One year after the Federal Energy Regulatory Commission rocked pipeline sector stocks by moving away from a tax benefit for midstream master limited partnerships, the story of the impact continues to unfold.
What stood to be a big blow to pipelines, and a possible boon for customers, has emerged as a more complex picture over the year. Uncertainties are rankling some in the industry, as FERC is still filling in the details on how its altered policy will apply to various pass-through ownership structures.
A handful of the most affected pipelines reduced their exposure by moving away from the MLP structure that was intended by Congress as an incentive for investments. Pipelines with negotiated rates were less affected.
At issue is FERC's March 15, 2018, proposed policy statement asserting that it no longer planned to allow oil and gas pipeline MLPs to recover an income tax allowance in cost-of-service rates.
The policy turnabout that shocked the industry stemmed from a federal appeals court ruling in United Airlines v. FERC that found the commission failed to show there is no double recovery of taxes for partnership entities that receive an income tax allowance in addition to a discounted cash flow methodology used to set returns on equity.
FERC somewhat softened that blow to pipeline companies last July in a final policy and order. It clarified that pass-through entities are eligible for a tax allowance if their income or losses are consolidated on the federal income tax return of their corporate parent.
Perhaps more importantly, FERC effectively found natural gas pipelines could keep monies previously collected from customers in anticipation of paying taxes, if those pipelines give up the tax allowance. Requiring refunds associated with accumulated deferred income taxes was barred by Natural Gas Act prohibitions against retroactive ratemaking, FERC said, even as some commissioners publicly wished Congress would change the statute.
In February, FERC began to show how it may handle those pipelines with hybrid ownership structures. In a preliminary decision involving Trailblazer Pipeline Co. LLC, it suggested a tax allowance was allowed for the 55% of the pipeline held by Tallgrass Energy LP, which pays corporate income taxes, but not for the 45% held by 11 private owners. It also opened the door for pipeline companies to show that a double recovery did not exist if they used alternatives to the discounted cash flow methodology — although it raised doubts about that result.
To the frustration of some, FERC sent the Trailblazer proceeding to an administrative law judge, rather than making a definitive policy call. After a year of volatility, pipeline industry finance experts said FERC's Trailblazer finding introduces more confusion for the midstream sector.
"From my experience working with investors, I think it's disastrous for capital markets that the commission continues to leave as much uncertainty in the market about how their policy is going to work for other rate-regulated entities, whether it's a natural gas or eventually a liquids pipeline," Height Securities LLC's Katie Bays said in an interview. "The biggest surprise to me is that we’re still so unclear on how the commission wants their policy to be applied."
According to Robert W. Baird & Co. analyst Ethan Bellamy, that uncertainty could persist. "[C]onsidering that the ownership is fungible and pipeline owners trade hands all the time, you're left with the absurd outcome that a pipeline tariff could change year to year or month to month based on who owns it," Bellamy said in an email.
Emily Mallen, a partner at Sidley Austin LLP, said her biggest takeaway from the Trailblazer order is that "FERC is not looking backwards. I think they've embraced their new policy and until the court tells them otherwise, [they're] not going to let pass-through pipelines get an income tax allowance."
"A lot of the industry has moved on in terms of restructuring, or trying to manage exposure," Mallen said in an interview.
Pipelines move away from MLP model
Dave Oelman, a partner at Vinson & Elkins LLP and board member at the Master Limited Partnership Association, sees limited benefit from the path FERC has taken.
"The idea was that they were going to level the playing field because of a legitimate shipper complaint," Oelman said in an interview. "I'm not seeing shippers get a benefit, but I am seeing expensive conversions that are in many cases materially taxable to investors."
MLPs with significant exposure to cost-of-service rates adapted to FERC's March 2018 policy proposal by rolling up into their parent corporations. Williams Cos. Inc., Enbridge Inc. and Dominion Energy Inc. merged with their MLPs to avoid giving up that tax benefit and boost their share prices amid an industry-wide stock market tailspin prompted by the regulator's announcement.
The bellwether Alerian MLP Index, which tracks a basket of the top North American midstream partnerships, plummeted 8% from market close on March 14, 2018, through the end of the month on a total return basis, including distributions. In the months since then, the Alerian swung up and down a bit before holding steady in recent weeks.
The proposed change also spurred a Loews Corp. subsidiary to buy out Boardwalk Pipeline Partners LP. The purchase followed a legal battle between the holding company and activist shareholders over the transaction’s price.
TC PipeLines LP opted to cut distributions 35% to compensate for the $40 million to $60 million impact it said it faced, but retained its MLP structure instead of merging with TransCanada Corp.. After FERC issued the final ruling in July, TC PipeLines reduced that estimate to $20 million to $30 million. Still, the MLP’s unit price has not recovered from the shock, with shares trading down nearly 28% from March 13, 2018 to March 13, 2019.
Last March, "we witnessed a scare moment on the announcement, with a few casualties," said John Olson, co-founder of the hedge fund Houston Energy Partners, in an interview. "But as matters progressed, the markets became more confident as individual cases were settled or expected to settle. … Events like the FERC tax policy changes may have had a momentary impact on the sector, but they were buried by crude oil price volatility."
Clark Sackschewsky, tax managing principal with BDO USA LLP's natural resources practice, said some companies have since simplified their corporate structures and their financing in a way that will be beneficial to the midstream going forward.
"I think we're still early in this," and it will take more time to sort out MLP structures, more likely over a five-year cycle, he said in an interview. Within their life cycles, MLPs will be looking at whether to convert to C corporations, and whether the corporate tax rate reduction will stick after the Trump presidency, he added.
Pathway to clarity
For now, FERC is working its way through informational filings it required from gas pipelines to help discern whether companies need to lower rates due to FERC's altered tax policy along with the lowered corporate income tax rate under the Tax Cut and Jobs Act of 2017.
FERC set out four possible paths for pipeline companies to take, and so far five NGA Section 5 rate probes have resulted, and FERC has closed 37 cases without requiring further action.
Like some others representing pipelines, Howard Nelson of Greenberg Traurig LLP cited a lack of clarity emerging. He found FERC's reasoning unclear on how it arrived at a different result for Trailblazer versus Enable Mississippi River Transmission LLC, a pipeline owned by an MLP. FERC denied a tax allowance for Enable MRT in July.
"To me it all stems from [FERC's] acceptance of a theoretical proposition to begin with" — that the discounted cash flow return provided to investors includes the taxes they will have to pay, according to Nelson. "Now the commission is stuck with trying to apply that theoretical proposition to various scenarios. I think they're having a difficult time doing it," he said in an interview.
As to how clarity will emerge, Nelson said "that all depends on whether these cases settle. If they settle, then you're going to be stuck with this lack of clarity. If they go to litigation, my guess is that the loser will appeal."
Shippers have backed FERC's effort to sort through whether pipelines needed to cut rates in light of the corporate income tax cut.
"We were there at the beginning urging the commission to get going on this and they did," said John Gregg, general counsel to the American Public Gas Association's board of directors. "The commission is methodically moving to resolve each docket … which we applaud," he said in an interview.
The group will be looking for Congress' attention on inequities they see in the fact that under the Natural Gas Act, in contrast to the Federal Power Act, any lower tax rate will only apply prospectively. "Consumers are never going to be made whole in this regard" because of that, said Dave Schryver, APGA executive vice president.
Michael Grande, S&P Global Ratings director of U.S. energy infrastructure, said in an interview that FERC's approach could still end up hurting pipelines, but investor attention has shifted since last spring's upheaval.
"I think investors have kind of moved on and realized that there might be a little bit of an overhanging risk of a reduction in cash flow and revenue on the rates that are not negotiated," he said.
In the worst case scenario, in which some companies lose some of the excess cash flow available to finance growth projects, it will pressure companies to find other financing sources, he said.
Maya Weber is a reporter for S&P Global Platts. S&P Global Market Intelligence and S&P Global Platts are owned by S&P Global Inc.