The Rise of Master Limited Partnerships in the U.S. Energy Sector
U.S. Energy Master Limited Partnerships: Worth the Hype or a Disaster in the Making?
To increase capital to finance upstream and midstream energy sectors the United States Congress enacted the Master Limited Partnership (MLP) legislation in the 1980s. MLPs offer substantial tax advantages to the partners to encourage investments. However, the MLP structure's requirement to pay out 90% of its taxable income to unit holders, may be undercutting necessary spending on basic maintenance of energy infrastructure that they operate. Underspending on energy infrastructure could lead to malfunctioning pipelines, oil spills, and associated environmental damages, energy shortages, and high energy prices to consumers.
|The Trans-Alaska pipeline is on slider supports where it crosses the Denali fault - source Wikipedia|
Over the last decade, the MLP structure has become increasingly attractive to the midstream and the now-booming upstream shale oil and gas producing sector because of its 'tax efficiency' and ability to raise capital. As a result, mergers and acquisitions among energy MLPs are on the rise. Avoiding the double taxation on corporate income and dividends, MLPs aim to have more access to cheaper capital. Confidence in energy MLPs has grown in recent years due to their resilience throughout the 2008 economic crisis and their ability to provide steady payouts of distributions to investors. There are about 100 energy MLPs in the U.S. [note 1], the majority of which are in the midstream sector that collects, processes, transports and stores oil, natural gas, and petroleum products. The National Association of Publicly Traded Partnerships claims that “the total MLP market is over $440 billion, of which $395 billion, or 89%, is in energy and natural resources.” [note 2]
Instead of issuing corporate shares, MLPs issue 'units' that are traded on an exchange like a common stock. Holders of these units are called 'unit holders', who are typically thousands of individual investors. The unit holders are limited partners, who invest capital and own assets. Under the partnership agreement, the general partner that runs the MLP's operations receives most of the cash distributions, up to 50%, due to the incentive distribution rights (IDRs) that allow the general partner to receive an increasing percentage of quarterly distributions. Unit holders are drawn to energy MLPs for 'payouts' of cash averaging around 6%, 8% and even 10%, which are higher than 10-year Treasury bonds. Such payouts are based on the distributable cash flow (DCF), which is defined as net income plus depreciation and minus sustaining capital expenditures. After the general partner receives 50% of the cash distributions, unit holders get the remaining sum in quarterly distributions from the MLP. These distributions are not taxable income and do not themselves trigger a tax liability. However, investors will pay capital gains taxes if they sell their MLP units at a profit (i.e. at a higher price for which they bought them).
The Inherent Risks of MLPs
Although the MLP structure has not evidenced any serious problems since its inception in the 1980s, the riskiness of investments in MLPs may be under-appreciated.
|The higher the quarterly distributions to limited partners, the greater the payouts to the general partner, which incentivizes the latter to continuously boost earnings through building or acquisition of new infrastructure and taking on debt|
Discussing the differences between distributions and dividends and the risks of investing in MLPs, Elisabeth Myers, a Washington DC-based energy lawyer, stresses that the critical point about the financial structure of MLPs is that the income earned by unit holders is not ordinary income. Instead, the cash they get as a distribution is “only receiving some of their investment back.” [note 4] Or, as David Johnston puts it, an MLP distribution is “not a return on capital, but a return of capital.” [note 5] In other words, unit holders get their own money back in the form of MLP distributions, not a share of the MLP’s actual profits. Obviously, being a return of their own capital, unit holders do not pay any taxes on distributions. The profits typically go to the general partner as a result of the high splits, whereby the general partner receives 50% of every incremental dollar paid to the limited partner. The limited partners are allocated losses to balance the books every year. The losses carry forward every year and can offset any income that may be passed through to them.
In the environment of low interest rates, analysts see investments in MLPs as both promising and risky – promising because unit holders can receive large cash payouts even in a short period of time, and risky because such distributions would plummet if interest rates rise. An increase in interest rates will raise borrowing costs to finance infrastructure acquisitions. Such risks notwithstanding, financial advisors are bullish about MLPs as the U.S. energy sector continues to experience growth in view of the shale gas and oil boom. In particular, the MLP structure is likely to maintain a stronghold in the midstream sector (i.e. pipeline networks) for its stable cash stream from energy transportation, which is not susceptible to crude oil price volatility as the upstream sector. But examples of two big energy companies, Linn Energy and Kinder Morgan, offer a glimpse of investment pitfalls and potential negative implications of the MLP structure on investors, energy customers, oil and gas production, pipelines, and storage terminals.
Ever since it became a publicly traded partnership in 2006, Linn Energy LLC has focused its hedging in the upstream MLP sector in the Mid-Continent. Although touted as one of the most solid investment options,
|Linn Energy’s growth was likened to Bernie Madoff’s Ponzi Scheme for its above-average yields and more cash distributions than it actual earnings from its operations|
In September 2013, the company acknowledged that its misleading accounting practices exaggerated the availability of cash to pay out its large cash distributions to unit holders.
Nevertheless, because MLPs create their own accounting rules in deviation from GAAP (Generally Accepted Accounting Principles) standards, typically acceptable as long as they disclose their practices in the partnership agreement, the accounting irregularities of Linn Energy — and other energy MLPs — are not even illegal. Yet the MLP structure's requirement to pay out 90% of its taxable income to unit holders and to maintain stable quarterly cash distributions, which compels steady growth of upstream and midstream assets and raising debt, may be undercutting necessary spending on basic maintenance of energy infrastructure that they operate. Underspending on energy infrastructure could lead to malfunctioning pipelines, oil spills, and associated environmental damages, energy shortages, and high energy prices to consumers.
Such concerns have recently focused on Kinder Morgan, the largest oil and gas pipeline transportation and storage company in the U.S. Similar to Linn Energy, Kinder Morgan came under criticism in 2013 for distorted accounting of its financial activities and underspending on pipeline maintenance. A study by Hedgeye, a Connecticut-based financial risk advisory firm, shows that Kinder Morgan Energy Partnership (KMP), the MLP of Kinder Morgan Incorporated (KMI), has sharply cut maintenance capital expenditure (CapEx) on many of its large oil and natural gas pipelines in the U.S. and transferred nearly $200 million a year from KMP to KMI at the expense of reduced maintenance CapEx [note 7]. Hedgeye calculated that Kinder Morgan's sustaining CapEx for the entire oil and gas pipeline system must be closer to $2 billion a year as opposed to its projected sustaining CapEx of $424 million in 2013 [note 8]. According to Hedgeye and Barron’s, KMP’s underspending on pipeline maintenance increases DCF available for distribution to MLP unit holders, as well as a higher yearly payment to the general partner, and helps keep a higher price of stock [note 9]. Barron’s stresses that compared to another large U.S. pipeline operator, Spectra Energy Partners, KMP “was spending about half the maintenance capital of Spectra per mile of pipeline.” [note 10] In February 2014, a KMP unit holder, Jon Slotoroff, filed a lawsuit against KMP in Delaware Chancery Court on the grounds that the company “is taking almost 50 percent of the allocations, when some of it should be kept for maintenance of the pipeline systems.” [note 11] According to Slotoroff, KMI, which controls KMP, improperly took $3.2 billion since 2010, creating an “unnecessary debt” for the MLP [note 12].
When Kinder Morgan spends capital on infrastructure, it often categorizes maintenance CapEx as expansion CapEx, not as sustaining CapEx, according to Hedgeye. It thereby defers spending on maintenance and profits from expansion. As a result, there has been an increase in pipeline outages, spills, and other incidents since the early 2000s in some of Kinder Morgan’s expanded pipelines, for example, its Santa Fe Pacific Pipeline (SFPP) burst in April 2004 and a gasoline line ruptured in Walnut Creek, CA, in November 2004 [note 13]. In August 2006, the U.S. Department of Transportation’s Pipeline and Hazardous Materials Safety Administration (PHMSA) ordered Kinder Morgan to address “at least 44 pipeline accidents with some 14 resulting in the release of more than five barrels of refined petroleum products, some in or near environmentally sensitive areas or major transportation corridors.” [note 14] Overstated depreciation (meaning allocation of more asset costs than corporate policies require) of Kinder Morgan's pipelines and potentially similar actions of other energy MLPs could lead to an increase in shipping rates. Excessive pipeline rates are already a controversial issue and a source of concern for oil pipeline shippers in the U.S.
“Just and reasonable” Shipping Rates?
In fact, oil pipeline customers and, by extension, the American consumer, is already paying pipeline rates that in many cases are above 'just and reasonable', a legal principle enshrined in the Interstate Commerce Act. A 'just and reasonable' rate means it should be cost-justified and market-justified [note 15], reflecting the actual costs of shipping. In classic cost of service ratemaking, rates are designed to cover the actual costs of providing the service plus a reasonable return or profit on the pipeline’s investment in the facilities used to provide the service. The current regime of 'indexing' pipeline rates to inflation plus an adder (a number that is included to a formula to determine the increase of rate percentage and is defined by the U.S. Federal Energy Regulatory Commission every year) is intended to track industry costs of providing pipeline service.
One of the typical components of rates is the income tax allowance. Traditionally, the corporate public utility is allowed to include in its rates
|However, even though pipeline MLPs pay no corporate income taxes (they are partnerships), the Federal Energy Regulatory Commission (FERC) essentially allows them to charge customers and shippers corporate income taxes anyway in their shipping rates, and then let them pocket this money|
One of the first examples of charging above 'just and reasonable' rates was the Santa Fe Pacific Pipeline. According to David Johnston, FERC “let [in the early 1990s] this pipeline charge rates that assumed it paid a 42.7 percent corporate income tax on profits,” [note 17] which shippers (BP and ExxonMobil) took to the federal district court of appeals in Washington DC to challenge the imposition of the false tax. Although the court reversed FERC’s decision and ruled that the tax was unjust and unreasonable, this additional corporate tax was restored and included to the pipeline cost rates in 2007 [note 18]. This time the court dismissed the challenge of shippers. According to Elisabeth Myers, oil pipeline companies have increased shipping rates more than 39% since the early 2000s, with “virtually automatic annual rate adjustments” that are unchallengable [note 19].
Myers argues that FERC has routinely thrown out shipper complaints or challenges of rising shipping rates. In Myers's view, one of the reasons FERC keeps its hands off from regulating oil pipelines is because it assumes that the 'big oil companies' can look after themselves, notwithstanding the fact that most oil pipelines are monopolies, and that the ICA requires protection of shippers and consignees. FERC’s 'de facto deregulation' of oil pipelines is in stark contrast with its stricter regulation of natural gas pipelines. Further deregulation of oil pipelines by FERC’s laissez-faire approach may lead to even higher shipping rates for oil companies, refiners, and utility firms, thereby nullifying the principle of 'just and reasonable' rates. Gordon Gooch, a former general counsel of the Federal Power Commission, FERC’s predecessor agency, warns about a similar outlook for electric utilities and other energy sectors that would be eager to get out of corporate income taxes while pocketing fictitious charges imposed on customers.
Implications of MLPs on Energy Stakeholders
A disturbing possibility emanating from de facto deregulation of oil pipelines is that the expansion of the MLP business model will directly harm unit holders, who are often retail investors (i.e., individuals). This could also affect the safety and integrity of vital energy pipelines and terminals, eventually raising energy prices for consumers. Harm will be realized when the MLP bubble bursts: increased interest rates and more expensive credit will make high distributions unsustainable, or poorly maintained infrastructure could breakdown and raise gas prices at the pump. Such scenarios are not unrealistic, particularly given that recent high U.S. oil production will be increasingly reliant on the midstream capacity. The growth of MLPs in the upstream (exploration and production) sector exposes it to more oil price fluctuations, lowering the unit holder value when prices fall. Given the popularity of MLPs in the U.S. energy landscape, a potential breakdown of this structure with unsustainable yields and cash distributions could affect the vitality of the entire midstream and the upstream oil and gas sector.
At this point, it appears there is little momentum in the U.S. to address the inherent flaws and weaknesses of the MLP model. On the contrary, a new bill submitted for review to Congress pushes for expansion of the MLP structure to the renewable energy sector [note 20]. Already struggling with growth and access to credit, the investment risk profile of renewables is bound to increase given the level of high financial yields and debt necessary to maintain the MLP status and cash distributions. Given this, the renewable energy sector will not likely be able to sustain MLPs over the long term.
A lesson for Europe
As the European Union seeks to dramatically modernize its energy infrastructure in the next decade through the Connecting Europe Facility (CEF), a major program aimed at funding interconnected trans-European networks of energy, telecommunications, and transportation sectors, it will rely on traditional grants and new financial instruments (i.e. infrastructure funds and pension/insurance funds) to fund its energy infrastructure development. The U.S. MLP structure as the means of raising capital to finance energy infrastructure, especially the midstream sector, may present itself as an alluring model for emulation to the EU. However, doing so would be highly risky and have broader implications on the vitality and continuity of the energy infrastructure given the inherent weaknesses of the MLP structure as analyzed above. As European energy infrastructure gets more interconnected and streamlined through CEF between 2014 and 2020, effective regulation of infrastructure investments and operations would be key to making the transition to the next-generation European energy economy possible.
- J.J. McAnelly, Charles Still and Molly Tucker, “Maturing shale plays help usher in recent increase in upstream MLPs,” Oil
and Gas Financial Journal, June 11, 2013.
- “What the heck are MLPs?” Hedgeye, September 16, 2013.
- David Cay Johnston, “The Fine Print: How Big Companies Use Plain English to Rob You Blind,” New York: Penguin Group, 2012, p. 101.
- Elisabeth Myers, “Ten Years On, Oil Pipeline Deregulation Leads to Excesses – Gas, Electric Next?” Natural Gas and Electricity, August 2010, p. 13.
- David Cay Johnston, p. 101.
- William Pentland, “Are MLPs like Ponzi Schemes?” Forbes, July 12, 2013.
- “Is Kinder Morgan Maintaining its Stock Prices instead of its Assets?” Hedgeye Risk Management, September 10, 2013.
- Andrew Bary, “Kinder Morgan: Trouble in the Pipelines,” Barron’s, February 22, 2014.
- Phil Milford, “Kinder Morgan Sued by Investor Over Pipeline Distributions,” Bloomberg, February 6, 2014.
- “Is Kinder Morgan Maintaining its Stock Prices instead of its Assets?” Hedgeye Risk Management, September 10, 2013.
- U.S. Department of Transportation, Pipeline and Hazardous Materials Safety Administration, Press Release, “Transportation Department Orders Kinder Morgan to Address Rise in Pipeline Incidents,” August 25, 2006. http://www.phmsa.dot.gov/portal/site/PHMSA/menuitem.ebdc7a8a7e39f2e55cf2031050248a0c/?vgnextoid=d1a69d97f8b40110VgnVCM100000762c7798RCRD&vgnextchannel=9a5145aabfa9f010VgnVCM100000762c7798RCRD&vgnextfmt=print
- Lawrence R. Greenfield, “An Overview of the Federal Energy Regulatory Commission and the Federal Regulation of Public Utilites in the United States,” Federal Energy Regulatory Commission, December 2010, http://www.ferc.gov/about/ferc-does/ferc101.pdf
- David Cay Johnston, p. 93.
- Ibid, p. 95-96.
- Elisabeth Myers, “Ten Years On, Oil Pipeline Deregulation Leads to Excesses – Gas, Electric Next?” Natural Gas and Electricity, August 2010, p. 9.
- S.795 – Master Limited Partnerships Parity Act, 113th Congress (2013-2014), http://beta.congress.gov/bill/113th/senate-bill/795