FERC Ruling Roils MLP Sector
Shortly after 11 a.m. today, the entire MLP sector got rocked by a Federal Energy Regulatory Commission (FERC) decision that would no longer allow interstate pipelines to recover tax costs via cost-of-service rates.
The revised policy could affect natural gas pipelines by late summer, while oil pipelines may not see any changes until 2020. Long-term favorites are getting hit hard in the selloff.
To what extent is today’s decline warranted?
Given recent selling pressure in the sector, we can’t blame investors for selling first and asking questions later when blindsided by the federal agency’s sudden reversal of longtime policy.
This decision stems from a D.C. Circuit Court of Appeals case that claims MLPs were recovering tax costs twice—in the cost-of-service component of rates, as well as in the allowed return on equity.
First, this may not affect pipelines under existing contracts, many of which have long-term durations. That’s because there’s a strong Supreme Court precedent, known as the Mobile-Sierra doctrine, that does not allow FERC to modify rates in existing, freely negotiated contracts unless they can be shown to adversely affect the public interest.
Second, if that is indeed the case, the new rates would only apply to new pipeline infrastructure or when contracts come up for renewal.
Third, as noted earlier, there are two components of pipeline rates.
- Cost of service allows pipelines to pass along costs to customers, but does not allow a return on those costs.
- Return on equity allows pipelines to earn a sufficient return to attract investor capital.
It sounds like pipelines could still recover tax costs via allowed return on equity. The FERC’s approach to setting rates uses a discounted cash flow (DCF) methodology that evaluates the after-tax return necessary to attract capital. That return should implicitly include the effect of tax costs.
In other words, there is still a mechanism for pipelines to recover tax costs via rates, but it’s now limited to the return calculated by the DCF methodology. This ruling would simply close the door on a potential double recovery of tax costs via the separate pass-through of income-tax allowance through cost of service.
Fourth, we would expect the pipeline industry to vigorously contest this decision via litigation and through regulatory proceedings.
Where does that leave us?
Today’s selling may be overdone. But it leaves an additional overhang on an industry that was already in turnaround mode.
Depending on how things shake out, this could lead to downward revisions of estimates of future cash-flow generation and price targets, not to mention near-term volatility.
A strong concerted response by the sector could help stabilize unit prices. We would expect this to come from various trade associations, though it would be good to hear from individual companies, as well.
Given the uncertainty this has injected into an already challenging market environment, all MLPs with buy targets should be considered de facto Holds until we have greater clarity on the effect of this rule change, the industry’s response, and how this might affect individual holdings.