Is MLP Parity Act a Game Changer?

Master limited partnerships (MLPs) are a popular investment these days, and now some in Congress want to use them to encourage investment in renewable energy projects. Less has been said about how such new-fangled MLPs might work out for investors. And therein lies the problem.

The first master limited partnership in the US was formed by Apache Oil Company in 1981. But it wasn’t until 1987 that Congress legislated the rules for publicly traded partnerships as laid out in Internal Revenue Code Section 7704.The rules state that at least 90 percent of an MLP’s income must come from qualified sources, such as real estate or natural resources. Section 613 of the tax code requires qualifying energy sources to be depletable resources or their derivatives such as crude oil, petroleum products, natural gas and coal. The range of activities qualifying for MLP treatment has been significantly expanded by the Internal Revenue Service in a series of recent case-by-case rulings.

The main attraction of an MLP from an investor’s point of view is that MLPs don’t pay corporate income tax. Profits are passed directly to unitholders via (usually) quarterly distributions. This is different than the tax liability faced by shareholders in a corporation. Their profits are taxed first at the corporate level, and then a second time as personal income tax on dividends. In contrast, MLP distributions are taxed just once, at the individual level.But MLP distributions aren’t immediately fully taxed either. In fact most of the distribution — typically 80 to 90 percent — is classified as a return of capital under the depreciation allowance, which subtracts capital depreciation from net income to account for the fact that assets like pipelines and wells lose value over time.

The depreciation allowance lowers the immediate tax bill but also the cost basis of the MLP investment, resulting in a larger capital gain when the MLP is sold.Over time the tax-deferred income can be invested elsewhere, allowing investors to compound returns that would have otherwise been taxed, while also earning a steady stream of income. This has made MLPs an extremely popular income investment.

The partnerships, in turn, gain access to a broader pool of stable (and as of late cheaper) capital to finance projects.There are currently more than 100 publicly traded MLPs representing some $445 billion in capital. Approximately $400 billion has gone into qualifying energy and natural resource projects, and the vast majority of that — perhaps 80 percent — into midstream projects such as oil and gas pipelines.

But current MLP rules exclude ventures in renewable energy, and many renewables advocates have long complained that MLPs give fossil fuels an unfair advantage. US Sen. Chris Coons, D-DE) aims to rectify that with the introduction of a Senate bill called MLP Parity Act.

Unlike a previous proposal by Sen. Bernard Sanders (I-VT) and US Rep. Keith Ellison (D-MN) to eliminate the MLP option for fossil-fuel projects, the legislation proposed by Sen. Coons would not affect current or future fossil-fuel MLPs. They would continue to receive the same tax benefits.

MLP Parity Act illustration

Rather, MLP Parity Act would expand the definition of “qualified” sources to projects involving wind and solar power, as well as closed and open loop biomass, geothermal, municipal solid waste, hydropower, marine, fuel cells, and combined heat and power (CHP).

The legislation would include biofuels such as cellulosic fuels, ethanol, biodiesel, and algae-based fuels. Energy-efficient buildings, energy storage, carbon capture and storage (CCS), renewable chemicals, and waste-heat-to-power technologies would also qualify.

A number of renewable energy advocates have written articles proclaiming the MLP Parity Act a potential game-changer for renewable energy. I disagree.

The main reason so many MLPs have been successful is their concentration on energy infrastructure, a booming industry with a long history of strong profitability.  This has attracted conservative investors, and MLP tax rules have given them an incentive to stick around for the long run.

Most renewable energy investments are in a very different business. The vast majority of renewable energy companies exist as a result of mandates at the federal or state level. I don’t mean to suggest that we shouldn’t support renewable energy, merely to note that if certain tax credits and mandates were eliminated, the industry would be decimated because for the most part it isn’t competitive with fossil fuels. Pipeline MLPs have a steady source of income from which to pay distributions. Where are advanced biofuel companies going to come up with the money for distributions? From added debt? From issuing more units?

The fact is that unless they can come up with long-term supply agreements that will see them through even if government support disappears, renewable energy MLPs could prove very risky investments.

Imagine if most advanced biofuel companies could have organized themselves as MLPs three years ago. Would that have prevented the 90 percent decline experienced across the sector? No, and this is volatility that traditional MLP investors will not accept.

The MLP Parity Act enjoys bipartisan support in both houses of Congress, and so has a good chance of becoming law.

And despite my skepticism that it will be a game-changer, I support passage of the bill: all forms of energy, whether fossil-based or renewable — and arguably all business activities in general — deserve a level playing field on taxes. It’s just that I won’t be recommending renewable MLPs until they demonstrate that they can consistently do what pipeline MLPs have done for their investors.

Around the Portfolios

Eagle Rock Energy Partners (Nasdaq: EROC)
When is a yield of more than 10 percent not worth the trouble? When it comes from a small-cap master limited partnership with multiple operational and commodity issues as well as distributable cash flow that covered just two-thirds of the distribution in the most recent quarter.

Sure, management claimed on the post-earnings conference call earlier this month that without the bad winter storms, one-off downtime and prior-period adjustments distributable cash flow would have been closer to 90 percent of the distribution. And sure enough, Eagle Rock plans to collect more cash than it distributes in the long run as the oil wells it’s drilling in Oklahoma start to pay off while its Texas gas gathering networks benefit from increased volumes and new customers.

But the bottom line is that this remains a speculative story dependent on the drilling decisions the natural gas producers feeding Eagle Rock’s pipes and plants the (still terrible) market pricing for natural gas liquids and Eagle Rock’s skill at assimilating the gas processing assets it recently acquired from BP (NYSE: BP), while at the same time delivering results from its very different oil producing venture.

That’s a lot of balls to keep in the air for a management team that’s recently dropped more than a few. We’d rather invest in more successful ventures, and there are lots of these around that don’t depend on a turnaround in commodity markets or other companies’ capital spending plans. So we’re removing Eagle Rock from the Growth Portfolio.

It’s possible, of course, that this amounts to “selling at the lows” and that unit holders who stick around for another six months, say, might get a couple of additional distributions as well as a higher exit price. But in general, when the best remaining reason to hold something is fear of selling at a low, it’s time to go. Sell EROC now.

— Igor Greenwald

Stock Talk

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