Kinder Morgan's (NYSE:KMI) latest drop-down transaction with affiliate El Paso Pipeline Partners (NYSE:EPB) has been telegraphed for a long time. That said, it still doesn't change the fact that the deal is being made with one goal in mind. Kinder Morgan wants to take the full benefit of the IRS tax advantage offered to MLPs like El Pas Pipeline Partners so that it can create additional value for its investors.
Details on the drop
The $2 billion drop-down deal sees El Paso Pipeline Partners acquiring a 50% interest in the Ruby Pipeline, a 50% interest in Gulf LNG, and a 47.5% interest in Young Gas Storage. Because these assets all qualify to be owned by an MLP, it simply makes sense for Kinder Morgan, which is classified as a C-Corp, to sell down these assets to one of its affiliated MLP, which, in this case, is El Paso Pipeline Partners. El Paso won't pay any federal taxes on the income it earns and can then pass on the profits to its investors, including Kinder Morgan.
The transaction is just the latest in a series of moves Kinder Morgan has made since acquiring El Paso in 2011. The former exploration and production company owned a number of pipelines and other MLP-type assets that just fit better in an MLP than in El Paso's corporation structure. The problem was that El Paso's MLP, El Paso Pipeline Partners, couldn't handle all of the assets being dropped down at once, which is why Kinder Morgan has taken its time and also dropped down some assets to its other MLP Kinder Morgan Energy Partners (NYSE:KMP).
That drop-down plan should be complete next year, which will turn Kinder Morgan into a pure-play General Partner holding company. Its only assets will be its GP interests in both Kinder Morgan Energy Partners and El Paso Pipeline Partners as well as its holding of the common units of both entities and shares of its management company. That arrangement will ensure that all of the assets are owned in an entity that can best maximize the value of the assets.
Why this matters
The reason this is key is two-fold. The tax advantage nature of an MLP actually lowers the cost of capital, which makes it easier for Kinder Morgan to raise money to grow its business. Further, investors tend to value MLPs at a higher multiple, so Kinder Morgan can sell assets down to El Paso and receive an instant value uplift from the marketplace. This dual advantage can lead to big-time outperformance over the long term.
Because of this MLPs are becoming important growth vehicles that really are helping to move America's energy boom forward. For example, natural gas export terminals are one of the projects that are easier to fund when held in an MLP. That's why we're seeing a number of companies sell potential LNG export assets into MLPs. Kinder Morgan is doing that too as its drop-down deal with El Paso Pipeline Partners includes its half interest in Gulf LNG, which is seeking to build a natural gas export terminal. El Paso Pipeline Partners can eventually use its units and debt capacity to fund the project at a lower capital cost than Kinder Morgan, thus improving the returns of the project.
Kinder Morgan is leading the way to build the critical infrastructure needed to keep America's Energy boom from slowing down. However, Kinder Morgan couldn't grow as fast as it is if it wasn't for the IRS. The MLP tax advantage, which is enjoyed by both El Paso Pipeline Partners and Kinder Morgan Energy Partners, enables both companies to raise capital at more favorable rates than Kinder Morgan. Because of this, Kinder Morgan can uses these entities to create a win-win situation that keeps oil and gas flowing while dividends and distributions keep growing.
Build your portfolio on top of this IRS "loophole"
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Matt DiLallo has the following options: short January 2016 $32.5 puts on Kinder Morgan and long January 2016 $32.5 calls on Kinder Morgan. The Motley Fool recommends El Paso Pipeline Partners LP and Kinder Morgan. The Motley Fool owns shares of Kinder Morgan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.