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.
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.
Read more of our views on MLPs and the commodities markets here.
John M. Devir and Danny Seth are portfolio managers on PIMCO’s MLP & Energy Infrastructure strategy and are contributors to the PIMCO Blog.