There looks to be a correction developing in the MLP sector that may bring up a significant opportunity that income investors should begin to have a plan for. Lets look at the drop in prices recently, potential reasons for the drop, and what it means for the sector and more importantly investors.
As of 1PM or so Eastern time most of the MLP names are down between 5-13% off their highs. Here are recent prices for the MLPs that I follow and how much they are off their 52 week highs.
Definitely looks like a correction is brewing if not here. But rumor in the MLP investor universe is that this is something more sinister, that the government is considering changing the tax status of MLPs and forcing them to pay corporate taxes. A few articles and the comments on Seeking Alpha are on fire with this rumor. Personally, I first heard about it on Mad Money from Jim Cramer – yes, sometimes he does add value. This is not the first time in MLP history that this rumor has come up. So, is it true and is it cause for the recent price drops in MLPs?
First, there appears to be some truth to the rumor. Credit Suisse put out a note on the topic three days ago where they said.
Proposal to Tax Pass Through Entities: The National Association of Publicly Traded Partnerships (the lobby group for MLPs) has informed its members that the Obama Administration is working on a proposal to tax pass-through entities. We checked with our DC Policy Group and they said this is not new and it is too late for any proposal to gain traction in the near term. Our Key Takeaways: 1) Any tax reform is unlikely until 2013 and at this juncture still we view taxation of MLPs as a low probability. 2) There are more pressing issues that have to be tackled. These are the debt ceiling and then the budget. 3) After these two issues are tackled we are likely to be in the fall and all attention will be focused on the 2012 election. We See Headline Risk but No Substance at this Juncture: To be clear, this is not an issue that is being taken lightly by the MLP lobby group. They continue to actively engage and inform Congress on the vital role that energy MLPs provide in building and maintaining US infrastructure. This in turn means US jobs.
I agree 100%. Also, I’ not convinced the recent price moves in MLPs are mainly attributable to this rumor. I’m sure you’ve noticed that the market in general is down and in particular the energy sector is down more than other sectors of the market. I decided to compare the move in MLPs (using AMJ, AMLP, EPD, KMP, and MMP) to the move in the energy sector (XLE), a large US royalty trust (BPT), and a large Canadian royalty trust (PWE). Neither XLE, BPT, or PWE have any of the tax advantages of MLPs. See the chart below.
As the chart shows, if anything, MLP are down less than these other energy sensitive investments. Also, the MLP space has had a record run, was at all time highs, and was trading at levels relative to historical yields and spreads to treasuries that have caused me to say many times here on the blog that the sector was frothy. So, based on the evidence to date, I think the sector is in a normal correction potentially based on fears of demand destruction from higher energy prices and yes, in part, due to the rumor of upcoming tax changes for MLPs. Personally, I think there is a great buying opportunity developing here. My personal trigger is a 15% correction in the likes of EPD, KMR, WPZ, and ETP.
Having said all the above, it does not mean MLP investors should ignore the MLP tax issue. It is a real risk even if remote and down the road, a fat tail risk as they say. I’m starting to look at one, the worst case scenario if the tax law change were to happen and two, the historical example of the Canadian royalty trusts and what effect the Oct 2006 tax law change (known as the Halloween massacre in Canada) has had on the income and performance of the Canadian trusts. I’m not done with my research but what I’ve found so far tells me that the Canadian change did not end up being as bad as everyone thought, although the initial reaction was a 30% price drop for the trusts. Also, on the MLP side it is important to remember that taxes are paid on net income, not distributable cash flow, so the impact on MLP distributions is not as large as the corporate tax rate would indicate. For example, KMP in Q1 2011, had DCF per unit of $1.21 and net income of $0.43 per unit. If the company had to pay the full corporate tax rate of 35% on net income they would pay about $0.15 per unit in taxes which represents only 12% of the DCF. And that is before considering that they pay about 45% of their cash flow to their general partner, KMI. As a worst case scenario that is not so bad.
Stay tuned for more on this issue.