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How Tax Reform Could Affect Energy MLPs

By Janet Levaux

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Master limited partnerships, or MLPs, generally offer investors yields of about 8% or more. They can do so by operating as pass-through entities — meaning that their earnings go back to shareholders.

While C corporations get a break in their future tax level with Congress’ passing of recent legislation (to 21% down from 35%), there have been concerns about how MLPs would be affected by the reforms and what these changes would mean for MLPs in the year ahead.

Raymond James’ energy analysts — which include Darren Horowitz, Justin Jenkins, J.R. Weston and Tom Murphy — recently addressed these issues in note to investors.

The new tax law provides “MLP unitholders with eligibility to receive the full 20% deduction for pass-through income off their individual tax rates without being subject to the wage limitation (as before, cash distributions would remain untaxed),” they explained.

On the other hand, the lower corporate tax rate is “a slight-to-moderate negative for MLPs, as the magnitude of relative cost of capital advantage [for MLPs] over C-corps may somewhat diminish,” according to Horowitz and his colleagues.

More Ups Than Downs

Individual MLP investors, the Raymond James analysts believe, “should generally benefit from lower individual ordinary income tax rates, which will move closer to the rates on dividend income (which are staying unchanged at 15% or 20%, depending on income).”

While the shifts in individual rates are less significant than those affecting corporations, some taxpayers in the current 28% and 33% brackets should end up in the expanded 24% and 32% brackets, they point out.

Furthermore, the 20% rate for business income from pass-through entities will probably reduce individual income taxes, at least the taxable portion of MLP distributions, for those in the current upper tax brackets, the analysts state.

Other Factors

Since late 2014, uncertainty associated with large funding needs and, at times, debt market turbulence has contributed to MLP equity-price weakness, according to Brian Watson, senior portfolio manager and director of research with OppenheimerFunds’ SteelPath unit.

But several key shifts in the midstream sector — or pipeline MLPs — should alter this situation, Watson notes. (Midstream players represent the largest sector in the MLP industry.)

First, the midstream sector is seeing some moderation in its level of capital spending and hence its funding needs. MLPs issued about $20 billion to $25 billion in equity in 2017, but 2018 equity needs seem to be falling to roughly $10 billion, “with needs for 2019 likely even lower,” he explains.

Second, trading prices and the demand for midstream notes and bonds have “normalized,” leading to an improvement in both the pricing and demand for midstream preferred equity, Watson says.

Midstream MLPs have issued some $7 billion in preferred equity through early December, “which is helping midstream operators affordably meet funding needs for important projects, without stressing balance sheet health or harming common equity holders by issuing undervalued units,” according to the portfolio manager.

Third, midstream providers are seeking partners for large projects to help with funding and lower the risk of such exposure, he says.

Kinder Morgan and Targa Resources, for instance, included partners in some projects, and Energy Transfer Partners had several joint-venture agreements this year.

Most important, Watson points out, the energy industry’s macro outlook “is much healthier than recent years with most midstream providers likely to experience growing volumes, and therefore margins, across their assets rather than flat or declining volumes.”

Some earnings metrics for the sector are starting to reflect “healthy year-over-year results,” Watson adds. “As recent volume trends continue and assets under multiyear construction periods finally enter service and begin to generate revenue, we expect this trend to continue.”

Future Distributions

Therefore, while some MLPs may still opt “to moderate their distribution growth targets or lower their distribution payouts to fund growth projects, we believe we are nearing the end of such strategic funding shifts rather than the beginning,” according to the portfolio manager.

“Additionally, it is worth noting that, across this energy down cycle, more midstream providers have actually increased payouts than have cut them,” he added.

Overall, Watson sees the midstream group as likely to benefit from a few important tailwinds that market sentiment and equity valuations may be underestimating. “Further, we believe that, as the broader energy markets continue to normalize, these tailwinds may begin to attract greater investor interest and aid in the sector’s recovery,” he said.

— Check out Mixed Bag for Bonds in 2018 on ThinkAdvisor.