Many pipelines are regulated by the Federal Energy Regulatory Commission (FERC), which has the ability to set rates. Any change in regulations by the FERC could significantly impact cash flows and the rate of an MLP’s distribution growth.
The FERC’s job is to ensure that companies charge “just and reasonable” fees and that exploration and production companies have fair access to transport products. Rates are usually set on a cost-of-service basis, factoring in capital and maintenance costs to keep the infrastructure running.
While regulations have generally been a good thing for pipeline company by providing clear returns on their infrastructure investments, they are a major uncontrollable factor the businesses depend on.
FERC revised a 2005 tax policy today to no longer allow interstate pipelines owned by MLPs to recover an income tax allowance in the cost of service customers previously had to pay for.
As pass-through entities, MLPs do not pay any federal taxes. In other words, they were essentially getting a double benefit on taxes, which is now being taken away.
The policy revision only affects interstate oil and gas pipelines and will not go into effect for oil pipelines until 2020 since they are regulated differently.
Many MLPs saw their unit prices fall as much as 10%. The degree of impact from this regulatory change really depends on the pipeline being evaluated – Is it an interstate pipeline? Are its rates regulated or negotiated with customers?
Here’s the official announcement:
FERC Revises Polices, Will Disallow Income Tax Allowance Cost Recovery in MLP Pipeline Rates
The Federal Energy Regulatory Commission (FERC) today responded to a federal court remand by stating it no longer will allow master limited partnership (MLP) interstate natural gas and oil pipelines to recover an income tax allowance in cost of service rates.
The U.S. Court of Appeals for the District of Columbia Circuit in United Airlines, Inc. v. FERC, (827 F.3d 122 (D.C. Cir. 2016) held that FERC failed to demonstrate there was no double recovery of income tax costs when permitting SFPP, L.P., an MLP, to recover both an income tax allowance and a return on equity determined by the discounted cash flow methodology.
The Commission today acted in response both to the court remand and comments filed in response to an inquiry issued after the court ruling. FERC will now revise its 2005 Policy Statement for Recovery of Income Tax Costs so that it no longer will allow MLPs to recover an income tax allowance in the cost of service.
The revised policy statement explains that, while all partnerships seeking to recover an income tax allowance will need to address the double-recovery concern, the application of the United Airlines court case to non-MLP partnerships will be addressed as those issues arise in subsequent proceedings.
In Docket Nos. IS08-390-008 and IS08-390-009, the Commission denies SFPP an income tax allowance and determines a real return on equity of 10.24 percent (Agenda Item G-3). In Docket Nos. IS09-437-008, et al., FERC accepts SFFP’s compliance filing, subject to the company submitting a further compliance that, among other things, removes the income tax allowance in SFPP’s East Line cost of service and calculates refunds (Agenda Item G-4).
We don’t hold any MLPs in our portfolios due to many of the risks I highlighted several years ago (including FERC rates) in an article here, and most of these business have long scored below average using our Dividend Safety Scores.
This news will result in less revenue and cash flow for most MLPs with regulated interstate pipelines, which could cause some of their credit ratings to come under some pressure.
A lower share price also raises the cost of equity capital for MLPs, which depend heavily on tapping capital markets to fund their growth projects (and distributions in some cases).
A higher cost of capital can affect the profitability of projects and, if extreme enough in some cases, cause the distribution to come under pressure if management needs to retain more internally generated cash flow to fund investments and protect the company’s credit rating.
There is a lot of dust that is yet to settle from this announcement (including potential appeals), but it is not good news at face value, especially for MLPs with lower Dividend Safety Scores, generally weaker financial health (higher payout ratios, higher leverage), and a higher percentage of revenue from regulated interstate pipelines.
For now, I would wait to hear how some of the impacted MLPs plan to respond to this news. It’s hard to figure out how much regulatory risk each company actually possesses based on their business mix, and there are likely to be some levers they can pull to reduce risk (perhaps even changing business structures or divesting interstate pipelines).
Until we know more, I would remain in a holding pattern with financially stronger names in the space that should have an easier time raising affordable capital. Enterprise Product Partners (EPD) has already come out and said it does not expect this ruling to have a material impact on its financial results (see the company’s statement here).
With that said, my personal preference has been (and continues to be) to largely avoid this space altogether given its complexities. Outside of a few high quality and financially conservative MLPs and pipeline companies, such as Enbridge (ENB), Enterprise Product Partners (EPD) and Magellan Midstream (MMP), many of these businesses operate with a slim margin for error and are inherently riskier due to the nature of their business models.
Maintaining a well-diversified portfolio with conservative position sizes and focusing on companies with conservative Dividend Safety Scores and fundamentals can help in these situations.
Enbridge should be unaffected for two distinct reason: 1) most of its pipelines are Canadian; and 2) it is not an MLP. Please correct me, if I am wrong.
My apologies, since Enbridge owns US based MLPs (at least via Spectra), the FERC ruling on rates could impact them. Enbridge itself is not an MLP and is Canadian; to the extent that the FERC ruling impacts the cash flows of the MLPs in which Enbridge owns significant stakes, Enbridge itself may be impacted.
Good article Brian. I disposed of most of my pass through investments a couple of years ago. The need to access capital markets all the time to obtain constant new capital make their distributions riskier to live off in retirement.
I think D is affected relative to DM.
D issued a press release reaffirming the company’s earnings growth goals through 2020: http://dominionenergy.mediaroom.com/2018-03-19-Dominion-Energy-Affirms-Earnings-Guidance-Credit-Objectives
Management also made the following statement:
“The company believes that FERC’s change in policy will take years to implement and, even then, will only impact revenues on a prospective basis from the conclusion of any ratemaking process.
Regarding Dominion Energy Midstream Partners, the company does not anticipate any revenue reductions in the 2018 to 2020 time period due to FERC’s actions and is still evaluating any long term impacts and their timing.”
It will take time to see how this all shakes out over the long term. Staying diversified and focused on businesses in good financial health are solid risk mitigation strategies.