Since the oil crash began in June 2014, the prices of both stocks have plunged catastrophically, far more than either crude or most other MLPs. Linn's surprise decision to suspend its payout is certainly the major cause of its most recent decline -- in July alone it collapsed by over 50% -- and serves as a painful lesson to MLP investors that a yield that seems too good to be true usually is.
For example, before the announcement, Linn was yielding 23%,the market's way of signaling a lack of confidence in the current distribution's sustainability.
To spare high-yield MLP investors from suffering a similar fate, let's examine three vitally important lessons income investors need to take away from the cautionary tale that is Linn Energy.
Debt takes precedence over distributions
MLPs, because they pay out the majority of earnings as distributions, use debt and equity offerings to raise money. Usually the cost of equity is much higher than the cost of debt, so some MLPs, such as Linn Energy, have preferentially chosen debt as its major form of funding.
However, the catch with debt -- in the form of bonds or a credit revolver -- is that interest payments take precedence over distributions. In addition debt covenants and credit facility reviews -- Linn has one in October that will likely reduce its access to further borrowing -- can force the reduction or suspension of the payout.
Excessive debt can destroy your investment
To pay for its growth -- 62 acquisitions worth $17 billion since its IPO in 2006 -- Linn accumulated a mountain of debt.
In fact, at the start of the oil crash, Linn's long-term debt stood at a staggering $11 billion. Today its current debt-to-EBITDA ratio -- a key metric that affects an MLP's credit rating and access to additional borrowing -- stands at a truly frightening 15.1; almost 6 times greater than the industry average.
Linn's bond holders are understandably concerned about the MLP's ability to repay its debt -- 49% of this past quarter's operating cash flows were consumed by interest payments -- $3 billion of which comes due in 2019.
Which is why management made the correct, if brutally painful, decision to suspend the payout to divert the entirety of its $450 million annual cost savings toward reducing debt by repurchasing its bonds -- $783 million worth thus far this year -- while they are selling at greatly reduced prices.
That's the smart long-term move, because through 2017 Linn Energy has the vast majority of its production hedged at about double the current market prices of oil and gas.
No one can predict how long low energy prices will last, so Linn must prioritize strengthening its balance sheet. That's because, if energy prices are still low in 2018, when Linn's hedges have rolled off, its greatly diminished cash flows might make servicing and paying off its crushing debt all but impossible.
However, many investors may be confused at just how Linn is even able to suspend its payout because of a misconception that MLPs have to make distributions to investors.
MLPs aren't required to pay investors anything
A lot of people think that MLPs are like REITs or BDCs in that they must pay out a fixed percentage of their profits to investors to maintain their preferential tax status.
While REITs and BDCs are required to pay out a minimum of 90% of taxable income to investors as dividends, MLPs are not.
In fact, according to Grant Thornton, an independent auditor and tax advisory firm, current tax laws simply require that 90% of MLPs' gross income be derived from "exploration, development, mining, or production, processing, refining, or transportation of any mineral or natural resource."
In other words, while MLPs are similar to REITs and BDCs in that they are "pass through" entities that avoid double taxation at the corporate level, there are key tax differences. This is what allows MLPs such as Linn Energy to suspend its payout if it feels it's necessary to ensure its survival in the face of a potentially long-term commodity crash.
Bottom line: MLP investors need to learn from Linn Energy's misfortune
Linn Energy's payout suspension and catastrophic price collapse over the past year should serve as a warning to high-yield energy investors. Never forget that oil and gas prices are inherently cyclical and volatile; coming in waves of boom and bust.
That means income investors need to perform their due diligence before risking their hard-earned money. Make sure your MLP's balance sheet is strong enough to survive the inevitable commodity crash without likely having to cut or even eliminate its payout.
Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.