After market close on July 18, 2018, the Federal Energy Regulatory Commission (FERC) issued a final rulemaking policy that essentially walked back its original proposal on March 15 that triggered a selloff of MLPs.
FERC’s original proposed ruling disallowed MLPs with regulated interstate natural gas and oil pipelines to recover an income tax allowance (ITA) in their pipeline’s cost of service rate calculation. The March ruling led to an overhang of uncertainty over the outlook for individual pipeline revenues, MLP cash flows and distributions, and corporate structuring, which plagued the performance of midstream equities over the next few months.
Key points of the FERC’s accumulated deferred income tax (ADIT) guidance and income tax final ruling:
- The FERC’s original proposed rule planned to eliminate the ability of a MLP to recover an ITA after the Tax Cuts and Jobs Act. The new FERC ruling permits an MLP to retain an ITA in cost of service ratemaking as long as it reflects the reduction of the corporate tax rate from 35% to 21%. We view this as a positive as it allows a pipeline to include an income tax provision in its cost of service rate methodology, which allows for higher rates compared to no income tax provision, all else equal.
- The FERC’s original proposed rule raised uncertainty as to how pipelines with multiple owners of various structures (corporations and MLPs) would be treated under the policy. In the most recent ruling, FERC concluded that a natural gas company organized as a pass-through entity (read: MLP) is considered subject to federal corporate income taxes if all of its income or losses are consolidated on the federal income tax return of its corporate parent (read: general partner). This allows an MLP to book an ITA (commensurate with the new corporate tax rate) in the cost of service ratemaking calculation and clears up the uncertainty regarding how pipelines with multiple owners of various corporate structures would be treated. We view this clarification as a positive.
- The March FERC ruling called into question the status of a pipeline’s ADIT, which is essentially a pipeline’s accumulated ITA (liability) that has not been paid to the federal government due to the application of accelerated depreciation rates on certain pipelines. The rule proposed in March led investors to worry that MLPs would have to refund ADIT balances to shippers over time, or in a lump sum, creating further downside risk for MLP cash flows and valuations. The July policy rules that a MLP that no longer recovers an ITA may also eliminate its ADIT, meaning FERC will not require a refund of MLP ADIT balances to shippers on the pipeline. Corporations will be able to refund excess ADIT created by the tax law change over the life of the asset. We view this clarification on ADIT balances as a positive, given the uncertainty of MLPs potentially having to refund ADIT balances is removed.
As highlighted in the press release issued on July 18th, the FERC policy gave MLP management teams operating these impacted pipelines four options to proceed, as noted below:
- A pipeline can make a Section 4 filing to voluntarily reduce its rates to reflect the lowered corporate tax rate. If a pipeline chooses this option, FERC will provide a three-year moratorium on initiating a Section 5 rate investigation if said pipeline is operating at or below a 12% return on equity according to FERC Form 501-G.
- A pipeline can file an uncontested tariff settlement. If the settlement is submitted before year-end 2018, FERC will not initiate a Section 5 rate case.
- A pipeline can explain why no tariff change is needed and FERC would have the option to initiate a Section 5 rate case if rates appear “unjust and unreasonable”.
- A pipeline can take no action and FERC would have the option to initiate a Section 5 rate case.
On a final note, FERC did acknowledge that “permitting MLP pipelines to include a tax allowance in their cost of service results in a double recovery of the MLP pipeline’s tax cost”. We view that this language from FERC may allow for future rulemakings on the issue, which could open the door for “case-by-case” variations in the direct application of the role that the income tax allowance plays in the ultimate cost of service return calculation.
The July 18th FERC release lifted a cloud of uncertainty weighing on investors since the initial Mid-March Notice of Proposed Rulemaking (NOPR) statement. In our opinion, greater clarity around key issues has restored investors’ confidence that midstream business models, by and large, should remain relatively unimpacted by FERC’s actions. As a result, we see midstream sector equity valuations continuing to respond accordingly, reflecting the significant improvement in industry fundamentals that we’ve witnessed over the last several quarters. While issues of simplification, distribution stability, deleveraging, and equity market access remain concerns for some investors, we believe these issues are confined to a shrinking subset of the industry’s companies, which should diminish their impact on the midstream sector investment narrative. As these lesser important technical issues fade, we believe that fundamentals will come into greater focus and attract capital into the group.