Fishing for Yield at the Bottom of the Oil Barrel

February 4th, 2020


The MLP market offers the potential for both yield and capital gains.


The asset of interest today is one that until recently was a favorite of yield investors - oil and gas master limited partnerships commonly referred to as MLP's. Income seekers were attracted to these somewhat esoteric assets because they usually sport very high tax-efficient payouts. The business of MLP's is not very exciting, they are the owners of pipelines in which they charge a fee for the movement of oil and gas. What was nice about these for income investors is that MLP's were assumed to be removed from the volatility inherent in energy prices because they had long term contracts that were not directly tied to oil and gas prices.


Then came fracking which changed the playing field. MLP operators discovered this new gusher of oil and gas supplies were not an opportunity but a problem. The fracking activity was usually not located near their existing pipelines and it was not very financially feasible to build new ones since fracking wells tend to have relatively short lifespans and are very scattered locations. Faced with this loss of new business, many decided to make a big change in the way they were managed. Many began to invest outside their specialty of transport into production itself. Some of those converted to corporations to facilitate more financing options. All this caused dividends to be cut and investors to exit the MLP category. The most popular index ETF that tracks MLP's is called Alerian MLP Exchange Traded Fund (NYSE: AMLP). Its recent trading price of 7.96, which is down 40% from its high made 3 years ago and nearly 60% from the highs made in 2014.

MLP's are not the only part of the energy sector taking a beating. As a whole, energies have been the worst-performing cross-section of the stock market for a number of years now. New supplies from fracking and expectations for a big switch to clean energy are the likely reasons. The turquoise blue line at the bottom of the chart below graphically depicts the woes of the sector.

Even though MLP's were thought to be immune to any bearish trends in their customer's businesses, they actually have done worst in recent years.

Any contrarian investor searching for opportunities probably has the beaten-down energy sector on their radar. Some energy stocks are actually trading below book values. MLPs certainly are a potential value play at their current levels. In future posts, I will attempt to take a deep dive into the business operations of some of the larger MLP's themselves, but as a group, things appear to be looking up. They have mostly given up on their diversification plans and returned to focusing on their old boring business of transport. Earnings are recovering, new borrowing has been curtailed, debt is being paid off and some are even buying back stock (not something MLP's were known for). For these reasons, distribution rates might even begin to rise after being drastically cut in recent years. The payout for AMLP peaked in 2015 at $0.299 a share before recently bottoming at $0.19 and rising for one quarter to $19.50. A rising trend in the dividends should entice yield investors again to buy and motivate the market to rerate the price of the stock higher.


The closing price on February 3rd, 2020 for AMLP was 7.96; down from an early January high of 8.88. The current price is still above the even lower low made last December at 7.68. The next quarterly payout is scheduled to be $0.195; assuming 4 a year at that level equates to a 9.8% yield. Even though the price trend has not turned bullish, for bottom-pickers, a near 10% cushion per year is helpful.


Another way to look at AMLP pricing is through its options, in particular, the long-dated variety as a replacement for buying the stock outright. The furthest out available expires on January 21st of 2022. Besides more closely resembling an investment than a trade, long-dated options are especially interesting these days. The level of short-term interest rates is a significant input in the models used for pricing options. Therefore, today's super-low interest rates (which are even negative in some places) tend to reduce the theoretical value for options, especially long-dated ones.


Below are the final prices and quotes for AMLP options on February 3rd, 2020 as per my Fidelity trading platform.


Circled in red are the at-the-money call with a strike price 8 and the put with a strike price of 6. If the market for AMLP trades a bit lower, they will most likely be quoted about the same. If that happens, the put should be able to be sold short for the same price as the cost to buy the call (no cash outlay except for commissions). This combination (technically called a "risk reversal" in options lingo) creates a position that, at expiration, will reap the upside beginning at 8 and experience the downside beginning at 6. The reason the call that is at-the-money (at the current trading price) is almost the same price as a put 25% lower is most likely due to a combination of bearish sentiment and the fact that option holders do not receive dividends like a stockholder.


If the market price for AMLP goes higher or stays at this level, the trade would probably have to be done at a small debit. If the market does not trade lower, another choice would be to sell the 6 put and buy the cheaper 9 calls for a credit. The breakeven would be lower in this case, 6 minus the credit.


Be clear too, once established, there can be significant price movement in the combination over time, up or down. So the size of the position taken is important.


You might be thinking, with such a high dividend payout, why use options? For some who want to keep it simple, a 10% yield at near all-time low entry price could be good enough. For those versed in options, here is the math that favors the put-call combination. Assuming a sale of the 6 puts at 0.40 (the current bid) and purchase of the 8 calls at 0.50 (the current offer), the net cost would be 0.10 per set (each option is based on 100 shares underlying). The breakeven at expiration would be 6.10 (6 + the debit paid). For a stockholder purchasing the shares at 8 and holding for the same 2-year period, there would be 8 dividends assumed to be $19.50 each, totaling $1.56. Subtract that from an entry price of 8 and the cost basis is 6.44, higher than the breakeven for the example option combination at 6.10. There would be some margin interest to account for using options but, depending on your broker, it should not change the outcome materially. At these levels, either trade is interesting, with the options offering a bit better deal.


Please keep in mind, this blog article nor my advisory entity is not making any recommendations, only pointing out an interesting value proposition for consideration. Investors should to do their own research and/or consult their advisor before making any investment decisions. Options should only be traded by those who fully understand the implications and risks (some of which are outlined in this disclosure downloadable: here).


For those that want more information, here are a couple of references that helped me with my thinking and offered ideas for this post:

1. The blog of SL Advisors, a manager of MLP investments: https://sl-advisors.com/

2. Harley Bassman's blog discussing a similar idea: https://www.convexitymaven.com/images/Convexity_Maven_-_Fail_Better.pdf


Disclosures

Notaro Wealth Advisory is a registered investment advisor. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. The views and opinions expressed in this blog post are as of the date of the posting, are subject to change based on market and other conditions. This blog contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Please note that nothing in this blog post should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax or legal advice. If you would like accounting, tax or legal advice, you should consult with your own accountants, or attorneys regarding your individual circumstances and needs. No advice may be rendered by Notaro Wealth Advisory unless a client service agreement is in place.