A March 15 decision to extinguish a tax benefit for oil and gas pipelines organized as master limited partnerships compounded the drag on an already burdened sector, potentially accelerating decisions to abandon the MLP structure.
The Federal Energy Regulatory Commission surprised pipelines by stating unequivocally that it no longer plans to allow oil and gas pipeline MLPs to recover an income tax allowance in cost-of-service rates.
The broader impacts to the midstream oil and gas sector may ultimately be muted, despite the roller-coaster ride of MLP stocks in the wake of FERC's decision. Not all pipelines have the cost-of-service rates directly affected by FERC's policy; many have negotiated rates or rates arrived at under settlement, and many oil and product pipelines have market-based rates. But some pipelines ultimately will be required to reduce their rates to come into compliance with the new FERC policy, said Ed Hirs, an energy economist at the University of Houston.
Most midstream oil and gas stocks plummeted March 15 after FERC's announcement, before rebounding some the next day, as companies clarified how their varied rate structures will mitigate the impact.
In the week that followed, though, pipeline MLPs like Dominion Energy Midstream Partners LP, Enbridge Energy Partners LP, Spectra Energy Partners LP and TC PipeLines LP saw stock prices dip even further, as the market clarified which partnerships would take the biggest financial hits.
"This is going to speed up the process of the exodus from the MLP structure," CBRE Clarion Securities' Hinds Howard said in an interview. "It just leads to more structural uncertainty and challenges for MLPs that remain as MLPs. … It's just one more thing to argue against getting involved with MLPs in general as an investor."
'Cloud hanging over the sector'
Drags on the sector already included concerns about incentive distribution rights, or IDR, structures, persistently high leverage and high public equity costs. Investors in recent months have urged MLPs to eliminate general partners' IDRs and retain more cash at the partnership level for self-funding equity needs.
The Alerian Master Limited Partnership Index, a bellwether for midstream infrastructure investments, had already dropped over 5% in 2018 before falling an additional 4.6% on March 15. It was down 8.4% overall since FERC decision as of the March 23 close. FERC's ruling will also have near-term negative impacts on the amount of cash available to distribute to MLP investors.
"This was a cloud hanging over the sector for a long time that turned into a hailstorm," John Olson, co-founder of the hedge fund Houston Energy Partners, said of the FERC proclamation. However, "it's not a deal-killer," he said, noting that some MLPs will not have to restructure.
"The only silver lining I can mention is that we have seen just about every negative that you can imagine impacting the MLP sector, and I am hard-pressed to tell you what else can afflict that sector," he said.
Clark Sackschewsky, tax managing principal with BDO's natural resources practice, said all MLPs likely are looking at whether their flow-through entity status makes sense over the long term. That will be decided on an MLP-by-MLP basis, with questions such as where they are in their life cycle factoring into the equation, he explained.
There is also an opportunity to take MLPs private. "There is a lot of money sitting on the sidelines," Sackschewsky said, noting that going private can cut back on regulatory costs and open the door to classes of investors currently barred by rules affecting MLPs.
For Enbridge Energy Partners and Spectra Energy Partners, the momentum favoring restructuring means parent company Enbridge Inc. might decide to merge with the two MLPs sooner rather than later.
Barclays in a March 16 note said exposure of the two MLPs to cost-of-service rates should incentivize Enbridge to "roll up" both entities. Barclays pointed to Enbridge Energy Partners' and Spectra's potential $140 million and $150 million distributable cash flow losses, respectively, as a result of FERC's tax accounting change.
At the March 23 close, Spectra stock was down 19% since the FERC ruling, while Enbridge Energy Partners had suffered a 28% drop.
Williams Partners LP, on the other hand, was outperforming the Alerian index after stock prices took a 4.8% hit March 15. At market close March 23, the company was down just 5.3% since the ruling, compared with the Alerian's 8.4% loss.
Expectations that the partnership will consolidate with Williams Cos. Inc. before filing a Natural Gas Act Section 4 rate case in August have outweighed market worries about the MLPs' exposure to cost-of-service-based assets like its Transcontinental Gas Pipe Line Co. LLC system.
The hardest hit, Dominion Energy Midstream Partners, has dropped 36% in the market since FERC's announcement, reaching $16.25 at the March 23 close. Wall Street's initial reaction makes it harder for parent company Dominion Energy to drop down midstream assets to its MLP, jeopardizing Dominion’s deleveraging strategy and potentially requiring comprehensive mitigation.
With Dominion Midstream "now trading well below the $21 IPO price and at a 6.9% yield, there are legitimate questions regarding the company’s original strategy," Wells Fargo analyst Sarah Akers wrote in a March 20 note. "If management determines that dropping assets at these levels is not in shareholders' best interest, then sizeable equity and/or asset sales are likely in order. Any way you cut it, expectations of cash from [Dominion Midstream] to [Dominion] over the next few years are lower … absent a material rebound" in Dominion Midstream’s unit price.
Still, Howard maintained that the quick Dominion Midstream sell-off was an overreaction given that the MLP will soon hold more assets unaffected by FERC's policy, such as the Cove Point LNG terminal. That would mean that just a small share of the MLP's holdings would be subject to cost-of-service rates. He called the stock movement a "shoot first and ask questions later" response by the market.
In taking the action, FERC was responding to a July 2016 decision by the U.S. Court of Appeals for the District of Columbia Circuit (United Airlines v. FERC, 11-1479) in a case involving the pipeline SFPP that found that FERC's rate policies could allow oil pipelines to set up partnerships to unfairly profit from their tax structure.
The battlefield is expected to turn to a multitude of rate proceedings now in play. For instance, a testing of the waters is possible in a Natural Gas Act Section 5 rate investigation launched over Dominion Energy Overthrust Pipeline.
FERC's remand order on SFPP could be a focal point for those seeking to take on FERC's altered stance. If SFPP choses to appeal, it can head straight back to the D.C. Circuit under the Interstate Commerce Act and take issue with not just FERC's treatment of SFPP rates but also with the broader policy change. Other pipeline companies could join in as intervenors.
SFPP, which is no longer organized as an MLP, said in the past week that it had not yet decided to appeal.
The agency made its altered stance known through a revised policy statement, and while companies may comment or seek clarification, there is no formal procedural path for seeking rehearing on that portion.
Natural gas pipelines are expected to be the first to run the gauntlet when they file the limited cost and revenue studies FERC has now required. For their part, shippers could respond with complaints seeking reparations.
Oil pipelines generally have some more breathing room, as the changes will be reflected in FERC's 2020 five-year review of the oil pipeline index level.
One point of contention ahead is whether FERC will apply its new policy to partnerships that are owned by C corporations, a matter not addressed in FERC's actions March 15. Also to be fleshed out is treatment of pass-through entities such as limited partnerships.
Some insiders expect a push to persuade FERC to balance its move by allowing higher rates of return on equity for pipelines — if it wants them remain attractive investment vehicles and continue to see more infrastructure being built.
MLPs have been around since the early 1980s, gaining in popularity over the last decade, especially in the pipeline industry, as the shale revolution led to the need for the midstream sector to quickly boost takeaway capacity from key basins. Dozens of infrastructure projects followed.
In particular, MLPs became a popular mechanism for slow-growing energy companies to hold some of their infrastructure because of the tax savings that come along with distributing most or all the entity's cash flow to investors.
Cash flow is the big draw. The stronger and more predictable that cash flow is because of the tax savings, the bigger advantage MLPs have in terms of cost of capital.
The growth of shale output in the Appalachian Basin in the Northeast and the Permian Basin in Texas and New Mexico has been a driving factor for MLPs in recent years.
There have been over 100 energy-related MLPs formed in the past 25 years, according to an analysis by the law firm Latham & Watkins LLP. Most were in the midstream pipeline sector, with others focused on upstream, mining, shipping, propane, fertilizer, oilfield services and refining.
Yet volatile commodity prices and rising interest rates have made MLPs less attractive of late because of IDRs, which affect how cash is divided between general and limited partners. The breakdown can increase cost of capital, making it more expensive for the operator to use equity to invest in new pipelines.
That runs counter to why MLPs flourished in the first place: to boost stable cash flow and gain a cost-of-capital advantage.
Some MLPs have been simplifying their corporate structures, in part by eliminating IDRs. Enbridge and Oneok Inc. have announced similar transactions over the last year. Analysts expect other MLPs to follow suit.
Hirs said FERC's decision means unit holders of some MLPs will receive less in profits going forward. "The market for these MLPs showed a strong unit price decline after the announcement last week. It appears that the market rapidly adjusted the pricing of these units," Hirs said.
Maya Weber and Harry Weber are reporters for S&P Global Platts, which, like S&P Global Market Intelligence, is owned by S&P Global Inc.