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Oil and Gas Pipeline MLPs

Tax Breaks Costly to the Government

Written by Swagato Chakravorty
Posted February 22, 2013

Have you heard about shale gas flaring? It’s a process where “flare stacks” are developed to continually burn off ‘excess’ natural gas. Yes, you read that right—right now, the nation is producing so much of natural gas that there just isn’t enough pipeline infrastructure to successfully transport all of it.

And that means there actually are stacks all over the country built for the sole purpose of burning off excess gas. Just last year, flaring in North Dakota increased by 50 percent, and nearly 30 percent of all the gas produced in that shale-rich state is burned off right there.

It’s this untenable situation that, perhaps, has led the U.S. government to drastically increase its estimate of tax breaks for pipeline companies, hoping to create a favorable climate for rapid infrastructural development.

According to Bloomberg, the Joint Committee on Taxation increased its cost estimate for exemptions of “master limited partnerships” to $1.2 billion, up from $300 million. By 2016, that is expected to go up to $1.6 billion. Ultimately, the tax break that benefits companies like Kinder Morgan Energy Partners LP (NYSE: KMP) will end up costing the government about $7 billion through 2016.

Tax-free publicly traded partnerships have become a hot thing and are rapidly expanding throughout the national pipeline sector; in fact, they're even expanding into the oil and gas sector.

Just recently, Linn Energy Inc. (NASDAQ: LINE) reached a buyout agreement with Berry Petroleum Co. (NYSE: BRY) for $2.42 billion. That marks the first time a publicly traded partnership has bought a tax-paying corporation.

It’s actually starting to become a worrisome thing because the cost to the government just can’t keep going up indefinitely. Indeed, Canada ended its own version of such a credit in 2011. Estimated savings? $500 million annually.

So far, though, MLPs remain a big business in the U.S. Last year, there were 204 such deals, worth some $146.2 billion in total, according to Barron’s. The latest such deal resulted in Kinder Morgan agreeing to pay a 24 percent premium to buy Copano Energy (NASDAQ: CPNO), primarily targeting its natural gas processing facilities and pipelines. It’s a $3.9 billion deal—with debt, that goes up to $5 billion.

The news sent Kinder Morgan’s shares down 2 percent, but Copano shot up 15 percent on Wednesday. The company has more than 6,900 miles of pipeline in place. Kinder Morgan currently has interests, one way or another, in 180 terminals and over 46,000 miles of domestic pipelines, Barron's reports.

Since it is an MLP, as long as the majority of cash flows are passed on to investors as tax-deferred distributions, no taxes need be paid. Kinder Morgan will pay a yield of 5.8 percent, while Copano will go for 6.9 percent.

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And in related news, Devon Energy Corp. (NYSE: DVN) is set to investigate the option of spinning off its pipeline and processing assets into an MLP, following major losses since 2008 in the wake of fracking and natural gas production booms. Devon, according to 24/7 Wall Street, has reported a Q4 impairment charge of $896 million, or a net loss of $0.89/share.

As of late 2011, Devon commanded over 3,000 miles of pipeline, two gas processing facilities, and a natural gas liquids fractionating plant. More capacity was added overall through last year, so spinning off these assets into a lucrative MLP could indeed be a salvation of sorts for the troubled company.

Although there’s clearly a real boom going on in U.S. natural gas production, the knowledge that we’re forced to burn off so much gas continuously simply because we don’t have the pipeline or processing infrastructure to successfully harvest the gas is galling. It’s a positive sign that energy companies are actively seeking out ways to expand the national infrastructure in these areas so the nation can make the most of the ongoing natural gas production boom.

As well, export terminals are increasingly becoming a major interest, with the U.S. government set to approve more such terminals. This way, at least some of the excess gas can readily be shipped over to East Asia, where demand for liquefied natural gas continues to grow at impressive rates. Better still, profits from these exports could be channeled back into infrastructure development within the U.S., thus creating a virtuous cycle of sorts.

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