Yesterday (10/8) we hosted an expert call with Elisabeth Myers, an energy lawyer with twenty years experience in oil and natural gas pipeline regulation, rates, safety, and compliance. Ms. Myers litigated on behalf of shippers against SFPP and CALNEV (Kinder Morgan subs) for ~10 years in several ground-breaking cases before the FERC and CPUC.
Listen to the replay, and see below for our key takeaways and notes.
- Regulation is always "playing catch-up."
- Regulation of oil/product lines is very different from that of natural gas lines.
- "De facto deregulation" of oil/product lines over last 10-20 years. Gets little FERC attention.
- FERC takes regulation of natural gas lines much more seriously, especially over last ~4 years; regulated under a consumer protection statute (NGA).
- No expectation of a change in FERC policy re: MLP income tax allowance "any time soon."
- No regulation of pipeline maintenance spending; DOT / PHMSA may come in "after the fact, if there is an issue."
- Pipeline only incentivized to "gold-plate" in twelve months leading up to a rate case; otherwise, the incentive is to cut costs.
- LP investors are getting their own money back; it's only sustainable if MLP can continue to issue new equity and debt.
Rate Setting Basics (2:55 mark)
- Both a federal and state component to regulation of pipelines … Rates typically set by pipeline filing tariffs, and settlements.
- Oil pipeline rates are largely regulated under the principle of settling with the shippers … If the pipeline can’t settle, then they have to cost-justify it … Primarily we are dealing with cost-based regulation for oil pipelines in the event there is a dispute.”
- Similar for natural gas. Natural gas pipelines are clearly cost-based regulation.
“Unjust and Unreasonable” Rates (7:38 mark)
- Oil Pipelines… Indexing is the most prevalent way of changing [oil] rates … Every year an index is established, and what that means is that any [oil] pipeline can file, basically automatically, an increase across the board for all of its rates within that index … The oil index can be applied annually.
- In the 2010 – 2011 reporting period, about 26% of oil pipeline companies were reporting over-recoveries on their FERC Form 6 … Some are substantial … Colonial was ~$250MM (annually) over-recovered.
- Natural Gas Pipelines… There is no indexing for natural gas lines.
FERC Resources and Attention (11:18 mark)
- Staffing… Can count on 1 or 2 hands how many staff are allocated to oil pipeline issues … Natural gas, in contrast, is well-staffed. Perception is that FERC indexing for oil pipelines was supposed to take care of the issue of unjust and unreasonable rates ... Perception is that shippers on oil pipelines tend to be major oil companies, can take care of themselves, don’t need regulators' help ... Seems forgotten that many pipelines have monopoly power.
- Statutes… Oil pipelines regulated under the Interstate Commerce Act (ICA, 1887) – designed to protect shippers and consignees … Natural gas pipelines under the Natural Gas Act (NGA, 1938) – it is a consumer protection statute ... Natural gas rates as well as sighting are regulated under the NGA.
Trends in Regulation (14:55 mark)
- "De facto deregulation" of oil lines over last 10-20 years ... Index increases have been unchallengeable by shippers ... Protests and appeals dismissed ... Trend of light-handed regulation of oil lines is here to stay unless new FERC chairman comes in, or cases get up to the Court of Appeals, and Court mandates change.
- In contract, on natural gas side, circa 2009, FERC called in natural gas lines for excessive rates; all proceedings were resolved with lower rates via settlement ... Commission is much more in tune to regulating natural gas lines ... Consumers can't protect themselves.
Maintenance Spending (19:10 mark)
- Pipeline safety is regulated, not spending ... Nothing that says "you must spend X to maintain your pipeline"... FERC presumption is that pipeline operators are "prudent."
- On gold-plating... If pipeline is coming in for a rate case, it may be incentivized to over-spend. If on the other side, during a rate settlement, the incentive is to cut costs. "Typically you don't really have 'gold-plating' going on unless you want to put, in a specific 12-month period, which is going to be your test period of 'representative costs,' you might want to bump that up. But, over time, once you establish a rate, the incentive is to cut costs as much as possible."
- Reorganizations / restructuring (via acquisition) often results in lower cost structures for pipelines ... This can lead to future rate cases.
Income Tax Allowance for MLPs (23:45 mark)
- C-Corp's given an allowance for income taxes in rates to avoid double-taxation of its investors ... At the same time, pass-through entities (MLPs, LLCs, and LPs) do not pay income taxes ... "However, the FERC, in its infinite wisdom, has decided that it will nonetheless allow a pass-through entity to collect an income tax allowance in its rates."
- 2004 FERC Court ruled that could not give allocation for "phantom tax" ... FERC then reversed decision and established principle on "policy basis."
- Raised same issue of "phantom tax" with CPUC ... CPUC found that there should be no income tax allowance for SFPP ... Rates were lowered, "major settlement payments."
- California's decision are not binding at FERC or other states ... "I do not think that the FERC will change its policy on income tax allowance any time soon."
More on MLPs (31:15 mark)
- Cash is flowed through to the LP investor, not income, which is why there is no tax liability ... Cash reduces the basis, or capital account ... LP investors are "getting their own money back" ... When LP investor sells unit, it pays a capital gains tax.
- On GP/LP relationship... Surprised that Kinder Morgan's partnership agreement expressly disavows fiduciary duty (of GP to LP) ... Partnership agreement signed on behalf of GP and all of LP investors by same persons ... Cash distributed to GP / LP based on IDR splits (currently 50% / 50%) ... The income follows the cash to the GP, and then the LPs are allocated losses to "balance the books."
- FERC is currently "quite happy" with the MLP structure ... FERC does not want to hear anti-MLP arguments ... Stark contrast to CPUC's decisions with respect to KMI's 2007 "go-private" transaction.
- A sustainable model? MLPs - Kinder Morgan referenced - only sustainable if able to raise debt and equity to pay cash distributions ... More concerned with what happens to shipper clients if the MLP "folds;" what happens to customers that rely upon the pipeline?
Q&A (42:10 mark)
- Typical natural gas rate case? Tariffs vs. complaints. Typically natural gas shippers are in reaction mode, i.e. protesting tariffs; burden of proof is on the shippers ... FERC can file proceeding against gas pipeline under Section 5 of NGA ... Burden of proof is on the FERC, not the pipeline.
- Are useful lives / depreciation expenses argued often? Not a "hot topic," but it is an issue that does get litigated from time to time ... Shippers tend to rely upon the FERC to regulate useful lives, as it has depreciation experts on staff.
- Mandated / regulated level of CapEx? No - nothing regulated by FERC. DOT / PHMSA will come in "after the fact, if there's a problem" with Corrective Action Orders / compliance plans.
- Importance of CPUC income tax allowance decision? Very significant decision - but not binding in other jurisdictions ... It is "reasoned decision making" - there is no tax liability, therefore there should be no tax allowance ... Ratepayers are paying personal income taxes of investors in MLP.
- Victories and defeats in Kinder Morgan cases? Major victory was overturning SFPP's "grandfathered rates" ... Disappointment was losing the income tax allowance case at the FERC (which they won at the CPUC).
- Respond to FERC Commission Spitzer's comments in December 2007 Order on Complaint (FERC Docket OR07-14-000)? "Let me first say that as an officer of the court, and in filing these pleadings, basically, it's not under oath, it is my ethical duty not to mislead the tribunal. That's one of the things that I could be disbarred for. We put into our pleadings for this case facts and evidence that we had obtained in the public record, in the records in our other proceedings related to SFPP, and in understanding how the MLP structure - with respect to Kinder Morgan - worked. And I stand by what we said there. We were since, since this order came out, the CPUC has pretty much vindicated what we said. CPUC did not throw us out for making these same allegations. Instead they offered us the opportunity to develop them with evidence, to cross-examine witnesses that Kinder Morgan put on, and to actually prove our point. In stark contrast to this [FERC] Order, which was an Order on Complaint, basically dismissing it peremptorily without any further procedures. I stand by what we said; and, frankly, as I said a few minutes ago, if the only way that the MLP structure can continue to pay out cash distributions at the level it's paying out is to issue new units or borrow money, to me, that is a classic example of ponzi. And in my discussions with some SEC folks early on in these cases, they said, 'Wow, that's amazing to us.'"
Client Talking Points
How did the United States' top creditors respond to Obama & Boehner fear-mongering “default” spew? Well, they both went up (China & Japan). China is actually up both days since the holiday week conclusion. It's bounced back and is now in positive territory year-to-date. We remain long China (new position) via the FXI exchange traded fund.
Most European Equity markets don’t care about the US fear-mongering either. The Eurostoxx600 is also up this morning. Over in Germany, the DAX is holding all lines of support. Meanwhile, Italy’s stock market is hitting a fresh year-to-date high post the USA smackdown to oversold. Bottom line: The global response to Washington is to put conflicted politicians on mute.
You would think the big Janet Yellen Fed news would be Dollar bearish. You would probably think the news would be Gold bullish too. Think again. It's certainly not the case this morning. That’s because the U.S. Dollar was oversold alongside S&P 500 into yesterday’s close and Gold continues to crash year-to-date.
|FIXED INCOME||0%||INTL CURRENCIES||15%|
Top Long Ideas
WWW is one of the best managed and most consistent companies in retail. We’re rarely fans of acquisitions, but the recent addition of Sperry, Saucony, Keds and Stride Rite (known as PLG) gives WWW a multi-year platform from which to grow. We think that the prevailing bearish view is very backward looking and leaves out a big piece of the WWW story, which is that integration of these brands into the WWW portfolio will allow the former PLG group to achieve what it could not under its former owner (most notably – international growth, and leverage a more diverse selling infrastructure in the US). Furthermore it will grow without needing to add the capital we’d otherwise expect as a stand-alone company – especially given WWW’s consolidation from four divisions into three -- which improves asset turns and financial returns.
Health Care sector head Tom Tobin has identified a number of tailwinds in the near and longer term that act as tailwinds to the hospital industry, and HCA in particular. This includes: Utilization, Maternity Trends as well as Pent-Up Demand and Acuity. The demographic shift towards more health care – driven by a gradually improving economy, improving employment trends, and accelerating new household formation and births – is a meaningful Macro factor and likely to lead to improving revenue and volume trends moving forward. Near-term market mayhem should not hamper this trend, even if it means slightly higher borrowing costs for hospitals down the road.
Financials sector senior analyst Jonathan Casteleyn continues to carry T. Rowe Price as his highest-conviction long call, based on the long-range reallocation out of bonds with investors continuing to move into stocks. T Rowe is one of the fastest growing equity asset managers and has consistently had the best performing stock funds over the past ten years.
Three for the Road
TWEET OF THE DAY
On the road seeing clients in Boston today. I'll walk through why I like China and Germany better than US Equities
QUOTE OF THE DAY
Fall seven times and stand up eight. –Japanese Proverb
STAT OF THE DAY
The new $100 bill costs 12.5 cents to produce — a 60% increase over the 7.8 cents it cost to print the older version of the bill. The U.S. government has printed 3.5 billion of the new $100 bills, which it began delivering to financial institutions yesterday.
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“You get embarrassed as a professional athlete. There has to be accountability in our room. That’s not acceptable. Not even close.”
- Shane Doan
Last night I trekked out to the dilapidated Nassau Coliseum with a few colleagues to watch a National Hockey League game between the New York Islanders and the Phoenix Coyotes. We worked to put a group together to buy the Coyotes and now own a piece of the team, so we had a bit of an emotional investment in the game.
The end result was a 6 – 1 trouncing of the Coyotes by the Islanders. For those that play sports or are fans of sports teams, you will be, on some level, accustomed to losing. It happens. It is part of the game. But Coyotes’ Captain Shane Doan’s point from above is adroit - if you lose you also have to be accountable. No doubt old school Coyotes Coach Dave Tippet made sure of that in the locker room last night after the game.
Given the current dysfunction in Washington, the one thing that we can all smile about this morning is that the Founding Fathers actually built a high level of accountability into the system. This is particularly true in the House of Representatives where elections occur every two years. But how does this all end? Who gets held accountable? And when can we go back to focusing on research and not the soap opera of Washington D.C.?
In terms of the first question, this probably all ends with a whimper, rather than a bang, despite the manic intimations of the media or fear mongering politicians. Keith and I did a short clip on HedgeyeTV (yes, the crazy lads at Hedgeye built their own T.V. studio!) and if the credit default swaps of U.S. government debt are telling us anything, it is that there is no imminent risk of a credit default.
In the Chart of the Day, we highlight a more interesting trend related to U.S. creditworthiness, which is the long-term federal deficit-to-GDP chart. The key takeaway from this chart is that the creditworthiness of the U.S. has actually been improving over the last three years based on this key metric. (Incidentally, it shouldn’t surprise anyone that the lagging indicators called rating agencies downgraded U.S. debt basically at the bottom.)
Last week, we brought in former Speaker of the House Newt Gingrich to discuss how the government shutdown is likely to play out. To summarize his view; it was that the Republicans push through some small reforms on the Affordable Care Act and likely come to some agreement on future tax reform or discretionary spending cuts with the White House. Speaker Boehner’s rhetoric has shifted from focusing on Obamacare, to focusing on the idea of a negotiation, which certainly underscores this point.
Our Healthcare team is currently doing a poll that is asking people the simple question: “How will the government shutdown end?” So far the results are as following:
- 2% - Shutdown ends, debt ceiling raised, Democrats make massive concessions
- 48% - Shutdown ends, debt ceiling raised, Republicans get very little in return
- 18% - Shutdown ends, debt ceiling raised, on concessions either side
- 18% - Shutdown continues, debt ceiling raised, on concessions either side
- 15% - Shutdown continues, debt ceiling raised, and the World Ends
So, there you have it. Almost half of those polled agree that the likely outcome is that the shutdown is ended and debt ceiling is raised, but the Republicans get very little for their actions.
The more interesting point is that almost 15% believe that the world could end (i.e. the U.S. has some form of a default). So, if you are wondering why there is volatility in the markets currently, it is because of this not so small minority that are pricing in the end of the proverbial world trade. In all likelihood, though, there is some form of resolution before the Oct. 17th deadline.
Incidentally, if you’d like to take the poll it can be found here: http://poll.fm/4ft5s
Shifting from policy makers to monetary policy, the writing appears to be on the wall this morning that President Obama intends to nominate Janet Yellen as the next chair of the Federal Reserve. In the coming days, there will be many assessments of Yellen, but I thought this one from Justin Wolfers, an economist at the University of Maryland and friend of Yellen’s, was particularly interesting:
“If Yellen had been in charge of the Fed over the past few years, millions fewer would be jobless, and we would be less concerned about the danger of deflation. The point is that Yellen’s pragmatic reading of the macroeconomic tea leaves has led her to avoid the errors of her theory-bound colleagues who have seen the threat of inflation around every corner. Both hawks and doves should applaud this appointment.”
Translation: according to Wolfers, Yellen is a miracle worker.
The reality is that is not really her broad reputation among stock market operators. Or those of us that operate in the real economy. The great Julian Robertson of Tiger Management fame, and likely a proxy for what many astute money managers think, said on CNBC earlier this week that Yellen is, “way too easy money.”
The broader implication of more easy money is a weaker dollar and a deceleration of economic growth. Whether it be the yield spread compressing, short term treasuries nearing the zero bound, or oil breaking out to the upside, the implications of more, and perhaps accelerated easy money, is ultimately slower growth. If that is the path our policy makers go down, it will be more embarrassing than just losing some hockey game.
Our immediate-term Risk Ranges are now as follows:
UST 10yr Yield 2.60-2.67%
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
THE MACAU METRO MONITOR, OCTOBER 9, 2013
RECORD HOTEL OCCUPANCY, CASINO VISITS AT SANDS Macau Business
Sands China Ltd properties recorded 1.5 million visitors in the first week of October, up 23% YoY. Sands China executive vice-president of operations Gunther Hatt says the company’s properties were “near full capacity” for the week and its 9,000 hotel rooms were fully occupied from last Wednesday to Friday.
GOLDEN WEEK ARRIVALS WERE UP BY 6.2% THIS YEAR Macau Business
Golden Week tourist arrivals were up by 6.2% YoY. From October 1 to Monday, 901,176 tourist arrivals were recorded by the police. The Macau Government Tourist Office says mainland arrivals grew by 12.1% to more than 722,000 people during the week.
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