disclose quarterly energy production data. The current requirement calls for annual reporting.

But the clause was struck from the bill after discussions with the industry, a Reuters investigation has found. Instead the law, which took effect in August, explicitly bars the government from publishing the quarterly figures it now obtains.

Almost every other energy-producing state releases production data and drilling results on a monthly basis; even Saudi Arabia now self-reports its once-secret production volumes once a month. The latest Ohio figures for 2011 provide information on only five wells. The volume of oil and gas pumping out of dozens of new wells drilled this year will not be available until April 2013, as much as 15 months after they were drilled.

This greatly reduces the transparency in Ohio investments.  Furthermore, because of the typical shale gas extraction rate decline (where the majority of the gas is extracted in the first year), this could lead to some nasty surprises.
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Topics: Master Limited Partnerships, MLP, drilling, limited partnerships, investments, natural gas, Chesapeake Energy, shale gas, Utica Shale, regulation.

Master Limited Partnerships and REITS

Posted by Jack Duval

Oct 25, 2012 4:55:31 AM

S&P CreditMatters TV has put out a video comparing MLP and REIT characteristics. (S&P)  At 8:34, it's not too in-depth, but for those of you wanting a quick introduction, it's useful.

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Topics: Master Limited Partnerships, MLP, CreditMatters, investments, REIT, video, S&P

Uh-Oh. Master Limited Partnerships Continue to Go Mainstream after 10 Years of Outperformance

Posted by Jack Duval

Oct 18, 2012 3:57:00 AM

This blog post continues our expert analysis of complex investments and their regulation.

The New York Times has joined the drumbeat of MLP coverage, noting how the relatively high yields and tax advantages of MLPs are drawing investors. (NYT)

Here's some facts that should give everyone pause before investing in these complex products:

    • They have an average 16.7 percent annual return for the past 10 years

    • This return is roughly 2x the S&P 500 over the same time period

I fear a lot of investors will be chasing the "hot dot" with MLPs and get in right at the top.  Remember, commodity prices can be volatile in the extreme, and these are almost exclusively energy plays.  The chart below shows the year-ending values of the Alerian MLP Index and the percent change from the previous year.

Click on chart for full screen version.

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Topics: Master Limited Partnerships, MLP, Data Analysis, S&P 500, investments, Complex Investments, Complexity, NYT

Historical Background on Master Limited Partnerships

Posted by Jack Duval

Oct 8, 2012 4:50:04 AM

Investment Consultants NEPC have one of the better background pieces on Master Limited Partnerships.  (NEPC)  They do a nice job showing the growth of these vehicles over the past 15 years or so.

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Topics: Master Limited Partnerships, MLP, NEPC, investments

Master Limited Partnership (MLP) Links

Posted by Jack Duval

Sep 26, 2012 3:31:02 AM

Below are some helpful links for your MLP research efforts:

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Topics: Master Limited Partnerships, MLP, research, links

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