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‘Simplification Day’ for Oil & Gas MLPs: What Investors Need to Know

We believe the trend to simplify complex corporate structures strengthens the case for investing in MLPs and in midstream energy more broadly.

On 17 May 2018, three oil and gas master limited partnerships (MLPs) announced “simplification” transactions that will effectively convert them from MLP structures into traditional C-corporations. The MLPs ­– which make up roughly 10% of the Alerian MLP Index cumulative weighting – will be absorbed by their corporate parent companies in all-stock transactions valued at over $65 billion, in aggregate.

We believe the news is evidence of a broader shift toward simpler corporate structures in the midstream energy sector – a trend that supports our investment approach and our constructive view of the sector.

FERC ruling drives the shift

The simplifications are likely a direct result of a recent U.S. Federal Energy Regulatory Commission (FERC) ruling that disallowed MLPs from receiving an income tax allowance on pipelines with tolling fees set under the “cost of service” framework. We believe the ruling will be an ongoing catalyst for MLPs to pursue simplification strategies, as C-corporations were largely unaffected.

Investment implications

After the transactions close, the three MLPs ­will drop out of the Alerian MLP Index and their approximately 10% weightings will be redistributed. This outcome reinforces PIMCO’s approach to investing in the midstream energy sector ­– in particular, an opportunity set that includes not only master limited partnerships but also midstream firms structured as C-corporations.

We view the transactions as positive for the affected companies and their equity unitholders: They will lower their cost of capital, reduce the complexity of their corporate structures and broaden their investor bases, given that MLPs are not included in most broad-market equity indexes.

Moreover, we believe the trend to simplify complex MLP corporate structures strengthens the case for investing in MLPs and in midstream energy more broadly over the next 12 months.  Several key factors support our constructive view:

  • High starting yields. MLPs in the Alerian index are yielding around 8%, with the potential for mid-single-digit distribution growth (pointing to 12%–16% total return potential over the next 12 months).
  • Attractive valuations. Current MLP valuations relative to high yield and other income-oriented sectors are some of the most attractive on record, trading at a 10%–15% discount to 10-year averages on key metrics (including yield, enterprise valuation/EBITDA and price/distributable cash flow).
  • Healthy company fundamentals. MLPs as a group have reduced leverage, increased coverage ratios, lowered their reliance on equity capital markets and become more disciplined in recent years.
  • Robust oil and gas backdrop. U.S. production remains strong, with increased crude, natural gas and natural gas liquid (NGL) volumes boosting underlying profits and providing opportunities for new growth projects secured by long-term cash flows.

Investing in midstream energy isn’t without risks, including commodity price risk as well as shifts in macroeconomic or investor sentiment, interest rate expectations or a particular issuer’s financial condition. Nonetheless, we believe MLPs may offer compelling risk-adjusted returns in today’s market.

For more on the potential benefits MLPs can offer, visit “Understanding Investing: MLPs” .

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The Author

John M. Devir

Portfolio Manager and Head of Americas Credit Research

Danny Seth

Global Equity Analyst, Long/Short Equity Strategies

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Master Limited Partnerships (MLPs)

Master Limited Partnerships (MLPs) are tax-advantaged and yield-oriented publicly traded U.S. infrastructure assets that operate primarily in the oil and gas midstream industry.

Disclosures

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in MLPs involves risks that differ from equities, including limited control and limited rights to vote on matters affecting the partnership. MLPs are a partnership organised in the US and are subject to certain tax risks. Conflicts of interest may arise amongst common unit holders, subordinated unit holders and the general partner or managing member. MLPs may be affected by macro-economic and other factors affecting the stock market in general, expectations of interest rates, investor sentiment towards MLPs or the energy sector, changes in a particular issuer’s financial condition, or unfavorable or unanticipated poor performance of a particular issuer. MLP cash distributions are not guaranteed and depend on each partnership’s ability to generate adequate cash flow. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

The Alerian MLP Index is the leading gauge of large- and mid-cap energy master limited partnerships (MLPs). It is a float-adjusted, capitalization-weighted index, which includes 50 prominent companies. It is not possible to invest directly in an unmanaged index.