MLP Stocks Slide On FERC Ruling: Is There An Opportunity?

There seems to be no respite for the energy infrastructure master limited partnerships (or MLPs). If the Trump administration's proposed 25% tariff on imported steel were not enough, now midstream network providers have found themselves entangled in an FERC tax ruling, bleeding them even further.

The benchmark Alerian MLP Index – tracking 40 partnerships – suffered its worst fall in more than two years on Thursday in a sell-off sparked by concerns of lower tariffs and cash flows. While selling hit most sector constituents, Plains All American Pipeline L.P. (NYSE:PAA) and Energy Transfer Partners L.P. (NYSE:ETP) were two of the biggest daily percentage decliners.

The Business of MLPs & Advantages of The Structure

MLPs differ from regular stocks in that interests in them are referred to as units and the unitholders (not shareholders) are partners in the business. Importantly, these hybrid entities bring together the tax benefits of a limited partnership with the liquidity of publicly traded securities. The assets that these partnerships own typically – oil and natural gas pipelines and storage facilities.

MLPs represent an attractive investment option for income-focused investors in the current environment. In addition to high yields, MLPs are structured as pass-through entities.

This means that they typically distribute nearly all of their cash flows back to unitholders. The MLPs are not required to pay a corporate income tax as the tax liability of the entity is passed on to its owners (or unitholders) in the form of a cash dividend (distribution). This allows the MLPs to offer very attractive yields to the investors.

The FERC Tax Ruling

On Mar 15, the Federal Energy Regulatory Commission (‘FERC’) ruled that the interstate oil and natural gas pipelines owned by MLPs can no longer avail a credit for income taxes they do not pay. Revising its 2005 Policy Statement for Recovery of Income Tax Costs, the federal regulators found that the longstanding income tax allowance in their cost-of-service fees could lead to double recovery of costs for the asset class who are pass-through entities not subject to corporate income taxes.

The Net Effect of the Policy Revision

Looking ahead, the FERC policy revision signals significant future changes on how the pipeline partnerships will go about treating income taxes in their books of accounts.

As mentioned above, MLPs, being pass-through entities, allocates their pre-tax income to unitholders on a proportionate basis. The unitholders are then responsible for paying their own share of the partnership's tax obligation. Therefore, the FERC felt that its 2005 policy on income tax allowance provided the partnerships an unfair benefit, possibly resulting in double recovery of costs and boosting their distributable cash flows.

FERC’s recent tax policy change is aimed at addressing this issue. The regulatory body is expected to issue a formal rulemaking guide, outlining the impact of the removal of income tax allowance on interstate pipeline rates.

Consequently, partnerships charging cost-based rates for interstate transportation service would have to lower customer tariffs to move oil, gas and refined products around the country by the amount of their income tax allowances - substantial in certain cases. A reduction in cost recovery would likely cut into their cash flows.

Impact on MLPS

While the FERC ruling is definitely a negative for MLPs, it must be remembered that the move will not affect all partnerships and assets. In particular, the changes are not likely to impact pipeline companies that are structured as ‘C-Corporations’ (and not as MLPs) like Kinder Morgan, Inc. (NYSE:KMI) and ONEOK, Inc. (NYSE:OKE) . The federal revision will also not apply to MLPs owning midstream assets that begin and terminate within the same state.

On the other hand, MLPs with significant ‘cost-of-service’ exposure and large amounts of interstate pipelines – including Energy Transfer Partners and Spectra Energy (F:SEP) Partners (NYSE:SEP) – look to be in most trouble. The change in income tax policies will result in rate reduction, and therefore lower cash flow for pipelines owned by these MLPs.

That said, all midstream operators with interstate pipelines will not be equally affected by the FERC ruling on tax allowances, with the impact essentially depending on how they charge rates. For example, pipelines under cost-of-service rates will be impacted but those subject to market-based or negotiated tariffs won’t be materially affected.

What Next

Though a number of MLPs came out with press releases claiming negligible or no material impact from the FERC ruling, the tax policy change has gripped the sector with wide-ranging concerns and uncertainty. With the new rule expected to be adopted only by 2020, the issue may remain a thorn in the flesh for the foreseeable future.

Opportunity for Bottom Fishing

The speed of Thursday’s jaw-dropping sell-off send MLP investors in a panic. Most of them are still jittery and are waiting for the dust to settle before coming back to the market. In particular, they will be carefully analyzing the partnerships’ press releases related to FERC’s ruling wherein the companies gradually come out with disclosures associated with cost of service exposure and potential impact to their cash flows.

However, most analysts saw the broad selling as an overreaction with enough opportunity to wade back in the industry. If you are a savvy investor — meaning you see a buying opportunity when stocks sell off — then it may be time to look at MLPs. One might opt for fundamentally strong names that are not likely to be impacted from the FERC rule change but got unfairly punished when the sector as a whole took a turn lower.

We have shortlisted two of them – Calumet Specialty Products Partners, L.P. (NASDAQ:CLMT) and Oasis Midstream Partners L.P. (NYSE:OMP) – carrying Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Calumet Specialty Products Partners is a major North American producer of high-quality, specialty products and fuels. The Indianapolis, IN-based partnership makes a significant portion of its money by processing crude oil into lubricating oils, solvents, waxes, and other petroleum products. These activities would experience no impact from the FERC change.

Oasis Midstream Partners is primarily focused on production gathering and gas processing. The Houston, TX-based partnership’s tariffs come from its economic interests in gathering pipelines, processing facilities and storage facilities, which will see no material effect from FERC's policy revision.

More Stock News: This Is Bigger than the iPhone!

It could become the mother of all technological revolutions. Apple (NASDAQ:AAPL) sold a mere 1 billion iPhones in 10 years but a new breakthrough is expected to generate more than 27 billion devices in just 3 years, creating a $1.7 trillion market.

Zacks has just released a Special Report that spotlights this fast-emerging phenomenon and 6 tickers for taking advantage of it. If you don't buy now, you may kick yourself in 2020.

Click here for the 6 trades >>