More Worries for Oil Patch Investors
Behavioral finance has a term for it: regret theory.
The theory holds that since investors anticipate regret if they make a wrong investment choice, they take their anticipation into consideration when making decisions. Sometimes that makes them act too hastily, and sometimes it immobilizes them, but whatever they do they worry about making a mistake.
If you’re like me, maybe you’ve felt a variant of regret theory in that you believe any investment decision you make is probably wrong. Whether it’s buying or selling, or reallocating, I typically feel that my timing is off and that I should have done what I was doing earlier, later or not at all.
MLP Losses
Given that stream of irrationality and penchant for regret, it’s no wonder I’m delighted that I don’t own any energy master limited partnerships — despite the lush dividends they paid when oil was $80 a barrel. As New York Times columnist Gretchen Morgenson explained recently, owners of many of these investments not only are facing losses and shrinking or nonexistent dividend income, but they also may be hit with hefty tax bills. Talk about regret!
Here’s what happened.
Most of the small oil exploration companies that set up drilling operations in North Dakota, Texas, and other states starting in 2006 used high-yield bonds to finance their exploration costs. Now that oil prices have fallen to the $30 range, these companies are having a tough time making their bond payments. Many are trying to restructure their debt.
Tax Implications
If that happens, Morgenson explains, and some of the debt is forgiven, that forgiveness creates something called “cancellation of indebtedness income.” This means that partnership owners will have to pay income taxes on their share of the debt forgiven by creditors — and the tax is due even though the unit holders received no actual income as a result of the restructuring.
Many master limited partnership investors, if they took the time to read their prospectus before investing, probably realized that MLPs are what’s known as pass-through entities. Such entities, which also include real estate investment trusts (REITs), don’t pay any tax themselves if they pass their income onto investors. Most times, of course, any income passed along is generated by normal business operations. In the case of the troubled limited partnerships, the “income” is a result of how the tax code treats debt restructuring.
A First
“We’ve never had this before in the world of MLPs where they were in such trouble and had to restructure their debts. This will be a first where these partners will have this income passing through to them,” Robert Willens, an investment tax and accounting expert, told Morgenson.
Even worse for some long-time MLP owners, any distribution received from a restructuring that exceeds the owner’s cost basis — which probably would have declined over time since dividends usually include a return of principal — would face additional tax.
Paying unexpected taxes on income you never received on an investment that has dropped in value is probably one of the worst-of-all-worlds investment scenarios that can be imagined. That’s not only regret theory, it’s regret reality.
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