Oneok-Magellan Midstream Deal May Be in Trouble

Magellan units were off 0.9% Monday to $58.55, while Oneok (OKE) stock was down 0.1% at $59.80. 

The deal spread has widened to about $5 per unit from about $1 in the aftermath of the deal announcement a month ago. That’s a wide spread for a transaction that the two companies said they aim to complete in the third quarter. Oneok is offering $25 a share in cash and 0.667 of Oneok stock for each Magellan unit.

On Thursday, the CEO of Energy Income Partners, the fourth-largest Magellan holder with a 3% stake, said it will vote against the deal, citing a potentially big tax hit for EIP investors. Barron’s highlighted this problem immediately after the deal was unveiled and also wrote the deal was no sure thing.

Magellan, like other pipeline or midstream companies, pays a lofty distribution of 7% that has largely been tax-deferred. The merger deal will result in much of those deferred taxes being payable.

EIP said “taxes paid by investors will exceed the premium offered by ONEOK and any other potential benefits from the merger,” and added that Magellan should remain a stand-alone entity whose returns “on invested capital are far superior to Oneok.”

Oneok is an energy pipeline structured as a corporation while Magellan is a partnership. Given the way the deal was structured, Magellan holders will face a large tax liability for what had been tax-advantaged distributions (the partnership equivalent of dividends) that they have received.

New York tax expert Robert Willens told Barron’s that much of the tax bite will be at ordinary income-tax rates and not more preferential capital gains.

EIP estimated that the average retail investor in one of its funds would pay an average tax of $10 to $12 per unit depending on their federal income-tax bracket versus the $9-per-unit premium offered by Oneok.

“Since the average Magellan unit holder has held their units longer than EIP, their tax bill would be higher on average. Such a tax bill paid by all 202 million units outstanding would amount to well over $2 billion. Compared to the purported tax benefit to the combined Oneok/Magellan entity of $1.5 billion, only 23% of which would accrue to Magellan unit holders postmerger, this deal represents an enormous transfer of value from Magellan unit holders to the Internal Revenue Service and Oneok shareholders,” EIP wrote in its letter to Magellan.

EIP urged Magellan and Oneok to provide a “full and detailed” assessment of the tax consequences for Magellan holders as part of the proxy statement for the deal. That proxy is due in about two weeks.

In a statement, Magellan said, “Our pending merger with Oneok will create a stronger and more diversified midstream company and deliver significant value to Magellan unit holders. The transaction provides a significant upfront cash component and an opportunity for Magellan investors to benefit from the upside potential and attractive cash dividend of the combined company.”

On the tax issue, Magellan has said, “While the transaction causes unit holders’ deferred taxes to become currently due, most of the taxes owed (all except any incremental gain generated by the premium received) will reflect tax liability that already exists as a direct result of significant deferral of income tax over the entire holding period.” 

Rob Thummel, a portfolio manager at Tortoise, an energy-focused investment firm that owns stock of both Oneok and Magellan, says the firm hasn’t decided whether to support the deal. He said that what James Murchie, the veteran CEO of EIP, wrote to Magellan on the tax issue was right. “We want to give the companies a chance to articulate their long-term plan” in the proxy, he said. 

Thummel added that Magellan holders also are asking whether the company is worth more than the current $65 per share offered by the Oneok deal.

The initial conference call wasn’t a big success with Citi analyst Spiro Dounis writing that investors “struggled with the strategic rationale” for the deal. There is little overlap between the two companies with Magellan mainly shipping oil products such as gasoline and crude, and Oneok focused on natural-gas liquids.

A key vote will be from ALPS Advisors, which runs Alerian funds. ALPS is Magellan’s largest investor with a 8% stake. It had no immediate comment.

Pipeline mergers generally get shareholder approval, and that looked like the case initially here. But the deal suddenly looks cloudy as Magellan holders weigh the tax hit from the transaction and other issues.

Write to Andrew Bary at [email protected]