Pipelines’ New Look
The point of a public equity listing is to be able to access public markets for financing, to use the stock as a currency for acquisitions, and to provide liquidity for investors. A company’s cost of equity moves inversely with its stock price, just like bond yields and prices. Access to cheap equity is vital for companies that have growth projects, including most energy infrastructure companies. MLPs continue to face a comparatively high cost of equity.
It’s one of the reasons why we believe over the past few years many of the biggest MLPs have “simplified”, which has often meant they’ve abandoned the MLP structure to become a regular corporation (a “c-corp”). An important objective behind each of these restructurings has been to lower their cost of equity. Kinder Morgan (KMI) led this move in 2014, when their desire for external capital to fund their backlog of growth projects collided with the interests of their income-seeking holders. Investors in Kinder Morgan Partners (KMP) weren’t much interested in plowing their distributions back into secondary offerings, so KMP’s yield rose to levels that made equity issuance uneconomic (see 2018 Lessons From The Pipeline Sector).
KMI decided to combine with KMP, creating unexpected tax bills for holders and leading (eventually) to two distribution cuts. The goal was to access a broader set of investors. Fewer than 10% of the money allocated to U.S. equities can invest in MLPs. Taxes and K-1s generally limit buyers to U.S. high net worth individuals. KMI wanted to reach U.S. pension funds, global sovereign wealth funds, and other significant buyers. They had outgrown the old, rich Americans, who used to own their stock. If you ever talk to a former KMP investor, you’ll learn how much bitterness this caused (see Kinder Morgan: Still Paying for Broken Promises).
Other MLPs followed, and today midstream energy infrastructure is more corporations than MLPs. The list includes Enbridge (ENB), Oneok (OKE), Pembina (PBA), Targa Resources (TRGP), Semgroup (SEMG), Transcanada (TRP) and Williams (WMB). None of these are in an MLP index.
In late 2017 we created the investable American Energy Independence Index (AEITR). It’s a market-cap weighted index of North American energy infrastructure companies. It includes some MLPs, because the structure still works for those not in need of external equity. But MLPs are kept at 20%, reflecting their diminished role.
The AEITR’s limit on MLPs also means that funds linked to it aren’t subject to corporate tax. A flawed tax structure has been a substantial drag on performance for MLP-dedicated funds. For example, the Alerian MLP ETF (AMLP) has a since inception return of 0.47% p.a., compared with its index of 2.75%. It’s delivered less than a fifth of its index since 2010, in part because of a structure that requires it to pay corporate tax. Nobody would create such a fund today.
See MLP Funds Made for Uncle Sam for more detail.
The Alerian MLP indices are becoming outdated, because they represent what the pipeline business used to be, before MLPs started converting to corporations. An MLP-only approach to energy infrastructure misses most of the sector. MLPs aren’t going away, they’re just becoming less important.
For the former MLPs who converted so as to lower their cost of capital, stock performance shows that these were good decisions. The AEITR’s 80% allocation to corporations makes it more representative than the Alerian MLP Index (AMZX). Performance differences between the two are driven by how corporations are doing relative to MLPs. This year, AEITR is 5% ahead.
What’s also encouraging is that it’s coming with lower volatility. Since AEITR’s creation in October 2017, it has had average daily moves of 1.5%, half that of AMZX. This makes sense, because the corporations that make up 80% of AEITR have a wider pool of investors. It’s precisely why MLPs have been converting. A more diverse set of buyers means a deeper market, which lowers the risk for investors and thereby lowers the cost of capital for those companies.
So far, we haven’t heard of a company that regrets its decision to drop the MLP structure in a simplification, and those that remain get questions on every earnings call about their possible plans to simplify. There are some well run, attractive MLPs, including Enterprise Products Partners (EPD), Magellan Midstream Partners (MMP), Energy Transfer LP (ET), Western Gas Partners (WES), and Crestwood Equity Partners (CEQP). But the evidence is mounting that the adoption of a corporate structure and the global investor base that comes with it is beneficial.
We are invested in ENB, EPD, ET, KMI, MMP, OKE, PBA, SEMG, TRGP, TRP, WMB.
We are short AMLP.
SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund. To learn more about the Fund, please click here.
SL Advisors is also the advisor to an ETF (USAIETF.com)
Important Disclosures
The information provided is for informational purposes only and investors should determine for themselves whether a particular service, security or product is suitable for their investment needs. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the disclosure, prospectus, and offering. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy, completeness or timeliness of this information. Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments. Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.
References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios managed by SL Advisors as they have different underlying investments and may use different strategies or have different objectives than portfolios managed by SL Advisors (e.g. The Alerian index is a group MLP securities in the oil and gas industries. Portfolios may not include the same investments that are included in the Alerian Index. The S & P Index does not directly relate to investment strategies managed by SL Advisers.)
This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involves a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of SL Advisors LLC or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made. r
Certain hyperlinks or referenced websites on the Site, if any, are for your convenience and forward you to third parties’ websites, which generally are recognized by their top level domain name. Any descriptions of, references to, or links to other products, publications or services does not constitute an endorsement, authorization, sponsorship by or affiliation with SL Advisors LLC with respect to any linked site or its sponsor, unless expressly stated by SL Advisors LLC. Any such information, products or sites have not necessarily been reviewed by SL Advisors LLC and are provided or maintained by third parties over whom SL Advisors LLC exercise no control. SL Advisors LLC expressly disclaim any responsibility for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on these third-party sites.
All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.
Past performance of the American Energy Independence Index is not indicative of future returns.
There are many reasons why EPD, ET, MMP , CEQP and many other well run MLPs, managed by financially sophisticated operators, have not converted to C corporations. Those factors deserve more attention in articles such as this.
The first reason is that the conversion imposes a tax on the partnership unit holders, and the more loyal the unit holder (that is, the longer the unit has been held by that person) the lower his or her adjusted basis, and therefore the higher the tax.
The second reason is that MLPs as pass through entities do not pay taxes themselves, whereas C corporations are tax paying entities. Therefore MLPs are more tax efficient vehicles than are C corporations.
The third reason is that because the depreciation deduction is passed through to partnership unit holders a large portion of the distributions from an MLP are tax deferred. Here several points should be noted. One is that with bonus depreciation under the new tax law the depreciation deductions will likely increase. Another is that generally midstream assets have far longer lives than the useful lives utilized for tax purposes.
And a fourth reason is that to the extent that there are taxable earnings and profits at an MLP, the new tax law provides for a 20% reduction for such earnings. That benefit is available from some pass through entities (MLPs and REITS), but not others (BDCs).
In short, the MLP model still has meaningful vitality and a truly interested constituency despite all of the nay saying. These positive attributes deserve recitation.
Excellent points Elliot, and while I had and still do disagree with most of what SL has done and promoted in the midstream space, I do commend them for having the courage and character to allow your comment to stand on their own site.
The entire midstream group has been a gross disappointment for investors, with numerous head fakes in all directions over the past few years. Ironically, one of the most notorious names in the business – one of the first names to have exposed the horrific lack of fiduciary responsibility in this industry – Kinder – is presently the top performing name in terms of relative market price.
With all of the issues plaguing this entire industry group, including without limitation some of the most share/unit-holder unfriendly management, its a wonder anyone continues to entrust their money. For the most part, I’m guessing people that directly manage their own money in serious quantities have scaled back or even eliminated altogether their allocations to this industry group.
I’d say a fund portfolio manager that allocated according to the level of ethical standards demonstrated by mid-stream management would be a good fund to invest in were it not for the fact that company that would score a ZERO in ethics is the top performing company in the field.