EUR 850.00 For Business Accounts Only

Morningstar | FERC Provides Relief for Interstate Natural Gas Pipelines; No FVE Changes to MLPs

The Federal Energy Regulatory Commission, or FERC, has now finalized its March proposal to incorporate the recent tax cuts enacted as well as the disallowance of a recovery of income taxes under a cost-of-service rate methodology for interstate natural gas pipelines. In response to substantial industry objections, FERC has softened the rulemaking effort considerably, in our view, while also providing the industry and investors with substantial clarity around the regulatory path forward, reducing investors' concerns regarding how the rule would be implemented. To be clear, the industry will still have to eliminate the previously obtained tax allowance, but it now has substantially more flexibility around the timing and actual path of implementation. As we stated in March, we don't see any fair value or moat impacts to the vast majority of our coverage, and with many stocks up 15%-20% from the post-FERC news lows, our call to buy the industry on the dip has proven very profitable. Our top pick remains wide moat Enterprise Products Partners, which remains undervalued amid a lack of appreciation for the coming surge in U.S. natural gas liquids, or NGLs, production and exports over the next five years.

In our view, FERC has weakened the implementation of the rulemaking effort considerably after stiff industry opposition while still complying with the spirit of the original D.C. Circuit Court decision. We think FERC felt it had to soften the rules because the industry threatened litigation as well as "no action" filings, forcing FERC to investigate each pipeline individually to force compliance, delaying actual implementation for years. By watering down the rule, FERC hopes that the industry will comply voluntarily with the rule and court decision to eliminate the tax allowance, thus enabling shippers and customers to obtain lower rates faster.

Comments from FERC Commissioners Cheryl LaFleur and Richard Glick rue FERC's lack of authority to compel pipelines to use previously accrued deferred tax allowances as part of future rate cases as well as its inability to set refund dates, providing incentives for prolonged litigation. In some ways, we're left with the impression that FERC lacks a lot of critical information about the industry that would make it a more effective regulator, such as actual pipeline return on equity, versus hypothesized return on equity.

FERC has offered numerous incentives for voluntary industry compliance, providing pipeline firms with considerable flexibility. First, the immediate positive is the fact that FERC has clarified that accumulated deferred income tax allowances are eliminated from consideration when filing for new rates incorporating the lost tax allowance, as asserting that these previously collected income tax allowances under the old regime would be affected under the new rule amounts to retroactive lawmaking and is not allowed. This change eliminates the possibility of further write-downs for the industry.

Second, pipeline firms agreeing to reduce their rates to reflect the lost tax allowance obtain a three-year moratorium on FERC investigations, provided the filing shows a return on equity of less than 12%. Without the direct ability to force pipelines to lower rates absent an investigation or rate filing, FERC will use information from optional revised rate filings and gathered from an informational filing (501-G) required from the industry to determine whether to initiate a rate challenge at a later date.

Third, FERC has clarified that the 50/50 equity/debt capital structure and 10.55% return on equity used on the required informational filing is used primarily so that FERC can analyze the industry in a consistent manner. An actual rate case filing can use the pipeline's actual capital structure when determining rates, allowing the entity to file with a larger equity contribution and then immediately issue debt in order to boost returns.

In terms of recent industry actions taken post-FERC news, we don't think the rationale for Williams Companies buying the remaining 26% of Williams Partners and the Enbridge family consolidation has changed materially. The stated reason for the transactions was that the combined entity could reclaim the lost MLP tax allowance because the MLP assets would now be held within a corporation. Post-finalization, FERC has clarified that MLPs that have their financials consolidated already at a corporate parent can claim the tax allowance still, removing a major reason for the deal. There still are some uncertainties regarding whether FERC means accounting consolidation or consolidation for tax reasons. However, in our view, this shifts our view from the transactions being a mild positive (reclaiming a lost tax allowance) to more neutral, with Williams seeing benefits from self-funding and an expanded tax-free period to 2024 but acquiring Partners at essentially a fair price.

For Enbridge, as it too now loses an important reason for its deal, we still think the family benefits from a lower cost of equity given the overall simplification of the entity and the prior existence of four separate stocks.

For more on why we see Enterprise Products Partners as undervalued, please see our July 2018 report "The Natural Gas Liquids Rubik's Cube Solved." For more on why Enbridge is a compelling investment, please see our report "Best Idea Enbridge is a Triple Threat."