On July 18, 2018, FERC1 offered up another surprise to the Master Limited Partnership (MLP or LP) market, after already causing turmoil in March when, during market hours, they announced a major policy change. Height Securities, LLC, a research provider, summarized the most recent change:2
In an unexpected move last night, FERC finalized their Income Tax Allowance Policy for MLP pipelines, but with substantial changes, which we believe should restore confidence in the sector. FERC offered MLP pipelines two major concessions: first, MLPs may take a tax allowance under certain circumstances for a 3-year period. Second, FERC is wiping clean MLPs accumulated deferred income tax balances, rather than requiring the MLPs to refund these balances to customers.
The full details of the announcement can be found on FERC’s website.3 We believe this surprise decision should help restore confidence in parts of the midstream sector that were impacted by the previous policy change. However, this partial reversal to the FERC policy announcement from March, which we discussed in a previous post doesn’t repair the damage created by the announcement.
It is important to recap the turmoil that subsequently occurred and discuss some of the key changes in the sector that were likely a direct result of the FERC decision. We believe investors should take time to reflect on major events, since it can help us make rational investment decisions based on fundamentals, which can experience rapid changes from exogenous policy-led shocks.
Prior to the market opening on July 19, 2018, Fort Washington’s Midstream team took a step back and reflected on what happened in March, why it happened, and why we saw the July 18, 2018, announcement as positive for company fundamentals, valuations, and thus investment opportunities.
On March 15, 2018, at around 11a.m. ET, FERC announced that MLP companies will no longer be able to take an income tax allowance (ITA) on interstate oil and gas pipelines. This created a plethora of concerns for investors, including that MLPs would be required to refund accumulated deferred income taxes to shippers. The result was a 10% intraday drop (within an hour) for the Alerian MLP Index (AMZ). The market recovered from this initial drop, closing down 4.8% on the day as the market came to a partial understanding of the impact of the ruling. Investors seemed to segment LPs into a group for whom the impact of the decision would be minor (mostly large cap and the bulk of the index), and those that could be materially impacted such that the equity became impaired (due to a significant “blow out” in the cost of capital). Within eight trading days, the impact was apparent — the AMZ was down 9%, with those having impaired equity off significantly more. The top four “losers” over the period were down 19%, 26%, 30%, and 36%.
While it was expected that some LPs would challenge the decision, the general view was that FERC wouldn’t waiver that much, if at all. And, if they did waiver, it would be after a prolonged period of industry consultation — a process that we felt could take at least a year. As a result, companies started to reassess their corporate structures. GP acquisitions of LPs that might have been off the table or “down the road” suddenly became topical.
Implications of the Announcement
One of Canada’s largest midstream companies decided to collapse the bridge between its various subsidiaries and announced plans to acquire the LPs, two of which were in the AMZ and were down 26% and 19% within eight trading days around the announcement (March 13, 2018 to March 22, 2018). This deal was announced on May 17, 2018, with an expected vote in late July. Part of the justification for their transaction included:4
- “…as noted on May 10, 2018, recent FERC actions and the regulatory rate impact from U.S. Tax Reform have called into question the long term viability of MLPs, in general.”
- “…market’s reaction to the FERC actions has compounded the funding viability of the sponsored vehicles.”
- “The FERC resolution is uncertain and may take quite some time to be fully resolved.”
Another large Canadian midstream company responded to FERC’s March statement:5
- “…potential to significantly reduce cash flow from our pipeline assets.”
- “MLPs are no longer a desirable structure in which to hold interstate pipelines.”
- “Growth as a dropdown vehicle for TransCanada is not currently economically viable.”
One of the equities that suffered the most after the announcement (down 36% during the eight days previously mentioned) filed a request for clarification or rehearing from the FERC to clarify the policy changes.6 These hearings, to the best of our knowledge, haven’t commenced yet. In addition, on the earnings call, the company’s management stated:7
As long as this issue at FERC is unresolved and pipeline MLPs continue to trade at such depressed levels, we do not believe we can access the capital markets for new equity at DM on reasonable terms. Therefore, absent a material improvement in the MLP Capital Markets and Dominion Energy Midstream’s market price, we will not be making the previously planned dropdown of a portion of our investment in Cove Point this year. Furthermore we plan to restructure the incentive distribution rights at DM prior to our returning to the market for new equity.
The FERC policy change resulted in material changes to the financial plans of the company, which included a slowdown in the pace of drop downs to the LP, and thus slower growth in potential cash flows and distributions to unit holders. It may have also resulted in the plan to sell assets that form part of a joint venture, a decision that we view as negative for the equity.
A large U.S. midstream C-Corp also decided to do the same, perhaps earlier than expected but opportunistically. This deal is coming for a vote soon. Regarding the announcement, they said:8
- •“…think that’s probably going to take a long period of time to settle, years probably for that to be settled with the FERC and obviously we don’t have time to do that…”
- “…following that announcement on March 15, we immediately began looking at alternative structures, things we could do to respond. One of those was a tax-free roll up, the other of course was the taxable roll up… you can see this morning where we landed…the ideal solution was to do with a taxable roll up.”
- “We reached final agreement last night to acquire all of the outstanding public units of WPZ. This will be structured as a 100% stock-for-unit transaction.”
While not impacted as much by the FERC policy change (and down 8.6%, largely a result of other issues), a midcap midstream company was acquired by its GP, with the deal closing just hours before the recent partial policy reversal from FERC. A deal, which was a direct result of the FERC policy change”9
…the effect of the FERC’s actions on the maximum applicable rate we may be able to charge in the future could result in our general partner being able to exercise its call right under the terms of our partnership agreement. These terms allow our general partner to purchase our outstanding limited partnership units at a formula price. The formula price would equal the average of the daily closing prices of our LP units for the 180 consecutive trading days preceding the date three days prior to when the general partner would give notice of its exercise of the call right.
When FERC announced the policy change on March 15, 2018, they opened a proverbial Pandora’s Box. While they have attempted to provide some clarity to the change and partial relief to LPs (and the many stakeholders—including the C-Corp—involved with LPs), it is important for investors to recognize that FERC is unable to turn back the clock. One acquisition has been completed since the FERC change, and others are well along the way to completion. We believe there could be a re-rating of some of these acquisitions. We also believe that this removes a significant overhang for some of the equities impacted by the initial policy change as well as the expected “long period of time to settle” for the policy change. Without a doubt there remains some overhang, but the relief that FERC has offered should help firm up cash flows for the LPs that suffered the most following the initial FERC decision. While we applaud the relief, we aren’t prepared to give a standing ovation.
Past performance is not indicative of future results. This publication contains the current opinions of Fort Washington Investment Advisors, Inc. Such opinions are subject to change without notice. This publication has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Fort Washington or its affiliates may from time to time provide advice with respect to acquiring, holding, or selling a position in the securities mentioned herein. Information and statistics contained herein have been obtained from sources believed to be reliable but are not guaranteed to be accurate or complete.
1 FERC is Federal Energy Regulatory Commission.
2 Height Securities, LLC.
3 Federal Energy Regulatory Commission.
4 Enbridge Energy Partners LP: Form 425, 2018/05/23 .
5 TC Pipelines, LP Press Release 2018/05/23.
6 Dominion Midstream has filed a request for clarification or rehearing and expedited action request seeks FERC to clarify the recent policy change, calling it unjust as applied to an MLP that is owned by a C-Corp which has the same tax liability as if the pipeline was a C-Corp.
7 Dominion Midstream Energy Partners, LP, 1Q18 earnings call transcripts. 2018/04/27.
8 Williams Partners LP, Analyst Day transcript 2018/05/17.
9 Boardwalk Pipeline Partners, 1Q18 earnings call transcripts. 2018/04/30.