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Robert Rapier

Robert Rapier

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The Energy Investment Model With A Glaring Problem

The first master limited partnership (MLP) was formed by Apache Oil Company in 1981. In 1987 Congress legislated the rules for publicly traded partnerships in Internal Revenue Code Section 7704.

MLPs slowly gained in popularity during the 1980s and 1990s, with about two new MLP IPOs each year. Then, in the 2000s, the popularity of the MLP model began to soar. There were six new MLP IPOs in 2004, ten in 2005, and eighteen in 2006.

The recession and oil price crash of 2008-2009 briefly derailed the momentum for new MLPs, but demand began to surge again in 2010. In 2013, an all-time high of twenty new MLPs hit the IPO market, but then popularity again began to wane as oil prices crashed in 2014.

The MLP Advantage

An MLP issues units rather than shares and passes profits to unit holders in the form of periodic distributions. Historically, the big advantage for MLP investors is that MLPs aren’t taxed at the corporate level. This arrangement avoids the double taxation of corporate income and dividends affecting traditional corporations and their shareholders. All things being equal, this structure should deliver more money to unit holders.

But the distributions aren’t fully taxed either. Because of the depreciation allowance, 80 percent to 90 percent of the distribution is considered a “return of capital” and thus not taxable when received. Instead, a return of capital reduces the cost basis of an investment in the MLP.

The rest of the distribution—typically 10 percent to 20 percent —is taxed at the recipient’s income tax rate. Being able to defer the rest of the tax until the investment is sold is a big advantage, since the income can be reinvested to generate compound returns that could more than pay for the eventual tax bill. Related: Washington Issues Waivers, Warns Against Trading Oil With Iran

When you ultimately sell the units or the cost basis drops to zero, a portion of the capital gain is taxed at the special long-term capital gains tax rate, and the remainder will be taxed at your normal income tax rate.

MLPs also issue Schedule K-1 forms instead of the 1099 forms you may receive from a corporation, and the K-1 will reflect your share of the taxable income.

The tax advantages made MLPs especially favored by the midstream (i.e., oil and gas storage and transportation) sector, which has been traditionally popular with income-seeking investors due to its ability to deliver stable income streams over time.

Pressure to Convert

However, several factors are now driving MLPs to convert to corporations, or otherwise get rolled up in the parent corporation. This can have significant tax implications for those holding those units.

Remember that tax-advantaged deferred income is one of the most compelling reasons for owning an MLP. But if the MLP gets converted to a corporation, the IRS is finally going to get paid, regardless of whether the timing is good for the investor.

There are several factors driving these conversions.

President Trump has been an advocate for the U.S. oil and gas industry. Among other actions, he signed measures designed to help kick start stalled pipeline projects. One of those measures was particularly beneficial to Energy Transfer Partners LP — which was recently merged into Energy Transfer LP.

However, Trump also signed a tax reform bill that dropped the corporate income tax rate from 35 percent to 21 percent. This is great for corporations, but it significantly reduced the key tax advantage an MLP held over a corporation. Because there is additional complexity in tax filing for MLP investors, this move made MLPs a less attractive option than they had been.

Second, a ruling by the Federal Energy Regulatory Commission (FERC) earlier this year to reverse a longstanding policy on MLP tax costs for interstate pipelines will drive up the cost of business for some. There are MLPs that will be significantly impacted by this ruling, again reducing one of the advantages they held over a comparable corporation. Related: UAE Announces Major Oil & Gas Discoveries

Finally, many MLPs pay incentive distribution rights (IDRs) to their sponsors. These IDRs can be a drag on growth after a while, so elimination of IDRs has been cited as another incentive driving some MLPs to convert to corporations. In fact, Tallgrass Energy Partners cited this specific factor in its decision to roll up into its general partner.

These are the key factors pushing many MLPs to convert to corporations. A conversion is the last thing most MLP investors want to see, because it can create an immediate tax burden from the accrued tax benefits.

Thus, while the midstream sector would appear to be fundamentally undervalued, investors are treading lightly around the midstream MLP sector. The best bets for investors would probably be long-standing MLPs like Enterprise Products Partners LP and Magellan Midstream Partners, LP. These are large, well-established MLPs with no IDR commitments, and are the least likely to convert.

But investors would be wise to continuing exercising caution around midstream MLPs that have only been around for a few years. These make up a disproportionate share of MLPs that are choosing to convert.

By Robert Rapier

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