MLP Webinar Replay: Self-Funding, Conversions, and FERC
Over the last 3 years, substantial domestic development in energy infrastructure has led to changes in energy market dynamics. With greater uncertainty across supply, demand, and energy pricing, investors face unprecedented changes within the energy industry. In this webinar, we discussed:
- The state of the MLP industry
- Understanding the self-funding model
- Effects of the FERC ruling
- Tax implications of MLP conversions
A transcript of the webinar can be read below.
Jay Jacobs: Thank you, everyone, for joining the webinar today. My name is Jay Jacobs. I’m the Head of Research and Strategy at Global X. I’m joined today here by Rohan Reddy, our Senior Research Associate and our in-house MLP expert. Today, we really want to focus on what we think are really the most top of mind issues, the most important developments in the MLP industry this year. I will kick it off by giving a state of the MLP industry, walk through some quick charts to show where we are today. Then I think the bulk of the conversation today will be around understanding the self-funding model and C-Corp conversions. Rohan will walk through what those are, why various MLPs are undergoing these changes right now, and what it means for investors.
We will touch a little bit on the effects of the FERC ruling as well, dating back to March- how that affects the MLP industry, and what it might mean going forward as well. Then we’ll wrap it up by touching on the implications of these MLP conversions and what investors should be really cognizant of going forward.
I will pause for a moment to show some important disclosures. In the meantime, I’ll also just give a little bit of background about Global X. We are an ETF issuer based out of Manhattan. We currently have over $10 billion in assets under management and over 50 ETFs; two of them are MLP-related ETFs.1 We’ll talk about those at the end of today’s webinar. MLPA, which is a pure-play MLP ETF, and MLPX, which is a RIC-structured, more tax efficient MLP ETF as well.
First off, I want to start by talking about the state of the MLP industry. I’ll kick this off with one of the questions that we saw come in multiple ways before this webinar even started. I’ll read off the question to you and we’ll start to answer it on this first slide. This question was, “Do you feel that the price of MLPs has risen proportionately with the price of oil?” That was also asked another way: “with oil prices remaining firm and the domestic economy growing, why aren’t the MLPs participating to a greater extent?”
There’s a few ways to think about this answer. The first is really basic if you look at the performance of MLPs versus the price of oil. On the right-hand side of this screen, you can see a clear divergence. Over the last year, oil has really been in a pretty nice bull run. If you look at the left-hand side, you can see a smoothed-out version of that by looking at the 90-day rolling prices. Unequivocally, oil prices have been rising over the last year. MLPs, on the other hand, have been flat to down, down about 10% whereas oil’s up about around 40%. Clearly, there’s a big divergence there. What is driving that divergence?
First of all, one of the things I think we need to think about is why MLPs should or should not have a correlation to oil. If we look back to 2016, we saw that MLPs and pretty much everything in the energy space sold off with oil prices as they really started to plummet and bottom in around the 20’s [dollars per barrel]. This was really caused by the contagion effect. It was not necessarily about any data that MLPs were producing themselves, but it was the fear that MLPs in the low oil price environment would not benefit from as much oil output in the United States. Midstream MLPs, of course, are compensated by how much volume they’re transporting or storing. When oil prices fall to $25 a barrel, there’s a real fear that not only are upstream producers going to suffer from these low prices, but they’re going to reduce output, and midstream pipelines are just simply not going to have as much volume going forward. That really brought down MLP prices.
The flip side of that is when oil prices rise. Wouldn’t you expect to see that correlation benefit on the rise up as well? That’s where this question is coming from. Again, we have to remember that MLPs are not really supposed to be correlated to the price of oil. They’re supposed to be correlated to changes in output in oil around the United States. Simply looking at this chart as oil versus MLPs is a little bit misleading I think. Because what this is really telling us is with higher oil prices, you would expect more output; and if you expect more output, you would expect MLPs to rise. Oil prices are up about 40% over the last year. Oil production is up about 15% if you look at the related EIA numbers over the last year. It is a little bit more muted, but it is overall a much – it is still a positive trend compared to MLPs.2
We will discuss why we think that there’s still that divergence, why MLPs have not benefited from the increase in oil production, that 15% increase over the last year. A lot of that we feel has to do with the movement to the self-funding model and how investors are responding to that, as well as some of the recent C-Corp conversions. In short, the reason why MLPs are not really participating on the upside with the oil is that correlation is not really supposed to be there to begin with. Oil prices rising does not directly impact MLP prices. It’s really supposed to be about oil production, which has grown a fair amount, but it is a much more muted number. It is not the same as on the downside where you have that contagion effect of really everything being thrown out with oil when prices get so low.
Here’s just the standard performance accompanying that chart.
The second two charts that we’d also like to discuss is valuations. We’ve seen a few questions come in around MLP valuations and the discussion around why this might be an attractive time for MLPs. Now, there’s a couple of metrics to look at MLPs on. The first is enterprise value-to-EBITDA on the left-hand side. We chart MLPs versus a couple of other alternative income-producing asset classes like utilities and REITs. What you can see is that over the last year or so, really from 2017 to 2018, MLP valuations have been in a mild decline.
That’s because EBITDA for these MLPs has really been pretty steady. As we saw in the chart below, we’ve seen that prices generally have fallen over the last year or so. That’s helped pushed valuations to be a little bit lower. In the meantime, you’ve really seen pretty flat valuations from REITs. Utilities have been trending down a little bit as well. Overall, valuations for MLPs have been coming down a little bit and certainly down from their near peak in 2014.
The other way to look at it is spread to US treasuries. I think this is an increasingly important one as we see the 10-year treasury rise. From 2017 to 2018, you’ve seen almost a doubling of the 10-year treasury. Over that time, the spread of MLP yields to those 10-year treasuries has actually increased though. That again speaks to the distributions of MLPs and the valuation of MLPs, where those are just really continuing to increase even at a faster rate than the 10-year treasuries. That spread is still very significant despite a rise in the 10-year treasuries.
What we’re really going to focus the meat of today’s discussion on and what Rohan’s really going to dive into are the two most important themes in the MLP space today. The first one is the movement to the self-funding model, which really started to ramp up back in 2016. We’re still seeing the impact of that today. The second is going to be what we’re calling re-evaluating the MLP structure. Where in 2018, with everything that’s happening from rising US oil output and capital expenditures opportunities, to TCJA, and the FERC ruling, you’re increasingly seeing these entities really rethink are MLPs the right structure for us? If so, why? If not, why?
These themes whether it’s coming from more of the financial market side like low unit prices, high amounts of debt, and rising interest rates, which really was the first wave of what drove people to the self-funding model to anything in the more macro regulatory space like rising US output and TCJA. These are all combining to really force these important questions on the MLP space. We think it’s really important to have a solid understanding of the self-funding model and why it’s happening and how that relates to the re-evaluation of the MLP space.
With that, let me turn it over to Rohan to really walk through the self-funding model: what it is, and why MLPs are increasingly turning to it for their corporate guiding principles.
Rohan Reddy: Thanks, Jay. First what we’ll do here is we’ll discuss the self-funding model, and then on the next slide, we’ll talk more about the C-Corp conversion model. Historically, MLPs have generally prioritized distributions, for the most part, given that they’re core investor base was looking a lot for income. They really prioritized that yield metric. That was what made MLPs popular back in the hay day. MLPs would pay out nearly all of their income and then look towards the equity and debt markets to raise additional capital.
This really didn’t cause much of a problem given how strong the MLP markets were. Debt financing costs were low. Equity valuations were doing very well until – even though these were capital-intensive vehicles, it didn’t cause MLPs too much of a problem because the model at the time was working very well in their favor. What you saw actually was a lot of entities with midstream assets utilize the MLP vehicle as their preferred type of investment for what the community and the markets could access. Nearly everyone with midstream assets whether it was upstream companies, just all the way to pure midstream entities, were utilizing the MLP vehicle broadly.
Unfortunately, as the MLP downturn hit and oil prices began to drop in late 2014, MLP distributions, which is what that income orientated investor base really valued, were perceived to be at risk here. The fear was that energy production would drop as oil prices fell and capital market conditions would subsequently begin tightening. This really put MLPs in a bit of an identity crisis here. They were unsure whether to maintain their distributions, or cut it, and then shore up the balance sheet. This introduced a lot of both questions and uncertainty at that time. I think that’s why you started to see MLPs fall quite a bit.
What this did end up necessitating though is a shift towards what we know now today as the self-funding model. Essentially, the self-funding model involves reducing an MLP’s reliance on outside sources of financing, namely the capital markets through equity and debt, and using more organic sources of financing such as internal cash flow. However, in order to do this, the MLP needs to find a source of cash savings since they’re paying out a lot of their income if not all of it to their investor base. Obviously, the primary source of cash outflows for an MLP are distributions to limited partners, and those IDR payments, or Incentive Distribution Right payments to their general partner.
Since that was the primary target for MLPs to attack in order to save money and shore up their balance sheets, this generally led to a broad industry movement of a) cutting distributions, b) restructuring IDRs, or both. Both of which would save the MLP a lot of cash flow that they could use for either organic purposes, or for capital expenditure purposes, paying down debt, etc. It definitely enables more flexibility than paying out all the distributions to the general or limited partners. Since they had that additional cash on hand, what this does allow the MLP to do is that they didn’t have that cash shortfall that they had before. One of the trends that many investors have begun to realize over the last couple years is that capital market issuance from MLPs has fallen considerably, particularly on the equity side as valuations have fallen a lot. The positive of this though is that this model becomes much healthier throughout multiple business cycles.
The previous model of paying out distributions to the limited partner and prioritizing those dividends, that is really only preferred during a period when there’s a bull market. If you’re thinking about sustaining yourself over multiple periods, which is the look around that MLPs have had to do over the last couple of years, certainly the self-funding model is a much healthier way to go about it. I think you’ve seen certain MLPs definitely be rewarded for it. It’s something that we certainly think for those MLPs looking to continue utilizing the MLP model going forward, they’re definitely bound to at least consider if they’re not already using it.
Jay Jacobs: Rohan, I’d like to weave in a couple questions here from the audience because I think they pertain to this discussion around the self-funding model. The first one is, “What is the sustainability of income distributions and likelihood of increases over time?” I think this has an interesting tie in with the self-funding model.
Rohan Reddy: That’s a great question, Jay. On the first part about the sustainability of the distributions, one of the things that certainly got drowned out over this downturn has been that the cash flows for MLPs have been there. I think it’s something where if you looked at a stock price chart, you’d think, okay, maybe this business model isn’t necessarily working. Energy infrastructure isn’t doing well. Maybe energy production has fallen. That was not the case. Volumes across oil and natural gas have definitely been flowing through US pipelines.
You’re actually seeing in certain areas, there’s pipeline constraints because so much is flowing through those pipelines and those fees-based businesses. These models are actually doing pretty well. In terms of sustainability of distributions, you’ve seen at least now post-distribution cuts. The sustainability right now looks pretty good. Coverage ratios are generally high. I think a lot of those pain points that you saw midstream MLPs take early during the downturn, they’ve shored up some of those problems. They’re definitely more in a sustainable model going forward to maintain those distributions.
On the growth side, I think this is something that’s structurally changed. As you’ve seen a shift towards the self-funding model, one of the groups that it does alienate quite a bit, and I think that’s why you’ve seen quite a bit of uncertainty and volatility in the MLP space, is that core income orientated investor base that really prioritize those distributions. They’ve been alienated by this move. They’ve valued distributions. They’ve wanted to see those distributions grow. The priorities have changed. Management teams have said they’re not looking to grow distributions as much. During the hay day, you saw distribution growth numbers in double digits during 2013, ’14. Now, those numbers are much more tapered. They’re in the low single digits somewhere between 3 to 5% say, maybe even lower as time goes on.
I think the sustainability of those distributions is there. It’s something you could start to see more of going forward. But the area that’s taking a hit particularly as a lot of MLPs have adopted self-funding has been that distribution growth figure. These MLPs are retaining more of that cash flow and using it for other purposes like CapEx, paying down debt, reducing reliance on the capital markets, etc.
Jay Jacobs: Alright, that’s a good overview of the self-funding model. That’s really started since 2016 and been a multi-year trend. Let’s go to something a little bit more recent. Although to be fair, this really started back in 2015 with Kinder Morgan. We’ve really seen an acceleration of what’s being called C-Corp conversions. Rohan, can you walk us through what are C-Corp conversions and how it’s affecting the MLP space right now.
Rohan Reddy: Yeah, certainly. C-Corp conversions have been something that have definitely heated up in conversation much more over the past year. We’ll talk about the reasons why for that. Just to set up this discussion, as Jay was mentioning, Kinder Morgan was really the pioneer of this idea of converting to the C-Corp model. If you think about what they did a few years ago, they had multiple MLPs underneath their family structure. They decided okay, let’s try and convert this model, roll-up the entire family structure, simplify things, and change our tax status from partnership to C-corp.
If you think about what that means, that means you don’t have to pay out all of your income to unitholders every year. You can maintain a more flexible business model in a sense. For Kinder in particular, they had a bit of a leverage issue that they cited as one of the reasons why they wanted to adopt this model. What you did see is that even though Kinder Morgan was the first to do this a few years ago, not many companies or MLPs were quick to try and adopt this. I think that’s for a couple of reasons. Some of which have really only sprung up in the last year or so.
The main reason why the C-Corp conversion model has been becoming a bit more attractive recently is that the state of the MLP market has been generally depressed over the last few years. Equity conditions are still expensive to raise capital. You’ve see MLPs be very hesitant to tap the equity markets. Debt conditions, they’ve improved somewhat, particularly as the self-funding model has taken hold. It’s shored up the balance sheet. They’ve worked to reduce leverage, etc. That’s improved credit ratings and also allowed debt financing costs to reduce.
The other two things that have definitely popped up over the last six to twelve months has been number one, tax reform. It’s made being an MLP frankly a little less appealing than it was five years ago. For the most part, MLPs retain that marginal tax benefit relative to C-Corps. It’s still pretty high, but just from not only a sentiment point of view but just from an investability point of view with some of the restrictions on investing in partnerships, it’s another factor towards the direction of what’s made C-Corps more attractive. Tax reform was certainly something that has at least made MLPs consider this model more closely than they would have before.
Then the third, which is definitely more centralized to certain MLPs than others was the FERC ruling. The ruling definitely for a handful of MLPs made it less appealing to retain that partnership structure and made it more appealing to convert to the C-Corp structure. I think from a high level, we’re discussing all these factors here, but things have shifted both cyclically and structurally in the MLP space. At least most management teams have now said they’re at least considering the move; whether they want to make it or not is a different story. It’s definitely made it over the past 10 years, there hasn’t been much of a move to talk about not retaining the MLP structure or that partnership structure. Definitely, in 2018, it’s something that most management teams have begun to at least talk about and maybe gauge investor interest.
In terms of why you would want to do this conversion, the primary goal ultimately as it is with any public market vehicle, you want to maximize the value of your assets or achieve valuation expansion. The C-Corp structure in that sense has a few advantages over partnerships. First, C-Corps can be a bit more flexible at things like dividend policy and balance sheet management. Instead of having a more centralized investor base that’s income-oriented or very focused on distributions, you can be a bit more flexible with dividends for an audience or an investor base that could be a bit more longer term in nature than what the MLP investor base could have been.
The other thing is balance sheet management. As we discussed earlier, the capital markets used to be heavily utilized amongst MLPs. That is changing. With the C-Corp structure, you can be more flexible during different business periods to appeal to what makes sense in that moment. I think that flexibility aspect is being rewarded in a sense. That’s why certain MLPs have at least explored and some have actually converted already. It makes the energy infrastructure business a bit more appealing throughout multiple business cycles as opposed to holding just during bull markets. I think when there’s cyclical shifts occurring, it makes this a more healthier vehicle to adopt.
Secondly, and this has certainly been discussed over the long-term, the partnership structure can be very complex. It does issue a K-1, which can be very complicated for retail investors to comprehend and fill out, especially as tax season is underway. It’s a pretty complex form. It kind of alienates certain investors. They may not want to deal with that. I think what we have heard, and I think what management teams have heard, is that it certainly does keep investors on the sidelines. C-Corps in that sense are much simpler. They offer a 1099 form. That’s certainly been something that at least from a tax perspective to the end investor, it is frankly more appealing to just be in that C-Corp structure.
The other thing along these lines of the partnership structure is that partnerships often have ownership or investment restrictions. Many index funds, for example, indexes like the S&P 500, they cannot invest in partnerships. There’s restrictions in that sense. Even some of the very large MLPs that would definitely qualify from a market cap perspective, they’re just not getting those passive flows that they could have otherwise. Also, institutions sometimes have restrictions. If you think about from a high level what this means, it just means there’s a wider investor base that you can access from the C-Corp structure than you would otherwise from the partnership structure.
Jay Jacobs: I think what’s interesting – and I’m going to bucket together some questions we’re getting from the audience, but the large common question here is, do you see a trend within the MLP space where the limited partnership arrangements go away permanently? Simply asked, do you see consolidation in the MLP space where you’re seeing less and less MLPs and more of these under these convert over to C-Corps? I’m just going to go back to the slide that we showed earlier. There’s a lot of reasons why MLPs are really considering these C-Corp conversions right now. It started with the movements of the self-funding model. The flexibility of being a C-Corp that you can really rapidly cut a distribution if you need to use that extra cash to pay down debt or for CapEx opportunities and really manage that distribution more dynamically. That was really the original principle driver for why people are thinking about the C-Corp conversion and what ultimately was what pushed Kinder Morgan to do it back in 2015.
Now you’re seeing just a series of things happen that have really continued to tip the scale in favor of that C-Corp model. When you see something like Tax Cuts & Jobs Act that reduced the tax rate from 35% to 21%, it’s just no longer much more punitive to be a C-Corp versus an MLP because they’re only paying a 21% tax rate. On top of that, with a lot of these C-Corp conversions, what generally is happening is you’re seeing a general partner buy the limited partner and reform as a company.
What that does is it’s a step-up in basis for the assets they have acquired. Meaning they now have a new book value for those assets and they can depreciate those going forward. Even in the instance where you’re seeing these C-Corp conversions, many of these C-Corps don’t plan on paying taxes for the next three to five years; it really depends on the C-Corp. They get a huge amount of tax deferral even as a C-Corp because of that step-up in basis of the assets. They’re paying a lower rate and they’re not really going to pay it for a few years in many instances.
Then with the FERC ruling as you were mentioning, that just simply allows C-Corps to charge more than MLPs if they have regulated cost-of-service pipelines. On the revenue side, many of those names that were really affected by the FERC ruling are seriously considering the C-Corp conversion or already have announced it. When you see the pattern of just many stars aligning for these C-Corp conversions, that’s why we believe it’s just going to accelerate going into the future. It’s not necessarily the case with every MLP, but certainly most MLPs I think are seriously considering the implications of this conversion and whether they would see a valuation expansion for some of the reasons that Rohan mentioned with access to a larger investor base and a more straightforward structure. Along those lines, I think what’s pretty interesting is just how has the industry changed over the last four years, really since the beginning of the oil market downturn. Rohan, perhaps you could walk us through what we’re showing on this slide.
Rohan Reddy: Yeah, it goes back to what you were saying about that limited partner, general partner structure changing. To be frank, that story is starting to disappear, especially recently. Where back in 2014, the C-Corp structure was just not very common for most midstream companies. What was much more common is you’d have a general partner along with a limited partner. That general partner would have those IDRs. It allowed the investor to play both sides of the structure. Now, what’s definitely changing is that for all the reasons that we’ve mentioned why C-Corps are being evaluated, LPs and GPs aren’t becoming – they aren’t as dominating a part of the market as they were before. I think people generally used to think of MLPs as synonymous terms with being invested in the midstream space.
Today, if you’re not invested in C-Corps, you’re essentially missing a large part of that market. The midstream market is becoming much more dynamic. It’s including partnerships, general partners, and C-Corps. And C-Corps – I think it’s something as Jay was mentioning, we’d continue to see accelerate going forward probably at a gradual pace. It’s not something where we’d see everything happen at once. It’s something that over the next one, two, three years is going to gradually happen over time.
More and More MLPs are going to evaluate the C-Corp model, some are going to execute it. I think what you’re going to see is a landscape that looks much more like that picture on the right where that orange circle is going to start to become bigger and bigger and those blue circles are going to become smaller and smaller. It’s not that partnerships are definitely going away per say. They’re going to be here to stay, but it’s not going to become the dominating vehicle for MLPs and midstream companies in the future. I think midstream assets are going to become much more diversified in terms of the type of vehicle that they elect to utilize.
Jay Jacobs: On this slide, we’re showing the history of some of these announcements. On the left-hand side, LP distribution cuts and IDR buy-ins, these are really more self-funding model moves. Whereas the C-Corp roll-up and partnership roll-up are more in the C-Corp conversion camp that Rohan’s been discussing. Rohan, if you could walk through this slide and I’ll work in another question from the audience here. What makes an MLP consider whether they should go the distribution cut route on the left-hand side or to go with the more dramatic C-Corp conversion?
Rohan Reddy: Yeah, I think today this discussion is becoming much more of a break those two columns on the left side away from those two columns on the right side. I think if you’re looking to maintain the MLP structure, distribution cuts and IDR restructurings are almost something that you have to consider if not do to maintain the MLP structure today and be more self-funding in that nature. So let’s evaluate those first two on the left. If you’re looking to maintain the MLP structure, I think one of the things that you definitely look at, there’s a multitude of factors, but who is your investor base? Who are you looking to appeal to? If you have a very income-oriented base, and you don’t see longer-term type of institutional investors accessing your midstream assets as an MLP in particular, you may elect to keep the partnership structure.
The other thing is tax implications. We’ll discuss this a little later on in this presentation, but there certainly are tax implications that are both positive and negative for an MLP if they elect to roll-up into the C-Corp structure. Managing your tax and balance sheet position is certainly one of those items that needs to be looked at. If it’s too inhibitive to convert, you may either just elect to not do a conversion or push it out to a later point in the future. The other thing is what we talked about with FERC exposure. If you were a heavily FERC affected MLP, it almost necessitates your need to roll-up into the partnership structure because you get to charge higher tariff rates to those shippers on your pipelines.
Then the final thing, which has been a bit more pervasive within the space over the last few years is just access to the capital markets. If you feel that you’re still going to be somewhat capital intensive, access maybe debt, preferred equity that we’ve been seeing a lot more recently, or maybe even common equity. If you still feel like those are going to be common in your capital structure, then you’re going to have to evaluate what’s the state of the MLP markets? What do we envision the C-Corp market looking like for capital markets? There’s a number of factors that go into it, but I think if you’re looking to maintain the partnership structure, distribution cuts and/or IDR restructurings are definitely two things that have to at least be strongly considered just because they shore up the balance sheet, allow you to be more self-funding in nature, but also allow you to sustain that business over multiple cycles within the partnership structure.
Jay Jacobs: We’re not showing it here, but I think the vast of majority of MLPs are doing what I’d consider a soft distribution cut where they’re not actually lowering their distribution from what it was before, but they are lowering their guidance for future increases where they may have maintained a more aggressive distribution increase schedule and now they’re scaling that back. Just for example, maybe they were increasing distributions at around 7% annualized; now, that’s coming back to 2 to 3%. It’s not just seeing distribution cuts across the board, but just the scaling back of the trajectory of those distributions.
Rohan Reddy: Yeah, distribution growth numbers that were previously say 7 to 10% might be more like 2 to 4% now for certain MLPs. They can retain that cash flow and use it for their self-funding model.
Jay Jacobs: You touched on this a little bit before, but could you walk through the FERC ruling specifically because I know we’ve gotten a lot of questions on that over the last few months, and how that’s impacting MLPs as a whole, and how that’s impacting just the MLP structure as well.
Rohan Reddy: Yeah, before we get into this, I think it’s important to note this was a very unexpected event. Nobody within the industry really saw this coming, and certainly, investors were blindsided by it. The day of the ruling, I think you saw the market react very volatilely. MLPs were down nearly 10% and then recovered to be only down about 5% on the day.3 This was something that was not priced in at all. Basically, what this ruling said is that if you are an MLP structured entity, and you are utilizing what’s known as cost-of-service pipeline contracts, which is a certain type of contract that some MLPs on some of their pipelines utilized, you cannot recover an income tax allowance within the calculation of how you formulate what tariff rates you charge to the shippers on your pipeline.
That was a mouthful, but basically what that means is to calculate what you charge shippers on your pipelines, there was a discounted cash flow analysis done. You would essentially come up with what’s a “reasonable and just” rate to charge. If you don’t have an income tax expense as part of that calculation, that essentially drives up the return that you earn on that pipeline. In order to bring that back down to that “fair and just” rate, you have to reduce your revenue rates which incrementally means a reduction in revenue for that MLP.
I will specify this though by saying most MLPs were not affected by this ruling. Only certain MLPs, maybe a handful were heavily impacted by this in the large-cap universe. If you look on that screen here, there’s a few MLPs that certainly had significant cost-of-service contract exposure. Most MLPs do not have significant cost-of-service contract exposure. The ones that did, you seen them very quickly engage in that C-Corp conversion right away. For some of the reasons that Jay was mentioning before, it makes sense. Basically, if you can charge more for that contract under just a different tax structure, it’s hard to rationalize maintaining the MLP structure then if you can’t really make the same level of revenue as you could in the C-Corp structure. That was almost some of these heavily affected FERC MLPs. They converted relatively quickly. That was not surprising.
The other method is potentially either a distribution cut, maybe even a reduction in distribution growth just to shore up the balance sheet for that unexpected loss in revenue. I will just again caveat all of this by saying most MLPs were not affected by this ruling. Most MLPs do not have significant if any cost-of-service contract exposure. Most contracts today are negotiated rate, market base rate index based, which again, were not under the prevue of this ruling.
Jay Jacobs: We’ll briefly show just top holdings here for regulatory reasons. Then we’re going to pass it off to the last poll question for the day for Natalie to read.
Natalie: Great, thank you so much. Alright, the last and final poll question reads, “Which industry trend do you believe is most significant for MLPs? The movement to the self-funding model, increasing C-Corp conversions, rising oil output in the US, rising interest rates, or none of the above.” Again, the question reads, “Which industry trend do you believe is most significant for MLPs? The movement to the self-funding model, increasing C-Corp conversions, rising oil output in the US, rising interest rates, or none of the above.” Again, just as a reminder, you can click your answer right on the screen and hit submit.
Jay Jacobs:Alright, we’ve got two more slides to go through before we open it up to Q&A. We are seeing a lot of questions come in. Thank you and we’ll certainly try to get to many of those with our remaining time here. The first thing we want to do is just summarize the C-Corp conversions and what are the implications for investors both on the positive and negative side. On the positive side, there’s really five key takeaways for us. The first one is when an MLP is bought by the general partners to undergo that C-Corp conversion, which is really one of the more common methods we’re seeing, that can result in some premium for the MLP as it’s essentially an M&A activity. We do see positives associated with the tax accounting. It moves from a K-1 tax form to a 1099, which investors generally prefer.
We talked about the step-up in tax basis, how these C-Corps now have new assets on their books that they can depreciate going forward and delay the payment of their tax bill. The fourth reason that Rohan’s talked about extensively is the FERC ruling; that these C-Corps can actually according to this FERC ruling charge more for those regulated pipelines. Lastly, that C-Corps have just a lot more flexibility than the MLP model around distributions, and how aggressive they want to be in cutting those distributions to self-fund CapEx, or to reduce debt if they’ve gotten over-levered.
On the negative side, and I hope this will answer a couple of the questions that have come in already, MLP conversions are taxable events to unitholders. This can create an unexpected tax bill for some of those unitholders. If you’ve been holding units of an MLP for a long time, you’ve likely been receiving distributions from that MLP that are treated as return of capital. Meaning, your basis would be chipping away lower and lower over time. If there’s a conversion where it’s being bought out, you would essentially have a tax bill for the difference between your basis and what it’s being taken out at.
This can create a taxable event especially if it’s a stock-for-unit transaction. There might not actually be any cash that changes hand; you’re just getting stock in a new entity. Some investors might be forced to sell some of that stock to raise the cash to pay for that transaction. Again, this is all the application if you’re owning MLPs directly. A negative is unitholders might be receiving a lower yielding C-Corp at the end of this. MLPs were originally designed to really be cash flow engines that were bringing in cash and distributing it out to shareholders. C-Corps might not necessarily take that tact especially if they’re aggressively going into the self-funding model or if they have a tax bill that did not exist for MLPs prior.
Also, the last potential negative implication is the nature of the distributions from a C-Corp would be much like – it’s a C-Corp, so it will be like most stocks in the S&P 500 that are paying dividends. It would be eligible for qualified dividends, but it would no longer be treated as return of capital that many investors have to come to expect from the MLP space. This is a significant shift with both positive and negative implications for investors at the end of the day.
Our last slide to bring it home in how this relates to Global X, we do have two MLP ETFs on our Fund Suite. The first is MLPA. This is a 100% midstream MLP ETF purely accessing the MLP space only investing in MLPs. It does not issue K-1s; it is 1099s. We think this is really the most appropriate vehicle for investors that are looking to really just maximize income from the MLP space. The second fund we have is MLPX. This is a RIC, a Regulated Investment Company structure. Meaning that it is not like most MLP funds that are out there. It is much more like a traditional ETF.
To do so, it limits its exposure to MLPs to less than 25% of the fund. The remaining 75% is in general partners and energy infrastructure corporations, which we believe is really more representative of the energy infrastructure space. As Rohan’s been talking about these C-Corp conversions, more MLPs becoming energy infrastructure corporations, the industry is looking more and more like the distribution of MLPX with a broad exposure to both MLPs and these general partners and energy infrastructure corporations. This is still 100% midstream exposure. We think it’s really for investors who are either one, looking for total return in the energy infrastructure space. This fund does not have deferred tax assets or deferred tax liabilities like MLPA or other pure MLP funds in the ETF or mutual fund space. It’s really looking at more complete exposure to the energy infrastructure space; as we saw over half of the market cap now for energy infrastructure is not in the MLP structure; it is in the general partner or energy infrastructure company structure going forward.
With that, we can look at some of the poll results and get into the Q&A. Okay, I kind of expected this. A lot of people answering that MLP performance has really weighed on them and they’re looking for commentary around why this is happening. I hope we’ve answered some of those questions today. I really do think this tracks back to the movements of the self-funding model. Something that was relatively unexpected by the majority of the MLP investor base back in 2013. It was really just looking for yield and growth on that yield. The self-funding model really stood in direct contrast to that. There’s been a continued shake up from that as more and more assets are moving out of those yield-seeking investors and more towards traditional more institutional investors.
Alright, the second, this also aligns with the disappointment before. A lot of people are still looking for yield from the MLP space. As we showed on one of the earlier slides, the MLP yields to treasuries, we’re still seeing that that’s a very high spread. Part of that is being driven by just the low valuations in the MLP space. We’re not here saying that MLPs are no longer an income play, but I do think the area that’s going to take the most brunt is just on the yield growth as you take into consideration some of those distribution cuts as well as some MLPs just really not looking to grow their yield as aggressively as before. Interesting results on yield potential as well as the low valuations there.
Lastly, good to see we spent the bulk of the presentation talking about the C-Corp conversions because that does seem to be on most people’s minds. Hopefully, we’ve helped to answer a lot of these questions.
Alright, the first question which is really the biggest question out there, “Why is this time different? Everyone has said that there’s potential for a breakout and valuations have been attractive for two years now. What really excites you today about this space?” This is really the heaviest question for the MLP space because I certainly agree people have been talking about valuations for a long time. The yields have looked attractive for a long time. Why do we think things might be turning around right now? Really what it comes down to is the MLP space has been in a state of transition for basically the last three to four years dating back to 2014 and starting with the oil price selloffs, how that affected MLPs, the push for the self-funding model, and now it’s being the C-Corp conversions.
This has been an industry in transition. It has resulted in a different type of industry than we’ve become accustomed to. It’s moved huge amounts of money from one type of investor base to a second type of investor base. It has essentially created a lot of noise. I think when we look at that, those charts that we showed earlier, that oil prices have been rallying, that oil output has been increasing, and yet MLPs have been flat to down. There really is a big disconnect there. That’s what’s been causing a lot of people to scratch their heads, not just investors, but the management companies of these MLPs as well.
It really just comes to the fact that this has been an industry in a state of transition. What we’re seeing is the development of what I believe is going to be a more sustainable industry going forward. I think these C-Corp conversions are healthy for some of these MLPs, especially if they’re not planning on being big distributors of yield and growing those distributions. We’re seeing improvements in the governance of some of these MLPs as they convert to C-Corps. We’re seeing that institutional investor base take on more and more of a percentage of MLP ownership, of energy infrastructure ownership, which I think is a positive as well. They’re able to self-fund CapEx, which as Rohan mentioned is just much more sustainable in the future if you’re not so dependent on the capital markets for every dollar you’re trying to raise.
This has been a tough period for MLPs. It’s not necessarily going to end tomorrow. In fact, we think we these C-Corp conversions are certainly going to continue in the near term. We do think to the medium to long-term is building a more sustainable, better long-term focused industry. Why is this time different? The entire industry is different. It’s frankly just been a painful process to go through. Hopefully, we’re out of the middle of it. We do see a lot of positive trends emerging from this state on transition.
The second question is capital spending trends. What are we seeing on the CapEx side of the MLP and energy infrastructure space? Rohan, I’ll kick that one over to you.
Rohan Reddy: Yes, one of the trends that we saw a few years ago was that capital spending and CapEx was definitely increasing quite a bit particularly as energy infrastructure constraints and pipeline constraints were becoming more and more apparent. The good news I think is that a lot of that heavy lifting in terms of CapEx spend, particularly on the Growth CapEx side, was done a few years ago.4 If you think about how long, especially federally regulated pipelines, it can take years and years for some of these pipelines to actually come online. What we’re seeing is that some of the constraints that are becoming more and more apparent in areas like the Permian, Marcellus for natural gas, those pipes are almost full right now.
A lot of that spending that was done a few years ago, some of these pipelines are projected to come online with additional capacity over the next one to two years to alleviate some of those constraints. I think the short answer to this question is we would expect to see CapEx spend but at a lower rate than what it was before over the last couple of years, particularly because there just wasn’t enough energy infrastructure capacity. I think what you could see more and more in the future is extension lines being created rather than new buildouts of brand new projects.
The other thing that we’ve been seeing a lot more and what could actually be more of a trend is that some of these MLPs that continue to maintain the model, what they could do to alleviate the cost burden is engage in these Joint Ventures or JVs with other companies where they don’t have to post as much of the upfront capital, but that also does reduce the growth expectations since they’re not taken in the full extent of the revenue. Definitely, CapEx spend is something that we’ll continue to see, but probably at a lower rate than we have over the last few years where a lot of that heavy spend was done.
Jay Jacobs: Alright, we have a few more questions here. I’m going to fire off the answers pretty quickly here as we get into the end of the hour. The first question I’ve seen pop up a few different ways: does MLPX issue a K-1? No, it does not. MLPA and MLPX both issue 1099s as an ETF, so no K-1s there. The second question on MLP research. The MLP Monthly Report, we do post that on a monthly basis at globalxfunds.com/research. You can check back regularly for those posts or you can sign up for company updates on our website. It’s really the best way to be added to that distribution list for receiving that report.
Third, do you see a scenario where MLP to C-Corp conversions impacts the supply of MLP names? Essentially, are we seeing a contraction in the number of names in the MLP space versus the C-Corp space? The answer is simply yes. If you really think about that world in two buckets or two and a half buckets if you combine corporations and general partners. Every time an MLP converts, it is contracting the overall market, especially if what’s happening is the GP is buying the MLP. You’re taking two names and turning it into one and the one remaining name is a C-Corp. What we have seen is the MLP space is consolidating.
We don’t think it’s going to go to no names. There are certain MLPs that I think are certainly going to maintain the structure going forward. As Rohan has mentioned, not every MLP is a candidate for undergoing a C-Corp conversion. With these conversions, you do see a shrinking of the MLP space and a growing aspect of the C-Corp space. Just to go back to a chart that we’ve shown before. We do expect the light green, greenish-blue, to continue to contract as we see more MLPs convert to the C-Corp structure and the orange to continue to expand over time.
With that, it is 2 o’clock Eastern. Thank you, everyone, for joining our MLP webinar today. Really appreciate your time. Please do not hesitate to reach out to us to ask any further questions or to get in contact with someone from Global X. Thank you all.
