The IRS Gives Energy Investors a Gift

With their high and potentially tax-deferred income, investors have been chomping at the bit get their hands on every master limited partnership (MLP) unit in sight. Aside from the typical 5% to 8% dividends these firms kick out, roughly 80% of the taxes on distributions are deferred until investors sell their partnership shares.

That makes them quite lucrative for shareholders willing to put up with the additional tax-time reporting hassles that come with owning MLPs — and considering that the Federal Reserve’s low interest rate policies aren’t ending anytime soon.

On top of that, there are plenty of advantages for firms that set-up or spin-off operations into the tax structure. And for some them, those rewards are about to get even better.

New IRS Ruling

Changes to the tax code back in 1986 allowed for pipeline firms to be structured as partnerships in order to stimulate construction of domestic energy infrastructure. This allowed MLPs to avoid paying corporate taxes by passing on most of their free cash flow as tax-deferred distributions to investors.

That partnership structure provides plenty of benefits on the corporate level for sponsors. Aside from avoiding taxation issues, MLPs provide their general partners (GPs) — i.e. the sponsoring refining firms — generous distribution payouts.

Those payouts get even juicer thanks to the continued relationship between GPs and their publicly traded MLP subsidiaries. After acquiring new pipelines or gathering facilities, GPs will often pass along or “drop down” some of the prime assets into their MLPs.

This allows the MLP to grow its distributable cash flow. These asset sales are priced at a level that guarantees cash flow accretion for the MLPs and enables the MLPs to raise distributions at a faster rate. The general partner benefits directly from increased distributions on the limited partner units it owns as well as from increased incentive distributions — all while avoiding taxation on those assets.

Not every firm meets the requirements of becoming a MLP. The section of the tax code specifically lays out that those businesses whose “income and gains [are] derived from the exploration, development, mining or production, processing, refining, transportation or the marketing of any mineral or natural resources” can qualify. While some “non-energy” MLPs do exist — like timber firm Pope Resources (NASDAQ:POPE) — the bulk of the focus on transportation or extracting of hydrocarbons.

Well, for now, but a new Internal Revenue Service (IRS) ruling could change that.

Last week, the IRS ruled that income from steam crackers — plants that are designed to processing natural gas liquids (NGLs) into chemicals called olefins — qualify for the MLP operating structure. The IRS also said that income from marketing, transporting and storing these olefins qualifies as MLP income.

Olefin and ethane production in the U.S. is expected to surge as current producers have access to huge and cheap reserves brought about by the hydraulic and fracturing revolution. Overall, analysts expect North American olefin manufacturers to generate substantial operating income until significant new NGL cracking capacity is built — probably sometime in 2018.

Betting On The Steam Crackers

So exactly which companies will benefit from the ruling? For starters, look at Williams (NYSE:WMB). Through its Geismar facility, the pipeline firm owns a light-end natural gas liquid (NGL) cracker that currently outputs roughly 1.35 billion pounds of ethylene.

Back in July — well before the IRS’s ruling — Williams agreed to drop down the facility to its MLP subsidiary Williams Partners (NYSE:WPZ). Williams Partners expects that the addition of the olefins unit would be accretive to distributable cash flow as well as bring more stability to those cash flows that are exposed to the market for ethane.

Williams Partners expects to fund the transaction largely with the issuance of more limited-partner units to Williams. WMB currently owns more than 68% percent of WPZ and will grab a bigger share of the MLPs steadily growing distributions as the deal can now legally take place.

Other companies could see similar benefits. New S&P 500 member LyondellBasell Industries (NYSE:LYB) and rival Westlake Chemicals (NYSE:WLK), for example, could see themselves with new MLP subsidiaries soon as well.

LyondellBasell has operations around the world, but its North American olefins unit — buoyed by cheap and abundant shale gas — has continued to see rising operating income. Likewise, Westlake’s largest business segment produces olefins and would likely qualify for an MLP structure given the IRS ruling — reason for investors to continue smiling on the pair.

This doesn’t even include the remaining major chemical players or the big oil producers who own olefin production capacity like Exxon (NYSE:XOM) or Chevron (NYSE:CVX). As we know, many of the larger oil firms have been looking at spin-offs of their refinery operations to unlock shareholder value. The IRS ruling could give them another avenue to pursue.

In the end, while it will take some time for us to see chemical MLPs on the market, the appeal and, now, the legality is there. For income seekers, that’s a win-win.

As of this writing, Aaron Levitt did not own a position in any of the aforementioned securities.

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