Master limited partnership (MLP) investors received some good news last
week. The Federal Energy Regulatory Commission (FERC) issued a final ruling
that clarifies and softens a previous order issued in March, which would
have disallowed a long-standing policy enabling MLPs to earn an income tax
allowance in their pipeline rates. The March ruling precipitated a 13% drop
in the Alerian MLP Index and hit MLPs exposed to natural gas especially
hard (due to the regulated nature of these assets), with many correcting to
final FERC ruling
issued 18 July essentially excludes MLPs with a C corporation parent – the
most common ownership structure – from the proposed policy changes. The
modified ruling triggered sharp rebounds for the names hurt most by the
March policy announcement, helping the Alerian index close up 2.9% over the
past three days and bringing overall year-to-date gains to 2.4%.
While the final order pertains primarily to long-haul natural gas
pipelines, we see positive implications for MLPs in general, including
regulated liquids pipelines, as it indicates FERC’s willingness to update
its views and provides a supportive backdrop for returns on capital
Simplification transactions will likely move forward
To overcome the headwinds arising from the March proposal,
a number of MLPs announced simplification transactions
that would convert them from MLP structures into traditional C
corporations. Although the final ruling appears to diminish the need for
some to do so, we expect these transactions to go forward nonetheless given
other potential benefits. These include lowering their cost of capital,
reducing the complexity of their corporate structures and broadening their
investor bases, given that MLPs are not included in most broad-market
We see the tide turning for the midstream energy sector after a frustrating
few months and four years of underperformance, during which the Alerian
index corrected 31%. The FERC’s surprise announcement in March overshadowed
an otherwise healthy first-quarter 2018 earnings season, where many beat
expectations owing to higher commodity prices, production growth and solid
margins. While still early, second-quarter earnings appear to be off to a
good start, and we expect the underperformance of the Alerian index
relative to the S&P Oil & Gas E&P Select Index and WTI spot
prices to narrow in coming months (see chart).
Several key factors support our constructive view on MLPs, including
still-high starting yields, improving company fundamentals, attractive
valuations relative to high yield and other income-oriented sectors, and a
robust oil and gas production backdrop
. This utility-like sector currently offers an attractive yield of around
8% with potential for mid-single-digit distribution growth (pointing to
12%–14% total return potential over the next 12 months), supported by
fee-based cash flows backed by long term take-or-pay contracts.
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
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.