The Selloff in Partnership Shares Should Not Have Happened
(Bloomberg View) -- A March 15 ruling on master limited partnerships could reduce electric and natural gas bills for energy consumers in parts of the U.S. But investors in MLPs aren’t rejoicing. In fact, they dumped their positions, even though this market still shows potential.
The ruling by the Federal Energy Regulatory Commission would no longer allow interstate natural gas and oil pipeline MLPs to recover an income-tax allowance in their cost-of-service rates. The policy revision was a response to a U.S. Court of Appeals ruling that the FERC “failed to demonstrate there was no double recovery of income tax costs” when the court permitted an MLP to recover both an income tax allowance and a return on equity while setting rates. MLPs had been able to claim a cost-of-service allowance, but the FERC insisted that some pipelines were artificially increasing their costs, which boosted rates.
After the announcement, MLPs traded downward, some as much as 12 percent and 15 percent. The Alerian MLP Index fell by 9.4 percent to its lowest since February 2016.
MLPs had been a lucrative sector after the financial crisis, with five strong years of returns. The catalysts behind the rally included yield-focused investors attracted by MLP’s reliable payouts; horizontal fracking, which spawned a shale revolution; and a 2014 oil price rally when crude peaked at $112 per barrel. Total return of the MLP sector from the crisis to the oil peak was twice that of the S&P 500.
Subsequent years were disappointing. Oil prices were cut by half and unit holders received reductions in distributions as long-term pipeline contracts were rejected in bankruptcy court. The industry was further hit in 2017 when legislation partially limited untaxed distributions. Today, skeptics focus on rising interest rates that make MLP yields less attractive.
The new rule is likely to strip some pipelines of the mechanism that had boosted the amount of pretax income pass-through. But there still are valid reasons to dip back into MLPs. For example:
- MLPs continue to be pass-though entities that pay no federal taxes. That means investors will still be able to achieve better after-tax returns than by investing in conventional corporations. Holders of MLPs continue to be compensated in the form of increased income. FERC lacks the power to change taxes that MLPs and unit holders pay. The regulator can only affect the way in which taxes are treated for purposes of rate settings on pipelines under its jurisdiction.
- The industry is composed of valuable hard assets, which tend to be good investments during market corrections.
- The FERC ruling won’t affect all MLPs equally. It should not hurt pipeline companies owned by C-corporations such as Kinder Morgan Inc. and is more likely to harm MLPS with large cost-of-service exposure. In addition, not all MLPs operate pipelines; they may be involved in mining and exploration or processing and storage. And even those that do operate pipelines may not have all of their pipelines subject to FERC rate-setting oversight. In the case of Enterprise Products Partners LP, a significant portion of income comes from oil and gas-processing plants and storage terminals that would not be affected by the change. Also, the rule only applies to interstate pipeline assets, not to those that begin and end within the same state. Cheniere Energy Partners, for example, feeds the Gulf Coast LNG gas export facility owned by its parent, Cheniere Energy.
- Any rate changes that could result would affect only a pipeline’s maximum, cost-based rates. Many MLP pipelines are under market-based rates, negotiated rates and discounted rates that are below reduced maximum rates for gas pipeline transportation and settled or committed rates for oil pipelines, none of which will change.
- Most MLP business lines do not have direct exposure to commodity price fluctuations. Their businesses function primarily on a set fee (or tariff) per volume or fee-for-service basis. That means the business model is simply price multiplied by volume. It’s largely market sentiment that causes energy prices to move the MLP sector, but those price movements tends to be short-term.
- In the new tax law, the immediate expensing provision (bonus depreciation) allows businesses to immediately fully expense capital expenditures over the next five years. Because MLPs by nature are capital-intensive, a more aggressive depreciation schedule may spur additional spending on growth projects.
For natural-gas pipelines, the change could go into effect this summer. But it won’t be in force for oil until 2020, meaning oil pipeline restructuring plans will be slower to evolve. Some refining companies may reverse spinouts and buy back their pipeline holdings. (Full disclosure: I own JP Morgan Alerian MLP Index exchange-traded notes and Kinder Morgan).
MLP valuations have fallen to levels that make the assets attractive buys. And this may be the window of opportunity for investors. But now, MLP investing requires an additional level of homework and being more selective when picking individual names.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Shelley Goldberg is an investment adviser and environmental sustainability consultant. She has worked as a commodities strategist for Brevan Howard Asset Management and Roubini Global Economics.
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