From Invesco: On March 15, the Federal Energy Regulatory Commission (FERC) stated that it will no longer allow master limited partnerships (MLPs) to recover an income tax allowance when setting cost of service rates for their interstate natural gas and oil pipelines.
This ruling reverses a longstanding (and long-debated) policy that was most recently affirmed by FERC in 2005. Although we expect the pipeline industry to appeal this ruling, the MLP market still dropped approximately 4.5% on March 15 in response to this announcement.1
To better understand the impact of the FERC ruling on the future of MLP investments, let’s explore the history of MLPs.
The evolution of MLPs
MLPs are limited partnerships that are publicly traded on stock exchanges. Unlike corporations, MLPs do not pay federal income tax. Rather, they pass their income to their unitholders, who may be subject to income tax on the distributions.
While MLPs are not new investment vehicles (in fact, they have been around since the 1980s), they have evolved over time. Initially, MLPs were open to a variety of sectors; for example, the Boston Celtics NBA team was once owned by an MLP. However, with concerns that many corporations would switch to the tax-friendly MLP structure, Congress limited the formation of MLPs in 1987 to companies where at least 90% of their income was considered “qualified income,” which includes income and gains from the exploration, development, mining, production, processing, refining, transportation or marketing of natural resources.
MLPs were reinvented in the 1990s when energy companies began moving their more stable assets, such as pipelines, to the tax-efficient MLP structure. Over time, this led to a focus of MLPs on midstream energy infrastructure that transported, processed and stored crude oil, natural gas and natural gas liquids. This was an important shift for the asset class, as it made MLPs less sensitive to potentially volatile energy prices.
In 1995, there were 16 publicly traded MLPs.2 At the end of 2017, there were more than 100 publicly traded MLPs, with a market cap near $400 billion.3
The evolution of the income tax issue
As MLPs have evolved, so have the policies concerning the treatment of income taxes when setting the cost-of-service rates that users pay to transport oil and gas over certain pipelines. As the name implies, these rates are based on a pipeline’s costs. In the early years of MLP history, MLPs were given an income tax allowance when setting these rates. FERC changed that policy in 1995, and then restored the allowance in 2005. A recent court case revived the issue, leading to this month’s ruling.
Beyond the initial MLP sell-off following the FERC announcement, what kind of long-term impact could the ruling have on the future of MLP investing?
FERC impact on MLP investing
For individual MLP companies, the degree of cash flow impact will differ based upon their underlying asset exposure and existing contract structure. For example, instead of charging cost-of-service rates, some pipelines charge market-based rates or negotiated rates, which are not affected by this rule. In addition, assets such as gathering, processing and storage facilities are not affected.
Additionally, the timing of a potential cash flow readjustment will also vary, with certain instances not likely occurring until 2020. For the Invesco MLP Fund, we are focused on positioning the portfolio around those companies with minimal exposure to the new announcement, in addition to those that we believe experienced an overreaction in stock price performance.
Overall, this ruling raises the risks of investing in MLPs in the current environment until there is overall better visibility into the long-term cash flow impact. The FERC ruling and the resulting volatility reaffirm our belief that active management continues to be an important aspect of MLP investing.
1 Source: Lipper, Alerian MLP Index as of March 15, 2018
2 Source: Alerian, “MLP: No longer an emerging asset class,” 2014
3 Source: Alerian, as of Dec. 29, 2017
Although the characteristics of MLPs closely resemble a traditional limited partnership, a major difference is that MLPs may trade on a public exchange or in the over-the-counter market. Although this provides a certain amount of liquidity, MLP interests may be less liquid and subject to more abrupt or erratic price movements than conventional publicly traded securities. The risks of investing in an MLP are similar to those of investing in a partnership and include more flexible governance structures, which could result in less protection for investors than investments in a corporation. MLPs are generally considered interest-rate sensitive investments. During periods of interest rate volatility, these investments may not provide attractive returns.
The Alerian MLP (AMLP) was unchanged in premarket trading Wednesday. Year-to-date, AMLP has declined -14.37%, versus a -2.35% rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of Invesco.