Turn the Beatdown Around
Assuming the market cooperates, we’ll have another trade alert early next week.
For now, I’d like to address the continuing selling pressure in the master limited partnership (MLP) space.
At the market level, we need the recent volatility to abate. The broad-market selloffs are extremely damaging when the MLP space is already on weak footing.
At the sector level, the MLP space needs to find a bottom. The entire sector continues to face significant selling pressure following the FERC ruling.
To this end, the sector needs to get past the various Wall Street analyst downgrades and target-price revisions prompted by the rule change and the sector’s continuing weakness. Most analysts have checked in at this point, but there are still a few stragglers.
At a company level, we need MLPs to quietly execute on their business and financial targets, while proving that the rule change didn’t merit the resulting selloff.
The question now is what might spark the eventual rebound?
After the sector bottomed in early 2016, the catalyst was the recovery in energy prices. But that correlation fell apart last year.
This year, the catalyst was supposed to be rising distribution coverage and lower leverage. But even before the potential strain on cash flows from the FERC ruling, that theme wasn’t gaining any traction.
Perhaps mounting a successful challenge to the rule change via regulatory rehearings or litigation is another possibility. While it’s probably too much to expect an outright reversal from this FERC—the new chairman only just took the gavel in December—there does appear to be some room to argue for a tailored approach to taxation.
In many ways, we’ve been here before. This is the third time the FERC has changed its mind about the rule. The first came in the mid-1990s, then again in 2005, only for similar litigation involving some of the same players to bring this matter to the fore, once again, 13 years later.
In fact, the FERC actually argued in favor of allowing income-tax allowances in cost-of-service rates for MLPs in the case before the D.C. Circuit Court of Appeals that triggered the latest revision.
This time around, however, the court swatted down the existing rationale, which was largely based on the court’s own prior ruling. And the FERC felt compelled to act accordingly.
The issue boils down to creating tax parity on returns for investors in corporations and MLPs. The court contends that because MLPs don’t pay taxes at the entity level and that taxes are implicitly taken into account in the ROE, an income-tax allowance and an ROE amount to an excessive double recovery of taxes.
Although MLPs don’t pay taxes at the entity level, tax liability is shared at the limited partner level. Both the court and the FERC are aware of that.
Further complicating the matter is that the vast majority of an MLP’s distribution is tax-deferred until an investor sells the units or their cost basis drops to zero.
As a fair-minded person, I can see how it’s reasonable to say that there’s a difference in the tax burden for corporations, MLPs, and their respective investors.
However, that doesn’t mean it makes sense to discontinue income-tax allowances for MLPs entirely—it just means that the FERC should probably use a different calculation for MLPs than the one used for corporations.
In fact, the court seemed to leave the door open to this possibility. And the FERC, itself, did invite feedback from the industry along those same lines. But the FERC’s proposed and final rules demonstrate no such nuance.
A skillful attorney should be able to be to make the case that a potential tax liability exists for MLP unitholders and that it’s just and reasonable for the FERC to account for it in a different manner than for corporations. That would help claw back some of what was lost.
But litigation and regulatory rehearings don’t move at the speed of markets.
Instead, the biggest potential catalyst for the sector may be the prospect of mergers and acquisitions (M&A).
MLPs may choose to sell FERC-regulated assets or swap them for assets largely contracted under market or negotiated rates. Or an MLP with sizable cost-of-service exposure could dilute it by merging with an MLP that doesn’t.
Corporations that own an MLP’s general partner may decide they’ll get better returns by buying back their former assets and bringing them in house. That hints at another detail for which we still lack clarity: how the FERC rule would affect a corporate owner’s cash flows from an MLP.
That could be what legacy holding Williams (NYSE: WMB) ends up doing. Although Williams is organized as a corporation, its main operating asset is MLP subsidiary Williams Partners LP (NYSE: WPZ).
Since Williams is a corporation, the FERC ruling suggests the potential for more favorable treatment for Williams over WPZ’s unitholders. Even if that is the case, that obviously won’t remove the entire overhang on the two companies.
Consequently, Williams could decide to roll up its subsidiary, which it hinted was a possibility in its press release responding to the FERC ruling.
And as Williams CEO Alan Armstrong observed more recently, “We’ve always been pretty agile when it comes to making structural changes when we needed to, and I would expect us to the same here.”
Lastly, some MLPs may decide to convert to corporations, though that’s a “forever election” that’s “not to be taken lightly” as one leading industry player recently put it. Indeed, the potential tax consequences of conversion would be a huge headache for longtime unitholders.
Nevertheless, this week the Tallgrass complex chose to do just that. Tallgrass Energy GP LP (NYSE: TEGP) agreed to acquire its MLP subsidiary Tallgrass Energy LP (NYSE: TEP) in a $1.7 billion deal that would see the combined entity taxed as a corporation.
While Tallgrass had announced it was considering such a restructuring well before the FERC ruling, federal regulators’ decision likely hastened this outcome.
Meanwhile, I keep reading reports about all the private-equity liquidity that’s sloshing around, searching for steady returns at reasonable valuations—you know, the kind that pipelines can offer.
To this end, MLPs could seek private-equity investors to help finance growth projects that are on hold due to low equity prices.
Or pipeline owners could carve out certain assets, sell them to private-equity firms, and then use the proceeds to reduce leverage or redeploy the cash toward better growth opportunities.
We could even see whole firms get acquired.
Let’s see if the surge of spring changes things.