Is It a Good Idea to Invest in Variable Distribution MLPs?

In 2013, at the height of the refining boom, variable distribution refining MLPs went public at mouth-watering yields of 20%-25%. 

Since that time Alon USA Partners (NYSE: ALDW), CVR Refining (CVRR), and Northern Tier Energy (NYSE: NTI) have slashed their distributions and their unit prices have suffered as a result.

Does this indicate a buying opportunity for long-term income investors, or should income investors even be investing in companies whose distributions are so volatile? To answer these questions we must first understand how MLPs are different than stocks and how variable-distribution MLPs are different than regular MLPs.

Master limited partnerships (MLPs) are pass-through entities that don't pay taxes as long as they get their income from certain assets (such as energy, fertilizer production, or shipping). They don't pay dividends to shareholders; instead, they pay distributions to unit holders. These are usually treated by the IRS as returns of capital (ROC.) This means that taxes owed by limited partners (general investors) are deferred until the units are sold. Specifically, the ROC portion of the distribution (as outlined in the annual K-1 the partnership sends unit holders) is deducted from the purchase price. When the purchase price hits zero, the future distributions are treated as regular income. 

If an investor never sells his/her units then the deferred taxes are never paid to the IRS. This gives MLPs a tax advantage over regular stocks. The downside is that the annual K-1 form (as opposed to a 1099 form) adds complexity to tax preparation.

Variable-distribution partnerships, such as Terra Nitrogen Company (NYSE: TNH) and CVR Partners (UAN 0.96%), have the added benefit of not having the incentive distribution rights (IDRs) that traditional MLPs have. These rights grant the general partner (who handles the management of the partnership) 50% of all income above a predetermined distribution. This means nearly all available cash flow (distributable cash flow) goes toward distributions.

Given the cyclical nature of the businesses MLPs operate in, should investors consider variable-distribution MLPs, which pile on additional volatility? With the tax benefits of holding units forever, is there any way investors can beat the market given the wild fluctuations in distributions and changing yields? The answer is yes, but investors interested in variable-distribution MLPs must invest differently than with regular MLPs in two key ways.

First, understand that most variable-distribution MLPs have very concentrated assets. For example, CVR Refining has only two refineries (in Kansas and Oklahoma) and Northern Tier Energy owns just one (in Minnesota). Alon USA Partners owns just one in Big Spring, Texas. Similarly, CVR Partners has one fertilizer plant and one distribution terminal (in Kansas). Terra Nitrogen owns just one plant in Verdigris, Oklahoma.

This creates a risk of unexpected accidents or other shutdowns. For example, CVR Refining suffered a broken fracking unit at its Coffeyville refinery. This knocked out 31% of refining capacity for the third quarter of 2013. 

This unexpected event plus a cyclical downturn in margins resulted in the partnership cutting its distribution by 78%. Even this had to be paid out of a cash reserve meant for maintenance as the partnership lost money that quarter. Worse off was Alon USA Partners, as the partnership's sole refinery suffered an unexpected shutdown during the third quarter of 2013. The partnership was forced to eliminate its distribution for the quarter and shares dropped 20% upon the announcement. 

This brings me to the second important difference between traditional MLPs and variable-distribution MLPs: increased volatility. Traditionally, MLPs are prized for their low volatility. For example, Kinder Morgan Energy Partners, one of the biggest natural gas pipeline MLPs, has a beta of .47. Linn Energy, the largest exploration and production (E&P) MLP, has a beta of .67. Compare this to Northern Tier Energy's 1.35 or Terra Nitrogen's .89.

The key to successfully investing in variable-distribution MLPs is to make this volatility a strength of one's portfolio. When distributions are slashed, the unit price will crash. Buying during this weakness can ensure higher yield on cost later and generate long-term market beating results. The history of variable distribution/dividend paying companies is limited but, as seen below, market outperformance can be achieved. 

Source: Fastgraphs

Bottom line
Income investors can do well with variable-distribution MLPs as part of a diversified-income portfolio, but only if they remember the key differences between variable-distribution MLPs and traditional MLPs. By using the volatile nature of these partnerships to acquire more units during times of maximum-market pessimism, investors can turn the greatest weakness of variable-distribution MLPs into their greatest strength.