MLP ETFs Face Oil & Tax Issues Ahead

[This article appears in our December 2017 issue of ETF report.]

Jeremy Held is senior vice president and director of research at ALPS Advisors, issuer of the Alerian MLP ETF (AMLP), the world's largest MLP exchange-traded fund, with $9.8 billion in assets under management. ETF.com recently spoke with Held to discuss what impact U.S. tax reform could have on MLPs and other topics related to the industry.

ETF.com: Do you expect the coming tax reform will impact the pass-through tax advantage MLPs currently enjoy?

Jeremy Held: First, I have to say it's too early to determine with any kind of certainty what we think the impact of tax legislation will be. That being said, we don’t anticipate any major changes to the MLP pass-through status.

What most investors are scared about is the 'Halloween massacre' in Canadian royalty trusts that happened 11 years ago, where they lost their pass-through status overnight, and investors are wondering whether the same thing could happen to the MLPs in the U.S. We think it's unlikely. Even prior to the election of Trump, MLPs have had very benign oversight from a federal standpoint.

It’s something we keep a very close eye on. If you listen to conversations from the House Ways and Means or Senate Finance committees, you’ll hear that MLPs have never been singled out for tax reform. There has always been a discussion about tax reform that would broaden the base and lower the rate, but MLPs have never been part of that conversation specifically.

More importantly, we think MLPs have the advantage that they are viewed quite favorably in Washington. Many in Congress see the sector as beneficial to national security, energy independence and job creation.

In fact, there's a bipartisan, co-sponsored bill before Congress called the MLP Parity Act that would apply the tax preference of MLPs to other parts of the energy landscape.
At the end of the day, there’s always a small chance that tax reform impacting MLPs could occur. We don't think the chance is any greater now than it has been in the past. We think it’s a remote possibility, and one that could impact MLPs if implemented, but we don't see it as being highly likely.

ETF.com: Something that’s almost certain to be included in any tax reform bill is a cut in the corporate tax rate. How will that impact MLP ETFs, which are structured as C-corporations?

Held: There are two potential impacts. If, for example, the corporate tax rate goes from 35% to 20%, there would be an immediate benefit to all MLP funds―not just ETFs, but also open-end funds, closed-end funds and any MLP mutual fund that's taxed as a corporation. All of these funds would receive a lift because they’d be accruing tax-deferred liabilities at a lower rate as opposed to a higher one.

The other potential impact, which is harder to forecast, is the impact on the MLP structure itself. Part of the reason companies structure their pipeline operations as MLPs is to take advantage of the federal tax preference.

With a reduction in the corporate tax rate, the federal taxation they're avoiding has decreased. Does it incentivize companies to keep the corporate structure as opposed to the MLP structure? That's hard to say. A 0% tax rate is still less than 20%, but the incentive is not as great as a 35% corporate tax rate.

We believe the MLP structure will continue to be very viable regardless of whether the tax rate gets lowered, but if it does, it could make for a higher hurdle rate to adopt the MLP structure.

ETF.com: Why are MLPs performing so poorly this year, even though U.S. oil production is rising again?

Held: It’s a crisis of confidence. You're right that oil production has climbed, but what's weighing on MLPs recently is the fact that oil production growth in the U.S. is actually slowing down. Rig counts have come down three weeks in a row, and they were down by 15 rigs last week, one of the biggest declines we’ve seen in a long time.

There’s also a lot of uncertainty about distribution growth, which, in our view, is the biggest factor weighing on MLPs.

For years, MLPs have had to do a constant balancing act. On the one hand, they want to grow distributions at a high rate because they know investors buy MLPs for income and for growth of income.

But at the same time, they also want to lower their debt burden; they want to make sure they have a healthy balance sheet; they want to keep a relatively high coverage ratio; they want to maintain an investment-grade rating; they want to be able to have cash on the sidelines to make acquisitions.

Enterprise Product Partners, the largest MLP and a bellwether for the sector, epitomizes some of the changes taking place in the market. It grew its distribution at the same rate for nearly 53 quarters in a row. Then it recently decided to cut its growth rate in half to pursue a self-funding model where it’s less reliant on the capital markets if it wants to conduct an acquisition or if it wants to expand.

That's the balancing act all MLPs face―how much to grow distributions versus how much to retain. You've seen the pendulum swing quite a bit from an aggressive stance a few years ago to a much more conservative one today. There have even been a handful of companies that have cut their distributions.

Plains All American Pipeline, one of the largest MLPs, cut its distribution twice. First in July 2016, and then more recently this past August. More recently, Genesis, a smaller MLP, cut its distribution last week.

You have an asset class that, for the better part of a decade, you could count the number of distribution cuts on one hand, and now all of that has changed. MLPs are erring on the side of healthier balance sheets and lower distribution growth because the market isn't really rewarding high distributions like it was in 2011, 2012 and 2013.

ETF.com: What's the outlook for the industry going forward?

Held: We think MLPs, regardless of entry point, are ideally designed for investors who have a medium- to long-term time horizon, and that have moderate to above-moderate risk tolerance.
MLPs are a small asset class with a shareholder base that is still comprises primarily individual investors. In addition, the asset class can experience long periods where its prices are divorced from fundamentals.

Investors also need to reset expectations. These are essentially toll road businesses that transport commodities from “point A” to “point B.” We believe a realistic medium- to long-term total return expectation for MLPs consists of distributions in the 6-7% range and growth of those distributions of 2-4% per year.

We think 7-9% total return expectations are very reasonable for MLPs over the long term. Short term, it could be higher or lower based on current volatility and valuations.
After the financial crisis, investors became accustomed low to midteen annual returns in this asset class. There was a long stretch, from the end of the crisis through the peak in oil prices, where MLPs were up 15, 16, 18% on an annualized basis.

That type of growth rate wasn’t sustainable. But for investors interested in participating in the buildout of energy infrastructure, and who have a long-term time horizon and can handle short-term volatility, we think the sector continues to look attractive.

Contact Sumit Roy at [email protected]