First of two articles.
As shale hydrocarbons development surges, redrawing the U.S. energy map, so has construction of pipelines and processing infrastructure. Most of the cash that is financing the enormous capital projects comes from tax-favored investments called master limited partnerships.
Capital spending by energy companies organized as master limited partnerships, or MLPs, in and around the nation's major shale oil and gas plays is expected to hit $25 billion this year -- bringing the total since 2007 to $113 billion, according to Barclays Capital. Wall Street and energy interests are lining up to make their case to Congress that MLPs are essential to funding the oil and gas boom.
Advocates for the corporate structure, under which the nation's biggest gas pipeline operators pay no corporate tax, are on red alert for signs that House and Senate tax-writing committees might eliminate the partnerships as part of a comprehensive tax reform package. If that happens, they argue, the torrent of investment in expanding U.S. oil and gas infrastructure would take a damaging hit.
"When we need to be energy independent, why do away with a great vehicle for financing the build-out?" asked Ken Kaszak, with Trustmont Financial Group outside of Pittsburgh, in the heart of the Marcellus Shale.
"To go and attack the financial viability of these companies doesn't seem to make sense," said Kenny Feng, president and CEO of Alerian, the Dallas-based publisher of a leading index of MLP performance.
A cross-section of political and financial analysts and congressional staff members say that Congress is more likely to expand the partnership tax break to include renewable energy than it is to scrap MLPs altogether. Many think that the most likely outcome is no change at all, given political realities on Capitol Hill.
But if lawmakers do trade energy tax breaks for a broader corporate tax cut, MLPs presumably would be on the chopping block.
The total market value of MLPs currently is about $400 billion. The Alerian MLP index, which tracks the 50 top MLPs' prices, has nearly doubled since 2010, when the shale surge took off. From retirees to hedge funds, investors have rushed for seats on the bandwagon by buying up units of the publicly traded energy MLPs, similar to buying shares of conventional corporate stock.
Here's the sales pitch: The handsome returns paid out by MLPs are as well as any investor can do in conventional stocks and bonds, particularly in light of today's low interest rates.
According to Alerian, MLPs had a 10-year total return of 341 percent through April 2012, compared to 58 percent for the Standard & Poor's 500 stock index.
Yet the prospect is real that the federal tax carveout for investments in oil and gas infrastructure could get a second look by U.S. lawmakers. In Canada, where the energy industry commands a bigger slice of the overall economic pie, the government already took that step. It hasn't stopped an infrastructure build-out accompanying Canada's own oil and gas production boom, one that is rapidly expanding Canada's role as a global energy supplier.
Canada's case study
In 2006 -- in what Canada's energy industry calls its "Halloween Surprise" -- Canada's government announced that it intended to shut down tax-favored trusts in order to stem the drain on its treasury. "Canada was concerned that too many entities were adopting the trust structure to avoid tax at the entity level," Kaszak noted in a blog post.
The trusts, Canada's version of MLPs, had to convert to conventional corporations by 2010.
Notwithstanding the disruptions caused by the conversions, pipeline and machinery investments in Canada's oil and gas sector shot up at the start of this decade as drilling and development accelerated. Statistics Canada reports producers' capital spending rose by nearly $25 billion in 2011, the largest yearly increase in more than a decade, according to Standard & Poor's. This year's spending is expected to be flat, at $58 billion.
In the United States, stripping out the MLPs' tax benefits would be a direct blow to oil and gas development, said Mary Lyman, executive director of the industry's trade group, the National Association of Publicly Traded Partnerships.
"The disruption in financing, the short-term market losses would be serious," said Lyman, who leads an industry lobbying campaign to preserve the MLP advantage.
"Investment in energy infrastructure would not go completely away, but the change would certainly reduce investment and slow things down," she added.
At a minimum, the methods of financing midstream shale infrastructure would have to be reset, analysts say. MLPs would have to be restructured. Investors would suffer market losses. "If you pull the plug, you get a three-year period where the market is in turmoil and there's no telling where the capital would come from," said one securities analyst.
But the economic and strategic case for developing U.S. shale gas and oil resources, assuming that can be done without environmental damage, will persist even if tax policy changes, said Kevin Petak, vice president of ICF International, a northern Virginia consulting firm.
"The underlying driver of infrastructure development is the growing hydrocarbon production and the expectation that the markets are going to be there for that production," said Petak, an author of an ICF forecast of pipeline investment made for the Interstate Natural Gas Pipeline Association of America. The ICF study estimated that $200 billion will be invested in pipelines and related infrastructure by 2013.
"That driver is not removed if the tax structure for MLPs is changed," Petak said. "The fundamentals are, there is a huge resource potential in the shale areas, and it's cost-effective to produce it. That driver is likely to be there, although maintaining the tax treatment for MLPs still improves the economics of development."
There is no question that the popularity of MLPs is tied to their tax benefits, and that also makes them vulnerable to tax reformers and deficit hawks.
MLPs, like the North American pipeline giant Kinder Morgan Energy Partners, do not pay federal tax at the organization level, as conventional corporations do, a benefit that carries a cost to the U.S. Treasury of about $1.5 billion a year and rising, according to the Congressional Joint Committee on Taxation. MLP investors pay income tax on the distributions they receive, as investors do on dividends, but the partnerships escape the first round of taxation at the corporate level.
Lyman's organization sponsored a 2012 analysis of the impact of MLP elimination, by Phillip Swagel, a professor in the University of Maryland's School of Public Policy, and Robert Carroll of Ernst and Young, that estimated the value of the tax savings MLP investors receive and the impact of eliminating the tax break.
Subjecting MLPs to corporate taxation "would mean higher taxes in investment and thus less investment," they said.
Because of the heavier tax hit, MLPs would have to pay more to attract investors, all other factors being equal, the authors said. MLPs' costs to fund midstream projects -- their added cost of borrowing capital -- would climb from 5.7 percent to 6.4 percent (after calculating for depreciation), the authors estimated.
Swagel and Carroll figure that every 10 percent increase in the cost of capital shrinks investment by about 8 percent. That causes pipeline industry investment to drop nearly 30 percent in the first year after the tax change, they estimate. Even though the impact lessens in following years, as depreciation charges are reduced, midstream investment is still more than 10 percent lower 10 years after the change than it would have been if the MLP tax advantage stayed in place, Swagel and Carroll said.
"There would be a considerable decrease in pipeline investment that would then recover to an extent over time but not all the way," Swagel added. "Investors would require higher yields and eventually capital would redeploy. But the higher required yields will mean less investment.
"Tax rates matter and the cost of capital matters, especially for capital-intensive activities such as pipelines," Swagel said.
MLPs and wider tax reform
Whatever their economic benefits, MLPs would be vulnerable if Congress goes after energy taxes in general, in return for lowering overall corporate rates, industry officials and analysts agree.
"If everything is thrown under the bus, will MLPs be immune? It's hard to make that argument," Feng said. "But I do have confidence that MLPs will not be attacked directly."
"MLPs face moderate risk within the context of broader tax reform," said Christi Tezak, managing director of ClearView Energy Partners, in Washington, D.C. "Budget-wise, MLPs are both high-fliers and fast-growers, and the Joint Committee on Taxation dramatically increased estimates of foregone government revenues this year," she said in a recent research note.
"Our GOP leadership sources recently reiterated that any pass-through reform should be paired with individual tax reforms to offset the rate increases the owners of pass-through structures would otherwise face. Democrats continue to show a general lack of enthusiasm for entitlement reform that would be part and parcel of comprehensive reform that extends to the individual tax code," she said.
One influential Democratic lawmaker, speaking off the record, said that in his view, a budget deal would have to precede major tax reform, a huge political barrier.
Tezak summed up the current political consensus: "We think the odds on tax reform are still low."
MLPs don't escape the criticism directed at all energy tax subsidies, which the Joint Committee estimates will reduce federal tax revenues by $60 billion in 2013-2017.
The energy tax expenditures are small compared to the $379 billion in estimated tax losses because of the home mortgage deduction, for example. The publicly traded energy partnerships are responsible for $6.7 billion of the $60 billion in five-year energy tax revenue losses, roughly equal to the impact of $7.7 billion in wind tax subsidies, $5.5 billion in home energy efficiency investment deductions and $6.2 billion in the expensing of oil and gas development costs between 2013 and 2017, the tax committee said.
The tax expenditures are increasing, not just with expanding shale oil and gas development, but also because the Internal Revenue Service is broadening the definition of businesses that qualify for the tax break.
"There are more entities that are going to try to become MLPs," Kaszak said. "You can argue there are entities adopting the MLP format that may not be in the true spirit" that Congress intended in creating the energy tax preference. "Convenience stores selling Slurpees and gasoline -- that's a loss to the taxpayer. "
Some in the debate question the validity of any energy tax benefits. "The question for the policymaker is, is this a sector that deserves favorable treatment for investment or not?" asked University of Colorado law professor Victor Fleischer.
"There are lots of reasons to think the hydrocarbons are trapped in ground and that's where they ought to stay because of the climate effects. Not only should we not be subsidizing the energy sector, we should be taxing it," Fleischer said.
MLPs present unique risks to investors along with their benefits compared to fully taxed investments. Unlike shareholders of common stock, the limited partnerships' "unit holders" have no vote to influence or replace the MLP's general partner, typically the partnership's corporate parent. Unit holders have no say in whether or when new pipeline projects will be "dropped down" by the parent into the partnership. MLP tax returns are complex.
But taxes head the risk list, Kaszak said.
"Without a doubt, the biggest risk factor an investor in MLPs faces is legislative risk," Kaszak wrote in an energy blog post on MLPs. Former Treasury Secretary Tim Geithner mentioned the idea of eliminating pass-through taxation during an appearance in front of the Senate Finance Committee in February 2011, and two months later, unconfirmed rumors of Treasury's intentions spooked MLP investors.
Feng's Alerian MLP Index hit a then-high of 390 on April 29, 2011, then abruptly pitched downward in May, erasing all of 2011's gains. David LaBonte, a senior analyst with Kayne Anderson, has attributed the May sell-off to the speculation about an administration move against MLPs. Most MLPs rebounded, but it remains a volatile sector for investors.
"You do still see growing pains," Alerian's Feng said in an interview. The 2011 sell-off is an example. "The fact that there was a 10 percent correction on a leaked proposal that wasn't going anywhere shows you that there are corrections that happen, unrelated to fundamentals."
Could that happen again? "Absolutely," he said.
Feng, like others in the industry, believe that MLPs have shown their value, and that can only grow with the expansion of shale gas and oil development, and the new infrastructure it requires.
But there is a growing view in and outside the industry that growth and profits won't fall evenly. A rising tide looks less likely to lift all the boats.
Next: Will the gap grow between winners and losers?