High MLP Yields Depend On Oil

November 17, 2015

Kenny Feng is president and CEO of Alerian, a leading provider of MLP indexes. About $18 billion is tied to the Alerian Index Series, including the $7 billion Alerian MLP ETF (AMLP) and the $3.9 billion JPMorgan Alerian MLP ETN (AMJ). ETF.com recently caught up with Feng to discuss which ETP structure makes most sense for investors and where the sector as a whole is headed next.

 

ETF.com: Would you explain what a master limited partnership (MLP) is for who might not know?

Kenny Feng: MLPs are engaged in the transportation, storage, processing and production of natural resources. Today there's about 123 MLPs and another 16 that are sitting in public registration. The vast majority of them are in the energy business, but there are probably 30 or so that are in other businesses.

ETF.com: One of the most attractive characteristics of MLPs has to do with taxes; would you explain why?
Feng:
The tax consequences are basically this: They're not subject to entity-level taxation. If you own IBM or Google, and they decide to pay a dividend, first the earnings of that particular business are going to be taxed at the corporate level or the entity level, and then that dividend that's paid later on by the company to its shareholders is going to be taxed again at the individual level.

So when we say they're not subject to entity-level taxation, it just means you avoid that double taxation that occurs.

Additionally, typically, 70 to 100% of MLP distributions are considered tax-deferred return of capital, which reduces the investor's cost basis. As long as the investor’s adjusted basis remains above zero, taxes on the return of capital portion of the distribution are deferred until the investor sells.

ETF.com: You're talking about individual MLPs, which are extremely tax efficient. Once you start talking about diversified MLP products, it gets a little more complicated.
Feng:
True. We would group MLP products into three main buckets. One is exchange-traded notes (ETNs). The second is ’40 Act funds (ETFs, mutual funds, closed-end funds) that are taxed as C-corporations and the third is ’40 Act funds that are not taxed as C-corporations.

ETF.com: Let's start with the ETNs. Tell us about that.
Feng:
With the ETN, you have an unsecured debt obligation of the issuer. That unsecured debt obligation tracks an index of some kind one for one. For an investor, that's appealing, because you don't have tracking error.

However, because it's an unsecured debt obligation, your distributions are going to be taxed at ordinary income rates.

Another thing to remember is that when you buy an ETN, you don't own the underlying securities. You're exposed to the credit risk of the issuing firm.

MLP ETNs are most suitable for tax-advantaged accounts [like IRAs and 401(s)] because then you have no tax at the MLP level, at the note level or the investor level. In that case, it doesn't matter if your income is taxed at ordinary income rates, because it's sitting inside of a tax-advantaged vehicle.

MLP ETNs may also be attractive to you if you're a total return investor who's more concerned with price appreciation. In that case, you would like that they have no tracking error and you're not as concerned about the income component of it.

ETF.com: How about the ETFs?
Feng:
A fund that doesn't hold more than 25% of its portfolio in MLPs can elect to be a regulated investment company, which allows them to pass through the entire return to their investors. However, that benefit is muted because you're limited to 25%. You also have to be mindful of what the fund owns in that other 75%.

You can fill that other 75% with whatever you want. We've seen all sorts of stuff get thrown in there. We've seen people own refining; we've seen people own power; we've seen people own utilities. Make sure you know what you own in that other 75% and you're comfortable with what's in there.

Now, an investor who wants 100% exposure to MLPs will have to look at other funds. A fund that holds more than 25% of its portfolio in MLPs will be taxed as a C-corporation.

The disadvantage of this structure is that it has to pay a corporate tax rate of 35% on its gains. The advantage is that, just like with individual MLPs, distributions lower an investor's cost basis and you get that deferred tax benefit.

If you think distributions are going to represent the majority of return for MLPs going forward, this structure would appeal to you.

On the other hand, if you think most of the gains are going to come through price appreciation and MLPs are going to go up 20 or 30%, then owning a structure that takes out 35% of that upward move via tax liability is probably not a decision you want to be making.

ETF.com: From what you've said, it's clear there are advantages and disadvantages with the different fund structures. But what is the point of buying an MLP ETF or ETN when an investor can simply buy a basket of individual MLPs and avoid the additional tax hits? Is it simply a matter of convenience?

Feng: For a U.S. taxable investor who is comfortable with K-1s and state tax filings (or who has an accountant to do it) and who is comfortable with single-security risk and building their own portfolio, they are always better off owning MLPs directly. That's an undisputed fact.

That being said, not everybody falls into all of those particular buckets. Not everybody is a U.S. investor. Not everybody is a taxable investor. Not everyone is comfortable with K-1s or state tax filing.

So when one of those factors is absent, there is an investment solution, and that's where these products come in.

ETF.com: Let's talk about the outlook for the sector. We've seen MLPs hammered this year amid broader concerns about energy. What's your take on that?

Feng: If you look at supply in the United States, we've seen production levels that we hadn't seen in 40 years. And while production has been growing, demand has not kept pace with that, so there's this imbalance that's led to plunging oil prices and cutbacks in drilling.

Now with production falling, that's where the midstream business comes into play. If you're in the crude oil pipeline business and you see volumes are going to be falling for the first time in four years, it's a concern.

If volume growth is going to slow or go negative, that has implications for the growth expectations for these companies.

We also don't know how much further production is going to fall. We've seen that rigs have been laid down and we've seen that production is starting to come down, but we don't know how much further it's going to come down. And because of that, there is this uncertainty. And, obviously, uncertainty is always bad for the market, unless you're a volatility investor.

As a result of that, people are sitting on the sidelines waiting for things to stabilize on the production front before jumping back in.

And I want to very specifically note that we don't believe that the business risks of an upstream business [exploration and production] are the same as a midstream [transportation, storage, and marketing] business. But right now, investors are lumping all of upstream and midstream energy together.

ETF.com: As prices for MLPs have come down, their yields have jumped up substantially. Do you think these high yields that we're seeing are sustainable? Or are they going to have to cut distributions?

Feng: The reason you're seeing these companies trade down over the course of the past year is because people don't see near-term catalysts for things improving.

But it's not just a function of distributions, it's also a function of distribution growth. Your business is inherently being valued on your ability to grow cash flow on a going-forward basis. If you look at industry over the past 10, 15 years, distribution growth across all the energy MLPs has been in the neighborhood of 7% annualized.

But because of the low-energy-prices environment and falling production, people are starting to take a more skeptical eye toward that 7%. Some analysts say 2016 is going to have zero distribution growth. Some even say 2017 might be zero distribution growth.

Feng (cont'd.): To answer your question about whether these yields are too high and whether they’re going to get cut, it really depends on what you think is going to happen at the macro level.

If you think Goldman Sachs' $20 oil price estimate is going to happen and it's going to be $20 oil for the next three years, it's kind of hard for me to tell you that MLPs are going to be able to maintain their distributions.

If you tell me the supply/demand imbalance picture fixes itself over the course of the next year or so, and oil rebounds to the $50s or low $60s by end of 2016/early 2017, then most of these guys—if not all of them—are probably going to be OK on the midstream side.

Now, if you look at the upstream names, it's a different story. Every single upstream name has cut its distribution in this cycle.

ETF.com: How many upstream names are there?
Feng:
There are 12, and all have cut their distributions, many of which are at zero. Two of them got taken out through M&A activity.

ETF.com: But the midstream names—which are the majority of MLPs—so far, are holding their distributions steady?

Feng: So far they’re holding steady. There's been one company—Niska Gas Storage Partners—that cut its distribution. That's not really representative of this industry for the simple reason that they were distressed, even before this commodity cycle happened.

Editor’s note: Related ETFs include the Alerian MLP ETF (AMLP), a ’40 Act ETF structured as a C-corp; the JPMorgan Alerian MLP ETN (AMJ), an exchange-traded note; the North American Energy Infrastructure Fund (EMLP), a RIC-compliant ETF that can hold a maximum of 25% of its portfolio in MLPs. Click here for a complete list of MLP exchange-traded products.


Contact Sumit Roy at [email protected].

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