FERC stated that it would comply with a federal court’s previous remand that cost-of-service1 tariffs on interstate natural gas and oil pipelines owned by master limited partnership (MLPs) would no longer receive an income tax allowance (ITA).2 For pipelines owned by c-corps, FERC also sought to adjust pipeline tariffs to reflect the recently reduced corporate tax rate to 21% (previously 35%) as a result of the Tax Cuts and Jobs Act that was signed into law in December 2017.
Natural gas pipelines have been directed to comply by the end of the year, whereas liquids pipelines will be reviewed in 2020, with implementation potentially in 2021.
Assessing the potential impact
Based on our analysis, though the ITA adjustment may have a negative impact in isolation, the impact could be potentially mitigated by factors such as whether the pipeline has been under-earning its cost-of-service and whether the rate base includes all of the investment and operating expenses incurred.
Importantly, the number of pipelines owned by MLPs that employ a cost-of-service tariff structure is relatively small. Even then, a pipeline often employs multiple tariff structures – such as negotiated rates – on various parts of the system.
It is important to note that negotiated tariffs are not impacted by today’s FERC actions. Generally, most pipelines built over the last few years have been based on negotiated tariffs. For example, major recent pipelines such as Energy Transfer Partners LP’s (NYSE: ETP) Dakota Access Pipeline and Rover Pipeline, Enterprise Product Partners LP’s (NYSE: EPD) Midland-to-Echo Pipeline, Targa Resources Corp’s (NYSE: TRGP) recently announced Grand Prix NGL Pipeline, and ONEOK Inc’s (NYSE: OKE) recently announced ElK Creek Pipeline, among others, all employ negotiated tariffs and are not affected by the FERC decision.
Further, typical midstream assets such as storage, import/export terminals, intrastate pipelines, gathering pipelines, processing facilities, fractionators, blending facilities, among other asset types are also not affected. Major midstream companies such as Energy Transfer Partners, Enterprise Product Partners, Targa Resources Corp., Williams Partners LP (NYSE: WPZ), MPLX LP (NYSE: MPLX), and Magellan Midstream Partners (NYSE: MMP) have diversified operations and derive a significant amount of their cash flow from these aforementioned types of assets.
What midstream management teams have said
We continue to assess the impact of FERC’s actions, though we believe that the actual impact will be less than what the immediate extreme market movements might suggest.
A number of major midstream companies have already publicly commented, virtually all of them stating that the impacts are small.
- ETP estimates that “these revisions are not expected to have a material impact to ETP’s earnings and cash flow”
- EPD announced the ITA changes “are not expected to have a material impact to earnings and cash flow”
- MPLX “expects these revisions to have a de minimis effect on its earnings and cash flow”
- Andeavor Logistics LP (NYSE: ANDX) estimates the ITA impact to be “less than $10 million annually”
- DCP Midstream Partners LP (NYSE: DCP) announced a “de minimis impact”
- Tallgrass Energy Partners LP (NYSE: TEP) expects “the impact to be immaterial”
- Magellan Midstream Partners LP (NYSE: MMP) “does not expect a material impact” from ITA
- Genesis Energy LP (NYSE: GEL) estimates “less than 5%” of segment margin are subject to FERC oversight
Further, we believe midstream valuation levels today do not reflect operating and financial fundamentals, even after baking in the impact of these ITA changes. For example, the Alerian MLP Index (AMZ) currently yields 8.5%, which is at levels we saw in the first quarter of 2016 when crude oil was trading around $30 per barrel (currently ~$60 per barrel) and in which both liquids and natural gas volumes were meaningfully lower than today’s volumes.
We will continue to monitor the effects of the March 15 announcements and expect additional MLPs to provide guidance that may further calm investors. We do believe that the resulting market movements were a knee-jerk reaction – a sell now and ask questions later panic ̶ that resulted in a sharp sell-off. We believe that as investors get a better sense of the true impact, the price impact will ultimately normalize and investor focus may return to what we believe are generally sound fundamentals.
- ^Previously, for pipelines with a tariff based on a cost-of-service methodology, pipeline owners could recover an income tax allowance.
- ^Revenue and tariff structure that allows a pipeline to recover the cost of owning and operating a pipeline. These costs generally include operating expenses, maintenance expenses, depreciation, a reasonable return on capital invested, and, until FERC’s 3/15/18 announcement, taxes.
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The Alerian MLP Index is a float-adjusted, capitalization-weighted index measuring master limited partnerships, whose constituents represent approximately 85% of total float-adjusted market capitalization.
Investing in MLPs involves additional risks as compared to the risks of investing in common stock, including risks related to cash flow, dilution and voting rights. Each fund’s investments are concentrated in the energy infrastructure industry with an emphasis on securities issued by MLPs, which may increase volatility. Energy infrastructure companies are subject to risks specific to the industry such as fluctuations in commodity prices, reduced volumes of natural gas or other energy commodities, environmental hazards, changes in the macroeconomic or the regulatory environment or extreme weather. MLPs may trade less frequently than larger companies due to their smaller capitalizations which may result in erratic price movement or difficulty in buying or selling. Additional management fees and other expenses are associated with investing in MLP funds. Diversification does not guarantee profit or protect against loss.