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Definitions:
Volatility: standard deviation of returns on a security or index. Securities or indexes with higher levels of volatility can see greater ranges of performance variation.
1. https://www.ferc.gov/media/news-releases/2018/2018-1/03-15-18-G-2.asp#.WsN89mrwa70
2. http://www.cpuc.ca.gov/uploadedFiles/CPUC_Public_Website/Content/About_Us/Organization/Divisions/Policy_and_Planning/PPD_Work/PPDReturnonEquityDCFmethodology_2.pdf
3. https://www.ferc.gov/whats-new/comm-meet/2018/031518/G-3.pdf
4. https://www.lexology.com/library/detail.aspx?g=65f64a7c-8e5a-408e-9ff4-af7cbcab6bde
5. https://www.ferc.gov/media/news-releases/2018/2018-1/03-15-18-E-1.asp#.WrvwImrwa70
6. https://www.gibsondunn.com/ferc-takes-aim-at-income-tax-over-recovery-in-pipelines-regulated-rates/
7. https://www.lw.com/thoughtLeadership/MLP-FERC-oil-gas-pipelines-cost-of-service-rates
8. Performance measured by the Solactive MLP Infrastructure Index on March 15, 2018.
9. Performance measured by the Solactive MLP Infrastructure Index between 3/14/18 and 3/23/18.
10. MLPData, with fund flows measured by MLP ETFs and Mutual Funds between March 14th, 2018 and March 21st, 2018.
11. Bloomberg, as measured by the Solactive MLP Infrastructure Index. Volatility measured as daily standard deviation, annualized.
Since 2005, the Federal Energy Regulatory Commission (FERC) allowed master limited partnerships (MLPs) to factor in the recovery of an income tax allowance (ITA) in setting their tariff rates for regulated cost-of-service pipelines.1 On March 15, 2018, FERC announced a new rule that will prevent MLPs from recovering this ITA.1
While there remain many questions about the implementation of this rule, we seek to provide a preliminary analysis of this policy change, including addressing how it could affect MLPs, the market’s reaction to this news, and how it could affect the MLP structure going forward.
FERC Policy Details
When FERC evaluates tariff rates on regulated pipelines they target a “just and reasonable” return on equity (ROE) to compensate pipeline operators. To determine these rates, operators calculate their expenses associated with running their pipelines and are allowed to charge a certain amount above those expenses.2 Previously, MLPs included an ITA as one of these expenses. Some shippers complained about this practice, and even took the issue to court. They argued that this practice represented a double-recovery of expenses because MLPs do not actually pay any federal income taxes, yet were including them in their expenses.3
On March 15th, FERC announced it will no longer allow MLPs to recover ITAs from their expense calculations. The impact of this ruling is that FERC-regulated cost-of-service pipelines may need to adjust their prices downwards to prevent over-earning their “just and reasonable” ROE. Natural gas pipelines have been directed to review their rates by the end of this year, while oil pipelines will face a review of their pricing in 2020.4
In a second announcement, FERC issued a Notice of Proposed Rulemaking (NOPR) for natural gas pipelines, regardless of whether they are owned by an MLP or a C-Corporation, to review their tariff rates by year-end to adjust for the corporate tax rate falling from 35% to 21% as a result of the Tax Cuts and Jobs Act.5
It’s important to note that this change in policy for MLPs is not expected to affect pipelines with negotiated rates, market based rates, or settlement rates.6 This ruling is only expected to apply to FERC-regulated cost-of-service pipelines, and may only negatively impact those that are over-earning under the new rules.7 Given the specificity of this rule, each MLP will have varying degrees of exposure to this change.
Adding to the complexity of the situation is how FERC will implement this policy for MLPs that are heavily owned by C-Corps. Some believe these MLPs should be allowed a partial income tax allowance given that their C-Corp owners pay taxes. Another outstanding question is how FERC will treat pipelines that are jointly owned by MLPs and C-Corps.
How could this affect MLPs?
MLPs with significant assets using cost-of-service contracts will be the most affected. In response to the FERC announcement, many MLPs have publicly responded to indicate their level of exposure to the new rule. Additional analysis on the types of pipelines various MLPs operate provide clues into their exposure to this change. In the table below, we relied on company announcements and our own research to indicate the expected level of exposure for each MLP in the Solactive MLP Infrastructure Index. The index is the underlying benchmark for the Global X MLP ETF (MLPA).
Source: Company announcements and Global X Research. ‘Minimal or None’ column is estimated to have less than 1% impact to Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). The ‘Modest Impact’ column is estimated to have between 1-5% impact to EBITDA. The ‘Significant Impact’ column is estimated to have greater than 5% EBITDA impact. Actual impact could vary.
Based on this analysis, the majority of MLPs in the Solactive MLP Infrastructure Index are expected to have minimal direct impact on their businesses from this ruling. However, as we will discuss later in this piece, the new rule may indirectly affect MLPs on a broader level.
How did the market react to the MLP ruling?
The market reacted sharply once the ruling was announced, with MLPs broadly falling over -5% on the day.8 Every index constituent in the Solactive MLP Infrastructure Index finished down that day, even those with next to no exposure to this FERC ruling, indicating the market was indiscriminately selling off the asset class.
Weakness continued in the days following, with MLPs down approximately -9.8% from March 14th to the 23rd.9 Poor investor sentiment and heightened volatility has led to continued pressure on the asset class. Between March 14th and March 21st, MLP funds experienced nearly $230 million in cumulative net outflows,10 and MLPs have experienced close to three times the volatility of the S&P 500.11
How could this affect MLP decision making change?
While many MLPs are unlikely to experience major direct impact from the FERC ruling, it could indirectly impact the asset class in the future. For one, we expect the ruling to make MLP sponsors more hesitant to dropdown additional assets to their MLP if it will cause a change in tariff rates. In addition, it could accelerate the trend of sponsors ‘rolling-up’ their MLPs into a unified C-Corp structure. With lower corporate tax rates, combined with the recent FERC ruling and low valuations in the MLP space, sponsors may find the MLP structure less attractive than the traditional C-Corp structure.
MLPs will also need to get more clarity from FERC as to how and when the MLP ITA policy will be implemented. Will there be opportunities for partial income tax allowance recovery? Will there be any follow-up rulings? How will mixed ownership of pipelines between C-Corps and MLPs be treated? Management teams will need answers to these questions in order to understand how to move forward and investors will need answers to these questions to properly value the space.
Related ETFs
MLPA: The Global X MLP ETF invests in some of the largest, most liquid midstream Master Limited Partnerships (MLPs).
MLPX: The Global X MLP & Energy Infrastructure ETF is a tax-efficient vehicle for gaining access to MLPs and similar entities, such as the General Partners of MLPs and energy infrastructure corporations.
The War in Iran could impair energy output and thus reshape supply chains. It also highlights the growing importance of North American energy infrastructure.
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