How One MLP Benefits From The Shale Gas Boom

The U.S. shale oil boom gave us lower fuel prices at the pump, and the shale gas boom brought cheaper heating and electricity bills. But most people are unaware of the impact of cheap shale gas on the chemical manufacturing industry.

Chemical manufacturing utilizes natural gas both as a raw material and as a source of fuel. The constituents of natural gas — methane, ethane, propane, etc. — can be separated out, with each being used as a raw material for different chemical processes.

The $768 billion U.S. chemical industry is the second largest in the world, with 15% of the global market. The industry provided 811,000 U.S. jobs and accounted for $174 billion of U.S. exports in 2016 — 14% of all U.S. exports.

According to the American Chemistry Council (ACC), as of July 2017, there are 310 completed, started or potential chemical industry projects chemical industry projects due to shale gas.

The ACC estimates that these projects represent $185 billion in new capital investment and will create 464,000 direct & indirect jobs by 2025, $310 billion in new economic output, and will bring in $26 billion in new tax revenue by 2025.

Shale Boom Creates Ethane Glut

Ethane is the second most abundant constituent of natural gas (behind methane) and is primarily used to produce ethylene, which is the world’s most widely used petrochemical. The flood of new shale gas supplies has overwhelmed the market for ethane, sending the price plummeting. This, in turn, has made the economics of producing ethane derivatives like ethylene and polyethylene extremely attractive in the U.S.

One company benefiting from cheap ethane is Westlake Chemical Partners (NYSE: WLKP), which went public in 2014. Westlake Chemical Partners is a master limited partnership (MLP) formed by Westlake Chemical (NYSE: WLK) to operate, acquire and develop ethylene production facilities, and related assets. 

WKLP owns a 200-mile ethylene pipeline and three ethylene production facilities in Kentucky and Louisiana, with an annual capacity of approximately 3.7 billion pounds. It is the only MLP engaged primarily in ethylene production.

Since going public in 2014, Westlake Chemical Partners has managed to grow its quarterly per unit distribution by 32%. But the unit price (unlike corporations, MLPs are priced by unit) has fallen by 22%. 

The primary reason for this decline is that in May 2015, the IRS issued a ruling that would disqualify income from ethylene production from benefiting from MLP status. This status is important for tax reasons. More on that below. When the IRS issued its ruling, WKLP’s unit price dropped by more than 30%. 

However, in January of this year, the IRS reversed this ruling (reiterating an initial private letter ruling for WKLP that granted MLP status), declaring that ethylene production, transportation, storage, and marketing does constitute “qualifying income” for the purpose of obtaining MLP status. The unit price moved 25% higher on the news, but the price has yet to recover to the level it was before the earlier negative ruling.

MLP Basics

Before investing in an MLP like Westlake Chemical Partners, it is important to understand how MLPs work. 

The big advantage of MLPs is they 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, all things being equal, should deliver more money to unitholders.

But the distributions aren’t fully taxed either. Because of the depreciation allowance, 80% to 90% of the distribution is considered a “return of capital” and thus not taxable when received. Instead, returns of capital reduce the cost basis of an investment in the MLP.

The rest of the distribution—typically 10% to 20% —is taxed at the recipient’s income tax rate. But being able to defer the rest of the tax until the investment is sold is an advantage since the income can be reinvested to generate compound returns that could more than pay for the eventual tax bill.

MLPs issue Schedule K-1 forms instead of the 1099 forms you may receive from a corporation, and the K-1 will reflect your share of the taxable income. Most K-1s are issued between late February and early April, which could delay your tax return.

The K-1 package will also include a state schedule. This schedule details the MLP’s share of income or loss attributed to each state in which it operates.

For example, a pipeline may cut across five states and have reportable income in each state. You may be required to file state tax returns for each of these states, which means your tax reporting may be more complicated and costlier, though most individual investors fall well under the threshold for having to do so.