The oil market has unraveled this year. Crude oil prices briefly went into negative territory because speculators couldn't find space to store oil in light of cratering demand from the COVID-19 outbreak. Meanwhile, several energy companies have already filed for bankruptcy, while many others will probably join them in the coming months. These issues have put tremendous pressure on energy stocks.
One subsector that has taken it on the chin is energy master limited partnerships (MLPs), especially those focused on gathering and processing oil and gas. Most have sold-off sharply, which has pushed the yields on their dividends up to eye-popping territory, with many offering investors an alluring double-digit payout.
However, as enticing as these income streams might seem, investors are better off avoiding these entities for now. Here are three reasons they're too risky.
1. Their fee sources are declining
Midstream companies like MLPs typically generate steady income streams because they get paid fees as oil and gas move through their gathering and processing assets. Those volumes tend to be highly predictable because of historical well production data, which informs customer drilling plans.
This year, however, oil and gas companies are adjusting their plans on the fly. Most have already reduced their drilling activity levels, which will affect production this year as the output from legacy wells decline and not enough new ones come online to fill the gap. Others, meanwhile, have shut in wells because of low prices and storage issues. Continental Resources (CLR -5.64%), for example, is shutting in most of its wells in North Dakota's Bakken shale because they're no longer profitable. Continental also reduced its output in Oklahoma because one of its refining customers couldn't handle the volumes. Meanwhile, ConocoPhillips (COP -8.60%) plans to start shutting in wells this May, which will affect 125,000 barrels of oil per day.
With the energy industry running out of storage space, more producers are likely to shut in wells, which will cut into the cash flows of the MLPs that would have gathered and processed this output. These volume concerns have caused many MLPs to slash their distributions and capital spending to help offset this impact.
2. A bankruptcy wave could take another bite out of cash flow
Another impact of low oil prices is that it could cause a wave of bankruptcies among oil and gas producers. So far, one notable U.S. producer has filed for bankruptcy protection, while several more appear to be on the brink. The main objective of these proceedings will be to restructure debt. However, some might also seek relief from vendors like midstream companies in the form of fee reductions. If that happens, it would be another blow to MLP earnings.
One of the many companies at risk of going under is Chesapeake Energy (CHKA.Q). If Chesapeake files and seeks to restructure its midstream contracts, then it could have a significant impact on the cash flows of MLPs that handle its volumes, including Energy Transfer (ET -6.89%), Crestwood Equity Partners (CEQP -6.28%), and Plains All American Pipeline (PAA -6.82%).
3. Investors have all but abandoned the vehicle
MLPs have never recovered from the oil market downturn of 2014. Many slashed their distributions in the years following that crash because they could no longer raise capital from investors to finance expansion projects. That inability to access funding led many companies to abandon the MLP structure by converting into corporations.
That trend seems likely to accelerate because of the latest downturn. Several more MLPs have had to slash their payouts over the past month so that they could retain more cash to fund growth and pay down debt. Plains All American, for example, recently reduced its dividend by another 50%, its third cut over the past several years. Those payout reductions are causing even more investors to flee these vehicles since they're not worth the hassle of dealing with the complicated Schedule K-1 they send at tax time each year. That will probably leave those remaining with no other choice but to convert into a corporation, which send a traditional Form 1099-DIV for taxes.
It's better to wait things out right now
MLPs offer income-seeking investors some enticing yields these days. Energy Transfer, for example, pays more than 15%, while Crestwood is up over 20%. However, these big-time payouts are at risk of reductions -- Crestwood warned as much when it declared its last payment -- because of falling volumes and the deteriorating financials of customers. That makes these entities too risky for dividend investors right now. Instead, they might want to consider one of the top-tier pipeline corporations, which should be able to maintain their payouts throughout this downturn.