The IRS hands the US petrochemical industry a favorable ruling

Even the tax man seems to smiling at ethylene makers these days.

Just as US olefins producers bask in near record-high margins thanks to cheap feedstock and healthy downstream demand, the Internal Revenue Service has decided that, at least in one particular instance, these petrochemical players might be eligible for a more favorable tax structure going forward.

Yes, you’ve read that right.

An October 12 ruling by the Internal Revenue Service has opened the doors for US chemical producers to structure olefins business units as master limited partnerships, which generally are exempt from corporate taxes and have a relatively low cost of capital.

The decision came in response to a request by a company seeking to acquire and operate a steam cracker, and the IRS is pretty straightforward in its wording.

“Based solely on the facts submitted and the representation made, we conclude that income derived by [Company] X from processing NGLs into olefins will constitute qualifying income within the meaning of [Code Section] 7704(d)(1)(E) [master limited partnership structure],” the IRS said in its ruling. “We further conclude that income derived by X from marketing, transportation and storing of olefins will constitute qualifying income within the meaning of 7704(d)(1)(E).”

The IRS identified that company only as “X.” At least one financial market report on the matter identified it as Williams Companies.

Now, to be clear, the ruling refers only to the taxpayer requesting it, and the IRS stipulates that it may not be used or cited as precedent.

But if financial analysts seem to agree on one thing, it is that this ruling most likely will open the doors wide open for other companies to take a similar path. That means chemical giants including ExxonMobil Chemical, Shell Chemicals, Chevron Phillips Chemical, Dow Chemical LyondellBasell, Formosa Plastics and Westlake Chemicals stand to benefit.

Fitch, the credit-rating agency, said in a note Thursday that it anticipates that the ruling could result in the creation of new MLPs in the chemical sector, “as firms with assets that generate qualifying income under the new structure may seek to take advantage of the ruling.”

Other believe that while there is reason to believe companies will consider such a move, plenty of questions remain, and the MLP route may not be the way to go for some producers, particularly those with highly depreciated assets.

“We view this development as incrementally positive for producers such as [Westlake, LyondellBasell and Dow], although the timing and scope of potential benefits remains uncertain at this early juncture,” analyst Kevin W. McCarthy of BofA Merrill Lynch Global Research said Wednesday in a note to investors.

Many of the aforementioned producers are vertically integrated and use the olefins in the production of other chemicals and/or plastics, meaning they would likely have to separate their ethylene production from their downstream businesses in order to qualify for the MLP structure.

That said, many of these same companies plan to build new steam crackers, leaving the door open for them to adopt the MLP for those particular assets, some analysts suggest.

US ethylene production capacity could expand by 30% or more by 2017, based on announcements by major producers seeking to bask in the shale gas bonanza. New steam crackers could account for as much as 9 million mt/year of expanded capacity, with expansions and debottleneckings accounting for another 3 million mt/year, according to Platts data.

The IRS ruling comes at a time when issues such as a ballooning debt and a looming fiscal cliff dominate the headlines ahead of next month’s presidential election.

It also comes as olefins producers rack up record-high or near record-high margins. US cracking margins using ethane as a feedstock hit record-highs in April around the 50-cent/lb ($1,100/mt). Wednesday’s margins using ETHANE as feedstock were estimated at near 34 cents/lb ($750/mt). Five years ago, producers considered 10-cent/lb ($220/mt) margins good.

But the reality is that the energy industry has benefited from MLPs for many years now. The oil and natural gas industries, both E&P and midstream, together account for approximately 58% of MLPs, according to the National Association of Publicly Traded Partnerships. Energy and natural resource partnerships account for 89% of MLP market capital.

The other reality is this: MLPs won’t make sense to everyone. Companies will need to carefully study their situation and long-term strategy to determine if adopting such a strategy makes sense.

But first, they need more clarification from the IRS, so don’t expect much to happen anytime soon.

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