There exists a small, interesting, little understood, and sometimes very profitable sector of the MLP space. This group consists of the master limited partnerships that pay variable distributions based on quarterly profit results. These partnerships have both variable raw material costs and variable pricing for the products they sell. The partnerships are set up to pay out 100% of the free cash flow each quarter as distributions to unit holders.
The variable pay MLPs own and operate crude oil refineries, fertilizer plants and chemical plants. The plants use energy products such as crude oil and natural gas as the raw materials needed to produce the refined fuels, fertilizers or chemicals that are then sold into the wholesale or end user markets. The profit margin earned depends on the price paid for the raw materials compared to the current prices for the produced products. For example, most investors are familiar with crude oil prices, which a refinery turns into gasoline, diesel fuel, heating fuel, and other refined products. If oil is relatively cheap and fuel prices are high, the refinery can be very profitable. However, there are other times when a refinery will not be able to sell fuels at a price that covers the cost of the current value for crude oil. The variable pay MLPs also own just one or two facilities, so a planned or unplanned period of down time will also hurt the bottom line profits for the quarter.
Investing in variable rate MLPs involves working with the facts that the quarterly distributions will vary by significant amounts and it is hard to predict what the next quarter will bring, profits wise. However, the savvy and patient investor who understands these partnerships will find periods when he can buy in to earn a 10% or better yield and also pick up 20% or more in unit price increases. Investors and the market will push up the price of a variable MLP after an especially large distribution is announced and push down the price when a small or even zero distribution is paid for a quarter. You need to be ready to buy when the news is bad and the distributions and yields are low. Spend some time to understand how the business of a particular MLP works and then watch the unit price and quarterly distributions to learn what happens when input and output price change and the resulting quarterly distribution. Investing in these MLPs can take patience, because the really good buying opportunities may come up just once or twice a year. From that point you can use a buy-and-hold strategy to earn a higher average yield due to your low cost basis, or trade out and in as you see patterns in the unit prices. Here are three variable MLPs from different sectors that deserve spots on your watch list.
