Another MLP Jumps Ship
Last week Antero Midstream (AM) became the latest MLP to simplify their structure. This is further evidence of the declining opportunity set for MLP-dedicated funds, and cause for investors to seek exposure to energy infrastructure that goes beyond MLPs to include corporations (see The Uncertain Future of MLP-Dedicated Funds).
Like many MLPs before them, Antero is becoming a corporation. Broader institutional ownership and enhanced trading liquidity were cited as the reasons.
The benefits of being an MLP persist – our friend and regular commenter Elliot Miller would note that the tax benefits remain significant: MLPs don’t pay Federal corporate income tax, leaving more money available for distributions. And those distributions are largely tax deferred, with the possibility of being tax-free to one’s heirs given thoughtful estate planning.
Nonetheless, Antero concluded that the MLP structure no longer suited them. They joined a long list of companies who’ve reached the same conclusion, including Kinder Morgan (KMI), Targa Resources (TRGP), Semgroup (SEMG), Oneok (OKE), Archrock (AROC), Williams (WMB), Dominion (D) and Enbridge (ENB). Tallgrass (TGE) has retained the partnership structure for governance but chosen to be taxed as a corporation, and Plains All American offers a option for both 1099 (PAGP) and K-1 tolerant (PAA) investors.
They’ve all found that MLP investors are too few and fickle to be a reliable source of equity capital. Tax impediments add cost and complexity to tax-exempt and non-U.S. institutions, a substantial portion of the investor base for U.S. public equities. The K-1s are how investors achieve the tax benefits noted above, but their complexity dissuades most retail investors. Once you eliminate these different classes of investor, almost the only buyers left are taxable, high net worth individuals. In other words, older, wealthy Americans.
These investors like their income, and the several dozen distribution cuts imposed in recent years have done irreparable harm. The high payout ratios of MLPs left little cash for funding growth projects (see It’s the Distributions, Stupid!). This wasn’t a problem until the Shale Revolution created the need for investments in new infrastructure, to support the huge increases in U.S. oil and gas output. Cash was duly diverted from payouts to growth projects, leading to a 30% drop in distributions (see Will MLP Distribution Cuts Pay Off?).
EBITDA improved and leverage came down, but MLP investors only care about distributions, which were cut by 30%. Consequently, the sector fell hard and is still 30% below its 2014 peak.
MLP-dedicated funds are left with fewer, smaller fish to catch. Their promoters still defend them, in spite of their flawed structure rendering them taxable with correspondingly eye-watering expenses (see MLP Funds Made for Uncle Sam). As pipeline companies continue to abandon the MLP structure, it’s showing up in the sinking market cap of the MLP indices. The market cap of both the Alerian MLP Index (AMZ) and the Alerian MLP Infrastructure Index (AMZI) are decreasing even while the sector is up this year.
It’s stark evidence of the declining role MLPs play in U.S.energy infrastructure. Affected ETFs include those from Alerian (AMLP) and InfraCap (AMZA). Mutual funds from Oppenheimer Steelpath, Centercoast, Mainstay Cushing and Goldman Sachs are similarly stuck with a declining opportunity set.
These MLP-dedicated funds can’t easily change their structure to avoid taxes by becoming RIC-compliant – they’d have to sell 75% of their MLPs, which is prohibitively disruptive. Some smaller funds whose MLP sales weren’t market moving have done so, which shows that others would if they could. Instead, MLP fund proponents are left to argue that their fund structure is optimal, even though no new MLP-dedicated funds are being launched any more.
Some big MLPs are happy enough. Enterprise Products (EPD), Magellan Midstream (MMP) and Energy Transfer (ETE) are all sticking with the structure. It works best if you don’t need external financing. We are invested in all three companies through our funds and separately managed account strategies.
MLPs can still be good. An MLP-only approach is not. MLP-dedicated funds are the worst place to be, given the shrinking MLP market cap and tax burden. But broad energy infrastructure, growing as we pursue American Energy Independence, is cheap.
We are long AMGP, AROC, ENB, EPD, ETE, KMI, OKE, MMP, PAGP, SEMG, TGE, TRGP, WMB. We are short AMLP.
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CS had a 100+ page report on MLP’s this week. Below is the feedback of a few days later.
Initial Investor Feedback on Launch
Initial Investor Feedback =>
Lingering Apathy: We launched coverage of 39 midstream stocks this week with a constructive
outlook. Investors did not pushback on the constructive outlook, generally agreeing that the space is undervalued and
fundamentals remains strong. That said, most
could not point to catalysts that would increase interest in the space.
Concern focused on the general apathy preventing multiple expansion. ETE appears to be the consensus long (CSe O/P),
most view the stock as very undervalued but are frustrated by its l
ack of positive stock response. We received the most
pushback on our MPLX O/P rating. TGE (CSe O/P) also received pushback due to re
contracting risk (that we view as
largely priced in against improving fundamentals). There appears to be disagreement on VL
P’s strategic review; investors
split on whether the outcome is positive or negative. No firm opinions on BPL’s strategic review conclusion; most leaning
towards distribution cut.
Simplification Continues with Antero: Antero announced the completion
of its strategic review; AMGP will buy AM at a
~6.5% premium. The surviving entity (“New AM”) is maintaining distribution growth. AM appears to have avoided sacrificing
its merits as coverage is expected to remain healthy at 1.2
1.3x and leverage increase
s temporarily but should return to
~2.0x by 2022. We expect the New AM to improve its status in the CS Investor Scorecard due to the improved corporate
governance and removal of IDRs.
Performance: This week, the AMZ outperformed the XLE and S&P 500 by ~3.
0%. Most sectors were down this week as a
result of the severe market correction on Wednesday and Thursday. Defensive names outperformed.
Thanks, Simon. I would also note that the vast majority of the private equity money going into midstream infrastructure is through LLCs, a sibling of MLPs often used for non-public entities, and not C corporations. Like partnerships, LLCs pay no entity level tax and depreciation defers most or all of the distributions. So to the list of older, wealthier tax-deferral seeking MLP investors, you can add private equity also favoring non-corporate forms of investing in midstream infrastructure.
Elliot, thanks for your comment. I think the availability of private equity money via LLC confirms that the problem lies with public equity investors. PE money is much more long term. Retail public MLP buyers have been totally turned off by distribution cuts.
NYTimes article printed today (14Oct18) complements your piece. https://www.nytimes.com/2018/10/12/business/energy-partnerships-rebound-as-us-oil-and-gas-output-rise.html
Forbes reported in 7/28/18 that “the number of companies moving from a MLP to a C Corp is small”. I see you report that 9 companies have changed to a C Corp. I found that there are a total of 114 MLP companies. So , it seems the companies changing is in-fact quite insignificant. Alerian reports that the aggregate MLP tax benefit has moved from 8% to 7%.
The market seems to have over reacted to this tax change.
Hi Hunter. Thanks for your comment. The problem is that the companies switching from MLP to corporate form are the big ones. They have the most to gain from broader equity ownership. That’s why the market cap of the Alerian indices has fallen even though price. s have risen. So the result is that MLPs are less representative of energy infrastructure overall.
Why are you short AMLP? Is it for hedging purposes?
Yes David. We are long energy infrastructure corporations and a few MLPs. Short AMLP as part of one pairs trade.