MLP Market Update: FERC Ruling

Transcription

1 MLP Market Update: FERC Ruling PM Perspectives Summary The Federal Energy Regulatory Commission ( FERC ) ruled that master limited partnerships ( MLPs ) can no longer include an income tax allowance in their rate base calculation for determining pipeline tariffs under a cost of service mechanism. The overwhelming majority of midstream businesses and companies should have minimal impact from the FERC ruling. We believe recent broader midstream market weakness is unjustified based on financial implications. We have narrowed the list of largest likely risk exposure to a handful of companies including Enbridge Energy Partners, LP (NYSE: EEP; 2.7% of MainStay Cushing MLP Premier Fund as of 12/31/17), Spectra Energy Partners, LP (NYSE: SEP; 1.6% of the Fund as of 12/31/17), TC Pipelines LP (NYSE: TCP; 0.0% of the Fund as of 12/31/17) and Williams Partners LP (NYSE: WPZ; 6.1% of the Fund as of 12/31/17). Unfortunately, we are expecting a protracted review process for the companies and assets impacted, which may have lingering negative implications on broader investor sentiment towards public midstream companies. At its open commission meeting on March 15, 2018, the FERC broke with nearly two decades of policy by revising its approach towards the recovery of income taxes for regulated pipelines operating under cost of service -based tariff rates owned by MLPs. We, along with the broader market of MLP investors, were surprised by this ruling which sent the midstream sector into a tailspin with stocks in the Alerian MLP Index ( AMZ ) selling off as much as 9.4% intraday, ultimately closing 4.6% lower for the day. While this ruling is clearly negative for a subset of the U.S. midstream sector, as it would result in a reduction of tariffs for some FERC-regulated pipelines, we view the wholesale decline of the sector s stock price performance as an overreaction, based on our analysis, since the overall financial impact should be non-existent in most cases, and for those affected, manageable. However, we do admit this adds yet another element of uncertainty for a beleaguered midstream sector that finally seemed to be finding its footing (e.g. positive 4th quarter 2017 earnings results, progress on structural simplifications, return of distribution growth, etc.). A Brief Explanation of the FERC Ruling Put simply, the FERC ruled that MLPs can no longer include an income tax allowance (typically referred to as an ITA ) in their rate base calculation for determining pipeline tariffs under a cost of service mechanism. Cost of service contracts allow pipeline operators to earn an adequate return assuming an established cost basis, with taxes being one component of that cost basis. All else equal, this ruling will result in lower maximum rates that select pipelines can charge shippers. The reversal follows years of litigation and debate culminating in a July 2016 court decision 1 that forced the FERC to consider whether its ITA policy allowed MLP investors to double recover taxes. Additionally, the FERC issued a notice of proposed rulemaking ( NOPR ) seeking to determine which natural gas pipelines would need to reduce their tariff rates to reflect the recent U.S. tax reform ( Tax Cuts and Jobs Act ). Most industry observers, ourselves included, believed the FERC would maintain the current treatment of ITA and address tax reform on a case by case basis. With this ruling, it appears the FERC now intends to address corporate tax reform in a more sweeping and accelerated fashion. Also addressed on March 15th (but perhaps less prominent in current discussion), the FERC noted it will address the ITA for older crude oil and liquids pipelines that use an index-based mechanism for their ratemaking process as part of the normal 5-year review in This change would be implemented over the period from 2021 to 2026.

2 Who is Likely to be Most Impacted? The greatest impact will be felt directly by FERC-regulated pipelines (typically natural gas) operating under cost of service rate mechanisms owned by MLPs, although impacts will vary depending on a multitude of factors. Specifically, natural gas pipelines that are deemed to be over-earning their allowed returns under the new policy will be most at risk, while pipelines that have been under-earning will be less impacted (or not at all). Natural gas pipelines owned by C-Corps will not likely be impacted by the ITA, but may have to reduce rates for tax reform depending on calculated returns on equity (ROE). On the crude oil side, older crude and liquids pipelines built before 1995 will be subject to the index revision in 2020, but we are not clear how C-Corps that use the same index will be treated. Based on the information above, we have narrowed the list of largest likely risk exposure to a handful of companies including Enbridge Energy Partners, LP (NYSE: EEP), Spectra Energy Partners, LP (NYSE: SEP), TC Pipelines LP (NYSE: TCP) and Williams Partners LP (NYSE: WPZ). As shown in Exhibit A, the most impacted companies currently represent approximately 14% of the Alerian MLP Index (AMZ). What are the Next Steps? Unfortunately for the select companies impacted, we are expecting a protracted review process, as there is no quick and easy fix here. We expect these companies to aggressively fight tariff reductions with the process potentially dragging on for two or more years. The first step will be for each pipeline to post an informational filing (FERC Form No. 501-G) to demonstrate whether it is over-earning in light of the recent changes. Astoundingly, FERC expects 133 pipelines to make these filings on a staggered schedule ranging from 28 days to 112 days after a public comment period! From there, pipeline operators have four options: 1) make a limited filing to reduce rates reflecting the lower taxes with no other changes (we view this acceptance by management teams as unlikely); 2) commit to filing a broader rate case by December 31, 2018 (we view this approach as most likely); 3) file a statement as to why no change is necessary; or 4) take no action. (We believe the last two alternatives would likely invite a forced rate review by FERC). As mentioned above, ITA is only one of several components included in a pipeline s cost basis for calculating cost of service tariffs. As such, we expect most companies to file a broader rate case (option 2 above), in order to offset the ITA exclusion with other costs that may have increased (maintenance and integrity spending, steel costs, etc.). In fact, on March 16th, Spectra Energy announced in a press release that it will actually request a rehearing of the ITA ruling and/or will subsequently pursue a full rate case to consider all costs of service. With 133 individual and unique pipelines to review, this process could take years. 2

3 Who is Least Impacted or Not Impacted at All? A critical point to emphasize is that the majority of midstream and related assets are not impacted by this ruling. Unregulated and competitive-based midstream businesses including crude oil, natural gas and natural gas liquid (NGL) gathering systems, natural gas processing facilities, intrastate pipelines, fractionators, storage/logistics terminals, trucking/rail terminals, export facilities, marine services, wholesale fuels distribution (including propane), etc. are not impacted whatsoever by this ruling. Secondly and with respect to interstate regulated pipelines, this ruling only applies to tariffs operating under a cost of service methodology. In other words, it does not apply to competitive market-based rates (where the operator can charge what the market will bear ), nor will it apply to negotiated or settled rates (an agreed upon tariff between a shipper and operator). Third, the ruling will be less applicable to regulated cost of service pipelines that are currently underearning their allowable ROE. This is probably most applicable to Boardwalk Pipeline Partners, LP (NYSE: BWP; 2.1% of MainStay Cushing MLP Premier Fund as of 12/31/17). Lastly, regulated cost of service pipelines held by C-Corps will be less impacted, but will need to reduce the assumed tax rate from 35% to 21%, to be partially offset by any other cost increases as noted above. Management Response Public midstream company and management team response to the ruling and market reaction has been swift and, in many cases, definitive. Numerous companies with FERC-regulated assets have issued press releases stating their expectation that the changes would have minimal impact on their financial results (see Exhibits A and B). Specifically, sixteen operating midstream companies, including MLPs and C-Corps representing combined market capitalizations of over $210 billion dollars issued public statements of no material impact. 2 Additionally, the Williams entities (NYSE: WMB/WPZ) representing over $50 billion of combined market capitalization issued a statement that their multi-year dividend and distribution growth guidance is unchanged after contemplating the EBITDA impact of the ruling. In relation to the benchmark Alerian MLP Index, companies representing approximately 63% of the current index weight made public statements of no material impact. 3 Based on our analysis and third-party sources, we believe an additional 23% of the current index weight will face little to no impact given their operation of non-regulated assets and other factors, 4 bringing the total of expected limited impact to approximately 86% of the index (see Exhibit A). For companies with assets subject to the ruling s impact, including the 14% with the most exposure, we expect the overall financial impact to weighted average index-level distributable cash flows to be less than 5%, based on current levels. 5 Accordingly, we believe the market s violent reaction and broad-based sector price decline was largely unwarranted. Poor Timing for Sentiment As we have suggested, the FERC ruling does not apply to the vast majority of the midstream sector, and we even expect manageable cash flow impacts for those companies that are affected. However, we have more difficulty measuring the lasting impact to sentiment of an already beleaguered sector and fragile investor base. One of the biggest problems recently impacting the space has been the decline in investor sentiment and resultant fund flows, despite a dramatically improved underlying fundamental and operating environment. This ruling (and increased trading volatility and sector weakness as a result of the ruling) will likely only add yet another source of uncertainty and frustration for investors. Additionally, the timing of this decision was unfortunate, as the sector seemed to be finding its footing and enjoying positive fundamental momentum with solid fourth quarter 2017 results and 2018 guidance. 3

4 Numerous Unanswered Questions As we stated in the beginning of this commentary, this FERC ruling came as a surprise to us and other sector specialists. While the disallowment for ITA recovery in MLP-owned pipelines sounds relatively straightforward, the details of implementation are complex. Just a few of the complicated questions the FERC will need to address from here are as follows: How does the ruling apply to joint venture (JV) pipelines that are jointly owned by unrelated MLPs and C- Corps? Does the MLP accept a different and lower rate than the C-Corp for its interest in the pipeline? Or, is the C-Corp forced to accept a single, lower rate because an unrelated MLP has an interest in the JV? How does the ruling apply to pipelines jointly owned by a C-Corp parent and an underlying MLP? What about MLP-owned pipelines that are majority owned by C-Corps? Ironically, would this put a C-Corp. owned pipeline at a disadvantage if it is competing for service with a lower tariff MLP-owned pipeline? Clearly, the FERC has opened a proverbial can of worms with this decision. From a simple logistical perspective, we wonder how the FERC expects to conclude this process and deliver the stated tax savings to consumers in a timely and efficient manner. As stated in Next Steps above, we expect there to be a flood of full rate cases, filings and complaints. In short, we believe a multi-year battle with the pipeline industry will soon be underway, as a resource constrained FERC wades through the many complex, contentious and unanswered questions this action raises. The ruling also raises questions around the merits of owning regulated natural gas interstate pipelines within the MLP structure. Will this accelerate sector consolidation or precipitate the roll-up of MLPs by their C- Corp parents? In its statement release from last week, the Williams entities stated they will evaluate the dual MLP/C-Corp structure going forward. What are the implications for natural gas-focused drop-down stories like Dominion Resources (NYSE: D; 0.0% of MainStay Cushing MLP Premier Fund as of 12/31/17) and Dominion Energy Midstream Partners, LP (NYSE: DM; 0.0% of MainStay Cushing MLP Premier Fund as of 12/31/17)? In other words, what is the point of having a sponsored MLP if it can t be used to acquire assets? Lastly, MLPs were established by federal tax legislation in 1986 to encourage investment in energy infrastructure especially pipelines. Isn t this ruling a direct contradiction to the stated purpose of MLPs in the first place? And ironically, will some MLPs convert to C-Corps in order to maintain the tax allowance in their cost of service rates? Brad Barron, President and CEO of NuStar Energy LP (NYSE: NS; 1.3% of MainStay Cushing MLP Premier Fund as of 12/31/17) cogently expressed the contradiction in a company press release last week as follows: We believe that FERC s action is inconsistent with the intended tax treatment of master limited partnerships, essentially negating the intent of Congress. 1. See United Airlines, Inc. v. Federal Energy Regulatory Commission, 827 F.3d 122 (D.C. Cir. 2016). FERC has been contemplating this policy change since December 2016 as a result of the U.S. Court of Appeals for the D.C. Circuit order in July 2016 that FERC consider whether its tax allowance policy enables MLP investors to double recover their taxes. 2. Note: Market capitalization includes public general partners and public tracking stocks related to the operating companies. Sources: Bloomberg and company press releases. 3. Sources: Company press releases and Alerian. 4. Sources: Company press releases, Alerian and Cushing Asset Management estimates. 5. Sources: Company press releases and filings, Alerian and Cushing Asset Management estimates. Wells Fargo, Weekender: FERC Triple Whammy, March 15, Evercore ISI, List of Corporate Responses to FERC Regulations Another Day in Midstream Paradise, March 15, Wolfe Research, Midstream Update Today s FERC Order, March 15,

5 Concluding Thoughts and Portfolio Implications The full evaluation of the FERC ruling and resultant implications for our fund holdings is ongoing. However, we note that our funds were either significantly underweight (versus the AMZ) or not exposed entirely to what we believe to be the most negatively impacted stocks (TCP, SEP and EEP). Additionally, our funds have substantial exposure to C-Corp midstream companies, which were less impacted by this ruling. For fund holdings with assets subject to the ruling, we believe the ultimate financial impacts will be manageable and/or immaterial, and recent company announcements appear to affirm this view. To reiterate, our investment and portfolio selection process is company structure agnostic, with more focus on the underlying assets, perceived valuation, total return potential and management quality. Therefore, we remain confident in our ability to execute our strategies going forward, even in the event that more midstream assets find their way into C-Corp structures over time. 5

6 Exhibit A: Summary of Alerian MLP Index (AMZ) Constituents Impacted by FERC Ruling Ticker Company Name Market Cap ($MM) ¹ AMZ Weight ¹ No Material Impact Statement ² EPD Enterprise Products Partners LP $53, Yes ETP Energy Transfer Partners LP $19, Yes MMP Magellan Midstream Partners LP $13, Yes MPLX MPLX LP $26, Yes PAA Plains All American Pipeline LP $15, Yes All / Mostly Unregulated ³ Expect Minimal Impact ³ Expect Some Impact ³ WPZ Williams Partners LP $34, Yes ⁴ BPL Buckeye Partners LP $5, Yes WES Western Gas Partners LP $7, Yes ANDX Andeavor Logistics LP $9, Yes EQM EQT Midstream Partners LP $4, Yes DCP DCP Midstream LP $4, Yes APU AmeriGas Partners LP $3, Yes SEP Spectra Energy Partners LP $16, Yes SHLX Shell Midstream Partners LP $4, Yes EEP Enbridge Energy Partners LP $4, Yes ENLK EnLink Midstream Partners LP $4, Yes AM Antero Midstream Partners LP $4, Yes PSXP Phillips 66 Partners LP $5, Yes GEL Genesis Energy LP $2, Yes TCP TC PipeLines LP $2, Yes TEP Tallgrass Energy Partners LP $2, Yes NS NuStar Energy LP $1, Yes SUN Sunoco LP $2, Yes SPH Suburban Propane Partners LP $1, Yes RMP Rice Midstream Partners LP $1, Yes BWP Boardwalk Pipeline Partners LP $2, Yes CEQP Crestwood Equity Partners LP $1, Yes CQP Cheniere Energy Partners LP $14, Yes HEP Holly Energy Partners LP $2, Yes NGL NGL Energy Partners LP $1, Yes ENBL Enable Midstream Partners LP $5, Yes DM Dominion Energy Partners LP $1, Yes TGP Teekay LNG Partners LP $1, Yes GMLP Golar LNG Partners LP $1, Yes NBLX Noble Midstream Partners LP $1, Yes VNOM Viper Energy Partners LP $2, Yes VLP Valero Energy Partners LP $2, Yes ARLP Alliance Resource Partners LP $2, Yes GLOP GasLog Partners LP $ Yes SMLP Summit Midstream Partners LP $1, Yes Count Total of AMZ Weight 63.2% 17.2% 5.8% 13.7% Total Weight of Expected Limited Impact 86.3% 1. Source: Bloomberg and Alerian, as of 3/16/ Source: Company press releases from March Source: Cushing Asset Management and company filings. Wells Fargo, Weekender: FERC Triple Whammy, March 15, Evercore ISI, List of Corporate Responses to FERC Regulations Another Day in Midstream Paradise, March 15, Wolfe Research, Midstream Update Today s FERC Order, March 15, While some cash flow impact is expected (not yet quantified), the Williams entities (NYSE: WMB and NYSE: WPZ) issued a statement on March 16, 2018 that respective dividend and distribution guidance is unchanged. 6

7 Exhibit B: Summary Select Midstream C-Corporations Impacted by FERC Ruling Ticker Company Name Market Cap ($MM) ¹ No Material Impact Statement ² All / Mostly Unregulated ³ Expect Some Impact ³ KMI Kinder Morgan Inc $34,845 Yes OKE ONEOK Inc $23,833 Yes WMB Williams Cos. Inc $22,114 Yes ⁴ TRGP Targa Resources Corp $10,192 Yes PAGP Plains GP Holdings LP $6,372 Yes TEGP Tallgrass Energy GP $3,382 Yes AMGP Antero Midstream GP LP $3,009 Yes SEMG SemGroup Corp $1,791 Yes 1. Source: Bloomberg and Alerian, as of 3/16/ Source: Company press releases from March Source: Cushing Asset Management and company filings. Wells Fargo, Weekender: FERC Triple Whammy, March 15, Evercore ISI, List of Corporate Responses to FERC Regulations Another Day in Midstream Paradise, March 15, Wolfe Research, Midstream Update Today s FERC Order, March 15, While some cash flow impact is expected (not yet quantified), the Williams entities (NYSE: WMB and NYSE: WPZ) issued a statement on March 16, 2018 that respective dividend and distribution guidance is unchanged. Important Disclosures This information update, does not constitute an offer of any securities or investment advisory services, which may be made only by means of materials which contain a description of material terms and risks of an investment. This summary is intended exclusively for the use of the person to whom it has been delivered and it is not to be reproduced or redistributed to any other person without the prior consent of Swank Capital, LLC and Cushing Asset Management, LP (collectively, Cushing ). The information in this report was prepared by Cushing and is current as of the date of this report. Opinions represent Cushing s opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. The mention of a specific security is not a recommendation or solicitation to buy or hold that security and should not be relied upon as investment advice. Cushing does not undertake to advise you of any changes in its opinions or the information contained in this report. Investments in MLPs are subject to price changes in crude oil and natural gas, as well as regulatory and interest rate risks, among others. This information is provided for illustrative purposes only and should not be construed as legal or tax advice. Investors should consult their financial and tax advisors for specific advice. Certain information contained in this presentation may constitute forward-looking statements, which can be identified by the use of forward-looking terminology such as may, will, should, expect, estimate, or believe or other variations thereof. Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking statements. 7

8 New York Life, MainStay Investments, and its affiliates do not provide legal, accounting, or tax advice. You should obtain advice specific to your circumstances from your own legal, accounting, and tax advisors. The information contained herein is general in nature, is provided solely for educational and informational purposes, and should not be construed as investment advice or an offer to sell or the solicitation of offers to buy any security. Opinions expressed herein are current opinions as of the date appearing in this material only. About Risk Before considering an investment in the Fund, you should understand that you could lose money. The Fund is a non-diversified, open-end management investment company under the Investment Company Act of 1940 and will not elect to be treated as a regulated investment company under the Internal Revenue Code. As a result, there are no regulatory requirements that limit the proportion of the Fund's assets that may be invested in securities of a single issuer. Accordingly, the Fund may invest a greater portion of its assets in a more limited number of issuers than a diversified fund. There are currently approximately 120 publicly traded MLPs. The Fund will select its investments in MLPs from this small pool of issuers, together with securities issued by any newly public MLPs, and may invest in securities of private MLPs, affiliates of MLPs, and non-mlp issuers, consistent with its investment objective and policies. An investment in the Fund may present greater risk to an investor than an investment in a diversified portfolio because changes in the financial condition or market assessment of a single issuer may cause greater fluctuations in the value of the Fund's shares. The Fund concentrates its investments in the natural resources sector, with an emphasis on securities issued by MLPs. MLPs and other natural resources sector companies are subject to certain risks, including, but not limited to the following: fluctuations in the prices of commodities; the highly cyclical nature of the natural resources sector may adversely affect the earnings or operating cash flows of the issuers in which the Fund will invest; a significant decrease in the production of energy commodities would reduce the revenue, operating income, and operating cash flows of MLPs and other natural resources sector companies and, therefore, their ability to make distributions or pay dividends. Securities purchased by the Fund that are liquid at the time of purchase may subsequently become illiquid due to, among other things, events relating to the issuer of the securities, market events, economic conditions, investor perceptions, or lack of market participants. The lack of an active trading market may make it difficult to obtain an accurate price for a security. As a result, an investor could pay more than the market value when buying Fund shares or receive less than the market value when selling Fund shares. Distributions made by the Fund to shareholders may be considered ordinary income or non-taxable return of capital. The Fund is organized as a regular or "C" corporation for U.S. federal income tax purposes and is subject to U.S. federal income tax on taxable income at the corporate tax rate (currently as high as 35%) as well as state, foreign, and local taxes. The investment strategies, practices, and risk analysis used by the Subadvisor may not produce the desired results. Definitions Alerian MLP Index is a capitalization-weighted index of the 50 most prominent large and mid-cap energy master limited partnerships (MLPs). C corporations are an alternative to S corporations, where profits pass through to owners and are only taxed at the individual level, and limited liability companies, which provide the legal protections of corporations but are taxed like sole proprietorships. A master limited partnership (MLP) is a limited partnership that is publicly traded on an exchange. It combines the tax benefits of a limited partnership with the liquidity of publicly traded securities. Midstream energy MLPs own and operate the infrastructure necessary to transport, refine, and store oil and gas for end users. These businesses generally generate stable cash flows from fee-based revenues. 8

9 For more information 800-MAINSTAY ( ) mainstayinvestments.com For more information about MainStay Funds, call 800-MAINSTAY ( ) for a prospectus or summary prospectus. Investors are asked to consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus or summary prospectus contains this and other information about the investment company. Please read the prospectus or summary prospectus carefully before investing. New York Life Investments engages the services of Cushing Asset Management, LP, an unaffiliated, federally registered investment advisor, to subadvise the Fund. MainStay Investments is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. The MainStay Funds are managed by New York Life Investment Management LLC and distributed through NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC. Not FDIC/NCUA Insured Not a Deposit May Lose Value No Bank Guarantee Not Insured by Any Government Agency MS MSCU02j-03/18