Since oil’s crash (West Texas Intermediate fell to $27 a barrel in January 2016), MLPs have had to demonstrate balance sheet virtue to investors—scrape debt off their books and curtail infrastructure spending. Prudence is the new watchword.
Tax Changes
MLPs have been touted as a godsend to retail investors for their tax benefits. They’re pass-through entities: Eighty percent of cash distributions investors receive from them is considered return of capital and tax free.
After the Tax Cuts and Jobs Act passed in 2017, Global X’s Reddy says they retained most of their taxable benefits relative to what the C corporation would. The corporate tax on C corporations fell drops from 35% to 21%. MLPs now get a 20% deduction on a cash payout as well as a from a 39.6% individual tax rate to a 37% tax rate. Those two things together means “the income rate on MLP income that is paid out to unitholders falls from 39.6% to 29.6%,” Reddy says.
Two more changes in the tax laws are going to affect the capital structures of the MLPs themselves, Reddy says: the interest deduction limitation and immediate expensing provisions on capex. The interest deduction is now capped at 30% of adjustable taxable income, and he says MLPs might thus issue less debt and turn instead to alternative sources of financing, maybe preferred equity or self-funding. They could also turn to common equity, though investors will watch for dilution of shares, Reddy says.
On the other hand, the law now allows MLPs to expense 100% of capex spending in the year it’s spent. “So this is obviously somewhat beneficial to companies looking to increase capex spending because it helps them from a tax perspective as well.”
And that’s happened at a time more oil pipes are needed for more oil fields coming online. That demand together with the potential changes in MLP capitalization and favorable tax treatment for capex under the tax law could incentivize MLPs to start spending more on infrastructure in the future. The fall in the C corp tax rate might also prompt some midstream MLPs to simply change their structures to C corps or fold up into their general partners.
“Energy production levels [are also important],” Reddy says, “because [MLPs] are getting paid to transport oil and natural gas.” That affects the rates they are getting, he says, “so there is recontracting risk. That’s one of the issues that hurt MLPs [in 2017] is that a lot of these contracts were signed in the later part of the last decade and they could be 10- to 15-year contracts that were coming up towards the expiration. And the market was sort of forecasting that there would be renegotiated rates on that and cash flows could fall as a result.”
Many MLPs are avoided by mutual funds because of their K-1 tax structure. For that reason, Bradshaw at Hodges likes companies that have been converted into C corps.
He likes two pipeline companies that he thinks are great buys: ONEOK, which recently bought in its MLP and converted it into a C corp. “ONEOK does pay a handsome dividend,” he says. The company is geographically diversified, with pipelines in the Mid-Continent region in Oklahoma, the Williston Basin in Wyoming and North Dakota and the Permian Basin in Texas. “They’ve got about 38,000 miles of pipeline for natural gas and natural gas liquids,” he says. The cost of capital at ONEOK has gone down, Hodges says, and the company never cut its dividend through the oil wreck (It was at 77 cents per unit in the first quarter of 2018.) “Their coverage ratio—how much their cash flow covers their dividend—is 1.3 times. And that’s very strong.” (Cash flows coverages below “1,” like that suffered by Plains All American, means a company paid out more than it earned.) When you see a coverage ratio of less than 1, Hodges says, you worry about whether the company can maintain the dividend. He likes Targa Resources for similar coverage reasons: The stock is $45 and pays an 8.07% dividend yield. “I think that stock could go to $65 over the next 12 to 18 months,” Hodges says.