FERC Ruling Pushes Pipelines Out of MLPs

The fragile mental state of MLP investors left them ill-prepared for Thursday’s ruling by the Federal Energy Regulatory Commission (FERC). By modifying how MLPs calculate certain tariffs, it sent the sector on another wild afternoon ride. It’s a complex issue – pipelines owned by MLPs that cross state lines and rely on FERC-regulated tariffs are most vulnerable. MLPs can no longer set tariffs by including taxes paid by their investors in calculating full cost of service (since MLPs are largely non-taxpayers themselves).

However, it’s possible to find many exceptions – large swathes of the U.S. pipeline network operate intrastate and are therefore generally not governed by FERC. Many contracts are negotiated or have market-based rates, and there are plenty of cases where customers have few attractive alternatives to their existing infrastructure provider. Pipelines owned by corporations rather than MLPs should be relatively unaffected, while non-pipeline energy infrastructure assets are also immune, including gathering, processing, terminals, fractionation, storage, and Liquified Natural Gas facilities.

But the ruling did provide another example of the complexity in the MLP structure. Investors have already had to contend with management teams redirecting cash flows from payouts to new projects (see Will MLP Distribution Cuts Pay Off?). MLP Limited Partners still tolerate their junior position relative to a General Partner (GP) that retains control, although the GP’s payments received via Incentive Distribution Rights (IDRs) are increasingly being phased out. K-1s have always been unpopular, and compounding 2017’s disappointing performance, users of the PWC website for electronic download are confronting additional authentication requirements that add to the burden of tax preparation.

Meanwhile, the FERC ruling exposed one more element of complexity. Calculating cost of service by including investors’ tax expense is another quirky feature of the MLP structure. Such tax rates are in any case unknowable by the MLP. The market’s superficial understanding of the issue was reflected in the sector’s initial 10% drop on Thursday before recovering approximately half, and by Friday prices were barely changed from prior to the ruling. In any event, few contracts nowadays are negotiated in such a way that FERC’s ruling affects them, compared with older, legacy contracts. Figuring in owners’ taxes turns out to be another anachronistic feature of MLPs.

Investors continue to show their disdain for the sector. Management teams long ago broke the implicit contract of stable payouts. The 30% cut in distributions since 2014 is reflected in the 40% drop in the Alerian Index. CEOs promise that much of this redirected cash will result in faster growth, and 15% annual Free Cash Flow (FCF) growth looks plausible to us. But the business model of attractive yields with little need to reinvest in the business has shifted in response to the opportunities created by the Shale Revolution. The older, wealthy Americans who were long the main MLP investor wanted their distributions, and this pursuit of growth projects has alienated them by disrupting their income. Consequently, the market is waiting to see if new projects will generate promised higher returns.

MLPs now represent less than half of U.S. Energy infrastructure, because the MLP has turned out to be a poor source of growth capital. MLPs are far from irrelevant, but they are a shrinking subset. The FERC ruling was another reason to make both investors and MLPs themselves question whether the structure is still worth the trouble. Furthermore, to be an investor in a dedicated MLP fund is to miss most of the sector as well as incur a substantial corporate tax drag (see AMLP’s Tax Bondage).  Broad exposure to energy infrastructure through a RIC compliant fund that caps MLP investments at less than 25% looks increasingly preferable.

However, there’s another class of investor that sees much to like in energy infrastructure, and that’s private equity. Although there’s limited public data available on transaction prices, these long term investors are steadily investing in long term energy assets. Blackstone acquired MLP asset manager Harvest Fund Advisors last August, in a clear bet on a resurgent asset class, having just paid $1.5BN for 32% of Energy Transfer’s Rover pipeline. Tortoise, another large MLP asset manager, sold out to a group of private-equity firms led by Lovell Minnick Partners. Other private buyers include 4 AM Midstream (acquired midstream assets from White Star Petroleum), Meritage Midstream (acquired Powder River basin subsidiary of Devon Energy), and Stakeholder Midstream (Permian gathering system).

Earnings calls often include grumbling that private equity, with its locked up capital, is outcompeting public MLPs for projects. Energy Transfer’s Kelcy Warren complained, “We lose out on projects routinely these days to private equity, not really to our peer group… there’s just a lot of private equity that hires management teams and they’re in for the short term. But it doesn’t matter, they’re winning and we’re not.”

FERC’s Thursday ruling on tariff calculations added another source of volatility to a sector not short of it. Later in the day, Enterprise Products Partners (EPD) CEO Jim Teague stated, “We do not expect the revisions to the FERC’s policy on the recovery of income taxes to materially impact our earnings and cash flow,” Other large firms soon followed, including Kinder Morgan. So the market’s initial response was disproportionate, but its vulnerability to a relatively obscure issue simply highlighted unnecessary complexity.

Energy infrastructure assets are doing fine, but the MLP entities that own them are taking a succession of body blows. The corporate ownership of energy infrastructure assets, with its access to worldwide equity investors and simpler tax reporting, is looking ever more attractive. On the week, the narrowly MLP-focused Alerian MLP Index was -2.9% whereas the broader American Energy Independence Index was -1.0%, as investors favored corporate ownership over MLPs following FERC’s ruling.

Investors in MLP ETFs such as AMLP, and similar MLP-dedicated mutual funds, already face a corporate tax drag (see again AMLP’s Tax Bondage). They are likely to see MLPs continue to lose favor as a financing vehicle, with a consequent diminution of names to hold. Investors who desire to profit from the Shale Revolution and the path to American Energy Independence should switch out of MLP-focused, tax-impaired MLP funds and into broader energy infrastructure exposure relying on simple corporate ownership of assets with no tax drag.

We are invested in Energy Transfer Equity (ETE), EPD and KMI

Print Friendly, PDF & Email

Important Disclosures

The information provided is for informational purposes only and investors should determine for themselves whether a particular service, security or product is suitable for their investment needs. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the disclosure, prospectus, and offering. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy,  completeness or timeliness of this information. Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments.  Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios managed by SL Advisors as they have different underlying investments and may use different strategies or have different objectives than portfolios managed by SL Advisors (e.g. The Alerian index is a group MLP securities in the oil and gas industries. Portfolios may not include the same investments that are included in the Alerian Index. The S & P Index does not directly relate to investment strategies managed by SL Advisers.)

This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involves a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of SL Advisors LLC or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made. r

Certain hyperlinks or referenced websites on the Site, if any, are for your convenience and forward you to third parties’ websites, which generally are recognized by their top level domain name. Any descriptions of, references to, or links to other products, publications or services does not constitute an endorsement, authorization, sponsorship by or affiliation with SL Advisors LLC with respect to any linked site or its sponsor, unless expressly stated by SL Advisors LLC. Any such information, products or sites have not necessarily been reviewed by SL Advisors LLC and are provided or maintained by third parties over whom SL Advisors LLC exercise no control. SL Advisors LLC expressly disclaim any responsibility for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on these third-party sites.

All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.

Past performance of the American Energy Independence Index is not indicative of future returns.

Print Friendly, PDF & Email
0 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.