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March 18, 2018

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Week Thoughts: FERC Upsets MLPs, March Sadness Continues

Midstream had another rough week.  The MLP Index has declined 5 out of the last 7 weeks and is off 15.2% from its peak in January.  Just when it seemed sentiment around MLPs couldn’t get worse with uncertain pending structural resolutions, poor fund flows and distribution cuts, FERC piled on with a ruling specifically targeting an MLP tax loophole.

In case you haven’t heard, FERC announced Thursday that it would reverse a long-standing policy that allows MLPs with FERC regulated interstate pipelines assets to recover an income tax allowance in cost of service rates.  See here for the initial response by the MLP Association.
While the FERC ruling sparked serious volume and intra-day volatility, MLPs were down just 2.9% overall this week, only the 3rd worst week so far this year.  Midstream overall actually beat the S&P 500 this week.  While FERC has added more uncertainty to the sector, but hard to imagine sentiment getting worse from here.
Thursday’s 4.6% decline was the worst decline in more than 2 years, the first 4%+ decline day since 3/8/16.  That sounds bad, but it’s not anywhere close to the worst day of all time (it was the 36th worst day all time), but the intra-day low at nearly a 10% decline for the index was notable, and the volume was massive.  It was the heaviest MLP volume day of all time for MLPs, so the intra-day volatility garnered attention.  It should also be noted that it was the second biggest day for traffic to mlpguy.com ever…
Signals Distorted by MLP Structure Noise
Meanwhile, ETP signed an offtake agreement and formed a joint venture with a Chinese company to build a large-scale ethane export facility on the Gulf Coast.  NGL supply growth was a key theme at EPD’s analyst day and in recent OKE management commentary and project announcements.

This latest news/noise is another MLP-specific distraction that draws drawing attention away from dramatically improved fundamental backdrop for midstream operators.
After all the IDR restructurings, distribution cuts, retail investor angst/apathy, and this FERC ruling, the survivors could emerge with a larger growth opportunity set and with fewer publicly-traded competitors.  If those survivors can make prudent capital deployment decisions and execute on those opportunities, investors from here could reap substantial rewards.
Back of the Envelop Math on Near-Term Impact
The FERC policy shift impacts MLPs only, corporations with FERC regulated assets are not impacted.  54% of the U.S. Midstream market cap is MLPs.  Out of the MLP universe, roughly 7% of the market cap (or 8% of the MLP Index weights) has potential direct impact from the FERC policy shift on tax impact (if you believe the press releases issued late in the week).
So, overall within the midstream universe, less than 4% is potentially impacted. And even those have contractual offsets (negotiated rates, discounted rates) and other operating segments that may blunt impact.
Included in that 8% are the following MLPs:

  • BWP – has not announced potential impact from the ruling
  • DM – has not announced potential impact from the ruling, but its biggest potential drop-down asset (Cove Point LNG export facility) would not be impacted by the ruling if owned by DM
    • Sponsor D has not announced any changes to its existing DM drop-down plan
  • EEP – announced further guidance reduction due to the ruling, and potentially will hasten a potential buyout
  • ENBL – issued press release outlining how most of its assets are not subject to FERC regulation and its natural gas pipelines have mostly either negotiated or discounted rates that won’t be impacted, but ENBL did not state the impact of the ruling on its near-term results
  • EQM – has not announced potential impact from the ruling
  • TCP – has not announced potential impact from the ruling

All other MLPs with significant FERC regulated pipeline exposure have made announcements indicating that at the current time the ruling will not have a significant impact on their operations, including: ETP, EPD, SEP, TEP, MMP, PAA, WPZ.
Initial Thoughts on Longer-Term Impact
The longer-term impact of the ruling can’t be captured by math, back of the envelope or otherwise.  Expect more MLPs to convert to or merge into corporations.  Expect drop-down plans to change for certain sponsored MLPs.  This may push some MLPs and sponsors to move away from the MLP structure faster than they would have otherwise.  As noted here ad nauseum lately, we expect the migration away from the MLP structure to continue, and for the MLP structure to become a less relevant corner of the midstream sector.
How pipeline rates eventually shake out when all the dust settles is also unknown.  Will FERC’s policy shift end up making a difference for customers of pipelines? Maybe.  For now, its impact has mainly been further pain for existing MLP investors.
Winners & Losers
Despite the massive swings towards the end of the week, there were actually some pretty big winners this week.  It’s probably not a coincidence that 4 of the 5 best performers are not included in the major MLP indexes tracked by big MLP ETFs.  NS is the outlier, bouncing early in the week, and extremely volatile on Thursday after filing an S-4 indicating a failed bid by ETE prior to its simplification announcement.
The biggest negative performers were down very big, and there was clearly a trend towards those with material exposure to the FERC ruling in current operations (EEP) or in a potential change in drop-down strategy resulting from the FERC ruling (TCP and DM).  AMID reported results on Monday that seemed to drag its price down more than the FERC ruling.

TLP went from bottom 5 last week to top 5.  SRLP reported results that helped it stand out.  CNXM followed through following its analyst day last week, driving its YTD performance to 20%, good for second best overall.  On YTD downside, TCP’s massive drawdown sent it all the way to last place, and NS’s recovery helped it gain 4 spots, better than EEP, SMLP and DM.  A wild week all around, with a surprising amount of return dispersion.

General Partners & Midstream Corporations
GPs and Midstream corporations traded up overall this week, dramatically outperforming MLPs and outperforming Canadian midstream this week. NSH dominated the GP and corporation group this week on the same drivers as NS.  PAGP continued its strong showing from recent weeks and finished with another 3% gain on the week.  TRGP’s lack of FERC regulated assets and lack of MLP structure helped it outperform.

On the downside, ETE’s ongoing project overhang, potential anti-simplification moves like buying NSH, and FERC regulated pipeline exposure did not help it this week.  WMB’s ownership of the largest FERC regulated natural gas pipeline in the country via an MLP was less of an issue by Friday, when WMB issued a press release implying that it could simply exit the MLP sector to avoid a blow to its rates from the FERC NOPR.
After the volatility this week, the leaderboard for the year didn’t change much.  OKE traded up on the week, despite trading down nearly 5% intra-day Thursday, and maintains its overall lead.  LNG has no exposure to FERC and actually could benefit from lower rates on pipelines if that materializes over time, so it’s positive week makes sense.

Canadian Midstream Corporations
Canadian midstream underperformed this week and continues to lag midstream overall, although the gap is narrowing.  ENF, leader this week, owns the Canadian side of the pipeline that drove the reduction in guidance for sister MLP EEP that owns the U.S. side of the pipeline.  Canadian customers of that pipeline will not see overall rates change with a change in EEP’s rates, because ENF’s rates are adjusted up in that case to keep the overall rate the same.  Pembina was the worst performer of the group, which doesn’t make much sense when ENB and TRP have clear read throughs from weakness at their subsidiary MLPs.  Pembina owns FERC regulated U.S. pipelines, but is a corporation.

Aside from TCP weakness potential leading to a change in de-leveraging path for TRP, TRP’s credit outlook was reduced to negative from stable at Moody’s prior to the FERC ruling, calling into question the pace of de-leveraging down to 5x net debt to EBITDA.
On the YTD leaderboard, ENB is still at the bottom, but there continues to be limited differentiation across Canadian midstream, with generally negative sentiment related to blown out differentials for Canadian oil vs. WTI as pipeline capacity additions have stagnated.

We spent extra time on this section this week, but price action was where the action was this week, as the market struggled to price in the surprise from Washington.
News of the (Midstream) Week
As expected, little company-specific news this week.  You may have missed the big news from ETE on a new ethane export facility.  That news followed heavy emphasis on ethane at EPD’s analyst day and at management meetings analysts had with OKE this week.  The massive expansion of ethane supply is creating global demand that EPD, ETE and others are mobilizing to satisfy.  Also, there was news that consolidation is at least being pursued behind the scenes (at least by ETE, as always).

Capital Markets

  • MPLX filed equity distribution agreement for sale of up to $1.7bn of equity sold at-the-market (filing)
  • Hoegh LNG (HMLP) priced 1.5mm share block trade priced at $16.80 in a clean-up trade for an institutional investor
    • Priced at 3.4% discount to prior day closing price, traded flat in next session

Growth Projects / M&A

  • Energy Transfer (ETP) and Satellite Petrochemical USA Corp. announced new joint venture, Orbit Gulf Coast NGL Exports, to construct a new export terminal on the Gulf Coast to provide ethane to Satellite for consumption at their ethane cracking facilities in China (press release)
    • The JV will also construct a 20-inch ethane pipeline originating at ETP’s Mont Belvieu fractionators that will make deliveries to the new export terminal as well as markets in the region
    • The export terminal will consist of an 800,000 barrel refrigerated ethane storage tank and a 175,000 bpd ethane refrigeration facility
    • ETP and Satellite also agreed for ETP to provide Satellite with 150,000 bpd of ethane under a long-term, demand-based agreements
    • Terminal will be ready for commercial service in 4Q 2020
    • Satellite announced expectations for $630mm of capital for the project, and for the JV to be owned 53% by ETP and 47% by Satellite
  • NuStar Energy (NS) filing showed Energy Transfer (ETE) offered to buy NuStar GP (NSH) on March 5th for $14.70/unit in cash, a 34% premium to prior day close (S-4)
    • NSH’s board and CEO Greehey (21% unitholder in NSH) rejected the offer and continue to support the NS/NSH merger announced early February
    • NSH shares were up +12% at one point intraday before closing down 3% following the sector selloff on the FERC news
    • The offer came pre-simplification announcement and pre-distribution cut, and if ETE had acquired the GP, NS would likely have been folded in to ETP to the benefit of the much higher IDR take at ETE (as opposed to NSH capped IDRs)

Other

  • FERC commissioners unanimously voted to bar MLPs from recovering income tax allowance in cost of service rates (FERC)
    • The policy impacts only FERC regulated interstate pipelines with cost of service contracts under MLPs, and applies to max rates
    • It does not include negotiated contracts, discounted rates, gathering lines, intrastate lines, or lines owned solely under a corporation
  • EQT Corp (EQT) announced CEO, Steven Schlotterbeck, resigned from the company for personal reasons and stepped down from the board as well as resigning from his positions with EQGP, EQM, and RMP (press release)
    • The board has appointed former CEO David Porges as interim president and CEO