Energy master limited partnership deals are expected to triple by the end of the year, analysts said this morning at an MLP summit in Houston.
Master limited partnerships are a corporate entity form that was established through a federal tax code change in the 1980s designed to attract investment into infrastructure, including the energy sector. Master limited partnerships have special tax laws similar to limited partnerships, with the tax liability following to investors in ownership shares called units.
While historically, master limited partnerships have been used for midstream pipeline companies, because of investor expectations for steady distributions, MLPs have begun to increasingly buy up upstream assets.
“We are going to see a very busy fourth quarter,” said Kevin Smith, an analyst with Raymond James, who said there are at least 90 new potential deals to sell properties in the MLP sector. “There is a tremendous amount of deal wealth in the MLP sector.”
Smith explained that while the cash flow generated by upstream assets, the value proposition generated by non-midstream assets still made them a worthwhile endeavor. The Securities and Exchange Commission has also become more liberal with its definition of exploration and development, Smith explain, which has made including non-traditional assets, such as a refinery, now possible.
In order for an asset to be permitted in an MLP, under tax law it must be engaged in one of the following categories: exploration and development, mining, processing, refining, transportation, marketing or storage. MLPs have also begun to buy assets with less predictable cash rate distributions, such as fertilizer manufacturing facilities and retail gasoline distribution.
Companies formed as energy MLPs typically structure their strategy around acquiring and developing their cash flow by growing their portfolio of assets. While companies are seeking out both natural gas and oil assets, LINN Energy CEO Mark Ellis said that his company predicts that purchasing natural gas assets will have a particularly attractive payoff in the near future.
LINN Energy has aggressively snatched up upstream natural gas assets this year, with $2.8 billion in purchases in the first seven months of 2012, including a $2.2 billion purchase from BP of the Jonah Field properties in the Green River Basin of Wyoming and the Kansas Hugoton Field.
LINN Energy immediately hedges against price fluctuation in these acquisitions at competitive prices to ensure that they will produce the desired cash flows with no associated commodity price risk.
“When we look at hedging this assets five years out, we are hedging them at significantly higher prices,” Ellis said. “If we purchase at 7 a.m. on Monday morning, we will be 100 percent hedged for five years by 11 a.m.”
Institutional investors have been slower to branch into the MLP investment sector, with the majority of investment currently dominated by mostly high net individual investors, according to Lori Siegel, a wealth advisor with UBS Financial Services.
Tax experts say that investor reluctance in having to deal with the IRS Schedule K-1 forms, a separate schedule designed exclusively has provided some resistance to investing in MLPs. A K-1 form is used to report income and losses for partnerships and S corporations to individual investors. Under current tax rules, an MLP investor must fill out include all the tax information from the the separate K-1 forms received for each MLP investment, making the related paperwork cumbersome.
Other tax rules on MLP losses may also make MLP investments slightly less attractive than other investment options.
“The passive activity rules make it worse for MLPS than for any other investment group,” said Tim Fenn, a CPA with Latham & Watkins, specializing in tax rules for MLPs. “Even if you have a net loss for the year for one MLP but have income in another, you can’t net those together. You have to indicate them as two separate silos.”
Fenn explained that the tax rules require each MLP investment to be tracked separately, but do permit losses to be counted against gains in the following year or when the MLP asset is later sold.