What’s Behind The MLP Sell-Off?

This month, the Federal Energy Regulatory Commission (FERC) ruled that certain master limited partnerships (MLPs) may have to reduce the amount that they charge their customers. The news triggered a knee-jerk sell-off in the already-beaten-down MLP space, pushing the group closer to its 2016 lows.

To get the latest read on what is going on with MLPs, ETF.com sat down with Jeremy Held, 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 $8.3 billion in assets under management. Held says that the impact of the FERC ruling is likely to be negligible and that the recent drop in share prices is a buying opportunity.

ETF.com: The recent ruling by the FERC has been all over the headlines recently and has acted as a drag on MLPs. Could you explain simply what that ruling was, and why it caused such a stir in the MLP world?

Jeremy Held: The FERC ruling has an impact, but to what degree is largely dependent on the type of pipeline in question and how the contract is structured. It’s much more nuanced than the market reaction first indicated.

For example, FERC allows MLPs to charge an allowable rate of return. This regulation operates in a similar fashion to the way state utility commissioners allow individual utilities to earn a regulated rate of return.

But the components of how MLPs calculate their rate of return varies significantly based on a number of factors. Interstate liquids pipelines—those that transport crude oil, refined products and natural gas liquids—typically increase their tariffs each year by an inflation escalator that is set by the FERC every five years. The current escalator is the Producer Price Index plus 1.3%.

On the other hand, long-haul, interstate natural gas pipelines have a number of different ways they can calculate the rates they charge their customers. Sometimes they’re indexed, sometimes they’re market-based rates and sometimes they use a calculation methodology called cost of service, which is what the FERC ruling was all about.

In a cost-of-service rating scenario, MLPs calculate all of the different components that comprise the cost of doing business, from maintenance to capital expenditures to commodity costs.

One of the components of that cost-of-service calculation was an income tax allowance. FERC recently ruled that MLPs, as entities that are exempt from federal income tax, can no longer use this income tax allowance as one of the components for the cost-of-service calculation.

Ascertaining the impact of the ruling is complicated, because on the one hand, the FERC is removing a cost that MLPs had historically been able to charge customers. However, it left unchanged the allowable rates of return MLPs are able to charge

Perhaps most importantly, this ruling only applies to a small number of pipeline operators

Almost three-quarters of the MLPs in the Alerian MLP Infrastructure Index announced shortly after the FERC ruling that they expected minimal—if any—impact to earnings, while a small number of names estimated an impact anywhere from 5-10% of their earnings or cash flow.

ETF.com: Despite having a limited impact on earnings, MLPs were hammered across the board after the ruling. Why is that?

Held: That speaks more to how jittery MLP investors are than it does of what the impact of this FERC ruling will be. There’s a crisis of confidence in the MLP sector.

For the better part of two decades, MLPs were able to very consistently grow distribution rates. They had a retail investor base that was primarily concerned almost exclusively with high levels of distribution.

Now the market dynamics have changed. MLPs are starting to be followed more closely by institutional investors that are much more discerning from a corporate governance perspective.

Uncertainty is the enemy of premium valuations in every asset class. A number of factors have created uncertainty over the last few years in the MLP sector. Between the U.S. becoming the swing producer in crude oil, MLPs seeking to improve corporate governance, adopting a self-funding model, growing at a slower rate, and the FERC ruling, there continues to be a lot of uncertainty in the space.

We're potentially entering a new repricing scenario, where MLPs may not be able to grow at the rates that they did for the early, mid- or late 2000s. But in that scenario, we still think that MLPs continue to provide a vital component of energy infrastructure, and many of the reasons to own MLPs haven’t changed as dramatically as the sentiment has.

ETF.com: It looks like MLPs are in a free fall, with prices for many of the names quickly approaching the 2016 lows, when oil was $26. What will be the catalyst to turn the group around?

Held: It does feel like we’re approaching market capitulation. It's hard to know exactly when markets find either a bottom or a top.

Despite the negative sentiment, there are some positive signs on the MLP horizon. U.S. export growth continues to rise; that’s positive for MLPs in terms of exports of liquids and natural resources.

Balance sheets are much healthier than they’ve been in the past. MLPs are adopting a more conservative governance stance, rather than paying out as much as they can from a distribution perspective.

ETF.com: You briefly mentioned the tax cuts. You said the market interpreted them as negative, but should it have? Also, what’s the impact of the tax cuts on MLP ETFs?

Held: I'll take the second part first. As far as MLP ETFs are concerned, we view tax reform as a positive for the ETF structure.

The ETF structure, while being very convenient in terms of diversification and tax simplification, creates a situation where investors don’t track the underlying MLP index perfectly because of the tax consequences inherent in the MLP mutual fund structure. All MLP mutual funds—whether they’re open-end funds, closed-end funds or ETFs—are required to be taxed as corporations.

Historically, the delta—the gap between the index performance and the fund performance—was larger, because that gap is essentially 1 minus the tax rate (1 – TR). With federal tax rates of 35% and a 1-2% allowance for state taxes, before expenses, you’d expect an MLP ETF to track the performance of an underlying MLP benchmark at about 63% or 64% of the underlying index. Now that the federal tax rates are lower, you’d expect an MLP ETF, before expenses, to track its index much closer, in the 78% or 79% range.

The relative attractiveness of owning a diversified, liquid, tax-simplified MLP ETF became more attractive with the reduction in federal tax rates, because now investors have a way to more closely track the underlying benchmark.

As for individual MLPs, they became slightly less attractive after the tax cuts on a relative basis compared to the tax cuts that were applied to traditional corporations. The tax preference for MLPs is not as great as it used to be, from an opportunity cost perspective. Instead of avoiding a 35% federal tax, now being structured as an MLP avoids a 21% tax. Even so, MLPs still retain a significant tax advantage over a corporation.

You can reach Sumit Roy at [email protected].