Oil’s Slide Exposes MLP ETF Risks

Master limited partnerships (MLPs) and the corresponding exchange traded funds, favored destinations for income investors over the past several years, have not been immune to oil’s tumble.

While significantly less bad than oil futures ETFs, the JPMorgan Alerian MLP Index ETN (NYSEArca: AMJ) and the Alerian MLP ETF (NYSEArca: AMLP), the two largest MLP-related exchange traded products, are down an average of 7% over the past 90 days. The United States Oil Fund (NYSEArca: USO) is lower by nearly 43% over that period.

Obviously, MLP ETFs are not moving in perfect lockstep with oil prices, but crude’s slide is exposing risks within an asset class heavily favored by investors that, generally speaking, would call themselves conservative and not tolerant of excessive risk. [MLP ETFs Endure Lower Oil Prices]

In particular, investors seem to be underestimating the risks of MLPs. These stocks are very expensive and have negative free cash flow yields. They offered free cash flow yields in excess of +5% years ago when we thought they were attractive. Today, they have free cash flow yields of almost -5%! A 50% drop in oil prices seems certain to have a negative impact on MLPs because of the sector’s overvaluation and increased dependency on external capital for funding,” according to Richard Bernstein Advisors.

Remembering that MLPs are required to distribute 90% of their income in the form of dividends to maintain favorable tax treatment, the ability of these firms to generate free cash flow is a vital evaluation metric.

Investors should look for MLPs that have distributable cash flow, or the amount the partnership could distribute to unitholders, that equals 120% of distributions, according to MLPInvestor.com.