Master limited partnerships (MLPs), as measured by the Alerian MLP Index (AMZ), ended March down 6.9% on a price basis and once distributions are considered. The AMZ results underperformed the S&P 500 Index’s 2.5% total return loss for the month. The best-performing MLP subsector for March was the Gathering and Processing group, while the Upstream subsector generated the weakest returns, on average.

For the year through March, the AMZ is down 12.8% on a price basis, resulting in an 11.1% total return loss. This compares to the S&P 500 Index’s 1.2% and 0.8% price and total return losses, respectively. The Upstream group has produced the best average total return year-to-date, while the Natural Gas Pipelines subsector has lagged.

MLP yield spreads, as measured by the AMZ yield relative to the 10-Year U.S. Treasury Bond, widened by 62 basis points (bps) over the month, exiting the period at 617 bps. This compares to the trailing five-year average spread of 467 bps and the average spread since 2000 of approximately 364 bps. The AMZ indicated distribution yield at month-end was 8.9%.

Midstream MLPs and affiliates raised no marketed new equity (common and preferred, excluding at-the-market programs) and $3.0 billion of marketed debt during the month. MLPs and affiliates announced approximately $0.2 billion of asset acquisitions during March.

Spot West Texas Intermediate (WTI) crude oil exited the month at $64.94 per barrel, up 5% over the period and 26% higher year-over-year. Spot natural gas prices ended March at $2.81 per million British thermal units (MMbtu), up 6% over the month and 9% lower than March 2017. Natural gas liquids (NGL) pricing at Mont Belvieu exited the month at $29.61 per barrel, 2% higher than the end of February and 5% lower than one year ago.

News

FERC Changes Tax Allowance. The U.S. Federal Energy Regulatory Commission (FERC) announced changes related to pipeline tariffs in reaction to a federal court’s previous remand that cost-of-service tariffs on interstate natural gas and oil pipelines owned by MLPs would no longer receive an income tax allowance (ITA). For pipelines owned by C corps, FERC also sought to adjust pipeline tariffs to reflect the recently reduced corporate tax rate of 21% (from 35%) as a result of the Tax Cuts and Jobs Act that was signed into law in December 2017. Natural gas pipelines have been directed to comply by the end of the year, whereas liquids pipelines will be reviewed in 2020, with potential implementation in 2021. This shift in FERC’s long-held position caused significant market confusion and volatility across the sector, though we believe the ultimate outcome is likely far more nuanced and any revenue impact much less widespread than the initial market reaction. For additional discussion, please see our recent blog, Assessing FERC’s Decisions on Pipeline Tariffs.

Targa Plans Grand Prix Expansion and New Permian Processing Plants. Targa Resources (NYSE: TRGP) announced plans to expand its Grand Prix pipeline, a Permian and North Texas natural gas liquids pipeline already under construction, into southern Oklahoma to capture additional volumes from the Midcontinent. Additionally, TRGP reported new long-term agreements supporting the construction of additional natural gas gathering pipelines and two natural gas processing plants in the Permian basin.

Tallgrass Announces Simplification. Tallgrass Energy GP, LP (NYSE: TEGP) and Tallgrass Energy Partners, LP (NYSE: TEP) announced an agreement under which TEGP will acquire TEP, thereby eliminating TEP’s incentive distribution rights, improving cost of capital, and simplifying the corporate structure. Upon closing the proposed transaction, TEGP will change its name to Tallgrass Energy, LP (Tallgrass Energy), and will trade on the New York Stock Exchange under the ticker symbol TGE. Notably, the new entity is expected to provide a dividend which approximates the current yield on TEP units, relieving market anxiety that TEP unit holders would effectively experience a dividend reduction through the transaction.

Thought of the Month: The Death of the MLP Structure Has Likely Been Greatly Exaggerated

Last month we discussed the ongoing trend of eliminating incentive distribution rights (IDRs) and noted on several occasions that the remaining entity, post transaction, has been a C corporation (examples include Kinder Morgan, ONEOK, and Targa Resources). Linking these simplifications with the recent corporate tax reduction and the FERC’s March announcement, discussed above, a narrative among some market participants has developed suggesting that a wholesale transition of MLP-structured entities into C corporations is now inevitable. While we believe these recent events have, at the margin, favored corporate structures, such a blanket shift across the asset class remains far from clear. In short, it is likely that the news of the death of the MLP structure has been greatly exaggerated.

While we consider entities structured as either MLPs or C corps for investment, and certainly applaud and encourage management teams to seek structural changes to benefit equity pricing, we see the simple shift from MLP to C corp as having limited potential value. We believe the elimination or improvement of the IDR mechanism to be a shift with a far greater impact, and expect a handful more of these transactions to result in a surviving C corp. 

However, the incentive for widespread conversion is less clear. To start, if management’s intent is to structure the conversion to offset the potential impact of FERC’s rule changes, then we believe the conversion is likely to be executed as a taxable event for long-term shareholders who may not react well to such a choice. Such a tactic is particularly risky given that the ultimate impact of FERC’s rule changes may be much less severe than the equity market’s initial reaction appeared to suggest. In addition, even if an operator does ultimately experience a material revenue impact from FERC’s about face, this impact may be years into the future. Further, few MLPs carry significant revenue exposure to this rule change, so its potential impact on mass conversions happening across the sector is limited.

For the majority of MLPs, which have little FERC-based incentive to become a taxable entity, the primary motivation for conversion is to seek a better equity trading price through the broadening of the potential investor base. Given the new, lower corporate tax rate, the threshold for seeking these new investors is also now lower. However, this too is not a simple choice. Should tax rates (or FERC policy) change in the future, converting back to an MLP is generally not an option. Also, post conversion, the company’s requirement to manage for and ultimately pay taxes is very certain, while the notion that a C corp structure will result in a materially better trading price is simply a hope.

There is some tricky circular logic to contend with when assessing the likelihood of an improved trading price as well:

  • Those with the greatest incentive to convert to a C corp are those companies that need to access the equity markets. However, a conversion may be interpreted by the market as an admission of near-term equity needs and an impending offering, which typically weighs on equity prices, whether it is an MLP unit or a C corp stock.
  • Conversely, if several MLPs convert to a C corp and experience significant price appreciation, it seems unlikely investors would sit idly by waiting for the next conversion announcement. Instead, investors would likely begin to bid up those names in which such a “conversion pop” seems probable and, simultaneously, lower management incentive to seek a conversion.
  • Also, to the extent that a C corp premium currently exists, it is likely to dissipate as more MLPs become C corps. Currently, a limited number of midstream businesses are structured as C corps. Therefore, those seeking to invest in midstream but who cannot own partnerships have few options. As the number of options increases, any premium based on structure is also likely to dissipate.

It also worth assessing the potential magnitude of the hoped-for C corp trading premium. While some of the higher multiple trading midstream operators are structured as C corps, those well-trading names are also some of the better positioned ones from a growth, distribution coverage, and balance sheet perspective. There are certainly well positioned MLPs trading in line with their C corp competitors.  Perhaps the cleanest comparison available is the one between the economically similar Plains equities, where ticker PAA is structured as an MLP and ticker PAGP is structured as a C corp. These securities trade at nearly identical levels.

Notably, this debate is occurring at a time when many MLPs have reached or are approaching a self-funding level of retained cash flows, and the industry’s heaviest capital spending obligations appear to be in the past. As a result, the need for a near-term equity price improvement is less critical today. In other words, while many management teams may feel their units are drastically undervalued, the need to issue equity is moderating and, therefore, so too is the risk of diluting current holders through necessary equity issuance. As a result, management teams are better positioned to be patient with the markets, lessening the incentive to make radical organizational changes. 

Oppenheimer SteelPath mutual funds may hold some of the above mentioned securities. A list of the top 10 holdings of each fund can be found by visiting oppenheimerfunds.com.