Master Limited Partnerships

by Jeffrey Saut of Raymond James, 7/24/18

Readers of these missives know that we have been favorable on the midstream Master Limited Partnership (MLP) space for a number of months. The reasons for that strategy have often been mentioned in these letters. First, the midstream MLPs sold off when the upstream MLPs blew up with most of them going bankrupt. The midstreams were sold because of guilt by association. Quite frankly, the upstream MLPs had way too much sensitivity to the price of crude oil, but the midstreams do not. You can think of them as a transportation company without wheels since they own pipelines and storage facilities. Second, most of them have reduced their dividend distributions, not because they had to, but to get their “leverage ratios” down. Third, in March 2018, the Federal Energy Regulatory Committee (FERC) dropped a bombshell on the MLPs when it wrote, “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 resulting MLP sell off accelerated, and many of the hedge funds actually sold the MLPs short. Indeed, from its peak price in September 2014, the Alerian MLP Index (AMZ/$270.94) declined some 63% into it’s the February 2016 low and now resides about 50% below those September 2014 highs. Fourth, that sell off has left the MLP group in aggregate trading at some of the most inexpensive valuation metrics in a long time. According to one Wall Street MLP fundamental analyst, “The aggregate EBITDA for the MLP/midstream names we cover has grown by 70% while [the] aggregate industry leverage has declined from 6.2x in 2015 to our 2018E of 4.6x.”

Fifth, last week, FERC modified its March 2018 statement that removed several concerns and uncertainties for the MLP space. As our MLP analyst, Darren Horowitz, wrote on July 19, 2018:

Overnight, the Federal Energy Regulatory Commission posted a final rule on several components of the revised policy statement (RPS) and notice of proposed rulemaking from March 2018 - we commented in this report. MLPs with corporate parents are essentially excluded from the proposed changes, and accumulated deferred income tax (ADIT) reimbursement concerns have been eliminated for impacted MLPs.

Although FERC determined in the RPS that permitting MLP pipelines to include a tax allowance in their cost of service results in a double recovery of the MLP pipeline's tax costs, FERC will not require MLP pipelines to eliminate their tax allowances in this rulemaking proceeding (i.e., no material change to ratemaking for MLPs with C-Corp. GPs).

MLPs are considered subject to the federal corporate income tax if all of their income or losses are consolidated on the federal income tax return of their corporate parent. This means that a pass-through entity is eligible for a tax allowance.

An MLP that will no longer recover an income tax allowance (ITA) may also eliminate its ADIT from cost of service rates, rather than flowing these back to ratepayers. This was a major question mark before this announcement as it was unclear if ADIT would be reimbursed, and over what time frame. As we stated when the news first broke in March 2018, these items are very difficult to quantify - we cannot quantify prior upside or newly perceived upside for all the stocks in our coverage. In the months between then and now, most midstream/MLP management teams had successfully explained the various mitigating factors that could be in play if the full FERC changes were introduced. Most of the stocks in our coverage universe have since recovered to reflect a much lower cash flow exposure than most investors initially feared