A toxic chain of events surrounding a new face in Washington, the COVID-19 pandemic, and the subsequent demand construction and price crash that roiled the markets has stripped the shine from Master Limited Partnerships (MLPs). Since their advent four decades ago, MLPs have become a popular strategy for investors in oil and gas pipeline companies looking to secure certain tax advantages. In the past, MLPs outperformed oil and gas stocks thanks to their considerably higher yields, favorable taxation, and less exposure to commodity prices.
In a past article, we highlighted these benefits and pointed out that MLPs can provide better downside protection in choppy markets.
However, that was before significant changes were made to the tax structure, and before the oil price war and a global pandemic …
MLPs have underperformed so far in the current year as the Trump tax bonanza and the biggest demand destruction in the history of the energy market took a heavy toll on income-generating assets, including MLPs and REITs (Real Estate Investment Trusts).
For instance, one of the better-known MLP funds, the Alerian MLP ETF (AMLP), has managed a dismal return of -42.5% vs. -37.2% by the Energy Select Sector Fund (XLE).
Now, there's no choice but to highlight the dark side of MLPs and why they might no longer offer a safe haven in this dire market.
Short Overview of MLPs
MLPs are business ventures that operate as publicly traded companies. The company that manages day-to-day operations serves as the general partner, while the investor acts as a limited partner.
The first MLP was formed by shale company Apache Corp. in 1981. Six years later, the MLP structure was recognized by law after Congress passed laws for publicly traded partnerships in Internal Revenue Code Section 7704.
An MLP is required by law to derive at least 90% of its cash flow from commodities, natural resources, or real estate. They, in turn, distribute cash to shareholders instead of paying dividends like a standard company would. MLPs combine the liquidity of publicly traded companies and the tax benefits of private partnerships because profits are taxed only when investors receive distributions.
The biggest draw of MLPs is that they are considered pass-through entities under the U.S. federal tax code. Whereas most corporate earnings are taxed twice (first through earnings and again through dividends), the pass-through status of MLPs allows them to avoid this double taxation because earnings are not taxed at the corporate level. Another key benefit: Midstream MLPs act as toll collectors for the energy companies that use their pipelines. As such, their cash flows are protected by long-term, take-or-pay agreements, meaning they are less susceptible to commodity price fluctuations.
MLPs are Bleeding
Unfortunately, not even MLPs are immune to a prolonged price crash.
The number of pipeline MLPs has plummeted ever since the 2014-'16 crude price collapse triggered a series of cuts to quarterly payouts. Before that, the majority of MLPs not only provided superior yields but also managed to consistently grow the payouts over the years. The latest oil price crash has only served to make an already bad situation worse.
That said, the Big Shift away from the MLP structure began in earnest after changes were made to the way partnerships are taxed. In 2018, the Federal Energy Regulatory Commission (FERC) reversed a key policy in MLP tax costs for interstate pipelines that led to an increase in the cost of business for some companies. To add insult to injury, Trump's tax bonanza that saw the corporate tax rate lowered from 35% to 21% significantly reduced the tax advantage that MLPs had held over corporations. Consequently, many MLPs are electing to convert to normal corporations.
The MLP model is no longer in favor, and selling pressure by institutional investors has been accelerating during the oil price rout.
Good case in point: Back in March at the height of the oil price crash, Goldman Sachs announced that it had decided to "effectively eliminate the net leverage" of two of its funds, MLP Energy Renaissance Fund and MLP Income Opportunities Fund. Shortly after, Kayne Anderson announced that its pipeline funds had sold securities in a bid to bolster its cash position. According to Hinds Howard aka the MLPGuy:
"We're seeing the death of the MLP-dedicated manager group, and that's happening faster than anyone was expecting."
Still, MLPs are likely to continue appealing to a group of yield-chasing investors. A few months ago, Stacey Morris, director of research for Alerian, ran a stress test on MLPs by assuming that they cut distributions by 75%. She concluded that MLPs as a group would still sport higher yields than REITs or utilities, traditionally regarded as some of the best dividend payers.
MLPs are not about to go the way of the dodo. It's just that they are no longer the oil and gas safe haven they once were considered.
Alex Kimani for Oilprice.com
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