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FERC tax decision puts MLP drop-down model under scrutiny as stocks take beating

An unfavorable federal tax ruling highlighted the sensitivity of energy master limited partnerships to policy changes as Dominion Energy Midstream Partners LP's stock plummeted, prompting some analysts to question the drop-down structure that oil and gas companies use to stash midstream assets in tax-advantaged partnerships.

"They are highly sensitive to capital markets access and overall sector sentiment, so during bull markets they trade at very high valuations but when the equity window closes they tend to underperform the [midstream] group," Guggenheim Securities analyst Matthew Phillips said in an email.

MLPs are formed to take advantage of partnerships' tax-advantaged status that puts the burden on investors, who pay individual taxes on an MLP's earnings, rather than the partnership paying corporate taxes. For a producer or pipeline corporation, selling an asset to an affiliated MLP, or dropping it down, during times of robust public equity access can be financed relatively cheaply. Housing midstream holdings in MLPs has even been adopted by giants like BP PLC and Royal Dutch Shell PLC.

But when public equity costs are high and stock prices in a slump, such as after FERC's decision to eliminate a tax benefit for MLP-owned pipelines, the drop-down model can become a financial hazard. Under FERC's ruling, oil and gas pipeline MLPs will no longer be allowed to recover an income tax allowance for cost-of-service rates, eliminating a boost to pretax income passed on to unit holders by partnerships that use that type of rate structure.

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Because of the cyclical nature of the equity-cost pitfall for MLPs, Phillips said, "most of the entities are well-capitalized enough that they can wait out the current turmoil."

That may not be the case for Dominion Midstream, which is poised to acquire the $4 billion Cove Point LNG export facility from its sponsor, Dominion Energy Inc. FERC's decision affects only pipelines with cost-of-service rates, and while Dominion Midstream has some exposure to those, what many analysts are calling a stock market overreaction is jeopardizing the partnership's finances and ability to absorb Cove Point.

Dominion Midstream shares have plummeted 37.6% since March 15, outpacing the bellwether Alerian MLP Index's 9.3% loss. That movement raises "legitimate questions" about the drop-down strategy, said Wells Fargo Securities LLC energy analyst Sarah Akers.

"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," she wrote in a March 20 note to clients. "Expectations of cash from [Dominion Midstream] to [Dominion] over the next few years are lower … absent a material rebound" in Dominion Midstream's stock price.

RBC Capital Markets analysts agreed in a March 25 note that a near-term drop-down of Cove Point is less likely due to "weakened" economics, Dominion Midstream's equity finance needs and 22% distribution growth guidance, while Mizuho Securities USA Inc.'s Brian Zarahn in a March 26 note cited the "negative feedback loop" instigated by the FERC order.

Dominion Midstream's performance is prompting speculation that Dominion could choose to sell part of Cove Point to a third party instead of to Dominion Midstream. Private equity might find the terminal particularly attractive because its cash flow comes from long-term contracts that eliminate volume and commodity price risks.

"Absurd behavior of public equities creates opportunities for private equity that better understands the situation and can more rationally value these companies," Height Securities' Katie Bays said in an interview, citing the steep stock drop for Dominion Midstream. "[This is] a very cheap company sitting in front of you."

In the meantime, however, Dominion will pursue debt financing for Cove Point to alleviate the parent company's leverage overhang.

Still, Dominion Midstream's troubles may not indicate that drop-down MLPs as a whole are broken, but rather that they might follow midstream peers like Enterprise Products Partners LP in reducing public issuances through retaining more cash for equity needs and eliminating their required incentive cash contributions to general partners.

RBC Capital Markets Managing Director TJ Schultz, for example, said in an interview that Shell Midstream Partners LP and Valero Energy Partners LP need to address those incentive distribution rights, or IDRs, in the near future to retain more cash flow and decrease the cost of capital. Mizuho's Zarahn agreed that getting rid of IDRs is a prudent strategy for drop-down MLPs wanting to execute transactions at attractive multiples.

Newer MLPs like CNX Midstream Partners LP, which recently acquired the Shirley-Pennsboro gathering system from CNX Resources Corporation and has a long list of potential future drop-downs, can meanwhile afford to maintain IDR agreements as long as the cost remains bearable.

"Where we are on our growth trajectory … it's a couple of years to three years behind where our peers in the basin and elsewhere are, so right now IDRs are playing a positive role to motivate the drops to be done," CNX CEO Nick DeIuliis explained in a recent interview.