Our take on the FERC’s ruling and the broad-based midstream selloff that followed.
What triggered the market reaction?
Yesterday, the FERC announced that it will no longer allow MLP interstate natural gas and oil pipelines to recover an income tax allowance in their cost of service rate calculation. The announcement, which came as a surprise to most, implied an immediate reduction in fees charged to regulated pipeline customers ultimately translating to net reduction in pipeline cash flow. Uncertainty associated with the ruling’s applicability and the lack of clarity around the magnitude of the ruling’s impact on each company triggered a broad based sector selloff.
What does the FERC announcement mean?
Simply put, with an elimination of the tax allowance, MLPs possessing regulated interstate pipelines would enjoy an immediate boost to pipeline returns on equity (ROE). Historically regulated pipeline ROE’s have fallen into a typical range between 10-14%. By example, the absence of the tax allowance could immediately boost pipeline returns to 20%+, a level significantly higher than what has previously been deemed acceptable.
In order to comply with FERC’s ruling, pipeline operators will be required to reduce cost of service fees to reflect the absence of the tax allowance. The reduction in cost of service fees will adversely impact revenue and cash flow generated by these regulated pipelines which is a clear negative for operators of these pipelines.
It’s important to point out that the ROE calculation for a pipeline can be influenced by variables other than revenue. For instance, William’s Transco pipeline boosted integrity spending during 2017. The corresponding increase in operating expense should effectively lower Transco’s ROE on a year over year basis. As a consequence, the ramp in Transco spending may ultimately mitigate the negative impact of the ruling.
Who is impacted?
There are three ways in which pipeline shipping rates can be structured. First, rates can be formulated on a ‘cost of service’ basis, second, they can be ‘negotiated’ between shipper and pipeline operator, and third, they can be ‘market based’ reflecting current supply and demand fundamentals for the transportation service provided.
Given the widespread nature of the market’s reaction, one might conclude the FERC’s announcement would have sweeping impact on the entire sector. In reality, FERC’s ruling only impacts long-haul pipelines, where ‘cost of service’ rates have been regulated by FERC.
Who is not impacted?
Importantly, other long-haul pipelines that do not apply fees on a cost of service basis will not be impacted. That would include those pipeline operators that charge fees that are determined on a market-based or negotiated basis.
Similarly, other midstream assets not impacted by the ruling are gathering assets, intrastate pipelines, processing and fractionation facilities as well as tanks, terminals and docks.
In addition, pipeline companies structured as C-corps will have to justify their rates based on ROE’s adjusted for recent tax reform measures. This issue was widely known and discussed by many companies during the fourth quarter reporting season. What was new, however, was the fact that compliance requirements associated with the ruling implied an acceleration in timing, which may have caught some off guard.
Several companies expecting to be unaffected by today’s ruling were quick to issue announcements to that effect. Enterprise Products Partners, LP (EPD), Andeavor Logistics, LP (ANDX), Energy Transfer Partners, LP (ETP) and Kinder Morgan, Inc. (KMI) all publicly stated that there will be no material financial impact to their business attributable to the FERC ruling.
Where is the greatest impact?
Again, clearly an impact to financial results will be felt by those companies that have significant exposure to regulated long-haul pipelines transporting natural gas as well as liquids and refined products.
What can operators of these regulated pipelines expect over the near term?
For natural gas pipeline operators, FERC has offered a number of ways to facilitate compliance with a necessary rate adjustment by year end 2018. Should these companies fail to comply voluntarily by year end 2018, FERC could initiate a section 5 investigation which would formally commence the evaluation of specific rates.
With regard to crude and liquids pipelines, FERC will examine and ultimately deal with tax changes for regulated pipelines within its regular five-year review of its pipeline cost index. The next such review will take place in 2020.
Given the diversified nature of many of the large capitalization companies within the industry, it’s logical to conclude that financial impacts will vary by asset composition. In our view, many of the companies impacted by yesterday’s volatility have already ‘paid the price’ in market capitalization in excess of what we believe the eventual liability will be.
What does this mean for midstream investors?
FERC’s ruling and its complexity came at an inconvenient time. With sector sentiment already pressured by concerns with GP/LP reorganization and the headwinds associated with potential Incentive Distribution Right (IDR) elimination transactions, the additional uncertainty presented with FERC’s adverse ruling clearly provided impetus for many to ‘give up’ on the sector.
We acknowledge that today’s market activity has, in some cases, appropriately reflected the impact of FERC’s ruling, but importantly, those instances are in the minority. For the remainder of the group, we believe downside pressure from levels already reflecting a discount to historical valuation has created an extremely attractive entry point. With recent quarterly results providing evidence of improvement in both commodity prices and volumetric growth, we remain confident in the view that midstream fundamentals are in fact getting better, which we believe should be supportive of sector valuation throughout 2018.
Past performance is no guarantee of future results.
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