For most of the past 25 years, there was no better investment for income-seeking investors than Master Limited Partnerships (MLPs). That changed with the oil price crash of 2014. Despite a recent rally in the energy sector, a deep disconnect has opened between the price of oil and the market valuation of MLPs.
To review, midstream oil and gas companies generally function as toll collectors for transporting and storing hydrocarbons. Historically, midstream companies have been more insulated from the commodity price volatility that can impact the upstream and downstream sectors. As a result, many investors gravitated to the midstream companies for predictable income streams.
Many midstream providers structured themselves as MLPs, which provided tax benefits for investors.
The biggest advantage has always been that MLPs aren’t taxed at the corporate level. MLPs pass profits directly to unitholders in the form of quarterly distributions. This arrangement avoids the double taxation of corporate income and dividends affecting traditional corporations and their shareholders and should deliver more money to MLP unitholders over time.
But because of the depreciation allowance, 80% to 90% of the distribution is considered a “return of capital” and thus also not taxable when received. Instead, returns of capital reduce the cost basis of an investment in the MLP.
Investors Sour On MLPs
MLPs crashed along with the rest of the energy sector in 2014. However, in recent months most of the energy sector has rallied. The MLP sector, on the other hand, has continued to fall.
There are several reasons for the drop.
First, the tax reform bill that President Trump signed reduced some of the tax advantages an MLP held over a corporation.
Likewise, rising interest rates may make certain financial instruments slightly more attractive relative to MLPs.
Finally, two weeks ago a ruling by the Federal Energy Regulatory Commission (FERC) to reverse a longstanding policy on tax costs for interstate pipelines really rattled investors.