For most of the past 25 years, there was no better investment for income-seeking investors than Master Limited Partnerships (MLPs). That changed with the oil price crash of 2014. Despite a recent rally in the energy sector, a deep disconnect has opened between the price of oil and the market valuation of MLPs.
To review, midstream oil and gas companies generally function as toll collectors for transporting and storing hydrocarbons. Historically, midstream companies have been more insulated from the commodity price volatility that can impact the upstream and downstream sectors. As a result, many investors gravitated to the midstream companies for predictable income streams.
Many midstream providers structured themselves as MLPs, which provided tax benefits for investors.
The biggest advantage has always been that MLPs aren’t taxed at the corporate level. MLPs pass profits directly to unitholders in the form of quarterly distributions. This arrangement avoids the double taxation of corporate income and dividends affecting traditional corporations and their shareholders and should deliver more money to MLP unitholders over time.
But because of the depreciation allowance, 80 percent to 90 percent of the distribution is considered a “return of capital” and thus also not taxable when received. Instead, returns of capital reduce the cost basis of an investment in the MLP.
Investors Sour On MLPs
MLPs crashed along with the rest of the energy sector in 2014. However, in recent months most of the energy sector has rallied. The MLP sector, on the other hand, has continued to fall. Related: Saudi Arabia To Fund Giant Solar Project With Oil Riches
There are several reasons for the drop.
First, the tax reform bill that President Trump signed reduced some of the tax advantages an MLP held over a corporation.
Likewise, rising interest rates may make certain financial instruments slightly more attractive relative to MLPs.
Finally, two weeks ago a ruling by the Federal Energy Regulatory Commission (FERC) to reverse a longstanding policy on tax costs for interstate pipelines really rattled investors.
Borrowing costs may increase a bit, and there will be increased competition for investor dollars, but tax reform and rising interest rates should have a minimal impact on the sector.
The FERC ruling could cause some MLPs to convert to corporations — a popular trend throughout the energy sector downturn. But many MLPs have already issued guidance that they will either be unaffected or minimally affected by this ruling.
A Widening Disconnect
How wide is the MLP disconnect? Consider that oil prices closed last week more than 30 percent higher than they were a year ago. West Texas Intermediate (WTI) is hovering around $65/BBL and Brent is at nearly $70/BBL. Related: Higher Oil Prices Boost Saudi Credit Rating
The Energy Select Sector SPDR ETF (XLE), which represents the largest energy companies in the S&P 500, is down by 3.6 percent over the past year. The XLE represents the stocks of large energy companies from different sub-sectors (e.g., integrated, oil production, equipment services). It is, therefore, a good benchmark for conservative energy investors.
The S&P Oil & Gas Exploration & Production SPDR ETF (XOP) is more representative of the smaller-cap drillers. Despite companies across the board posting much-improved year-over-year financials, the XOP has done a bit worse than the XLE, falling 6 percent in the past 12 months.
But the Alerian MLP Index (AMZ), which captures about 75 percent of the midstream sector’s market capitalization, has dropped by 20 percent since last August — a time that oil prices were still ~$45/BBL.
In my view, the steep sell-off in the sector is overdone. MLPs should see improving business conditions with the higher price of oil, so a 20 percent sell-off is unwarranted. This disconnect can’t last.
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