MLPs: Debunking the Bears

The S&P 500 Index trades roughly 5 percent lower than it did five years ago. That’s certainly understandable, given the time that’s passed includes the worst bear market in 80 years and a near default by the US government.

Over this same time, however, the Alerian MLP index returned nearly 87 percent. And master limited partnerships (MLP) have delivered a rising stream of dividends as well, much of which passed through to investors without giving rise to either individual or corporate taxes.

Ironically, the more MLPs have succeeded the greater investor skepticism has grown. Some is due to a genuine misunderstanding of what makes MLPs tick—for example, their use of distributable cash flow instead of earnings per share as a measure of profit and hence dividend safety.

Lately the bear case against MLPs has extended to doubts that current expansion rates can con­tinue even for the strongest players, or that favored tax status will survive continu­ing federal budget nego­tiations. And some have posited that rising interest rates will squash the group flat in coming months.

As a result, the group has been taken down a notch. And MLPs perceived as most sensitive to shifting commodity prices are off by double-digit percentages in just a few weeks.

Even after these declines, most MLPs are light years above where they stood in March 2009, when the stock market made its last major bottom. But the recent drop does beg the question of whether the MLP bull is just taking a well-deserved rest or if this really is the end of the line.

Although all good things come to an end, this bull still has longer to run. In fact, after five years of growing businesses with record-low bor­rowing rates, MLPs are stronger inside than ever.

Surest Sign of a Top

The clearest indication that we’ve hit a final top in energy midstream MLPs will be when managements start build­ing new assets before they lock in rev­enue with contracts. Fortunately that’s not happening yet, for two reasons.

First, there’s an enormous infra­structure deficit serving fast-growing energy production areas such as the Bakken Shale.

Weaker prices for oil and gas this year have slowed drilling in North America. But with producers rely­ing on trucks to ship energy in some regions, there’s still a massive need for new gathering systems, processing and storage facilities and pipelines.

And the more energy that’s pro­duced in the US and Canada, the more infrastructure will have to be built to get it to market.

Second, the crash of 2008 and the possibility of a fiscal cliff-triggered re­cession in 2013 are fresh in the minds of energy developers and lenders alike.

Rather than use record-low borrow­ing rates to lever up and embark on speculative building projects, MLPs have used cheap money to eliminate near-term debt maturities and cut in­terest costs. Funding for new projects is locked in immediately, with much coming from cash flow and equity financing rather than debt.

Conservative financial policies have also inoculated MLPs against a future spike in interest rates. With few immediate refinancing needs, management can pull back bond offerings and wait for better conditions if credit markets get tighter.

And MLPs have reduced traditional reliance on credit lines, further limit­ing exposure of earnings to interest-rate swings.

MLPs’ unit prices don’t even fol­low benchmark interest rates. The link between the yield on the benchmark 10-year Treasury note and MLPs was smashed during the crash of 2008, when the latter cratered and prices for the former rallied to historic highs as yields plunged to their lowest level ever.

Since then, MLPs’ correlation to the stock market has been twice as strong as to the bond market. MLPs have rallied when the news for the economy has seemed to improve and dropped sharply when it’s worsened.

A permanent boost in interest rates would raise borrowing costs. But that won’t happen unless economic growth picks up and inflationary expectations rise.

And in that case rising energy prices and production would spur demand for new midstream assets. Higher interest costs would be more than offset by more generous project returns.

Ghost of the Trust Tax

Unfortunately, MLP bears’ third argument—less favorable tax treat­ment—can only be refuted with time.

On Feb. 22, 2012, the Obama administration introduced what it called the “President’s Framework for Business Tax Reform,” which included proposals for reforming the federal income tax on business income.

The headline proposal was to reduce the statutory corporate tax rate to 28 percent. At the same time the White House and the Department of the Treasury proposed closing a number of loopholes and tax expenditures to broaden the tax base.

The Framework included language that, if codified, would expand the scope of the corporate income tax to potentially include MLPs.

This is clearly an existential threat to MLPs as tax-efficient, high-yield in­vestments. But there are precious few details provided in a document that has absolutely no legal significance and hasn’t even found its way into a Congressional bill.

If such a proposal were enacted, income that otherwise would be taxed at the top ordinary rate of 39.6 percent in 2013 would instead be sub­ject to a corporate income tax of 28 percent plus a dividend tax of approxi­mately 44 percent on earnings distrib­uted to partners or shareholders.

It’s not clear, however, whether ex­ceptions would be provided for certain partnerships that would otherwise be subject to corporate tax.

The 2005 report of President George W. Bush’s Advisory Panel on Federal Tax Reform suggested that if large partnerships were subjected to an entity-lev­el tax, exceptions should be provided for regulated investment companies such as mutual funds and REITs.

If exceptions are provided for mu­tual funds and REITs, it’s not hard to imagine a carve-out for MLPs as well, given the effective role they’ve played in directing investment to domestic energy infrastructure.

At the same time, the Master Limited Partnerships Parity Act has been introduced as a bill before both houses of Congress. This bill would amend the Internal Revenue Code to expand the range of MLPs’ qualifying income from fossil fuel-based energy projects such as oil, natural gas, coal extraction and pipeline projects to also include renewable energy projects.

This bill essentially recognizes the MLP structure as a positive instru­ment for development of domestic energy resources. And it has biparti­san support.

Even if there is a boost in MLP taxes, however, there’s a silver lining. From Oct. 1, 2006, to the present, the S&P/Toronto Stock Exchange Income Trust Index has returned more than 100 percent, making it the top-performing measure of income stock performance.

This period includes the infamous Halloween Massacre of 2006, when the Canadian government announced the tax on income trusts, the hor­rific 2008-09 crash and eventually the conversion of most income trusts into corporations by January 2011.

It points to one thing: Strong un­derlying businesses enabled the former trusts to absorb taxes while maintaining solid balance sheets, paying generous dividends and keeping growth on track.

If Congress does wind up taxing MLPs, there will no doubt be an initial selloff of even the strongest US MLPs. But as the example of the trusts makes clear, strong and growing companies in a dynamic industry will build wealth for investors no matter how they’re taxed.

This article was written by David Dittman.