Master Limited Partnerships (MLP) Update
June 7, 2017
Less than 18 months ago, investors were writing obituaries for midstream Master Limited Partnerships (MLPs), calling their business models “broken”. Since bottoming in early 2016, the Alerian MLP index has soared almost 50% as reality set in, oil prices recovered from their artificially low levels of February 2016 and investors realized that the industry fundamentals were generally healthy.
Despite the recovery, the Alerian MLP Index remains 44% below its highs of August 2014 and price to 2018 distributable cash flow valuation for Wells Fargo’s MLP universe is below its 5- and 10-year averages. We continue to recommend an allocation to MLPs within the Real Asset portion of portfolios. Sound cash flows coupled with growth prospects make MLPs an attractive total return vehicle.
Most midstream MLPs, the backbone of the U.S. energy infrastructure, continue to provide (1) fairly stable, contracted cash flow, (2) relatively strong balance sheets, (3) attractive cost of capital leading to solid project returns and (4) good growth prospects in what we project as a stable, not dynamic, energy environment.
The bull case for MLPs looks at our country’s ability to produce substantially higher quantities of oil, natural gas and natural gas liquids (NGLs) at costs below $50 equivalent for oil, and sees it as a distinct advantage that will ensure the movement of large quantities of product here in the U.S. It also looks at the coming wave of petrochemical plants nearing completion with their huge needs for ethane that must be processed and moved to market by midstream energy companies. MLP proponents expect to see a much lower correlation in the price of MLPs to the price of the underlying commodities as new sources of domestic energy demand come on-stream, requiring increased infrastructure usage and construction. The bull case for MLPs also looks at the political climate.
The Trump administration would appear to be a positive for the MLP industry. In both verbal support and initial actions favoring energy independence and less regulation, President Trump seems to be a clear positive for the energy industry as compared to the Obama administration. Although we’ve seen few specifics regarding future policy changes, President Trump did quickly facilitate approval of both the Dakota Access Pipeline and the Keystone XL pipeline, a swift reversal of the Obama administration’s efforts to make the construction of energy facilities more difficult and expensive.
Additionally, the Trump administration’s April 26th outline of its proposed changes to the tax code had some positives for MLPs. At first blush, it appears that the reduction in the corporate tax rate would apply to pass-through entities like MLPs. If that is indeed the case, the tax rate on income from an MLP would shift from an investor’s marginal tax rate to 15%, increasing after-tax returns. The Trump tax reform also benefits MLP funds. Currently, a fund which invests 25% or more of its assets in MLPs is treated as a corporation for tax purposes. This means that MLP funds like Maingate (IMLPX) must accrue at a corporate tax rate of 35% on total returns (capital gains and income). This is referred to as a “tax drag” unique to MLP funds. The drag would drop considerably if the corporate tax rate were to drop from 35% to 15%, improving MLP fund performance. Clearly it’s premature to assume which elements of the administration’s tax reform will pass through Congress. However, we believe that the thrust of the reform highlights how tax-driven investment vehicles like MLPs would be direct beneficiaries of proposed changes.
The Alerian MLP Index is down about 5% year-to-date as MLP prices continue to show a high correlation with energy prices. West Texas Intermediate (WTI) oil is currently trading at $46.15, just above its lows for the year. We believe oil prices are range bound and that we’re near the lower end of the mid-$40 to mid-$50 range that we anticipate for WTI this year. With the yield on the index at 7.1%, its spread over the 10-year Treasury has widened this year and is approximately 25% wider than its 10-year average 394 bps spread. Overall, MLPs seem to offer fairly attractive valuations, particularly if the fundamental backdrop of increased domestic demand that we laid out in the “bull case” for the industry holds true. We continue to believe that an allocation to the group offers solid participation in a total return vehicle that will benefit from increased usage of, and investment in, U.S. energy infrastructure.
Investment and insurance products and services are not a deposit, are not FDIC insured, are not insured by any federal government agency, are not guaranteed by the bank and may go down in value. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. This material was prepared on June 7, 2017.