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MLP roll-ups can protect pipeline rates after FERC tax changes, researcher says


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MLP roll-ups can protect pipeline rates after FERC tax changes, researcher says

Natural gas pipeline companies that moved to absorb their sponsored partnerships can protect their pipeline tariff rates and revenues amid federal tax policy changes, a veteran researcher of the midstream energy sector said.

The stocks of midstream companies "got hammered" after an announcement by the Federal Energy Regulatory Commission of tax policy changes unfavorable to the master limited partnership structure used by many of them, said Jim Simpson, president of energy assets research firm East Daley Capital Advisors Inc. But he explained to an audience at the LDC Gas Forum Northeast in Boston that pipeline companies are mitigating the damage by rolling up their MLPs.

FERC announced a proposed tax policy change in March that would stop pipeline MLPs from recovering an income tax allowance in their cost-of-service rates. This came on top of a 2017 overhaul of federal taxes that dropped the corporate income tax rate from 35% to 21%, which helped C corporations and reduced the tax benefits that made MLPs attractive to some investors. FERC Chairman Kevin McIntyre said the commission was not trying to reshape midstream companies, and it would be up to each individual company to determine the best way forward.

In response to the tax changes, pipeline companies such as Enbridge Inc., TransCanada Corp. and Williams Cos. Inc. announced that they planned to absorb their U.S. MLPs or take similar actions. In explaining its decision to absorb Williams Partners LP, Williams said it could take years for the industry to convince FERC to rethink the MLP tax policy, and the effort could be unsuccessful.

Simpson said the removal of the MLP tax shield and the establishment of an approved return on equity of 10% to 14% put pipelines at risk of being forced to lower their tariff rates. Both MLP and C-corp pipelines have to file an informational form that reports their return on equity, "so now it is completely public," Simpson said. "The world can see exactly what my ROEs are."

"So let's look at [Williams Partners' Transcontinental Gas Pipe Line Co. LLC], a major pipeline in the Northeast," Simpson said. "What does this mean for a pipe like Transco?"

Before the changes to tax policy, Transco's income before taxes was about $567 million, Simpson said. Transco's income tax burden was about 37.5%, with a federal rate of 35% and a state rate of roughly 2.5%. Its composite tax was about $212 million, which lowered its net income to $354 million. "That makes my ROE 10%," comfortably within the allowable 10% to 14% range. "Life is good."

With Transco in an MLP structure, the tax allowance is zero, Simpson said. "My ROE is now 16%," above the allowable range. "My max tariff rate is at risk."

If Transco is rolled into the C-corp with Williams Partners, its tax allowance is 23.5%, with a federal tax rate of 21% plus about 2.5% for the state rate, Simpson said. Transco's composite tax is about $133 million and net income is about $433 million. Its ROE is 12%. "I'm in my allowable range of 10% to 14%, and I'm probably OK."

"One driver for the Williams LP — not the only driver — to roll up to a C-corp is to lower the ROE on a pipe like Transco," Simpson said.

There could be similar effects on other pipeline companies, depending on their corporate structures and their tariff arrangements. "So from the FERC tax standpoint, essentially that risk to an MLP can be mitigated by rolling up to a C-corp," Simpson said. He observed that the equity market was pleased with the Williams corporation and its general partner after it announced that it would absorb the partnership.

As for the impacts to Northeast producers that move gas on pipelines, most of the larger contracts are under negotiated rates on the new pipeline expansions, so the producers are unlikely to see reductions on these rates. Simpson said it is "longstanding FERC policy not to adjust negotiated rates except in extreme circumstances."

For Northeast LDCs, savings are possible through rate cuts on max-tariff contracts on some pipelines, such as Kinder Morgan Inc.'s Tennessee Gas Pipeline Co. and Enbridge's Algonquin Gas Transmission LLC, Simpson said.