Paul McPheeters, CFA
March 16, 2018
The MLP and broader pipeline sector was negatively impacted yesterday by actions at the Federal Energy Regulatory Commission (FERC). We will learn much more in coming days and weeks on the issue, but we wanted to provide a general summary of what was announced and the implications.
As a backdrop, FERC regulates Interstate pipelines (those that cross state lines) and has historically allowed a Tax Allowance to be included in tariff rates where a pipeline is basing its rates off of cost of service and an acceptable rate of return. Regardless of whether the ownership was a C-Corp or an MLP, this tax allowance has been included with the view that taxes were being paid either at the corporate level or at the investor level in the case of the MLP structure. Based on surviving previous legal challenges by shippers, we believe most investors expected that structure to stay in place going forward with FERC simply reducing the tax allowance being included down to a 21% rate from the previous 35% corporate rate. This likely would have been a non-event for the security prices as we believe it was viewed as the likely outcome.
Instead FERC chose to leave the tax allowance in place (with the lower 21% rate) for C-corps and remove it completely for MLPs. This primarily relates to Natural Gas Pipelines and a few of the older crude oil pipelines that use a “Cost of Service” structure. This was a surprise and will have the effect of reducing tariffs on some pipelines (those under cost of service structure and owned by MLPs and not C-Corps). In addition, FERC plans to address tax changes for interstate liquid pipelines in 2020 that are based on an index that grows with inflationary escalators plus a margin. This would include some Crude Oil, Refined Products and NGL (Natural Gas Liquids) pipelines that cross state lines and use the index structure. We have seen conflicting views by experts on what the effect might be on the liquid side. Not clear yet whether MLPs and C-corps will have a different tariff pricing and also not clear whether this change will simply limit tariff increases in some situations or actually cause some tariff reductions.
What are the likely Implications?
We have seen a majority of pipeline companies issue press releases since the FERC news release and the message has been very consistent: We expect the impact from this news to be Immaterial or De Minimis to cash flow going forward. There are three companies (approximately 4% of the AMZ MLP Index) where we anticipate a material impact from this FERC news. In 2 of those 3 situations, we would expect the related C-corp company entity to buy-in the MLP and mitigate the impact. Despite the minimal impact on company cash flows from this announcement, we would expect the sector to stay volatile in the short-term as a result of the negative headlines and potential confusion among some of the investor base about the issue. Longer-term, this will likely accelerate more use of the C-Corp structure for interstate pipeline assets, which we view as a positive.
Paul McPheeters is the lead portfolio manager for CIBC Atlantic Trust Private Wealth Management's Energy Infrastructure strategy, which he developed in 2003.
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