Master limited partnership (MLP) investors received some good news lastweek. The Federal Energy Regulatory Commission (FERC) issued a final rulingthat clarifies and softens a previous order issued in March, which wouldhave disallowed a long-standing policy enabling MLPs to earn an income taxallowance in their pipeline rates. The March ruling precipitated a 13% dropin the Alerian MLP Index and hit MLPs exposed to natural gas especiallyhard (due to the regulated nature of these assets), with many correcting to10-year lows.
Thefinal FERC rulingissued 18 July essentially excludes MLPs with a C corporation parent – themost common ownership structure – from the proposed policy changes. Themodified ruling triggered sharp rebounds for the names hurt most by theMarch policy announcement, helping the Alerian index close up 2.9% over thepast three days and bringing overall year-to-date gains to 2.4%.
While the final order pertains primarily to long-haul natural gaspipelines, we see positive implications for MLPs in general, includingregulated liquids pipelines, as it indicates FERC’s willingness to updateits views and provides a supportive backdrop for returns on capitalemployed.
Simplification transactions will likely move forward
To overcome the headwinds arising from the March proposal,a number of MLPs announced simplification transactionsthat would convert them from MLP structures into traditional Ccorporations. Although the final ruling appears to diminish the need forsome to do so, we expect these transactions to go forward nonetheless givenother potential benefits. These include lowering their cost of capital,reducing the complexity of their corporate structures and broadening theirinvestor bases, given that MLPs are not included in most broad-marketequity indexes.
We see the tide turning for the midstream energy sector after a frustratingfew months and four years of underperformance, during which the Alerianindex corrected 31%. The FERC’s surprise announcement in March overshadowedan otherwise healthy first-quarter 2018 earnings season, where many beatexpectations owing to higher commodity prices, production growth and solidmargins. While still early, second-quarter earnings appear to be off to agood start, and we expect the underperformance of the Alerian indexrelative to the S&P Oil & Gas E&P Select Index and WTI spotprices to narrow in coming months (see chart).
Several key factors support our constructive view on MLPs, includingstill-high starting yields, improving company fundamentals, attractivevaluations relative to high yield and other income-oriented sectors, and arobust oil and gas production backdrop. This utility-like sector currently offers an attractive yield of around8% with potential for mid-single-digit distribution growth (pointing to12%–14% total return potential over the next 12 months), supported byfee-based cash flows backed by long term take-or-pay contracts.
Investing in midstream energy isn’t without risks, including commodityprice 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 intoday’s market.
For more of our views on oil and gas MLPs, see related content on the PIMCO Blog.
John M. Devir is a portfolio manager on PIMCO’s MLP & Energy Infrastructure strategy and is a regular contributor to the PIMCO Blog.