Yesterday’s MLP Selloff: Much Ado About Not All That Much?
The first responses to yesterday’s Federal Energy Regulatory Commission (FERC) reversal of a longtime policy on tax costs for interstate pipelines started crossing the wires shortly before the market’s close and in the hours thereafter.
The good news so far is that for most midstream master limited partnerships (MLPs), the effect of the sudden change to cost-of-service rates would appear to be minimal. For additional background on this matter, see yesterday’s alert.
That’s because these days pipeline contracts mostly use index-based, market-based, or negotiated rates. Utility-style cost-of-service rates were more the norm in decades past when the business was a lot less competitive.
The FERC’s new policy would only apply to interstate pipelines with cost-of-service rates. And it looks like this policy would be applied via rate-case proceedings on a pipeline-by-pipeline basis, not all at once.
But even for those pipelines with cost-of-service rates, there are ways for operators to offset changes to the tax-allowance rule in other areas.
First, perhaps owing to price competition in the sector, there are some costs that MLPs have not previously sought to recoup via cost-of-service rates, such as maintenance and depreciation.
We would expect them to aggressively seek recovery of those costs now.
Second, the FERC believes that its former policy was double-counting tax costs, in both the cost-of-service component of rates and in the allowed return on equity (ROE) that it calculates.
With the tax allowance gone from the former, tax costs will need to be addressed in the latter. While an MLP is not allowed to earn a return on tax costs, the FERC’s rationale is that its ROE calculation will take those costs into account when determining returns necessary to attract investor capital.
If MLPs were lax about this aspect of ROE in the past, they will almost certainly press their case for full recovery via ROE now.
Third, MLPs with cost-of-service rates for some pipeline infrastructure could choose to shift more contracts to index-based, market-based, or negotiated rates for new contracts or when contracts come up for renewal, if that ends up being better than the alternative. For some, this transition was already underway long before today.
Lastly, we would expect those most affected by this change to vigorously challenge this ruling via litigation and regulatory proceedings.
Now, let’s run through brief summations from the MLP holdings we’ve heard from thus far.
Underlying MLPs for Recent Options Trades:
Buckeye Partners LP’s (NYSE: BPL) pipelines mainly operate under index-based, market-based, and negotiated rates. So they’re not affected by the FERC order. As such, Buckeye does not expect the change to have a material impact on its operating results.
Enterprise Products Partners LP (NYSE: EPD) said that while it does have interstate pipelines with rates based on cost of service, the MLP does not expect the disallowance to have a material effect on posted tariffs. Further, EPD said it does not expect the FERC revision to materially impact earnings or cash flow.
Spectra Energy Partners LP (NYSE: SEP) has more substantial exposure than others to cost-of-service rates, which cover about 40% of its U.S. gas pipeline transmission revenue (or about 25% of consolidated revenue).
Meanwhile, rates on its oil pipelines (about 20% of consolidated revenue) are negotiated, so they’re not affected by this change.
Although some of its gas pipelines are affected by this change, SEP says there should be no material financial impact to its previous guidance for full-year 2018.
For future rate cases, SEP expects to offset a significant portion of the lost tax allowance by requesting other items be included in cost-of-service rates.
Even before this tax-allowance issue came to fore, SEP previously noted it had substantially built up its gas transmission rate base in recent years, but had yet to file for returns on any of it.
That, along with its request for inclusion of other cost-of-service factors, could mean this rule change would not materially affect SEP’s cash flows in the years ahead.
Legacy Equity Portfolio Holdings:
Andeavor Logistics LP (NYSE: ANDX) has some FERC-regulated pipelines, but estimates a total drag on annual EBITDA of less than $10 million, an amount equivalent to 0.8% of this year’s projected cash flow.
Interestingly, ANDX was actually a party to the court case that prompted the FERC ruling, and it expects to receive refunds that would add to future cash flows.
No word from CNX Midstream Partners LP (NYSE: CNXM), though its units are up nearly 3% today.
Energy Transfer Equity LP’s (NYSE: ETE) flagship subsidiary Energy Transfer Partners LP (NYSE: ETP) said that many of its rates are set via negotiation, which would not be affected by the change. And potential adjustments to other rates would be limited.
Further, ETP notes that since it provides many of its pipeline services at a discount to the potential maximum tariff, there would be little cause for adjustment.
As such, ETP believes the revision is not expected to have a material impact on earnings and cash flow.
Enterprise Products Partners LP (NYSE: EPD) was covered in the section above.
EQT Midstream Partners LP (NYSE: EQM) said that 89% of its contracted transmission capacity is under negotiated agreements and, therefore, not subject to the FERC ruling. Accordingly, it expects a minimal impact, if any on its financial performance.
No word from Sanchez Midstream Partners LP (NYSE: SNMP), though the MLP is up nearly 3% today.
Even though it’s a C Corp., TransCanada Corp. (NYSE: TRP, TSX: TRP) has a midstream subsidiary structured as an MLP. While TransCanada’s share price is basically where it was a week ago, its U.S. subsidiary TC Pipelines LP (NYSE: TCP) has gotten hammered in the absence of any official statement from either entity.
That’s a bit concerning since TCP is an important source of funding for TRP. So it would be nice to have some clarity on how the ruling will affect their operations.
Like TransCanada, Williams (NYSE: WMB) is structured as a corporation, but relies even more heavily on its MLP subsidiary Williams Partners LP (NYSE: WPZ). About a third of WPZ’s gross margin is derived from three main interstate pipelines.
The company says FERC’s revised policy would only affect rates on a prospective basis, such as when it files for rate cases in the future.
Further, its massive Transco pipeline will earn 50% of revenue from negotiated rates by year-end, which would not fall under the FERC ruling.
And its Northwest Pipeline settled rates with shippers last year.
Lastly, rates on its Gulfstream Natural Gas System are all negotiated.
The bottom line is that the FERC ruling should only affect a relatively small percentage of revenue. Accordingly, management does not expect the change to impact previous guidance for dividends, distributions, and growth rates at either entity.