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The FERC Ruling and Its Impact on MLPs

Apr 5, 2018

View all Rohan Reddy's ArticlesRohan ReddyRohan Reddy

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.

 

Category: Articles

Topics: MLPs

The information presented here is for informational purposes only. It was prepared on information and sources that we believe to be reliable, but we make no representations or guarantees as to the accuracy or the completeness of the information contained herein. All expressions of opinion reflect Global X’s judgement as of the date set forth above and are subject to change. This information is not intended to be individual or personalized investment or tax advice. Please consult a financial advisor or tax professional for more information regarding your tax situation. Global X Management accepts no responsibility for the conclusions and decisions clients make utilizing this information.

Investing involves risk, including the possible loss of principal. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Investments in securities of MLPs involve risk that differ from investments in common stock including risks related to limited control and limited rights to vote on matters affecting the MLP. MLP common units and other equity securities can be affected by macro-economic and other factors affecting the stock market in general, expectations of interest rates, investor sentiment towards MLPs or the energy sector, changes in a particular issuer’s financial condition, or unfavorable or unanticipated poor performance of a particular issuer (in the case of MLPs, generally measured in terms of distributable cash flow). The Global X MLP funds invest in the energy industry, which entails significant risk and volatility. The funds invest in small and mid-capitalization companies, which pose greater risks than large companies. MLPA and MLPX are non-diversified.

The potential tax benefits from investing in MLPs depends on the MLPs being treated as partnerships for federal income tax purposes. If the MLP is deemed to be a corporation then its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution to the fund which could result in a reduction of the fund’s value.

MLPA has a different and more complex tax structure than traditional ETFs and investors should carefully consider the significant tax implications of an investment. MLPA is taxed as a regular corporation for federal income tax purposes, which differs from most investment companies. Due to its investment in MLPs, the fund will be obligated to pay applicable federal and state corporate income taxes on its taxable income, as opposed to most other investment companies. The fund expects that a portion of the distributions it receives from MLPs may be treated as tax-deferred return of capital. The amount of taxes currently paid by the fund will vary depending on the amount of income and gains derived from MLP interests and such taxes will reduce an investor’s return. The fund will accrue deferred income taxes for any future tax liability associated certain MLP interests. Upon the sale of an MLP security, the fund may be liable for previously deferred taxes which may increase expenses and lower the fund’s NAV.

Shares of ETFs are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Brokerage commissions will reduce returns.

Carefully consider the Funds’ investment objectives, risks, and charges and expenses before investing. This and additional information can be found in the Funds’ summary and full prospectuses, which may be obtained by calling 1-888-GX-FUND-1 (1.888.493.8631), or by visiting www.globalxetfs.com. Please read the prospectus carefully before investing.

Global X Management Company LLC serves as an advisor to the Global X Funds. Global X Funds are distributed by SEI Investments Distribution Co., which is not affiliated with Global X Management Company or any of its affiliates. Solactive Indexes have been licensed by Solactive AG for use by Global X Management Company LLC. Global X Funds are not sponsored, endorsed, issued, sold, or promoted by Solactive AG nor does this company make any representations regarding the advisability of investing in the Global X Funds. Neither SIDCO nor Global X is affiliated with Solactive.