What a difference a turn of the calendar page has made for master limited partnerships. By nearly any measure, midstream pipeline valuations look attractive. We also have certainty in tax reform for MLPs with the definition of qualifying income remaining unchanged and the tax-advantaged status preserved. Given that, and the fact that volumes for crude oil, natural gas liquids, and natural gas will likely be meaningfully higher this year, we are excited about the prospects for MLPs in 2018.
Tax Reform an Impact and Game Changer
The C-Corp and the MLP both received an incremental benefit through tax reform. MLPs continue to receive tax exempt status, and therefore, in our view, they are advantaged against corporations.
So, what changed? The corporate tax rate was reduced from 35.0% to 21.0%. MLP investors will now receive a 20% deduction for pass-through income. Also, bonus depreciation was replaced with 100% expensing of capital investments, and we think that’s a pretty nice benefit or income shield for the foreseeable future for both structures.
Sector Shifts Away from Incentive Distribution Rights
The prolonged energy downturn and related poor equity capital market access have resulted in management teams evaluating the right mix of equity sources to fund their growth projects. Historically, that playbook has been to pay out nearly all distributable cash flow in the form of distributions to limited partners and fund growth projects with a 50/50 mix of new debt and equity. In recent years, in particular 2017, we’ve witnessed a shift toward reducing new equity needs and instead relying more on retained cash flow to balance against new debt financing for capital investments.
The result to investors is lower distribution growth potentially, but greater distributable cash flow on a per unit basis. So, we think the bottom line is while investors may receive less upfront distribution growth they can earn on offsetting benefit in the form of less total units outstanding with ever increasing coverage and cash flow accretion. On the structure side, we’ve witnessed an acceleration of companies moving to simplify their structure and eliminate incentive distribution rights (“IDRs”). Removing IDRs results in a more sustainable MLP model, in our view, as cost of capital is lowered and corporate governance is improved.
About 50% of the companies in the Tortoise MLP Index® no longer have IDRs. That number was virtually none about 10 years ago, and currently, six of the seven largest MLPs no longer have IDRs. We expect MLPs will continue this trend of eliminating IDRs. And we anticipate by the end of 2019, approximately three-fourth of the companies on a weighted basis in the Tortoise MLP Index will no longer have IDRs, and all of the 10 largest MLPs, based off today’s sizes, will not have IDRs.
Self-Funding Gains Momentum
Though total capital market issuance in 2017 was nearly equal between debt and equity, debt markets remained supportive for MLPs throughout the year, while equity access was fickle. Consequently, management teams are working towards being less reliant on the equity capital markets.
We expect MLP equity issuance to decline over the next three years as excess cash flow and debt capacity increase, while capex budgets remain relatively stable. Further, multiple alternative funding options exist and may come in the form of preferred offerings, PIPEs, or other structured equity offerings.
Specific to capex, our long-term outlook for the midstream sector remains positive as the need for greater pipeline takeaway capacity remains due to strong production growth. We project capital investments in MLPs, pipelines, and related organic projects at approximately $145 billion for 2017 to 2019.
Disclaimer: Nothing contained in this communication constitutes tax, legal, or investment advice. Investors must consult their tax advisor or legal counsel for advice and information concerning their particular situation. This article contains certain statements that may include “forward-looking statements.” All statements, other than statements of historical fact, included herein are “forward-looking statements.” Although Tortoise believes that the expectations reflected in these forward-looking statements are reasonable, they do involve assumptions, risks and uncertainties, and these expectations may prove to be incorrect. Actual events could differ materially from those anticipated in these forward-looking statements as a result of a variety of factors. You should not place undue reliance on these forward-looking statements. This podcast reflects our views and opinions as of the date herein, which are subject to change at any time based on market and other conditions. We disclaim any responsibility to update these views. These views should not be relied on as investment advice or an indication of trading intention.
Tortoise MLP Index®
The Tortoise MLP Index® is a float-adjusted, capitalization weighted index of energy master limited partnerships (MLPs). The index is comprised of publicly traded companies organized in the form of limited partnerships or limited liability companies engaged in transportation, production, processing and/or storage of energy commodities.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.