The recent ruling reverses a longstanding tax policy affecting MLPs’ interstate pipelines
On March 15, the Federal Energy Regulatory Commission (FERC) stated that it will no longer allow master limited partnerships (MLPs) to recover an income tax allowance when setting cost of service rates for their interstate natural gas and oil pipelines. This ruling reverses a longstanding (and long-debated) policy that was most recently affirmed by FERC in 2005. Although we expect the pipeline industry to appeal this ruling, the MLP market still dropped approximately 4.5% on March 15 in response to this announcement.1
To better understand the impact of the FERC ruling on the future of MLP investments, let’s explore the history of MLPs.
The evolution of MLPs
MLPs are limited partnerships that are publicly traded on stock exchanges. Unlike corporations, MLPs do not pay federal income tax. Rather, they pass their income to their unitholders, who may be subject to income tax on the distributions.
While MLPs are not new investment vehicles (in fact, they have been around since the 1980s), they have evolved over time. Initially, MLPs were open to a variety of sectors; for example, the Boston Celtics NBA team was once owned by an MLP. However, with concerns that many corporations would switch to the tax-friendly MLP structure, Congress limited the formation of MLPs in 1987 to companies where at least 90% of their income was considered “qualified income,” which includes income and gains from the exploration, development, mining, production, processing, refining, transportation or marketing of natural resources.
MLPs were reinvented in the 1990s when energy companies began moving their more stable assets, such as pipelines, to the tax-efficient MLP structure. Over time, this led to a focus of MLPs on midstream energy infrastructure that transported, processed and stored crude oil, natural gas and natural gas liquids. This was an important shift for the asset class, as it made MLPs less sensitive to potentially volatile energy prices.
In 1995, there were 16 publicly traded MLPs.2 At the end of 2017, there were more than 100 publicly traded MLPs, with a market cap near $400 billion.3
The evolution of the income tax issue
As MLPs have evolved, so have the policies concerning the treatment of income taxes when setting the cost-of-service rates that users pay to transport oil and gas over certain pipelines. As the name implies, these rates are based on a pipeline’s costs. In the early years of MLP history, MLPs were given an income tax allowance when setting these rates. FERC changed that policy in 1995, and then restored the allowance in 2005. A recent court case revived the issue, leading to this month’s ruling.
Beyond the initial MLP sell-off following the FERC announcement, what kind of long-term impact could the ruling have on the future of MLP investing?
FERC impact on MLP investing
For individual MLP companies, the degree of cash flow impact will differ based upon their underlying asset exposure and existing contract structure. For example, instead of charging cost-of-service rates, some pipelines charge market-based rates or negotiated rates, which are not affected by this rule. In addition, assets such as gathering, processing and storage facilities are not affected.
Additionally, the timing of a potential cash flow readjustment will also vary, with certain instances not likely occurring until 2020. For the Invesco MLP Fund, we are focused on positioning the portfolio around those companies with minimal exposure to the new announcement, in addition to those that we believe experienced an overreaction in stock price performance.
Overall, this ruling raises the risks of investing in MLPs in the current environment until there is overall better visibility into the long-term cash flow impact. The FERC ruling and the resulting volatility reaffirm our belief that active management continues to be an important aspect of MLP investing.
1 Source: Lipper, Alerian MLP Index as of March 15, 2018
2 Source: Alerian, “MLP: No longer an emerging asset class,” 2014
3 Source: Alerian, as of Dec. 29, 2017
Darin Turner
Managing Director, Portfolio Manager
Invesco Real Estate
Darin Turner is a Managing Director and Portfolio Manager for Invesco Real Estate. He performs quantitative and fundamental research on real asset securities, and his primary portfolio responsibilities include midstream energy, utilities, renewables and transportation infrastructure on a global basis.
Mr. Turner joined Invesco in 2005 as an acquisitions analyst and later served as the associate portfolio manager for Invesco Real Estate’s US Value Added Funds. Prior to joining Invesco, Mr. Turner was a financial analyst in the corporate finance group of ORIX Capital Markets, where he was responsible for the daily evaluation of a structured finance portfolio, as well as for analyzing the performance of specific collateralized debt obligations. Additionally, he was responsible for the execution of a high yield repurchase facility and a leveraged loan swap agreement, as well as the implementation of certain portfolio hedging strategies.
Mr. Turner earned a BBA in finance from Baylor University, an MS degree in real estate from the University of Texas at Arlington and an MBA degree specializing in investments from Southern Methodist University.
Important information
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Although the characteristics of MLPs closely resemble a traditional limited partnership, a major difference is that MLPs may trade on a public exchange or in the over-the-counter market. Although this provides a certain amount of liquidity, MLP interests may be less liquid and subject to more abrupt or erratic price movements than conventional publicly traded securities. The risks of investing in an MLP are similar to those of investing in a partnership and include more flexible governance structures, which could result in less protection for investors than investments in a corporation. MLPs are generally considered interest-rate sensitive investments. During periods of interest rate volatility, these investments may not provide attractive returns.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
All data provided by Invesco unless otherwise noted.
Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. Each entity is an indirect, wholly owned subsidiary of Invesco Ltd. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC, investment adviser. Invesco PowerShares Capital Management LLC (PowerShares) and Invesco Distributors, Inc., ETF distributor, are indirect, wholly owned subsidiaries of Invesco Ltd.All data provided by Invesco unless otherwise noted.
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What does the FERC ruling mean for MLP investing? by Invesco
