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3Q Midstream and MLP Update

Strong earnings, a robust growth outlook and improved energy fundamentals pushed midstream companies higher in the third quarter. We believe the strength should continue as there are significant tailwinds at play in the sector. One strong tailwind is the continued growth in oil and gas production in the United States. In early September, the Energy Information Agency announced that the U.S is now the largest oil producer in the world. With further production gains expected, midstream energy companies are in prime position to capture additional volumes and cash flows. The U.S is also emerging as a global power in the export of Liquified Natural Gas (LNG). These positive energy trends will continue to drive midstream earnings higher for the foreseeable future. Despite a strong quarter, MLPs remain significantly undervalued versus historical metrics. After a difficult four years for energy markets, it is a welcome development to have multiple tailwinds at the back of MLPs once again.

What Happened in 3Q18?

Midstream energy companies reported exceptional earnings during the third quarter with most companies surpassing analyst estimates. The results were driven by increasing volumes, improving commodity prices and new projects coming on-line. Oil prices continue to rebound and are now approximately $75/barrel; the highest in 4 years. A long-awaited merger between Energy Transfer Partners and Energy Transfer Equity was announced during the quarter. The deal is expected to close by year end and it will eliminate incentive distribution rights. We view the merger as bullish for the sector as improved corporate governance has been a major focus for the sector. The Permian Basin continues to be a growth driver for midstream companies. Crude production in the Permian is moving towards 4 million barrels/day but has slowed significantly as there are not enough pipelines to move the oil. New pipelines are being developed and we expect pipeline takeaway capacity to be sufficient by the second half of 2019. Some other shale basins that will be facing infrastructure shortages are the Bakken in North Dakota and the Marcellus in the Northeast.

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A petrochemical boom is driving strong demand growth for natural gas liquids (NGLs), specifically ethane. Ethane is used as a building block for plastics. Demand for ethane is expected to increase by nearly 700,000 barrels/day in the next three years. This demand is driven by seven new world-class ethane steam crackers coming online in the coming years. This petrochemical boom is driven by lowcost feedstock that U.S shales produce. They are now competitive or superior to Middle East petrochemical facilities. MLPs that operate infrastructure that processes these liquids are benefiting from significant volume growth and high processing margins.

LNG: A Global Game-Changer

One of the most impactful shifts in global energy in decades is the rapid growth in the LNG trade. Technological advancements have allowed natural gas to be liquified and traded globally just like the crude oil. Countries around the world are attracted to LNG as they move away from dirty coal and oilbased electricity generation. Demand from India and China has been surging as they try to lower pollution in their major cities. Europe is also a major source for LNG demand. The Trump administration is pushing the Europeans to buy more U.S gas as an alternative to Russian gas. The U.S is in a prime position to dominate LNG exports as natural gas prices in the U.S are $3/MMBtu versus over $10/MMBtu in Asia. Several new export facilities are under construction, and MLPs are building out pipelines to feed gas to the facilities.

Two companies that we have been actively allocating to in the LNG sector are Golar LNG (GLNG) and Teekay LNG Partners (TGP). Both companies are involved in shipping LNG around the world. LNG shipping rates have surged from lows last year of $40,000/day to around $100,000/day currently. Rates are expected to remain high as vessel supply is limited. Teekay LNG is one of the largest LNG shipping businesses in the world. They essentially operate as a floating pipeline with long-term fixed rate contracts. In 2015, Teekay slashed their dividend to fund the construction of several new ships. Fast forward to today and those ships are being delivered and placed into service. We expect Teekay to announce a return to distribution growth in November which should drive the stock price significantly higher as it trades at a significant discount to peers. Golar LNG is one of the most exciting companies in the energy sector. They operate a large fleet of ships and have developed technology for Floating Liquefied Natural Gas (FLNG). The FLNG technology is a massive ship that produces natural gas from offshore fields, liquefies the gas, and then offloads it to LNG carriers that carry it to end destinations. Earlier in the year Golar put their first FLNG asset into service. The economics are very good for Golar and each FLNG asset provides sizeable earnings growth for the company. We expect Golar to announce a new FLNG asset by year end.

MLP Valuation

MLP valuations continue to be discounted relative to history, other energy subsectors and other yieldoriented securities. Of the three most widely cited metrics, MLPs are between 15% and 35% undervalued, and this is occurring during a period where fundamentals are as strong as they have been in year. Why are we here? There

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is no doubt that many factors outside of the fundamentals continue to weigh on sentiment. These include corporate governance issues, high leverage and fears that there is less distribution growth ahead. Another issue impacting the midstream is a lack of fund flows as many investors are heavily invested in technology stocks. We believe we are entering a period where we will see a rotation into value stocks which should benefit MLPs.

Conclusion

We are very optimistic for a strong finish to 2018. Midstream companies are primed to benefit from improving operational economics, growing volumes and stable commodity prices. Several major projects will be coming online in the coming months that will enhance cash flows and drive earnings growth. The United States is an energy superpower and the buildout of infrastructure is critical to its success. With a dividend yield of 7.9%, and valuations at significant discounts to historical metrics, we view the asset class as one of the few great values in the market. It’s been a tumultuous road for MLPs since 2014, but the future remains bright as we return to growth in the energy sector.

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Are we Entering an MLP Bull Market?

At DeWitt Capital Management we rely on our own extensive knowledge and research to make decisions when it comes to investing the often-tricky sector of MLPs and energy infrastructure. We have been steadfastly bullish over the past year and have been telling investors that we feel we are on the edge of entering the next bull market for MLPs and energy infrastructure. Thus, when one of the top midstream analysts in the country agrees with us, it validates what we’ve been saying. In Wells Fargo’s latest weekly note, Michael Blum, the firm's Senior Analyst covering the midstream sector, speculates that maybe the next bull market is finally here and offers his thoughts why.

Based on the fundamentals alone MLPs should probably have been in a bull market for over a year now. Fundamentals improving alongside deteriorating stock prices has been one the most frustrating and confusing aspects of being a midstream investor lately. Something else has been weighing on the sector, and one of the clearest factors is without a doubt corporate governance, and more specifically, incentive distribution rights (IDRs).

Wells Fargo wonders if the long-anticipated collapse of ETE/ETP will be the moment that marked the end of the IDR era. Over the past year, many investors have felt that one of the largest overhangs that have weighed on the midstream sector was the coming Energy Transfer simplification. Energy Transfer has been, as Wells Fargo puts it, “the poster child for IDRs, perceived conflicts of interest, and misalignment.” Now that they are waving goodbye to the structure for a better-aligned configuration, this “could very well be the catalyst the MLP/midstream market’s been waiting for.” Wells Fargo also thinks that the accelerated timeline for the Energy Transfer simplification is going to put additional pressure from investors on those who still own IDRs, which could provide further catalysts.

Operating results for MLPs have been stellar and continue to improve. Corporate governance is getting better and could attract further investment in the sector. We believe the next bull market is here, and now Wells Fargo agrees we may be right!

 

FERC Taketh and FERC Giveth – MLP and Energy Infrastructure Rally Continues

The Alerian MLP Index was up over 2% yesterday on the back of a final ruling from FERC on recently proposed changes on how certain interstate pipelines could set their rates- specifically as it relates to a pipelines ability to receive an income tax allowance. The final rule modifies a notice of proposed rulemaking (NOPR) that was issued in March. DeWitt Capital Management believes the changes are positive for the sector. Some of the changes include the following:

  • Accumulated deferred income taxes (ADIT) will be eliminated for MLPs. This removes the risk of ADIT-related refunds for several MLPs. It also will serve to increase the pipeline’s rate base, everything else being equal.
  • Natural gas pipelines that have a corporate parent will be able to include an income tax allowance in its rates. This is meaningful for a few MLPs and less meaningful for those without a corporate parent, or for those who do not charge cost of service rates.
  • Pipelines that choose to voluntarily reduce their rates to account for the change in the income tax rate will no longer be required to eliminate its income tax allowance.
  • For any pipeline that has an return on equity of 12% or less, which is FERC’s threshold to determine if a pipeline is over or under-earning, the FERC has granted a three-year moratorium on any section 5 rate cases.

The overall impact should be an even more muted impact of cost of service rates than we initially expected based off the original March ruling. Some analysts have made statements based on the new ruling. James Lucier, managing director of Capital Alpha Partners LLC, wrote in a note that the latest ruling “takes a number of the rough edges off the previous FERC announcement by reducing the threat of rate probes, and letting companies with complex structures make a case for why they deserve a partial allowance.” Katie Bays, an analyst at Height Securities LLC, said in a note to clients, “FERC offers pipelines that are willing to reduce their rates an option to do so on a limited basis (i.e., retain a tax allowance) in exchange for expediting the process.” 

FERC, for their part, said they hope the order yields “the intended effect of encouraging the pipelines where appropriate to make voluntary filings, taking advantage of the rate moratorium we have assured they will enjoy if they do so.” 

If you would like to learn more about DeWitt Capital Management, do not hesitate to call us at 610-975-4435 to speak to an analyst about how to participate in the recovery and renewed growth of America’s energy infrastructure.

2Q18 Midstream and MLP Update

Midstream energy companies bounced back in the second quarter and are poised to have a strong finish to the year. Strong earnings, a robust growth outlook, and strong energy fundamentals are supportive of further gains in the midstream sector. After years of underinvestment, new concerns about having enough oil to supply growing demand has pushed oil prices into the $70-$80 range. Pipelines are beginning to fill up throughout the country, and new investment in infrastructure will be needed to support further U.S shale growth. The Permian Basin in West Texas has seen production increase by nearly 50% to 3.5 million barrels/day in the last 12 months. All this growth is positive for energy infrastructure companies as all the product needs to be processed, transported and stored. The growth has positioned the United States to be one of the major energy exporters in the world. Despite a strong quarter, MLPs remain undervalued versus historical metrics. The MLP sector continues to evolve as companies continue to pursue the elimination of incentive distribution rights, simplified structures, a move to a self-funding model and a slow down in distribution growth. All these changes are creating a stronger sector for the long run.

What Happened in 2Q18?

Midstream energy companies reported strong earnings during the second quarter with many companies surpassing analyst estimates. The results were driven by increasing volumes, improving commodity prices and new projects coming on-line. The strong results and positive outlook resulted in

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positive fund flows and strong returns for midstream infrastructure. The MLP landscape continues to change. Simplifications were all the rage this quarter as companies continue to clean up their structure to address investor concerns surrounding complexity, potential conflicts of interest and weak corporate governance. On May 17th, C-Corporations Williams Companies, Enbridge Inc and Cheniere Energy announced roll-ups of their underlying MLPs which ultimately will reduce the MLP count by 5 names. We expect future roll-ups to continue as companies address their complicated business structures. Midstream C-Corps historically trade at a slight premium to their MLP brethren, and for the most part, C-Corp conversions have traded positively after announcing the transaction.

During the quarter, crude oil prices increased by over 14% to $74. This increase in prices was driven by global supply disruptions, a recognition that oil markets are rapidly tightening, and infrastructure constraints in U.S Shale that will keep a cap on near-term growth. Natural gas and natural gas liquids (NGLs) pricing remained strong with demand from exports continuing to increase. Demand for NGLs is driven primarily by the petrochemical industry which has invested billions for new plants that take advantage of the low-cost feedstock. Pipeline companies that process NGLs continue to benefit from increased NGL pricing and increased volumes.

Additional Infrastructure Needed

Production growth in shale basins throughout the country is driving new demand for pipelines and associated infrastructure. During the quarter, The Interstate Natural Gas Association (INGAA) updated their 2016 report on energy infrastructure needs. The update shows a significant increase in the expected midstream infrastructure

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investment required through 2035. The new study indicates that $791B of midstream investment is needed through 2035, versus $546B from the 2016 study. Increased spending estimates underpin longer-term growth opportunities for the sector. With domestic production levels of oil, natural gas and NGLs at all-time highs, it appears we are in an era of long-term growth. The chart below illustrates where the infrastructure investment is expected to take place. The majority of the investment will be in natural gas. On the oil side, much of the near-term investment is being done in the Permian Basin. A key area of investment will be to grow our export capacity across all hydrocarbon markets. Historically, natural gas has been a commodity that mostly traded in regional markets. However, Liquified Natural Gas (LNG) markets are rapidly developing and giving natural gas the ability to be a globally traded commodity akin to crude oil. This global shift in natural gas trading is sending demand to new highs as countries around the world are focused on clean-energy initiatives of which gas a major part. India and China are two markets that are seeing the most investment as they have prioritized reducing pollution.

MLP Valuation

MLP valuations are discounted relative to history, other energy subsectors, and other yield-oriented securities. Of the three most widely cited metrics, MLPs are between 20% and 35% undervalued, and this is occurring during a period where fundamentals are as strong as they have been in years. Why are we here? There is no

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doubt that many factors outside of the fundamentals continue to weigh on sentiment. These include corporate governance issues, high leverage, and fears that there is less distribution growth ahead. The issues are being addressed, and there is a gorwing list of MLPs known as the “reformers” which have acted to better align the interests of the various stakeholders. The simplification transactions that occurred during the quarter are moving more companies in the “reformer” direction. As we continue through this period of consolidation and restructurings, we think it is an ideal time to be allocating to the sector as fundamentals and outlook remain robust. Fund flows into energy infrastructure were positive over the quarter, and we think this trend will continue.

Conclusion

We believe now is an ideal time to be allocating to midstream energy. The sector has rarely been more attractive. With strong underlying fundamentals and growing earnings, the sector is poised for further gains. At a time when we hear about global trade wars in the daily news, domestic energy infrastructure is an ideal, defensive sector to invest in. After several years of pain for the sector, we are once again on the growth path. Investors do not often come across a sector with strong current and future fundamentals that is materially undervalued versus historical metrics. The robust performance in Q2 was encouraging, and we expect the strength to continue.

MLPs: Patience is a Virtue

No matter the time frame, whether daily, weekly, or even monthly, a chart of the Alerian MLP Index paints a picture of a sector that has gone nowhere over the past three years. As investors and believers in this sector, we can tell you first hand this ride has not been easy and certainly not fun. We can talk about fundamentals all day long and how America is on track to become the largest energy producer in the world. Imagine that, the USA being the undisputed king and leader of fossil fuels. Energy stocks, and MLPs in particular, trade at valuations that suggest this story of the Shale Revolution 2.0 is a façade, something that is only a remote possibility.

 

MLP Valuations March 2018

 

MLPs trade at valuations that only make sense if you were to disregard every action by management teams to shore up balance sheets and increasingly rely on internal cash flows. These valuations make sense if you ignore the outlooks of distribution growth that many MLPs are guiding to and assume there will be none. In fact, to make our models fit current valuations for several MLPs we follow, we have to make assumptions for distribution growth to be zero or even negative. And this so blatantly is in violation of what is happening on the ground. For example, fitting our dividend discount model to Buckeye Pipeline’s (BPL) current price requires us to plug in -3% distribution growth per year in perpetuity. With coverage currently at 1x and multiple large cash generating projects expected to come online shortly, it is obvious this negative growth assumption is ludicrous, not to mention Buckeye has never cut its distribution in its history.

Looking at Wells Fargo’s most recent figures at the top of this blog, you can see the extremely large discounts to historical averages that MLPs are currently trading. With fundamentals continuing to improve and unit prices continuing to remain stagnant, these discounts will only increase, making what is a compelling value proposition all the more compelling. Fourth quarter earnings came in very strong overall, and this is yet more evidence that fundamentals continue to improve. 

Before the start of the new year, the feeling was that a lot of fresh capital was going to flow into space. We wrote a blog in December of last year detailing the evidence that suggested that generalist investors, investment advisors, as well as some banks, saw value in the space and wanted a part of it. The feeling was confirmed when MLPs started off the year on a tear, moving up 10.4% in two weeks. Fund flows were strong, and a downtrend that defined all of 2017 was broken. Since then, almost as fast as we went up, we gave up nearly all the early year gains. 

So, the question is, what is going to trigger fresh capital into the space? We know how quickly MLPs can rebound. ETF fund inflows for January were $248MM according to Wells Fargo. During that time the index outperformed, but easily surmounting that number were February (through 2/21/2017) outflows of $322MM. We still see anecdotal evidence that generalist investors are paying attention. At a recent investor conference, Morgan Stanley noted that global infrastructure investors had US midstream pegged as the best relative value in their investable universe. Wells Fargo’s most recent weekly update wonders, “where is the generalist cavalry?” They surmise that generalists are still shying away due to volatility, the possibility of more distribution cuts, and restructurings. Wells Fargo appears just as bullish as we are on the space and are also just as confused about the lack of buyers. In our view, it is only a matter of time before we see the fund flows we have all been waiting for. With the businesses performing well on the ground and an outlook for growth, sentiment can only stay this low for so long. From here, the risk is to the upside, and you get paid handsomely while you wait.

 

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2017 4Q Earnings Recap

Quarterly earnings from the MLP sector are out with generally positive results. In this article, whether the company is structured as an MLP or a C Corp, I will use the term MLP to refer to both. Out of 29 MLPs and energy infrastructure companies we follow that have reported, results were a little better than expected.

The areas of growth-supporting increased distribution coverage are the following: 1. Increasing oil exports. 2. The increasing use of ethane and propane to support the massive build-out of chemical plants located primarily on the Gulf coast to make ethylene and propylene. 3. Increasing use and exports of natural gas in the form of liquified natural gas (LNG) as well as continuing exports of natural gas to Mexico.

None of these positive results seem to be reflected in the price of the MLPs. Investors are more focused on growth stocks and not paying much attention to the strengthening fundamentals of the MLP sector, the high level of tax-deferred income they offer, or the fact that the industry is moving toward a self-funding model, far less dependent on equity (dilutive) financing. The investor base of MLPs has been going from retail dominated to being dominated by value-oriented institutional investors who are looking for long-term sustainable investments that have not been caught up in the runaway stock market.

Therefore, we recommend putting a portion of your portfolio in this undervalued sector and in the top names that will benefit most from the long-term trends. These trends again are clear: 1. Rising production and exports of LNG and natural gas. 2. Increased production and use of ethane. 3. Increasing production and export of U.S. produced oil.

In the meantime, here is what we have seen so far from 29 MLPs that have reported that we include in our universe that we would invest or consider investing in:

  • 51.7% raised their distribution
  • 48.3% kept the distribution steady
  • 22 MLPs met earnings expectations
  • 5 MLPs beat earnings expectations
  • 2 MLPs missed earnings expectations
  • Average EBITDA growth was 13.2%

The markets have been volatile. MLPs have not been immune to this. However, by investing in a growing sector with solid fundamentals, good growth projections, strengthening balance sheets and coverage ratios, you can diversify now and get paid 8% to do it. Let us help you select those MLPs that will profit most from these positive trends and be prepared when investor sentiment shifts!

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Jeffrey Gundlach, Touted as Today's "King of Bonds", has a Change of Heart on MLPs

On April 19th, 2015 Jeffrey Gundlach made a cautionary investment call on high yield bonds, REITS, and MLPs. He warned investors about master limited partnerships (MLPS) saying that they are massively leveraged and risky if interest rates rose.

Gundlach is widely followed on Wall Street because of his timely investment calls over the years.

However, on January 20th, 2018 in a Barron’s roundtable, he is quoted saying this: “What is interesting as a bond-surrogate investment is master limited partnerships, which don’t need oil to go up. You just don’t want it to go back down to $20, so you don’t worry about a bankruptcy situation. MLPs have tremendously underperformed the XLE. We aren’t looking to triple our money here; we are looking for an income vehicle that has a lower risk profile. I’m having a hard time finding more-traditional bond investments that look good, but I like a particular closed-end fund that owns MLPs. " Click the link below to see one of the interviews where Gundlach talks about MLPs.

Jeffrey Gundlach Interview

We like the idea that a well-known market genius is changing his opinion about master limited partnerships. It is difficult today to find yield that is not overpriced. However, we are not so sure that buying a leveraged fund, as Gundlach suggests, which tends to duplicate the index is the best way to invest in MLPs.

By selecting individual MLPs, you avoid the fees embedded in the fund. Also, MLP funds have to reduce the MLP’s net asset value by the amount of the holdings that are above their cost basis and pay a tax on that differential. If you want to beat the index, it is better to select and advisor with years of experience and a strong track record to actively manage a portfolio of individual MLPs. A fund may be fine for investors with limited capital to invest in MLPs. However, if you have $250,000 or more to dedicate to the sector, you may be better off investing in individual MLPs to get the full tax benefits that come with owning the actual MLP.

4Q17 MLP Commentary

 

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  Investor sentiment for MLPs and midstream energy companies is turning positive. While 2017 was a difficult year for MLP prices, the outlook has rarely looked better. Crude oil production is closing in on 10 million barrels/day, natural gas production is booming, and new pipeline projects are being developed. The Alerian MLP index bottomed in early December as the sector was the victim of significant tax loss selling, but since the bottom they have bounced back nearly 15% and are poised for further gains. Crude, natural gas, and NGL volume increases will result in “free” cash flow growth for midstream companies with available pipeline capacity. MLPs remain an attractive investment for many reasons including; improving underlying energy fundamentals, valuation metrics towards historical lows, cash flow that is rising, and volume growth in the coming years. MLPs with assets in the low-cost basins such as the Permian and Marcellus will benefit from rapid volume, and cash flow growth as producers focus on those locations. Another tailwind for MLPs is the expected completion of up to seven world-class petrochemical facilities that will significantly boost demand for ethane and propane. After a difficult three years for energy markets, it is a welcome development to have multiple tailwinds at the back of MLPs once again.

What Happened in 2017

MLPs peaked in late January 2017 and then entered a downtrend until they broke above the trendline in mid-December. The negative performance was driven by too much new MLP equity coming to market, concerns about oil prices, tax-loss selling and uncertainty surrounding the MLP business model. Historically the MLP business model was to fund growth capital expenditures with 50% equity and 50% debt. The market has soured on this model so the MLP companies are adjusting to a new normal. Enterprise Product Partners (EPD) addressed this new normal in the 4th quarter when they announced they were cutting their distribution growth rate from 5% to 2.5% and using the excess capital to develop new growth projects. They have the goal of being self-funded on the equity side of the equation by 2019. We view this as a very positive development for the midstream world as it demonstrates better capital discipline and will increase per/unit earnings in the years to come. This move to the self-funding model and a focus on return on invested capital should attract more institutional capital to the sector. 

Another theme that continued to play out in 2017 was the elimination of incentive distributions rights (IDRs). IDRs are rights held by the general partner that entitle the GP to an increasing percentage of excess cash flow as the MLP raises its distribution. By eliminating IDRs, MLPs have a lower cost of capital which makes growth projects more profitable. We expect to see this trend continue in 2018. As the sector waned, some management teams lowered their cost of capital by cutting distributions. Five years ago, the thought of cutting the distribution was a death wish, but as the sector moves towards self-funding, some MLPs that cut distributions have traded up on the news. We believe we are moving out of the phase of distribution cuts and look forward to growth in 2018.

2018 Outlook

We are very excited for 2018. Underlying energy fundamentals are rapidly improving as the oil markets tighten, the global LNG trade is accelerating faster than analysts predicted and U.S. energy production will be at all time highs. We believe we are currently seeing a sector rotation into energy as investors look for sectors that have underperformed. Technological advancements in drilling have enabled producers to significantly increase efficiency and decrease break-even costs which gives midstream companies further confidence that volumes will be there even in oil prices stall. We expect to see more consolidation in 2018 as larger MLPs use M&A as a tool to pursue growth. As many of the major pipeline projects from previous years are completed and placed into service, we will see a significant boost in cash flows and a decrease in growth capital expenditures. 

Demand for ethane is expected to increase by nearly 700,000 barrels/day in the next three years. This demand is driven by seven new world-class ethane steam crackers coming online in the coming years. This petrochemical boom is driven by low-cost feedstock that U.S shales produce. They are now competitive or superior to Middle East petrochemical facilities.

U.S crude production has increased by over 15% since the lows of 2016. According to Goldman Sachs, crude is expected to grow a further 6% in 2018. Natural gas production is also expected to grow by 6%. Natural gas liquids supply is expected to grow by 40% by 2040. Consensus analysts estimates expect the Alerian MLP Index EBITDA to increase by a remarkable 18.5% in 2018. All this growth flows through pipelines and associated infrastructure to demand centers.

Tax Plan

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The recently passed tax bill is a positive for midstream infrastructure companies. According to Wells Fargo and Latham Watkins LLP, pass-through income could be taxed at an effective max rate of 29.6%. The bill provides for a 20% deduction (or a lower max income tax rate of 29.6% vs 39.6% currently) for income earned from pass through entities for tax years through 12/31/25. For C-corp midstream companies, the corporate income tax has been permanently lowered to 21% from 35%. This is a positive and will likely be recognized as a longer-term benefit as many of the midstream C-corps don’t pay full cash taxes. One potential negative in the bill was the limitations on deduction of business interest. The bill limits the amount allowed as a deduction to 30% of annual EBITDA for tax years through 12/31/2021 and 30% of EBIT thereafter. Wells Fargo estimates that only 5 midstream companies under coverage would incur an interest expense in excess of 30% of EBITDA. Another feature of the bill is accelerated depreciation. Businesses are able to fully and immediately expense 100% of the cost of qualified property acquired and placed into service between 9/27/17 and 1/1/23. The percentages decrease in 20% increments over the following 5yr period. However, the bill excludes natural gas pipelines, which would not be able to fully expense depreciation in year one. As most MLPs are diversified, there will be assets that certainly benefit from this deduction. Another likely benefit of accelerated depreciation is that it will increase the tax shield for MLP income, so less of your distributions will be taxable. 

Conclusion

We are very optimistic that midstream energy infrastructure will have a strong 2018. Most of the question marks surrounding MLPs during the downturn have been answered. MLPs are primed to benefit from improving operational economics, growing volumes and a supportive regulatory environment. Several major projects that are coming on-line in the coming months will enhance cash-flows and drive earnings growth. Management teams shifting towards the self-funding model will create a healthier sector over the long term. The United States has emerged as an energy super-power, and the buildout of infrastructure is vital to the success of shale. With a 7.5% yield, and valuations at significant discounts to historical metrics, we view the asset class as one of the few great values in the market. It’s been a tumultuous road for MLPs since 2014, but the future remains bright as we return to growth in the energy sector. DeWitt Capital Management strives to put its clients in the MLPs participating in the growth areas and provide index-beating returns to its investors.

 

 

 

 

 

 

 

 

Tax Plan Implications on MLPs

A question that is increasingly weighing on our clients’ minds is how the proposed tax legislation will impact MLPs. We called the Master Limited Partnership Association (MLPA) this morning, which is the lobbying group for MLPs based in DC, and spoke with Lori Ziebart, its Executive Director. She updated us with what she expects to be the implications for MLPs when the House Committee on Ways and Means reveals their final plan tonight at 5:30 PM EST.

The two largest sources of uncertainty for MLPs were whether they would maintain their status as a pass-through entity and whether or not they would be eligible for the 20% ordinary income tax deduction that initially looked to exclude MLPs. Last week, the senate added a provision last minute to ensure MLPs would be eligible. This means that unitholders effective tax rate would go from 39.6% to 29.6%, a definite win for MLP investors. The MLPA strongly believes that MLPs will maintain their current status as a pass-through entity and that the provision allowing MLPs the 20% deduction will be in the final bill.

Below is a chart showing the before and after effects of the likely tax plan.

Tax Table

 

Tax Table 2

 

Breaking News: MLPs Closed above Long-Term Trendline

Little did MLP investors know, but back on February 16, 2017, MLPs began facing strong southerly winds and began sailing south. From the close on 2/15/17 to the close 11/29/17, MLPs gave up 26% in what turned out to be a textbook downtrend. It was a painful and at times confusing period.

However, MLPs may have just begun to tack north. On 11/30/17, MLPs rose 4.1%, its largest one-day gain in almost two years. Over the last ten trading days, MLPs have closed green seven times. Over this period, the chart has formed the classic “1-2-3” reversal pattern (see below) on strong volume. In fact, over the last ten trading days, as compared to the previous ten trading days, average total volume for the ten largest MLPs in the Alerian Index is up 16%, helping to lend credibility to this breakout. The index has broken through its 50-day moving average and is knocking on the door of the 100-day moving average.

Finally, MLPs have closed today above its long-term trendline for the first time since it started back in February. While a few more trading days above this trend line would help to confirm this breakout and trend reversal, it’s looking pretty good, and we expect momentum to continue.

MLP Trend

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