Recently, Gretchen Morgenson of the NY Times published an article entitled “Oil Price Drop May Add to Tax Bills for Popular Energy Investments.” In it, she quoted some tax experts regarding the possibility of an onerous tax bill for unit holders of limited partnerships including MLPs (master limited partnerships). The hyperlink to the article is below.
Cumberland Advisors has a dedicated MLP strategy, and thus we want to address some of the issues raised in the article. The article uses Linn Energy as an example of a tax exposure. Linn Energy is an upstream partnership. Upstream partnerships produce oil, gas, or coal directly and have high exposure to the price risk of the commodities produced. Most upstream partnerships are now in a weakened financial condition due to the significant decline in oil prices, combined with the extended time that this drop has lasted. These partnerships use price hedges to reduce their risk, but those hedges are now in the process of expiring. Expiration leaves cash flow exposed to lower energy prices, and that means the debt burden becomes onerous.
In fact, many upstream corporations, not just MLPs, are distressed. Since MLP unit holders, unlike owners of a corporate stock, are taxed on a pass-through basis, events that lead to the restructuring of debt can have burdensome tax implications for them. Gretchen Morgenson has outlined the mechanics that lead to that exposure – but not all MLPs have the sort of exposure she describes.
Our Cumberland strategy has never been based on upstream MLPs. When oil prices initially declined, we sold some very small upstream positions and have not owned any for some time. In addition, upstream MLPs, even at the height of the energy boom in 2013–2014, made up less than 10% of the market value of the Alerian Index, the most widely used index that tracks MLPs.
Equating the market price drop in the midstream MLP sector with the idea that many of the debts of these partnerships won’t be repaid may mislead the investor. While the midstream sector has done poorly on a price-return basis, average distributions, similar to dividends, are still mostly growing or are flat. There are some exceptions for partnerships that have too much leverage and are having difficulty raising new capital at reasonable prices. In those cases, companies and MLPs have cut their payouts in order to reduce their leverage and fund growth.
A recent case of one entity is instructive, even though it is a pipeline corporation rather than an MLP. Kinder Morgan Inc. (KMI) recently cut its dividend when its leverage and capital structure were questioned and after Moody’s lowered its outlook for KMI’s debt. This is the first step the rating agency takes in notifying investors of a possible future downgrade. Note that KMI’s cash flow was intact and its earnings outlook was still pretty solid. Kinder subsequently cut its dividend payout, and the company’s stock took a large hit. On the other hand, KMI’s bond-rating outlook was restored; and in coming years it will not have to raise much new capital – it will generate most of its capital from its own cash flow. However, many smaller investors who owned KMI for its dividend yield sold it at a loss. It has recently been disclosed that Berkshire Hathaway and other “smart money” have been buying KMI, and now the stock is recovering some of its losses. It is also getting new respect from investors and Wall Street analysts.
There are also other methods for midstream companies to adjust to the new energy environment and reduce financial leverage as well. While there is risk of default in any corporate sector, there are a number of reasons why the risk in the midstream energy sector overall is not the same as for comparable upstream energy producers. MLP midstream-focused partnerships and midstream energy companies in general are unique entities that rely on the demand to transport energy product. This demand, of course, can be influenced by the price of a commodity, but it is primarily dependent on volume related to the profitability of shipping product around the country and from producers to consumers.
Each partnership has its own strengths and weaknesses, and we don’t want to sugarcoat the risks. Because of counterparty risk, the extreme energy price drop has impacted the outlook for midstream companies to some extent. Transportation companies are certainly not riskless. However, when one compares actual operating results for most midstream MLPs and companies in this sector to those of upstream producers, it is apparent that their results are much less volatile than those of most upstream exploration and production companies. The market price correction in this sector is not completely irrational. But when we look at the operating results in a dispassionate manner, it is apparent that the correction has probably gone too far and is related to some panic selling by holders and reduced liquidity of the partnerships.
We are not blind to the current volatility in the energy business. There is obviously risk. However, as energy prices stabilize and eventually recover, MLP prices will present extremely attractive entry points from a historical perspective. We believe MLPs offer an attractive risk reward opportunity for patient investors, based on distribution yield spreads, cash flow/earnings metrics, and other financial measurements. Finally, our view is that professional management of MLP investments makes sense due to the complexity of investing in this asset class.
Rick Daskin is the research and valuation sub advisor for the MLP strategy at Cumberland Advisors.