Opportunity brewing in MLP land

There looks to be a correction developing in the MLP sector that may bring up a significant opportunity that income investors should begin to have a plan for. Lets look at the drop in prices recently, potential reasons for the drop, and what it means for the sector and more importantly investors.

As of 1PM or so Eastern time most of the MLP names are down between 5-13% off their highs. Here are recent prices for the MLPs that I follow and how much they are off their 52 week highs.

Definitely looks like a correction is brewing if not here. But rumor in the MLP investor universe is that this is something more sinister, that the government is considering changing the tax status of MLPs and forcing them to pay corporate taxes. A few articles and the comments on Seeking Alpha are on fire with this rumor. Personally, I first heard about it on Mad Money from Jim Cramer – yes, sometimes he does add value. This is not the first time in MLP history that this rumor has come up. So, is it true and is it cause for the recent price drops in MLPs?

First, there appears to be some truth to the rumor. Credit Suisse put out a note on the topic three days ago where they said.

Proposal to Tax Pass Through Entities: The National Association of Publicly Traded Partnerships (the lobby group for MLPs) has informed its members that the Obama Administration is working on a proposal to tax pass-through entities. We checked with our DC Policy Group and they said this is not new and it is too late for any proposal to gain traction in the near term. Our Key Takeaways: 1) Any tax reform is unlikely until 2013 and at this juncture still we view taxation of MLPs as a low probability. 2) There are more pressing issues that have to be tackled. These are the debt ceiling and then the budget. 3) After these two issues are tackled we are likely to be in the fall and all attention will be focused on the 2012 election. We See Headline Risk but No Substance at this Juncture: To be clear, this is not an issue that is being taken lightly by the MLP lobby group. They continue to actively engage and inform Congress on the vital role that energy MLPs provide in building and maintaining US infrastructure. This in turn means US jobs.

I agree 100%. Also, I’ not convinced the recent price moves in MLPs are mainly attributable to this rumor. I’m sure you’ve noticed that the market in general is down and in particular the energy sector is down more than other sectors of the market. I decided to compare the move in MLPs (using AMJ, AMLP, EPD, KMP, and MMP) to the move in the energy sector (XLE), a large US royalty trust (BPT), and a large Canadian royalty trust (PWE). Neither XLE, BPT, or PWE have any of the tax advantages of MLPs. See the chart below.

As the chart shows, if anything, MLP are down less than these other energy sensitive investments. Also, the MLP space has had a record run, was at all time highs, and was trading at levels relative to historical yields and spreads to treasuries that have caused me to say many times here on the blog that the sector was frothy. So, based on the evidence to date, I think the sector is in a normal correction potentially based on fears of demand destruction from higher energy prices and yes, in part, due to the rumor of upcoming tax changes for MLPs. Personally, I think there is a great buying opportunity developing here. My personal trigger is a 15% correction in the likes of EPD, KMR, WPZ, and ETP.

Having said all the above, it does not mean MLP investors should ignore the MLP tax issue. It is a real risk even if remote and down the road, a fat tail risk as they say. I’m starting to look at one, the worst case scenario if the tax law change were to happen and two, the historical example of the Canadian royalty trusts and what effect the Oct 2006 tax law change (known as the Halloween massacre in Canada) has had on the income and performance of the Canadian trusts. I’m not done with my research but what I’ve found so far tells me that the Canadian change did not end up being as bad as everyone thought, although the initial reaction was a 30% price drop for the trusts. Also, on the MLP side it is important to remember that taxes are paid on net income, not distributable cash flow, so the impact on MLP distributions is not as large as the corporate tax rate would indicate. For example, KMP in Q1 2011, had DCF per unit of $1.21 and net income of $0.43 per unit. If the company had to pay the full corporate tax rate of 35% on net income they would pay about $0.15 per unit in taxes which represents only 12% of the DCF. And that is before considering that they pay about 45% of their cash flow to their general partner, KMI. As a worst case scenario that is not so bad.

Stay tuned for more on this issue.

Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.

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10 Responses to Opportunity brewing in MLP land

  1. Doug says:

    This is an alert on this very subject from a newsletter i subscribe to. Although I would rather have just emailed it to you Paul for your info I think you screen comments. If not well I hope others benefit from some good information here although much of it is what you have already stated.

    “Master limited partnerships (MLP) have sold off over the past few days, with the Alerian MLP Index down roughly 4 percent from its high in late April. Some individual names have suffered corrections of a greater magnitude.

    The main catalyst for the selloff is a rumor that the US Treasury Dept will introduce a proposal to change the taxation of MLPs and other pass-through entities whose gross annual receipts exceed $50 million, a level that would include most publicly traded partnerships.

    This news originated from an email that the National Association of Publicly Traded Partnerships (NAPTP) sent to its members. At this point, it’s not clear whether the Treasury Dept ultimately will introduce such a proposal. But any speculation about new taxes is enough to send investors into a fit.

    This isn’t the first time MLPs have sold off after rumors of a change in tax policy circulated. Last year, the debate over the taxation of carried interest confused many investors and weighed on MLPs’ unit prices. Carried interest is a form of compensation paid to a partnership’s managers in exchange for their services.

    Carried interest paid to general partners represents a share in the income produced by the partnership and is taxed accordingly. If that carried interest is generated by buying and selling financial assets such as stocks and bonds, it could represent capital gains rather than ordinary income. Under the current law, managers who receive carried interest earned through capital gains would be taxed at the lower capital gains tax rate.

    This doesn’t apply to the energy-focused MLPs we recommend in the model portfolios. Energy-related MLPs represent operating businesses; the carried interest income they generate isn’t a capital gain and has always been taxed at ordinary income tax rates–this law wouldn’t affect their tax treatment.

    Carried interest has nothing at all to do with those of us who are MLP unitholders. As MLP unitholders, we don’t receive carried interest income as part of our regular quarterly distributions, so this doesn’t change the way we’re taxed.

    Some members of Congress support a change in the taxation of carried interest, but legislation introduced in past sessions has failed to pass. A now-infamous article published in The Wall Street Journal a few years ago caused the group to sell off when the writer incorrectly suggested that carried interest taxation would hit MLP unitholders.

    Carried interest legislation is aimed squarely at hedge funds and private-equity firms that use the partnership structure to lower their tax bill. This risk is why we have never recommended publicly traded financial partnerships such as AllianceBernstein Holding LP (NYSE: AB) and Icahn Enterprises LP (NYSE: IEP).

    At this point, it’s unclear whether the Treasury Dept is contemplating substantive changes to how MLPs are taxed or if the recent rumors refer to another effort to close the carried interest loophole.

    However, one point is certain: Even if the Obama administration proposes a change to corporate or individual income taxation that affects MLPs, such a measure would face a long road before becoming law.

    Such a change is definitely not something the Obama administration can act on unilaterally; any such measure would need to pass through a gridlocked Congress that’s focused on the 2012 general election. Recall how long it took the government to agree to a budget compromise. Meanwhile, the debate about the government’s debt ceiling rages on. In this environment, any change to corporate or individual tax laws would be difficult to pass.

    Further, MLPs enjoy considerable support in Congress. MLPs account for the vast majority of the nation’s spending on energy-related infrastructure, including natural gas pipelines and storage facilities that are crucial to US energy independence. Obama proposed greater use of natural gas in the transportation industry in a recent speech.

    And in 2007 Congress expanded the purview of an MLP’s approved activities, allowing them to engage in the processing, transportation and storage of alternative fuels such as ethanol. Others have proposed expanding the structure to support alternative-energy investments such as solar and wind power installations.

    Finally, the NAPTP and the energy industry represent powerful lobbies in Congress. Elected representatives in Washington are aware of the potential political fallout from supporting a change in taxation that would increase energy prices.

    To date, the Treasury Dept has yet to issue a proposal that changes how MLPs are taxed–only rumors. Although such a proposal shouldn’t be ruled out, a change of this nature would face a long and politically difficult route to passage, especially with the 2012 elections around the corner. We will continue to monitor the political debate and issue Flash Alerts to keep you apprised of these developments.

    Meanwhile, we continue to focus on the underlying businesses and market conditions for the MLPs we recommend. On that score, the news is favorable: Our picks have reported quarterly results that exceeded expectations, and the number of MLPs that boosted distributions in the first quarter hit its highest level since 2007. We recommend taking advantage of the correction to buy units of any Portfolio holdings that trade under our buy target prices.

    Investors should also remember that MLPs are prone to sizable intraday swings from time to time. We have repeatedly warned readers against the use of stop-loss and trailing stop orders when buying MLPs. Stop orders instruct your broker to automatically sell you out of a stock when it touches a predetermined “stop” price. But many investors set stops at similar price levels; when an MLP’s unit price declines and these stops are triggered, the wave of selling can temporarily overwhelm the market and send the MLP even lower.

    Often, intraday weakness is reversed by the close of trading, but the damage is already done for those investors who set stops and were sold out of their MLP holdings at unfavorable prices. Do not be tempted to set stops on MLPs.”

    • libertatemamo says:

      Thanks Doug. Good alert from your newsletter and I agree with their take. I think other readers here will find it useful.
      Whatever proposals get made there is no way it makes it through the house at the end.


      BTW, email me anytime you’d like. My email is paul.novell@gmail.com

    • Joe says:

      Happy to see this article and comments, especially from Doug’s newsletter. I’ve been long EPD for a long time. I recently, before the news came out bought OKS. I have EPB on my radar. I did have a stop loss in place on the day the market experienced it’s “Flash Crash” last year and got stopped out of EPD, which closed up later that same day. No more stop losses on MLPs.

      I think that MLPs are definitely buy & hold for the dividends. Not good trading products at all.

      This article has given me confidence in staying in and possibly adding to my MLP investments.

      Thank you for the timely and useful information.

      • libertatemamo says:

        Sure thing Joe. MLPs are definitely not good trading products although the hedgies seem to try and do it all the time. I wrote something related a while back you may be interested in, see here.

        Also, what is nice about the volatility is that if one is able to remain patient and calm some awesome opportunities present themselves in the sector. This little correction hasn’t hit my trigger point yet but its getting close.


  2. Wyatt Junker says:

    Was curious about Canada’s ‘massacre’. Didn’t those companies also restructure afterward as normal corporations?

    How did that affect valuations, after the restructuring process?

    • libertatemamo says:

      Hey Wyatt, I’m still working on re-constructing the Canadian royalty trust history. From what I know so far the gov’t announced the change on Oct 31 2006. The companies had until the end of 2010 to change structure or make other plans. A lot of the trusts cut their distributions but many of them didn’t. In general, the small caps were hurt more than the large caps. Many of the large cap names took the 4 years they had to make the change and put excess cash flow into ‘tax pools’ to offset future taxes. Those companies say they won’t have to pay taxes until 2014. As far as the stock prices go, on the announcement date the prices for the trusts dropped about 30% but over time came back. If you’re interested check out the history of Canadian Oil Sands Trust.

      Hope that helps some for now.


  3. C Decker says:

    would appreciate mlp updates

    • libertatemamo says:

      C Decker, I usually provide updates only on the big 5 MLPs (KMP, EPD, ETP, WPZ, PAA), usually shortly after they report quarterly earnings. For Q1, I’ve covered KMP’s earnings and will post the others in the next week or so. On the overall MLP sector, I usually cover its valuation in my monthly dashboard updates and every so often in specific posts.


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