FERC Change in Stance Is Positive for Oil and Gas MLPs

FERC Change in Stance Is Positive for Oil and Gas MLPs

Master limited partnership (MLP) investors received some good news lastweek. The Federal Energy Regulatory Commission (FERC) issued a final rulingthat clarifies and softens a previous order issued in March, which wouldhave disallowed a long-standing policy enabling MLPs to earn an income taxallowance in their pipeline rates. The March ruling precipitated a 13% dropin the Alerian MLP Index and hit MLPs exposed to natural gas especiallyhard (due to the regulated nature of these assets), with many correcting to10-year lows.

Thefinal FERC rulingissued 18 July essentially excludes MLPs with a C corporation parent – themost common ownership structure – from the proposed policy changes. Themodified ruling triggered sharp rebounds for the names hurt most by theMarch policy announcement, helping the Alerian index close up 2.9% over thepast three days and bringing overall year-to-date gains to 2.4%.

While the final order pertains primarily to long-haul natural gaspipelines, we see positive implications for MLPs in general, includingregulated liquids pipelines, as it indicates FERC’s willingness to updateits views and provides a supportive backdrop for returns on capitalemployed.

Simplification transactions will likely move forward

To overcome the headwinds arising from the March proposal,a number of MLPs announced simplification transactionsthat would convert them from MLP structures into traditional Ccorporations. Although the final ruling appears to diminish the need forsome to do so, we expect these transactions to go forward nonetheless givenother potential benefits. These include lowering their cost of capital,reducing the complexity of their corporate structures and broadening theirinvestor bases, given that MLPs are not included in most broad-marketequity indexes.

Investor takeaways

We see the tide turning for the midstream energy sector after a frustratingfew months and four years of underperformance, during which the Alerianindex corrected 31%. The FERC’s surprise announcement in March overshadowedan otherwise healthy first-quarter 2018 earnings season, where many beatexpectations owing to higher commodity prices, production growth and solidmargins. While still early, second-quarter earnings appear to be off to agood start, and we expect the underperformance of the Alerian indexrelative to the S&P Oil & Gas E&P Select Index and WTI spotprices to narrow in coming months (see chart).

FERC Change in Stance Is Positive for Oil and Gas MLPs

Several key factors support our constructive view on MLPs, includingstill-high starting yields, improving company fundamentals, attractivevaluations relative to high yield and other income-oriented sectors, and arobust oil and gas production backdrop. This utility-like sector currently offers an attractive yield of around8% with potential for mid-single-digit distribution growth (pointing to12%–14% total return potential over the next 12 months), supported byfee-based cash flows backed by long term take-or-pay contracts.

Investing in midstream energy isn’t without risks, including commodityprice risk as well as shifts in macroeconomic or investor sentiment,interest rate expectations or a particular issuer’s financial condition.Nonetheless, we believe MLPs may offer compelling risk-adjusted returns intoday’s market.

For more of our views on oil and gas MLPs, see related content on the PIMCO Blog.

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John M. Devir is a portfolio manager on PIMCO’s MLP & Energy Infrastructure strategy and is a regular contributor to the PIMCO Blog.

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Disclosures

All investmentscontain risk and may lose value. Investing in the bond market is subject to risks, including market,interest rate, issuer, credit, inflation risk, and liquidity risk. Thevalue of most bonds and bond strategies are impacted by changes in interestrates. Bonds and bond strategies with longer durations tend to be moresensitive and volatile than those with shorter durations; bond pricesgenerally fall as interest rates rise, and the current low interest rateenvironment increases this risk. Current reductions in bond counterpartycapacity may contribute to decreased market liquidity and increased pricevolatility. Bond investments may be worth more or less than the originalcost when redeemed. Investing in MLPs involves risks thatdiffer from equities, including limited control and limited rights to voteon matters affecting the partnership. MLPs are a partnership organised inthe US and are subject to certain tax risks. Conflicts of interest mayarise amongst common unit holders, subordinated unit holders and thegeneral partner or managing member. MLPs may be affected by macro-economicand other factors affecting the stock market in general, expectations ofinterest rates, investor sentiment towards MLPs or the energy sector,changes in a particular issuer’s financial condition, or unfavorable orunanticipated poor performance of a particular issuer. MLP cashdistributions are not guaranteed and depend on each partnership’s abilityto generate adequate cash flow. There is no guarantee that these investmentstrategies will work under all market conditions or are suitable for allinvestors and each investor should evaluate their ability to investlong-term, especially during periods of downturn in the market. Investorsshould consult their investment professional prior to making an investmentdecision.

Return assumptions are for illustrative purposes only and are not aprediction or a projection of return. Return assumption is an estimate ofwhat investments may earn on average over the long term. Actual returns maybe higher or lower than those shown and may vary substantially over shortertime periods.

The Alerian MLP Index is the leading gauge of large- and mid-cap energymaster limited partnerships (MLPs). It is a float-adjusted,capitalization-weighted index, which includes 50 prominent companies. It isnot possible to invest directly in an unmanaged index.