Income investors searching for the highest possible yields are inevitably attracted by energy production master limited partnerships (MLPs).

These companies boast some of the highest nominal yields available, and many of them claim to have hedged the oil and gas prices of their output through the derivatives market.

Yet the recent troubles of Linn Energy (LINE) show that even the best-hedged production MLPs can’t maintain their dividends with oil and gas prices at such depressed levels.

Like real estate investment trusts (REITs) in a real estate downturn, energy MLPs are a risk to investors’ wealth.

[ad#Google Adsense 336×280-IA]My colleague, Alan Gula, pointed out way back in December 2014 that Linn Energy was in danger of cutting its dividend.

In particular, he noted that the company’s operating cash flow had been perpetually negative.

Yet, since the company has consistently hedged the price of its output in the futures market, many investors assumed that a rapid decline in oil and gas prices wouldn’t affect LINE’s ability to pay a decent dividend.

They assumed wrong.

The company has announced that, within a few months, it will suspend the dividend altogether to conserve cash flow. LINE shares are down more than 90% from their peak and 70% from the beginning of the year.

Linn’s condition should’ve been clear to rational investors who viewed its income statement. The company recorded substantial losses in each of 2012, 2013, and 2014. There’s not much point in hedging against income fluctuations if your actual results each year show a large loss.

Through its hedging, Linn had achieved the magnificent feat of reporting a large profit in 2008, when oil prices collapsed, and a substantial loss in 2009, as they recovered. In other words, investors (and presumably lenders) had been left completely in the dark as to whether Linn was making any money or if it could afford to pay its large dividends (which, in 2014, amounted to nearly $1 billion in cash outflow).

And Linn is by no means unique. Another MLP fashionable when prices were high, Breitburn Energy Partners (BBEP), lost $146 million in the second quarter of 2015 because of low oil prices. Its share price is also down almost 90% from its level a year ago.

Because of vigorous hedging, Breitburn managed to make a $411-million profit in 2014 after suffering losses in the two previous years. It was enough to cover its dividend, but profits on its derivatives contracts accounted for $361 million of the $411 million.

In actuality, Breitburn only avoided running out of money because of massive share issues and leverage, which it used to finance a capital spending program of about $1 billion per year. And remember, all of this was undertaken at $100 oil.

Now, Breitburn is still paying a dividend of $0.50 per annum, paid monthly. At the current level, the shares yield a munificent 16.7%. Based on its drilling program, the hedges it still has in place, and its ability to pay preferred stock dividends in shares, the company claims the dividend is covered twice over. But I wouldn’t be tempted.

Even if Breitburn maintains its dividend for the rest of 2015, there can be no assurance of its doing so in 2016, when its hedges (worth $670 million at July 31) start to run off. Plus, there’s the $3.1 billion in debt to worry about.

Avoid Perceived Value and Move On

Linn and Breitburn are both well if aggressively managed companies. And theoretically, with Linn selling at 30% of book value and Breitburn at 19%, there’s value there – though I’d say it’s for aggressive bottom-fishing value investors, not income investors.

The bottom line is that the decline in oil prices has played merry hell with these companies’ operations. They invested massively at $100 oil, and their assets have collapsed in value. No amount of derivatives flimflam can hedge that fact. It can only disguise its reality – and not very effectively, either. Bitter investors are now wise to the tricks that can be played.

Indeed, the accountants bear a heavy responsibility for the energy MLP fallout, as their foolish mark-to-market accounting obscured the realities of many companies’ operations.

If oil prices are still in the $40 to $50 range at the end of the year, the accountants will presumably force both Linn and Breitburn to suffer billions of dollars in “value-impairment” write-offs, which will almost certainly cause them to violate bank and bond covenants and probably go bankrupt.

For income investors, this is a silly game, made much more so by derivatives and mark-to-market accounting. Let’s avoid this mess entirely and find something else in which to invest.

Good investing,

Martin Hutchinson

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Source: Wall Street Daily