High dividend stocks call out to investors with a siren song as the high yield has an alluring appeal of easy riches. But, more often than not lying behind the enticing yield is a potentially dangerous risk that can strike without notice. Here's some advice to help investors avoid some of the riskier MLPs on the market.
Beware of the glittering allure of commodities
Most MLPs base their business around owning fee-based assets. Those fees provide rather stable income for the partnership, which translates into a consistent distribution for investors. The problem that many MLPs run into is that they own assets that aren't fee-based, but instead provide income derived from commodity prices.
A lot of investors learned the hard way that upstream MLPs simply can't hedge away all of their commodity price risk. Its why well-known oil and gas producers Linn Energy (NASDAQOTH:LINEQ), BreitBurn Energy Partners (NASDAQOTH:BBEPQ), and Vanguard Natural Resources (NASDAQOTH:VNRSQ) all cut their distributions after oil prices collapsed in late 2014 as the drop was much deeper than the companies expected. However, the siren song of double-digit yields deceived many investors into thinking that there wasn't a possibility that these companies could be very volatile if commodity prices changed course.
In addition to upstream MLPs another risky MLP to watch out for are midstream companies that own assets that are directly exposed to commodity prices. Natural gas gathering and processing companies are particularly vulnerable to this as the revenue from processing assets are often linked to commodity prices. This is why most midstream MLPs are shifting from this model to a more fee-based model to lock in more of their revenue. We can see a great example of this shift toward fees at Targa Resources Partners (UNKNOWN:NGLS.DL) on the slide below.
Investors that want to avoid volatility in their portfolio should look for MLPs that have 75% or better fee-based margins. This focus on fees will lessen the blow should commodity prices collapse and threaten to take other high yields with it.
Beware of the folly of focus
The other risky MLPs that investors with less tolerance for risk might want to avoid are those that own one main asset. The reason these MLPs are risky is due to the fact that if something happens to that asset it has the potential to derail the distribution for quite some time. An example of a focused MLP is Northern Tier Energy (UNKNOWN:NTI.DL) as its refining business consists primarily of one refinery. While the company does own a couple hundred gas stations, the bulk of its cash flow comes from its refinery and when that asset is down for maintenance or poor performance the distribution follows.
In addition to MLPs focused around a single asset, investors focusing on keeping risk out of their portfolio should also avoid MLPs that have little diversification in general. MLPs focused on natural gas gathering and processing are really tied to that one volatile commodity. Others to be wary of are basin focused MLPs or the MLP spin offs of larger energy companies. Many of these companies are reliant on one energy basin or one customer, which is a risk that could come back to bite investors if activity in that basin dries up or if the customer runs into trouble.
There's just something about high dividend stocks that investors find so alluring. However, behind the allure of that high yield is the potential for risk. That's why investors that can't afford to be burned need to look past the yield and make sure it's not being fueled by volatile commodities or by one asset, customer, or basin as these add more risk that some investors simply can't handle.
Matt DiLallo owns shares of Linn Energy, LLC. The Motley Fool recommends BreitBurn Energy Partners. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.