The Federal Energy Regulatory Committee (FERC) provided another hit to already exhausted MLP investors with its announcement Thursday that it would remove tax allowances from its rate calculation for certain pipelines using an older ‘cost-of-service’ formula. FERC formerly allowed MLPs, which do not pay corporate income tax, to include a tax adjustment on the rates for regulated pipelines because their investors were presumed to be taxable. FERC’s ruling impacts only federally regulated interstate pipelines, which represent about 8% of the assets within the Alerian MLP Index. It does not cover assets with privately negotiated contracts or intrastate pipelines. Likewise, the change does not affect regulated interstate pipelines owned by C-Corps such as Oneok Inc. or Kinder Morgan.
The large MLPs – Enterprise, Energy Transfer, Magellan, Williams and MLPX quickly issued press releases stating the potential impact on revenues and distributions would not be material. Enbridge (EEP), one large MLP that did have significant exposure to the ruling (and importantly not a holding of Miller / Howard), fell nearly 25% in after the announcement.
Despite the limited, and in most cases, immaterial impact of the ruling, MLP investors are justifiably tired and this news proved to be the final straw for many. A promising 10% rally in the first part of the year faded as outflows from mutual funds, closed-end funds and exchange-traded products continued to drag on the sector, despite generally positive first quarter earnings and distribution announcements.
What happens from here and what should investors do?
One result from this ruling will likely be to accelerate the migration oil and gas pipelines out of MLPs into C-Corps (i.e. ordinary dividend paying stocks). As stated above, tax-paying corporations can still claim the tax adjustment on rates for their regulated pipelines. With the new lower corporate income tax rates and a large investor base that does not want to deal with the tax filing requirements imposed by MLPs, C-Corps already own over half of the midstream assets in the US. Additionally, C-Corps qualify for membership in indexes such as the S&P 500 or Russell 1000 whereas MLPs do not.
With yields over 7% and projected mid-single digit distribution increases, MLPs remain one of the very few cheap assets in a frothy market. The tax-deferred income compensates investors for their patience. If conversion to C-Corps becomes the mechanism to unlock this value then it should be welcomed by investors. Ultimately MLPs own valuable assets that pay a steady income and comprise essential infrastructure for the delivery of energy and raw materials to US businesses and consumers.
-Stephen C. Browne, CFA, CIO