Commentary: IRS ruling opens the door for US crackers to become MLPs

19 October 2012 09:45  [Source: ICB]

As if US petrochemical producers needed yet another incentive to build ethane crackers, it got just that from the Internal Revenue Service (IRS) tax authority.

Dollars Rex Features

Rex Features

The US ruling could provide a windfall for petrochemicals

On 12 October, the IRS issued a Private Letter Ruling in response to an undisclosed company (X), concluding that "income derived by X from processing NGLs [natural gas liquids] into olefins will constitute qualifying income within the meaning of [the Master Limited Partnership structure]. We further conclude that income derived by X from marketing, transporting, and storing olefins will constitute qualifying income within the meaning of [the MLP]".

Businesses engaged in the production and transportation of US natural resources such as oil and gas, as well as fertilizers, can qualify for an MLP structure.

An MLP is required to "pay out all earnings not needed for current operations and maintenance of capital assets to their unitholders in the form of quarterly cash distributions", according to the National Association of Publicly Traded Partnerships. Unlike those for a regular company, these earnings are not taxed.

Deutsche Bank's MLP analyst concludes company X is Williams Companies, fellow Deutsche Bank chemical analyst David Begleiter notes. Williams is one of the many firms expanding ethylene capacity in the US.

The IRS ruling opens the door to petrochemical companies potentially "dropping US ethylene production assets into MLPs", which would have significant tax benefits, says Begleiter.

He estimates the potential tax benefit to LyondellBasell at around $700m of earnings before interest, tax, depreciation and amortisation (EBITDA) in 2013, or $1.25/share. For Westlake the benefit would be around $200m in EBITDA, or $2.97/share, and for Dow Chemical $550m in EBITDA, or $0.47/share.

Shares of US commodity chemical firms jumped on the back of the ruling. On 16 October, shares of LyondellBasell surged 5.7%, and on 17 October they powered ahead another 2.5% to a new all-time high of $55.74.

However, some Wall Street analysts contend the overall rally was an overreaction.

"Shares in US petrochemical producers rallied 5%-8% [on 16 October] on optimism that the IRS could allow MLP structures for olefin producers, and possibly even extend the same principles to other commodity chemicals," says Laurence Alexander, analyst with US-based investment bank Jefferies & Co. "Barring specifics on potential deal structures and acceptable assets, this could well prove [to be] aggressive discounting."

Alexander says it could take two to three years for companies to find ways to navigate an MLP carve-out process, "particularly if they wait for clarity as to the degree to which the IRS allows chemical firms to explore putting vertically integrated assets into an MLP".

Frank Mitsch, analyst with US-based investment bank Wells Fargo, also suggests a lengthy process for putting existing assets into an MLP.

"Although the IRS Private Letter Ruling does present some interesting structural options, it by no means is a law or sets precedence given its fact- and company-specific nature," said Mitsch. "We believe undertaking an MLP classification is a highly complicated and time-consuming process - one which needs to be examined carefully to determine value creation for all interested shareholders."

TAX BREAK FOR NEW CRACKERS?

While carving out existing assets into an MLP could be quite complicated, putting a brand new asset - such as an ethane cracker - into such a structure may be less so, providing a better way to fund new projects.

"A more likely alternative, in our view, is for companies to explore MLP structures for new US ethylene crackers, which would represent a much lower cost of funding, due to investor appetite for yield," he says.

Publicly traded MLPs typically provide higher yields for investors than publicly traded stocks. And as investors value publicly traded MLPs higher than their commodity chemical counterparts, financing such projects through an MLP structure could make sense.

Alexander points out that the benchmark Cushing MLP 30 Index currently trades at about 10.8 times estimated 2013 EBITDA versus an average of 5.8 times EBITDA for commodity chemical companies.

Looking ahead, the analyst asks: "Could the IRS extend the MLP structure to cover other commodity chemical producers - [such as] ethanol, methanol or acetic acid?"


By: Joseph Chang
+1 713 525 2653



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