by Robert Rapier, Investing Daily
Article of the Week from Investing Daily
Oil prices closed last week more than 30% higher than they were a year ago. West Texas Intermediate (WTI) is hovering around $65/BBL and Brent is at nearly $70/BBL.
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Yet a significant disconnect has developed between the price of oil and the energy companies that produce and transport that oil. That disconnect can’t last.
Battered Indices
The Energy Select Sector SPDR ETF (NYSE: XLE), which represents the largest energy companies in the S&P 500, is down by 3.6% over the past year. The XLE represents the stocks of large energy companies from different sub-sectors (e.g., integrated, oil production, equipment services). Its biggest holdings are ExxonMobil (NYSE: XOM), Chevron (NYSE: CVX), and Schlumberger (NYSE: SLB). It is, therefore, a good benchmark for conservative energy investors.
The S&P Oil & Gas Exploration & Production SPDR ETF (NYSE: XOP) is more representative of the smaller-cap drillers. Despite companies across the board posting much-improved year-over-year financials, it has done a bit worse than the XLE, falling 6% in the past 12 months.
But the biggest disconnect can be found between oil prices and companies that transport and store oil and gas.
MLP Basics
To review, midstream oil and gas companies generally function as toll collectors for transporting and storing hydrocarbons. Historically, they have been more insulated from the commodity price volatility that can impact the upstream and downstream sectors. As a result, many investors gravitated to the midstream companies for predictable income streams.
Many midstream providers have structured themselves as Master Limited Partnership (MLPs), which provided tax benefits for investors. For most of the past 25 years, there was no better income-producing investment than the MLP sector.
The biggest advantage has always been that MLPs aren’t taxed at the corporate level. MLPs pass profits directly to unitholders in the form of quarterly distributions. This arrangement avoids the double taxation of corporate income and dividends affecting traditional corporations and their shareholders and should deliver more money to MLP unitholders over time.
But because of the depreciation allowance, 80% to 90% of the distribution is considered a “return of capital” and thus also not taxable when received. Instead, returns of capital reduce the cost basis of an investment in the MLP.
Investors Sour On MLPs
MLPs crashed along with the rest of the energy sector in 2014. However, in recent months most of the energy sector has rallied. The MLP sector, on the other hand, has continued to fall. The Alerian MLP Index (AMZ), which captures about 75% of the midstream sector’s market capitalization, has dropped by 20% since last August – when oil prices were still ~$45/BBL.
There are several reasons contributing to the drop.
First, the tax reform bill that President Trump signed reduced some of the tax advantages an MLP held over a corporation.
Second, rising interest rates may tempt some income investors to shift some money into bonds at the expense of MLPs.
Finally, two weeks ago a ruling by the Federal Energy Regulatory Commission (FERC) to reverse a longstanding policy on MLP tax costs for interstate pipelines really rattled investors.
Borrowing costs may increase a bit, and there will be increased competition for investor dollars, but tax reform and rising interest rates should have a minimal impact on the sector.
The FERC ruling could cause some MLPs to convert to corporations – a popular trend throughout the energy sector downturn. But many MLPs have already issued guidance that they will either be unaffected or minimally affected by the FERC ruling.
None of these factors, in my view, warrant such a steep sell-off in the sector. This is especially true given the recovery in the price of oil. Of course, it’s hard to say how long the negative sentiment will last, but this is a sector that is being discounted far beyond what is justified given the underlying fundamentals.
