Markman: Expect a Bounceback in Limited Partnerships

by Jon Markman | May 18, 2011 1:02 pm

Master limited partnerships have been shellacked over most of the past week in tandem with the decline in crude oil prices, though they are well off their lows.

A key problem has been news that the White House and Congressional leaders are thinking about changing the way certain partnerships, including MLPs, are taxed, as part of an effort to raise more revenue for the government . I don’t think this is likely to make much progress, and that the decline was likely to be seen as a good entry point for investors seeking high yields.

I have been a big advocate of owning these for the past two years as they provide an ideal mix of high and rising dividend yields, strong balance sheets and rising stock prices. And now the case for MLPs is as strong as ever.

To learn more about what’s going on, let’s turn to the energy analysts at Citigroup, who weighed in on this subject last week. I agree with their view.  Here is an excerpt from their analysis:

”Since the end of last week MLPs have underperformed the broader market by 500 basis points. For an explanation some investors have pointed to a tax reform proposal that could impact pass-through entities such as MLPs. Alternatively, we do not think this is the primary driving factor behind recent weakness. In our opinion, a broad sweeping corporate tax bill that would threaten pass-through entities does not have a very good chance of making it through the existing House of Representatives with a Republican majority and getting passed into law by the current Administration. Therefore, a market reaction that has been as broad and sustained as what has occurred over the last week is most likely related to the overall sell-off and weakness in the energy sector….

“Taking this into consideration we see the recent weakness in the sector as an enhanced opportunity to buy MLPs with strong underlying fundamentals and multiple years of growth opportunities at more attractive valuations. We have a positive view of owners/operators of midstream assets with a particular focus on natural gas liquid (NGL) assets and liquid rich resource basins.

“It is common for the MLP unit prices to be volatile following distribution payments and equity issuances especially if compounded by broader market weakness. During 2010 MLP unit prices were weakest during February, April/May, and August — all following a series of equity issuances or distribution payments. Toward the end of April most MLPs have gone ex-dividend, which we believe has been compounded by weakness throughout the energy sector. 

”The modern MLP was born out of the Tax Reform Act of 1986, which lowered the top marginal tax rate paid by individuals to a level below that paid by corporations. The passage of this legislation caused many companies to change to the partnership structure in order to take advantage of the tax benefits. As numerous companies made the switch to the MLP structure, lawmakers passed the Revenue Act of 1987 to help protect corporate tax receipts. 

“This legislation required publicly traded partnerships to receive 90% of their income from qualified sources. Qualifying sources include natural resource activities such as exploration, development, production, mining, refining, and transportation (including pipelines) of oil, natural gas, minerals, geothermal energy, and timber.

“The spirit of the 1987 legislation was to: 1) protect corporate tax receipts by prohibiting all businesses to seek a tax beneficial structure, and 2) provide incentives for the domestic development of natural resources and the build out of critical infrastructure such as oil and gas pipelines. Looking back it appears that these incentives have largely worked. A large majority of new pipeline and storage projects that have been constructed over the last several years have been undertaken by energy related MLPs. In our coverage universe alone, MLPs have spent over $61 billion on expansion projects over the last five years and a result the cost to move and store natural gas has declined dramatically.

“This is important especially when production is growing because expanded infrastructure is needed for consumers to ultimately benefit from lower prices at the point of sale. Without expanded infrastructure, pricing would remain depressed at the point of production yet the price to the consumer would not change dramatically as bottlenecks in the system restrict this new production from getting to the market. This price disparity manifests itself through regional price differentials also known as basis differentials. Through infrastructure investment these regional pricing differentials are alleviated and reduced pricing can be passed onto the consumers. Over the last five years natural gas basis differentials and storage margins have come down substantially as a result of infrastructure investment. 

“New and expanded infrastructure has also provided producers with easy access to liquid market hubs at attractive pricing for the oil and gas that they produce. As a result, domestic production of both natural gas and crude oil have shown improving production trends. This is particularly interesting in regards to domestic crude oil production that had been showing an almost unrelenting decline for over 25 years until 2009 when domestic production finally rose from around 4.5 million barrels a day to around 5.5 million bpd currently. 

“Similarly, low natural gas prices have provided the petrochemical industry with a globally competitive feedstock (ethane) that is reviving domestic industrial demand. As a result, MLPs in our coverage universe have announced investments of more than $10 billion over the next 3 years toward new infrastructure projects to get these new sources of production to revitalized industrial consumers. 

“Taking into consideration these facts it is our opinion that the MLP structure provides an efficient way to fund infrastructure investment that allows for cheap and reliable transportation and development of natural resources that benefit the US economy. In short, we believe the MLP structure is part of an effective energy policy that is proven to work over an extended period of time. In our view, removing the benefits of this structure could lead to reduced investment in domestic energy resources and infrastructure, while increasing regional price volatility and the ultimate cost to the consumer.

This is very well said, and one of the many reasons I expect the attempt to change the tax structure very unlikely. Look for the MLPs to move back up over the next few weeks and months.

For more guidance like this, check out Markman’s daily trading service, Trader’s Advantage,[1] or his long-term investment service, Strategic Advantage[2].

Endnotes:
  1. Trader’s Advantage,: http://www.jonmarkman.com/
  2. Strategic Advantage: http://www.markmancapital.net/

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