Guest Column: The Evolution of MLPs in Fuel Distribution
New players step up industry's embrace of master limited partnerships
ST. PETERSBURG, Fla.-- Wholesale fuel distributors and retail convenience store marketers are increasingly evaluating the use of Master Limited Partnerships as an alternative corporate structure with significant benefits. Northern Tier Energy LP recently completed an initial public offering, Alon USA Partners LP recently filed to go public and a number of other companies are pursuing similar transactions.
Further, with the Global Partners LP acquisition of Alliance Energy and Energy Transfer Partners LP's pending acquisition of Sunoco Inc., the industry saw its first two major acquisitions of convenience store and fuel distribution assets by existing MLPs.
Given the tax advantages available to MLPs and the demand by investors for higher yielding investments, energy related companies have taken advantage of the MLP structure for many years. However, as the Internal Revenue Code rules relating to MLP's have evolved to include certain income streams generated by wholesale fuel distribution, petroleum marketers are seizing a market opportunity to access capital that will enable them to fund future growth and drive further consolidation in the industry.
Corporate structures in the U.S. can take many forms. The vast majority of public companies are incorporated as C Corporations, which for federal income tax purposes are taxed separately from their owners. Partnerships, another corporate structure, have certain tax advantages over C Corporations in that they generally are pass through entities, whereby the partnership's income and certain deductible expenses are reported and taxed by the individual partners that have an ownership stake in the partnership.
Master Limited Partnerships (MLPs) were first formed in 1981 as publicly traded partnerships to raise capital from individual investors through the public markets. As the number of MLPs grew, the US Internal Revenue Code (IRC) was changed by Congress to limit the size, scale, and scope of publicly traded MLPs. As part of a 1987 enactment, Congress specifically permitted an exemption for public MLPs to derive income from natural resource businesses in order to promote the development of these resources and the associated infrastructure. For this reason, the majority of MLPs today generate income from the production, processing, transportation, and storage of oil, natural gas, coal, and refined products.
Initially, MLPs were generally pipeline companies that transported crude oil, refined products, and natural gas. Over time, other qualified assets were placed in MLPs to benefit from the tax efficiency associated with the MLP structure. More recently, MLPs have been formed that derive income from the wholesale distribution of refined products to convenience stores. MLPs may also own real estate and collect rent, since real estate rental income qualifies under the tax code. In the next several years, it is likely that more assets involved in the wholesale distribution of refined products will end up in an MLP. However, note that the income from convenience store retail operations, including the final transfer of fuel to consumer motor vehicles, is not qualified MLP income under the tax code.
MLPs generate significant cash flows and pay out the majority in the form of distributions. Public ownership in an MLP is represented by common units that trade on public stock exchanges such as NYSE or NASDAQ. Similar to stock dividends, distributions are paid quarterly. MLP units are considered a yield security, and they are generally valued on the size of the annual distributions paid per unit. MLPs that consistently grow their distributions will usually trade at lower yields. Over time, growth in distributions results in unit price appreciation. MLP distributions are not guaranteed; however, and increasing interest rates could have an adverse effect on unit prices as alternative yields become more attractive.
Stable cash distributions are very important to the MLP investor, so the traditional MLP structure provides certain protection against possible fluctuations in operating performance. Since not all the cash generated by the MLP must be paid to the unit holders, a certain amount is held back. The amount of cash flow available to distribute divided by the amount actually paid is called the coverage ratio. MLPs with volatile cash flows, such as those with commodity price risk, operate at higher coverage ratios than low risk assets such as interstate pipelines to help ensure that expected distributions can be made. Subordinated units are also used to protect investors. New MLPs at IPO typically have half of their limited partner units classified as subordinated units. These units are held by the owner of the General Partner and only receive cash distributions after the common units have been paid. As the MLP matures, the subordinated units convert into common units, usually after the common units receive consistent distributions over a three year period.
MLPs generally trade at higher cash flow multiples than C Corporations due to the fact that MLPs do not pay corporate income tax. This translates into a lower cost of capital and the ability to effectively compete for the acquisition of assets to grow the MLP. For this reason, owners of qualified MLP assets have pursued the formation of new MLPs.
These and other benefits, we expect interest in MLPs within the convenience and downstream petroleum segments to remain strong. More assets will continue to be moved into this structure over time to benefit from the many advantages that the MLP provides. For this reason, the transfer of wholesale distribution assets and convenience store real estate into MLPs will continue.
Mark Huhndorff, Scott Garfinkel and Roger Woodman are managing directors of Raymond James & Associates Inc. Raymond James is full-service securities firm offering investment banking, securities brokerage, wealth and asset management. Raymond James offers one of the most highly regarded equity offering and advisory practices in investment banking today. Additional information about Raymond James can be found at www.raymondjames.com.