Review & Outlook

Our take on the investing, financial, & economic themes of the day

Despite Kinder Morgan, MLPs Are Here to Stay

14 August, 2014 by Ben O'Brien in Commentary

Earlier this week the giant energy pipeline company Kinder Morgan (KMI) announced that it would restructure and give up its special tax status as Master Limited Partnership (MLP). This came as a shock to many investors because MLPs have been an increasingly popular investment class, and Kinder is the largest and most well-known MLP.

(Source:kindermorgan.com)

Master Limited Partnerships (MLPs) are a complex legal structure but, explained simply, they are a “pass-through security” which means they don’t have to pay federal corporate income taxes as long as they pay out the majority of profits to shareholders through “distributions”. Their dividend yields are often large, making MLPs popular in our current low-yield environment.

We have invested in oil and gas pipeline MLPs through the Tortoise Funds for many years and found them to be a great way to profit from the U.S. energy boom. These MLP pipelines profit from the volume of energy that is transported rather than its price. This means that pipeline MLPs have prospered in recent years even while the glut of natural gas supply pushed down prices, hurting the earnings of most natural gas production companies.

But now that Kinder Morgan is leaving the MLP structure does this mean that the status of other MLPs may be in question? The Wall Street Journal today says no:

As Kinder Moran MLPs were structured, incentive payments to the general partners were growing bigger and making equity more costly. Other MLPs haven’t yet matured to this stage and some are structured differently. There are currently about 120 publicly traded MLPs, up from about 70 just four years ago, and “they are a long, long way off having to contend with the situation that Kinder [Morgan] found itself in,” [Chris Eades, portfolio manager for multiple energy MLP strategies at ClearBridge Investments] said.

Ethan Bellamy, a Robert W. Baird & Co. analyst, agrees that the move makes sense for Kinder Morgan in a way that it wouldn’t for others. The company’s cost of equity is substantially higher than that of most of their peers because of its incentive structure, he noted.

The market received the news positively. Kinder Morgan’s various entities and MLP funds generally got a big boost from the news. Non-Kinder Morgan MLPs went up because now that some of the largest MLPs will no longer be available, there will likely be more money available to go into all the other MLPs. The downside for MLP fund owners is perhaps a somewhat higher tax bill from MLP funds that held Kinder Morgan as they take gains from the departure of the funds.

Analyst Paul Britt writing at ETF.com makes the case that the Kinder Morgan story only confirms the current status of MLPs:

The remaining mix of risk and opportunity remains unchanged for MLP ETPs. It starts with a two-pronged investment thesis: income; and participation in the North American energy renaissance. I don’t see interest in these two drivers weakening anytime soon, rate-risk notwithstanding. . . .  Regulatory risk—the change that lawmakers might strip the MLP structure of its tax-deferred pass-through status—isn’t increased by the Kinder move either, in my view. Instead, I see it as slightly lessened: Why should Congress bust up the structure when one of the largest players has just voluntarily opted into corporate taxation? Besides, Congress is—one hopes—more focused on losses to the Treasury from inversion.

So while the Kinder Morgan deal may lead to somewhat higher taxes paid by MLP funds such as the Tortoise funds that we own for our clients, this was already partly counteracted by the boost in share price earlier this week.  We spoke with Tortoise management and confirmed that the tax impact of Kinder’s departure was not significant. Kinder Morgan’s MLPs made up less than 5% of the Tortoise funds. More importantly, though, the Kinder Morgan story only confirms the long-term attractiveness of the MLP asset class.