What you need to know about energy MLPs

At several different periods in time, people would have told you, convincingly, that there was such a thing as the Fountain of Youth, the Northwest Passage and a cure for male pattern baldness. They probably would have also told you that you could get dividend rates far above the risk-free Treasury rate with little additional risk.

The most recent example was in 2014, when investors swarmed to mutual funds that invest in energy master limited partnerships. Energy MLPs, they would say, are like toll booths: Their revenue was based on volume, not oil prices, and their long-term agreements shielded them from major price fluctuations. The next year, the funds swooned 34%, and they have yet to top their August 2014 peak, even if you included reinvested dividends.

Advisers who are tempted by the current oil price rally — and the juicy yields on some energy MLP funds — should remember the last time that the funds started pumping mud.

Let’s start with the happy news in the energy patch. So far this year, the price of West Texas intermediate crude has risen to nearly $52 a barrel from about $37 at the beginning of the year. The U.S. Energy Information Administration projects that oil prices will range from $39 a barrel to $63 a barrel through December.

It’s a forecast that’s wide enough to drive a truck through, although Tom Kloza, Global head of energy analysis for the Oil Price Information Service, generally agrees with the outlook. “It’s an interesting rally: We have two worlds, where overseas crude is about $58.50 and West Texas intermediate is about $51.80,” he said. “Ultimately, the two should move closer in price. We might see $60 a barrel, but I don’t think it’s the new normal. We’re in the 8th or 9th inning of the rally.”

One reason he doesn’t see a spike higher: The U.S. has lots of oil waiting to be extracted. Although the full effects of hurricanes Harvey and Irma haven’t been measured yet, EIA forecasts total U.S. rude oil production to average 9.3 million barrels a day for all of 2017 and 9.8 million in 2018, the highest annual average production in U.S. history, surpassing the previous record of 9.6 million set in 1970.

Those increases in oil prices and production have sent a stream of warm feelings through energy investors. Equity energy funds have popped 7.1% the past month, according to Morningstar, while energy MLP funds have gained 4.4%. And at least at this point, energy MLPs look interesting, particularly for income-seeking investors. For example, the largest MLP ETF, Alerian MLP ETF (AMLP), has a 12-month yield of 5.85%, according to Morningstar.

But before you go drilling for profits in energy MLPs, it’s a good idea to reflect on what MLPs are, and why they collapsed. An MLP is a tax structure, not an industry sector, said James Murchie, manager of the EIP Growth and Income Fund Class I (EIPIX) fund.

Energy M.LPs that are engaged in the pipeline business have to pay out most of their profits in dividends to unit holders. In return, unit holders pay the taxes on those distributions, rather than the company itself. In order to expand, energy MLPs depend on the credit markets and continued inflows from mutual funds and ETFs. Companies such as Kinder Morgan became caught between their need to offer high payouts and their expansion plans, and as investors fled, companies cut dividends and prices collapsed.

Fund investors should be aware that, under the rules of the Investment Company Act of 1940, mutual funds can invest only 25% of their assets in MLPs in order maintain those their tax-free “M” corporation status. Those that exceed that limit become normal “C” corporations, paying or accruing a 35% tax rate on all the fund’s income and capital appreciation of the underlying securities that it holds. (The largest MLP ETF, Alerian MLP ETF, is taxed as a regular corporation, rather than a mutual fund).

Mr. Murchie’s fund, currently the top performer in the Morningstar energy MLP category, avoids the problem by staying within the 40 Act’s strictures. “If you’re interested in noncyclical energy infrastructure in North why limit yourself to MLPs? They represent only about 20% of opportunity set,” he said.

Mark Bass, a financial planner with Pennington, Bass & Associates, echoed the sentiment. “We haven’t really gone down that path because the energy sector is bigger than MLPs,” Mr. Bass said. “And it’s like real estate in that the components of the subsectors rotate. In mutual funds or ETFs, we much prefer to invest in the entire sector.”

For Mr. Bass, the preferred fund is Vanguard Energy (VGENX), which has a 2% yield and 0.41% expense ratio. At the moment, the only fund with a better five-year record – and only slightly – is Williston Basin/Mid-North America Stock (ICPAX).

The lesson from the 2015 crash in energy MLPs: For most investors, investing in the entire energy sector is probably a better route than going all in in MLPs, or at least to use them sparingly. “If you take a 35,000-foot view, energy is an important component of the economy, and some sectors do better than others during others at any point in the economic cycle,” said Mr. Bass. And if you still believe you can get investments with triple the yield of a 10-year Treasury note for less than triple the risk, you might reflect on the fact that Ponce de Leon didn’t age well at all.