By Karyl Patredis
I have a three-year-old little boy, and we're at the stage where the ride to preschool is an open forum for every question you can imagine. "Why are the tags on my shirts so itchy?" and similar. I explain things to him in the simplest terms possible, and it got me to thinking about how sometimes we all need things explained in the simplest terms possible. Yes, you've read about the FERC decision, but can you explain it in a way that your three-year-old (or client who acts like a three-year-old) can understand? My mailbag today attempts to do just that.
- I heard the FERC (Federal Energy Regulatory Commission) issued a decision that affects MLPs and investors freaked out. What happened, exactly?
There is a type of oil & gas transportation fee that a company that owns interstate pipelines1 can charge called a "cost-of-service" rate. Basically, this just means that the pipeline company takes all of its costs into account then adds a reasonable rate of return on top of the costs. Before the FERC decision, an income tax allowance was permitted as a cost for MLPs. The recent FERC decision has taken away the ability for MLPs to count income tax as one of the line items that determines the rate they can charge to customers.
As an example, let's pretend that I started a cleaning company and I charged my clients using the "cost of service" rate method. I decided to bill my customers $50 for two hours of work, and I arrived at this amount by listing out my expenses (first four lines), adding in a profit for myself, and then including the income taxes I'd have to eventually pay on my profit:
If Karyl's Cleaning Company was an MLP regulated by the FERC, I could no longer charge that 20% (or $4) to the customer. It's true that this doesn't make anyone's heart sing, but the reality is that there are several different types of rates and lots of MLPs have publicized that, due to diversification of rates charged, this announcement won't have a significant impact on their overall earnings. Also, in keeping with the cleaning example, if I can prove that other costs have increased since the last time I decided to evaluate my prices, I could end up continuing to charge $50, or potentially even more. If you want to read about this topic in more detail, check out this blog post.
- I've heard that there have been a lot of simplifications and mergers happening in the MLP and energy infrastructure space, should I panic?
I'm pretty sure that panicking is never a reasonable reaction to anything (unless, obviously, you are being chased in the woods by a killer, then by all means...). It's fair to observe there are several simplifications and mergers happening (or that have happened recently) in the MLP space. One thing to note, however, is that not all MLPs are rolling up into C Corporations. For example, in the NuStar Energy (NYSE:NS) and NuStar GP Holdings (NYSE:NSH) merger, NS (the MLP) will be the surviving entity. The same is true for the Alliance Resource Partners (NASDAQ:ARLP) and Alliance Holdings (NASDAQ:AHGP) simplification. ARLP, the MLP, will remain. My point in saying this is that although consolidations and changes are happening, it doesn't mean it's the end of MLPs as we know it. It just means that some company structures are "under construction" right now in order to improve long-term growth potential and overall stability. For more detail, check out Part 1 and Part 2 of our MLP Structural Simplifications series.
- Why are MLPs performing like Fergie at the NBA All-Star Game?
There's been a lot of noise in the MLP space with distribution cuts, restructurings, the shift to self-funding and moderating distribution growth. Arguably, these can all be described as causing short-term pain for long-term gain. At this point, we've just seen the pain, and the aforementioned FERC announcement added insult to injury.
It's worth emphasizing, however, that MLP fundamentals are still intact. According to the EIA, US oil and gas production is expected to see record annual growth in 2018, and this requires more infrastructure and more exports.
For MLPs to improve from here, we think a few things would help:
- Oil price stability. The Energy Information Administration (EIA) expects West Texas Intermediate (WTI) to sit in the high $50s for the next couple of years, though WTI crude is higher today at almost $69 per barrel.
- No bad headlines. If we can go a stretch without any new announcements from governmental agencies or distribution cuts, that would be great! Operational execution should help shift the focus back to MLPs' growth projects and underlying business fundamentals.
- Inflows into the space. Comfort with investing in energy would be helpful and could be supported by the improvement in oil prices.
1 Interstate pipeline means the pipeline runs between states, not to be confused with an intrastate pipeline meaning that the whole pipeline is contained within a single state.
2 20% was picked arbitrarily for this example, but realize that the old income tax rate was 35% and the new rate is 21%.
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