In my last post I described what I consider the worst case scenario for MLPs in the event that their tax favored status ends overnight. Today I want to look at a few of the upsides of such an event. Yes, I do think there are upsides to ending the MLP tax favored status. I can think of four upsides right away; incremental share demand, potential higher valuations, expanded business opportunities, and pricing power. Lets look at each of these possibilities.
While the MLP sector has enjoyed strong and increasing investor demand over the years the tax complications and tax risk has kept many investors away. An ending of the tax break for MLPs would lead to a large incremental demand for shares from several sources. First, many individual investors simply don’t want to deal with the tax complications of K-1 filings or take the risk that the tax advantage goes away thereby hammering share prices. Also, besides a few special share classes, also for tax reasons (UBTI income) MLPs are not suitable investments for retirement accounts. On the institutional side, mutual funds and pension funds, are not large owners of MLPs for similar reasons to those of individual investors. And lastly, no MLPs are included in any of the major indexes like the S&P500. They are not allowed to be. All of these would be the source of incremental share demand for the MLPs, especially the large caps. For example, consider ETP or KMP. ETP has a market cap of $34B and KMP has one of $22B. For the S&P500 index the average market cap is $23B. ETP and KMP would be candidates for the index after the tax change. Choosing an example mid tier S&P500 company, CHK, lets look at the volume of shares traded. CHK has a market cap of $17.8B and its average daily volume is 10.5 million shares. ETP and KMP, with larger market caps, have average daily volumes of 1.3M shares and 0.75M shares respectively. After a tax change, as normal operating companies, EPD and KMP could be added to the index. Needless to say this would lead to more demand for shares in the companies. In short, incremental demand from individuals, institutions, and potentially indexes would be a positive catalyst for MLP post a tax change.
The next potential upside for MLPs post a tax change is higher valuations. The tax complications and risk keep a lid on valuations. The best comparison I can make to MLPs is the utility sector. The company structures, stability of cash flows and dividends, and regulatory environment are very similar. Taking a look at the utility sector, using the utility sector ETF, XLU, we can compare valuations to the MLP sector. The XLU trades at a dividend yield of about 4% and the MLP sector, using AMZ, trades at a yield of about 6%. That’s about a 33% premium for XLU vs AMZ. That’s remarkably similar to the US corporate tax rate of 35%. Coincidence? Maybe but probably not. Post a tax change MLPs would most likely trade at higher valuations than they do today, a big reason of which would be the incremental share demand I described in the first paragraph.
A third potential upside for MLPs from a tax change would be potential new business opportunities. Today, to qualify for MLP status MLPs are limited to businesses that have to do only with energy and energy infrastructure. With an end to the MLP tax status MLPs could potentially pursue other types of infrastructure projects. For example, several MLPs have expressed interest in pursuing water pipelines. And a few have even sought regulatory approval for water pipelines that are related to energy projects.
The last potential upside is the pricing power that MLPs have. Actually, I think this is more of a mitigating factor. One of the core strengths of MLPs is their economic moats. Because of the huge upfront capital investments and lead times required to build energy infrastructure MLPs are able to enter long term contracts, 10-20 years, with their customers. Also, these contracts tend to be predominantly fee based and not subject to commodity price movements. This dynamic leads to strong competitive positions – once a $1B pipeline is built someone is not going to come along and build another $1B pipeline right next to it to compete. In the event of a tax change, where the economic returns of projects go down suddenly, the MLPs would be in a position to renegotiate the contracts with their customers. The impact of the tax change would not just be born by the MLPs but also by their customers, the energy exploration and development companies. I’m not saying the MLPs could make up all the impact but they could certainly offset some of it.
In summary, there are some potential upside catalysts to an MLP tax change. While there is no doubt that in the short term such a change would be painful to existing shareholders it is not all bad. I showed in my previous post, the downside impact is not as bad as it appears on the surface and here I describe a few potential positives from such a change. I don’t think such a tax change is a risk anytime soon, probably not until late 2013 at the earliest, and even then it is only a small risk. But its always good to be prepared and think about the potential consequences of such an event.
8 Comments
J Carroll · June 19, 2011 at 7:10 am
Paul, thanks for a couple of thoughtful articles on the potential consequences of a change in MLP tax status. Given the fiscal realities of 2011 and the shared sacrifices that have to come, I think it is more likely than many of us want to think (look at the recent Senate vote on ethanol subsidies, the general talk on “entitlements” reform, and some local/state governments finally standing up to their public employee unions). I was surprised you didn’t look at the impact on the tax changes of the Canadian Royalties as a sort-of preliminary model. Any parallels/potential parallels you can make with that change? Again, thanks.
libertatemamo · June 19, 2011 at 8:41 pm
J,every investor needs to judge the risk of such an event for themselves. Like I said before I see no risk of any such change before late 2013 at the earliest and even then only a slight risk. But there is a finite risk nonetheless so I don’t have as much allocated to this sector as I would otherwise. In a way the best thing that could happen to MLPs is for the tax break to end, suffer the pain and move on. This will always be a cloud over the industry which will keep valuations compressed. But for long term investors this a good thing for compounding wealth.
I spent over 20 hours sifting through the Canadian story. There wasn’t much there frankly that added value to my story. My worst case scenario would be worse than what happened to the Canroys. In general, all the Canroy’s share prices took a big hit but most, especially the big caps, recovered in time. The big caps did better than the small caps. Some small caps who should never have been Canroys went away. Most of the big guys have yet to pay any taxes due to the large tax pools they build since late 2006. At least at the big caps, dividends have not suffered much if at all from the tax change. Take a look at the big boys like Baytex and Enerplus if you’re interested. In other words the companies and their share prices and dividends have weathered the storm just fine in the long run. Also, all of the Canroys were E&P companies, not energy infrastructure companies like MLPs are. MLPs are better suited to weather such a change IMO.
Paul
Tony · June 19, 2011 at 1:11 pm
A negative issue to consider is that if the tax break was eleminated, the incentive for the dropdowns may also disappear. As a result, the expectation for future dividend growth for some MLPs may be lowered. And this will influence the valuation model.
Not relating to this, I am wondering why the price of REITs have little impect from the tax break issue? May be REITs were never mentioned in the Congress? I would tend to think the tax break given to the MLPs benefits the society more than that of the REITs.
libertatemamo · June 19, 2011 at 8:50 pm
Tony, if such a change happened there would be no reason for the companies to remain partnerships. They would reorganize into normal companies, C corps or LLCs. No more GPs or LPs so the issue of dropdowns goes completely away. All the assets would be part of one company. This is what happened in Canadian Royalty trusts and the gov’t allowed the reorganizations of the companies as a tax free event and allowed them 4 years to make the change.
On the topic of REITs, A REIT tax status change has not really come up but elimination of the mortgage interest deduction did come up in the Bowles-SImpson commission report which has been summarily ignored. The REIT sector is $600B vs $250B for MLPs so maybe its gotten too big. And while I completely agree with you on the societal benefits of MLPs vs REITs, since when has this kind of common sense thinking been a necessary factor in political decisions?
Paul
Bruce J · June 19, 2011 at 7:38 pm
When exactly is the vote on this or when will we know if the tax status stays or changes?
libertatemamo · June 19, 2011 at 8:51 pm
Bruce, there is no vote. There is no current bill or proposal in Congress to eliminate the MLP tax break. Its just pure speculation so far and it comes up every few years for MLPs.
Paul
john · August 25, 2011 at 11:15 am
While you make some good points why the values of MLP’s may not be terribly impacted by a tax change if it were to incerease their tax bill, that would suggest that a taxpaying business that gets significant tax relief (the opposite tax result) would see it value go down which would go against economic theory.
libertatemamo · August 25, 2011 at 1:10 pm
John, thanks for the comment. What I’m saying is that all else being equal, MLP prices will adjust by the amount of taxes that they will pay at the minimum, according to economic theory. But all else is not equal in the market. There are a ton of reasons why shares trade at the prices they do, a lot of other issues affect the supply and demand for shares, not just tax policy.
Paul
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