May 24, 2018 | Annalisa Kraft
The Federal Energy Regulatory Commission (FERC) has busted the midstream MLP space wide open with its March 15 proposal to discontinue the income tax allowance on cost-of-service rates on MLPs holding natural gas pipelines. In this edition of Get The Point we analyze why companies are buying up their MLPs and which companies might be the next to consolidate.
FERC proposal is now considering stakeholder comments on the proposal, and a date for a final plan has not been announced.
But the impact of the announcement has been significant, and if anything, it's accelerating. The month of May has already seen Enbridge, Cheniere Energy and Williams announce on May 17 their intention to buy their respective limited partnerships, and both TC Pipelines and Boardwalk Pipeline Partners announced they are seriously considering changing their corporate structures.
It’s something that was at least touched on during the first-quarter earning updates by every company with gas pipeline assets structured as MLPs. Those lucky enough to own a preponderance of non-FERC jurisdictional or intrastate assets, or those with negotiated rates that are not going to be impacted much, made it clear that they will weather the storm. But some of their MLP brethren will be sweating.
Just to give a representative view of the expanse of the assets, the map below shows most of the major pipelines owned by MLPs in the U.S.
Source: OPIS PointLogic
The FERC notice
As OPIS PointLogic has reported, a 2016 federal appellate court decision, United Airlines v. FERC, forced FERC’s hand as the court found pipeline tariff rates’ return on equity calculations and income tax collection amounted to double recovery. FERC's March 15 announcement shouldn’t have come as a surprise as the agency was duty-bound to address the issue.
FERC stated, “The Revised Policy Statement establishes a policy that all pipelines organized as MLPs should eliminate any income tax allowance from their rates. Therefore, the Commission is initiating this rulemaking proceeding to consider the most efficient and expeditious method of accomplishing this goal consistent with the requirements of the NGA [Natural Gas Act] and the NGPA [Natural Gas Policy Act].”
FERC issued a notice of proposed rulemaking (NOPR) in Docket RM18-11. “The Federal Energy Regulatory Commission is proposing a process that will allow it to determine which jurisdictional natural gas pipelines may be collecting unjust and unreasonable rates in light of the recent reduction in the corporate income tax rate in the Tax Cuts and Jobs Act and changes to the Commission’s income tax allowance policies following the United Airlines, Inc. v. FERC decision,” it said.
The revised policy statement “explains that a double recovery results from granting a Master Limited Partnership an income tax allowance and a discounted cash flow (DCF) return on equity (ROE), and accordingly establishes a policy that MLPs are not permitted to recover an income tax allowance in their cost of service.”
While FERC is reviewing input before issuing a final rule, it seems that companies are anticipating that its ultimate form will be similar to the proposal. With the May 17 roll-up announcements and possibly more to come, there may be few big companies left actually affected by the MLP income tax policy change when it does takes effect. The May 17 restructurings alone total almost $30 billion.
In addition, it reduces the universe of midstream MLPs from 64 to possibly less than 50 by year end. And lastly, MLP unitholders will see distributions of more than $400 million go away from the three companies that announced the roll-ups last week.
At first, it seemed like FERC’s rulemaking had only prompted restructuring chatter for TransCanada’s TC Pipelines and Loews Corporation’s Boardwalk Pipeline Partners, but the roll-ups soon gained momentum with the big boys.
East Daley Capital’s Director of Financial Analysis Matthew Lewis explained to OPIS PointLogic that at least some roll-ups were to be expected. “The WPZ [Williams Partners] roll up isn’t a huge surprise to the market as management has hinted at it for a while. The tax allowance change by FERC is a significant headwind for [Williams Partners-owned] Transco, especially since they are required to file a rate case this year," Lewis said.
Daley concluded that "Transco would need to lower rates moderately if they stayed under an MLP. Under a C-Corp structure, they could probably squeeze out slight rate increases," he said.
The tax change was also "a decent headwind" on WPZ’s Northwest Pipeline, Lewis continued. "Although smaller, NW Pipeline has most of its revenue under maximum tariff rates, which means little revenue protection from negotiated rates. A C-Corp structure will save them from rate cuts on NW Pipeline. To sum up on WPZ, management must have felt the upsides (higher revenues on Transco and NW), outweighed the downsides of eventually having those earnings taxed,” he said.
A look at Spectra Energy Partners (SEP) by Daley Capital reveals a similar situation. "Positives on higher rates must be seen to outweigh negatives of becoming a taxable entity," Lewis said. "Texas Eastern, Algonquin, East Tennessee and Maritimes and Northeast all need to lower rates in our base scenario if they stay an MLP ($113 million annually we estimate)."
Of those, Daley calculates that Algonquin and East Tennessee could still see cuts under a C-Corp, but less severe, whereas "a C-Corp structure puts Texas Eastern on much safer (lower) ROE metrics.”
On the other hand, Lewis added said that he considers Enbridge Energy Partners's (EEP) decision to be "a bit of a surprise, as their revenue structure is set up to where costs of the tax allowance policy on EEP flow back to ENB [Enbridge] as benefits. So it’s taking from one hand and moving to the other...at the total company level no revenue is lost from these tax changes."
In the case of Enbridge, other factors might be part of the equation, Lewis said. "EEP has sold off a lot though, so perhaps management views the units as undervalued now. They also rolled in all their other subsidiaries (EEQ,ENF), so they are likely looking to simplify that structure. [It] could help their cost of capital down the road,” he said.
Lewis also offered OPIS PointLogic his best guesses on who might be next and why: TC Pipelines and Dominion Midstream.
”TC Pipelines (TCP) has large incentives from a tax allowance standpoint to roll up into the parent," he said. "They were by far the most exposed to downside from the tax allowance changes (on a percent of company revenue basis). Of course there are other downside variables that should be weighed (those assets become IRS taxable entities). But given the trend I would be surprised if they didn’t roll into TransCanada.”
For Dominion Midstream (DM), Lewis said the restructuring "also makes some sense. The pipes they hold don’t have huge downside exposure to the tax policies (they do have some), but the unit price has been shredded by the assumption Dominion will no longer use it to drop down assets into. The units may be cheap enough now where Dominion just buys them in.”
Outside of the abovementioned names, there aren’t too many other candidates for rollups.
FERC's MLP announcement came at the same time that the federal corporate income tax rate has been reduced from 35% to 21%, and FERC said it will be reviewing the tax allowances that pipelines receive, in light of the lower federal corporate tax rate. And this only one of several other issues that could factor in to an MLP's decision to restructure now, said Simon Lack, who founded and manages the American Energy Independence Index, an ETF devoted to North American energy infrastructure. These other issues happen to be coming to the fore right now, he said in a phone interview.
“MLPs are an expensive form of equity capital, and the investor base is very limited. A standalone MLP is not a good financing vehicle …if you’re raising money for growth," he said.
By rolling up their assets, MLPs can access the global equity investor instead of the wealthy, older American investor, Lack said. “MLPs are becoming a shrinking portion of energy infrastructure, but the fundamentals for energy infrastructure remain very good,” Lack added.
The shale revolution really changed the landscape for income-seeking investors, Lack said, as now the companies they invested in need the money for growth, and many of them have instituted distribution cuts. “The shale revolution has ultimately been the cause of that change,“ he said.
But FERC definitely played a role in the companies’ decision, too. “The change in the rules is definitely adverse for MLPs. The FERC proposal is a factor, definitely. There’s less incentive to be an MLP. They changed the economics of cost-of-service rates for pipeline,” Lack said
On top of it, the uncertainty and glacial pace of the FERC rulemaking process is a concern -- Enbridge highlighted it its announcement, Lack said. “FERC moves very slowly,” and the company wanted to get ahead of it, he observed.
When the corporate income tax rate was 35%, the savings for being an MLP were large enough to overcome the negatives, Lack said. Now, with the rate at 21%, the tax advantage of the MLP is significantly lower, and its less attractive to hold an MLP. Upon restructuring, these companies “can now check the box of a C-corporation and can access the global equity investor,” said Lack. “The general partners have these preferential economics with these incentive distribution rights and the governance rights are weaker for investors,” he said which is another drawback for long-only investors.
Lack also mentioned that U.S. pension funds have held back from midstream MLPs as they do not get the preferential tax treatment for holding that individual investors do.
Really big deals
Lack's comment about MLPs and growth valid, as, for example, Williams CEO Alan Armstrong said on the May 17 Williams Analyst Day that his company's decision is really about the growth projects. The transaction frees up excess cash at the Williams level to invest in growth, he said.
Armstrong offered anecdotal comment that he had visited some long-only investment firms in Europe which said while they loved Williams and Williams Partners's investment stories, they were just not impressed with having an MLP, given the tax situation.
Williams CFO John Chandler commented further on Analyst Day that he believes upon closing of the roll-up, the ratings agencies will deem Williams investment grade. Yet, the transaction will be structured to extend the period the company will not be a cash income tax payer to 2024.
The simplification of the structure is appealing “to a broader range of corporate investors," Williams said.
Source: Williams Analyst Day presentation
Enbridge said much the same in its release and conference call on its roll-ups, but gave a more negative spin to the reasons why.
“Under the newly changed FERC tax policy, holding certain interstate pipelines in MLP structures is highly unfavorable to unitholders and is no longer advantageous for Enbridge or the U.S. MLPs. The combination of this changed policy and the negative capital markets reaction has impaired the MLP structure for Enbridge's interstate pipelines," it said.
As proof, Spectra Energy Partners, which is being rolled up by Enbridge, stated in its May 8 earnings release it expected an approximate $100 million-plus per annum hit from the FERC rulemaking. “While many uncertainties remain in regard to the implementation of the recent FERC actions, if implemented as announced, SEP estimates the unmitigated impact to revenue to be approximately $100 million to $125 million per year, which is inclusive of an assumed disallowance for income taxes and exclusive of a payback of accumulated deferred income taxes.” markets reaction has impaired the MLP structure for Enbridge's interstate pipelines," it said.
And TransCanada CEO Russ Girling remarked on the company’s earnings call on April 27 that, “While approximately half of TC pipeline’s revenues are earned under non-recourse rates, in the absence of some form of mitigation, the remaining revenues under recourse rates are expected to decline as rate adjustments occur. Individual pipelines owned by TC Pipelines do not currently have a requirement to file for new rates until 2022, however that timing may be accelerated by the NOPR, except where moratoriums exist.”
On May 2, TC Pipelines announced it was slashing its distribution by 35% as a result of the FERC rulemaking and noted parent TransCanada would likely not support any growth from dropdowns. "The revised policy that would allow for no recovery of an income tax allowance in the cost-of-service rates of our pipelines with related follow-on impacts have had a profound impact on us and many in our industry... if implemented as expected, [it] will result in a material decrease in cash flows from our pipelines," CEO Nathan Brown stated at the time.
TC Pipelines’ stock plunged 28.7% on the day of the distribution cut news and has not recovered any ground through May 22.
Last men standing
So who’s left?
Bank of America Merrill Lynch (BAML) upgraded Energy Transfer Equity (ETE) to a buy on May 17, as analyst Dennis Coleman speculated on a similar roll-up into Energy Transfer Partners (ETP) in 2019.
On its May 10 earnings call, Energy Transfer Partners CFO Tom Long said most of its pipelines were under negotiated or discounted rates and the company expected no material impact.
But in the Q&A Chairman and CEO Kelcy Warren said all options are on the table “We are evaluating a C-Corp structure within our partnership it would most certainly be a structure whereby ETE acquires ETP….we don't see any mathematical scenario that makes any sense other than that one. If we had to make a decision today, we believe a simple purchase by ETE of ETP would be the structure,” he said.
Lack said he expected there might be roll-ups from Antero or Plains All-American, and like BAML analyst Coleman he thinks a deal may be brewing at Energy Transfer. Of the latter, he said, “They get asked about it on every earnings call.”
Hinds Howard, senior MLP research analysts for CBRE Clarion Securities, said in a May 20 note he expects there will be further simplifications. Like Lack, he expects action from Antero Midstream Partners, Energy Transfer Partners and possibly Plains, but he also speculated that Boardwalk Pipeline Partners, EnLink Midstream Partners, Dominion Energy Midstream Partners, EQT Midstream Partners, TC Pipelines, Western Gas Partners and Andeavor Logistics could do roll-ups. ”The structure is clearly under fire, primarily from a shift in the investor base, but also due to poor financial positions and FERC uncertainty," he wrote.
Hinds also put forth Enterprise Products Partners and Magellan Midstream Partners as roll-up candidates, but Lack said he didn’t believe Enterprise would do a roll up any time soon.
Interestingly, Kinder Morgan pioneered the structure of a midstream energy infrastructure MLP but exited the space in 2014, reversing the MLP trend. ONEOK also rolled up its ONEOK Midstream Partners last year, months before the FERC announcement.
Summing it up
Even as they make moves in reaction to the proposal, members of the pipeline industry are frustrated with the plan and do not agree that FERC has come up with the correct solution.
Attorneys for Vinson & Elkins LLP summed up the industry’s reaction via rehearing requests to FERC in a note soon after the FERC notice.“The requests covered a myriad of issues, but consistently claimed FERC failed to engage in reasoned decision-making, misinterpreted the Court’s Order, departed from the important policy goals underpinning its prior policy, did not adequately consider the multiple forms of MLP structures and ownership, failed to assess the overall impact on the industry, and was too broad-reaching in scope," they wrote.
The attorneys noted cost-of-service rates are complicated. “Most FERC-regulated entities do not charge cost-of-service rates for all of the services they provide. Revenues from negotiated rates and market-based rates do not change, and discount rates may not change, when the cost of-service rates are updated,” continued the attorneys. “This diversity of facts for each regulated entity and the collection of regulated entities in each MLP or other organization must be analyzed on a case‑by‑case basis to understand what impact, if any, the March 15th issuances will have on any given company.”
The industry's trade groups are watching for FERC's final decision, said Interstate Natural Gas Association of America President Don Santa. “Pipelines and their parent energy holding companies make decisions based on their particular circumstances and their judgment about what will best enable capital attraction and create shareholder value," Santa told OPIS PointLogic. "Still, because the energy pipeline business remains subject to economic regulation, the regulatory climate is a factor in making such decisions. On point, the statement by Enbridge announcing its corporate restructuring highlighted the risks created by FERC's revised income tax policy statement as a principal driver for this proposal.”
However, the comments are unlikely to sway the Commission, said ClearView Energy Partners in an April 24 note made available to OPIS PointLogic. The firm believes most of those companies will ultimately be disappointed, although it says FERC might allow ‘limited’ tax allowances.
Ultimately, FERC’s final rule will have major implications for MLPs if the rule as proposed stands. But it's not necessarily the end of pipeline MLPs. “We would disagree that FERC’s hard line approach to MLP tax recovery precludes the use of structure in the sector altogether – although we would readily concede that it would likely have adverse consequences for those corporations that own MLPs,” ClearView said.