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Pipeline Operators Eliminating MLPs: Victims of FERC Ruling?

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The May 17, 2018 date is marked important on the calendar for energy infrastructure master limited partnerships (MLPs). This is because major energy companies made headlines on this day as they consolidated their respective pipeline assets. A flurry of merger and acquisition deals hit the energy MLP industry yesterday, mainly in response to the Federal Energy Regulatory Commission (FERC) tax overhaul, announced a couple of months ago to reduce certain benefits for the MLPs.  

FERC Tax Overhaul: A Deadly Blow to the MLPs

MLPs have long been attractive investment vehicles for energy investors, courtesy of the high yields and tax advantages for being structured as pass-through entities. As a result, MLPs used to allocate their pre-tax income to unitholders on a proportionate basis. The unitholders were responsible for paying their own share of the partnership's tax obligation.

While FERC is not a tax-setting regulator, it does influence the rates a pipeline company can charge its customers to seek a proper balance between the pipeline companies’ profits and demands of the ratepayers.

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.

Thus, on Mar 15, the FERC barred the pipelines owned by MLPs from including their investors’ income tax allowance in their cost of service fees. The regulatory body ruled that the interstate oil and natural gas pipelines owned by MLPs will no longer be able to avail a credit for income taxes that they do not pay.

The FERC ruling has definitely been negative for MLPs as the tariff rates will fall for certain pipelines. The partnerships charging cost-based rates for interstate transportation service would now have to lower customer tariffs to transport 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. Under the new FERC ruling, holding interstate pipelines in MLP structures will no longer prove beneficial to the unitholders.

Consolidation Trend Picks up on FERC Tax Ruling

In a bid to simplify their corporate structure amid concerns emerging from the tax policy change, three leading energy companies, namely Williams Companies Inc. (WMB - Free Report) , Enbridge Inc. (ENB - Free Report) and Cheniere Energy, Inc. (LNG - Free Report) announced merger deals yesterday, to snap up the remaining stake of their midstream subsidiaries. While Cheniere Energy holds a Zacks Rank #2 (Buy), Williams Companies and Enbridge carry a Zacks Rank #3 (Buy). You can see the complete list of today’s Zacks #1 (Strong Buy) Rank stocks here.

Williams Companies, which currently holds a 74% stake in its pipeline unit Williams Partners L.P. (WPZ - Free Report) , was the first to announce the buyout of the 26% interest in the MLP in a deal worth $10.5 billion.

Further, Enbridge Energy inked an $8.9 billion all-stock deal to roll out two of its partnership units, namely Spectra Energy Partners LP (SEP - Free Report) and Enbridge Energy Partners LP (EEP - Free Report) along with two independent units of Enbridge Energy Management LLC and Enbridge Income Fund Holdings Inc., under a single entity.

Later, Cheniere Energy kept the momentum alive by announcing its acquisition plans as well. Cheniere Energy currently holding 91.9% of its midstream subsidiary, inked a $530-million deal to secure the remaining 8.1% stake in Cheniere Energy Partners (CQH - Free Report) .

Offer Terms and Benefits of the Triple Deals

Williams Companies will acquire 256 million outstanding units of its midstream subsidiary. The company will exchange 1.494 shares of its common stock for each unit of Williams Partners. Williams’ bid represents 6.4% premium to Williams Partners’ closing unit price of $38.42 on May 16, thus valuing William Partners at $40.875 a unit. The deal has been approved by the board of directors of both firms.

Subject to satisfactory closing conditions and shareholders’ approval, the transaction deal is expected to complete by autumn this year, post which, Williams Partners will become a wholly owned subsidiary of Williams Companies. Along with easing the organizational structure and improving the credit profile, the deal will also help Williams Companies enhance its dividend coverage, making its 5% yield payout more sustainable.

Cheniere Energy plans to exchange 0.45 shares of its common stock for each unit of Cheniere Energy Partners. Notably, the top U.S. natural gas exporter rolled up its subsidiary for just 1% premium based on Cheniere Energy Holdings’ closing unit price of $27.95 as of May 16, thereby valuing the latter at $28.24 a unit. At the given price, Cheniere Energy Partners market cap would be $6.54 billion.

The proposed transaction is subject to approval by the board of directors of both firms, post which, the deal would be culminated after meeting the closing conditions. The successful closure of the buyout will improve the company’s trading liquidity and facilitate access to the capital markets as well as lift its credit ratings besides simplifying the structural complexity.

Per the Enbridge pact, the company will swap its shares for the equity of its four affiliates at a ratio equivalent to the closing price as of May 16, thereby denoting no premium. The deal will result into simplification of Enbridge’s organizational structure and boosting its credit rating, which witnessed a fall last year as the company’s decision to take over Spectra Energy in a $37-billion deal increased its leverage metrics.

Having all the core assets under a single entity is likely to be a prudent move for expanding its investment appeal and attracting premium valuation. The merger plans, if it comes into effect under the proposed terms, are expected to have not much an impact on Enbridge’s current three-year financial outlook but will definitely prove conducive to its post 2020 guidance owing to tax and other synergies.

Are Others to Follow Suit?

The trio of deals amounting to a total of around $20 billion indicates a massive industry shift on a single day, which in turn might also motivate other akin companies to jump on the bandwagon.

Notably, Energy Transfer Equity L.P. might just be the next in line. The firm is also considering a merger with its MLP Energy Transfer Partners LP, provided it gets a nod from the rating agencies suggesting that the combined entity would be able to maintain an investment grade-rating. In fact, the Energy Transfer Partners CEO hinted on the recent quarter earnings call that the merger would prove to be a strategic move by the company amid the tax ruling.

Further, TransCanada Corporation believes that its MLP TC Pipelines LP no longer remains an attractive funding instrument under the new tax policy and hence, it mulls over purchasing its MLP.

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