Advisors Capital White Paper A Review of Master Limited Partnerships

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Anna Floyd
6 years ago
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White Paper Master Limited Partnerships, MLPs, have had another rough quarter, so a review of the causes and outlook for the sector is appropriate.

1 White Paper Master Limited Partnerships, MLPs, have had another rough quarter, so a review of the causes and outlook for the sector is appropriate. AMLP, the Alerian MLP ETF, declined by almost 20% in the third quarter, despite rebounding almost 8.5% on the very last day of the quarter. But the sector has been in decline since the fourth quarter of 2014, as oil prices started their steep descent, so the cumulative damage has been considerably greater. Without any doubt, MLPs have been walloped. Does this make sense? Is it sustainable? Is recovery possible? Is recovery likely? Are the dividend payments, called distributions, sustainable? These are the questions that need to be addressed. Most importantly, it is critical to differentiate between upstream MLPs, mid-stream, and downstream. Upstream firms operate around the well, either actively drilling for oil or gas, or supplying critical services to firms engaged in drilling. Mid-stream companies collect oil or gas from the drilling companies, transport it (mostly by pipeline) to refineries or gas processing plants, and then store or transport the refined products to distribution centers close to our population and industrial centers. The downstream companies store and distribute the refined products to users. The economics of the upstream business is quite different from mid-stream and downstream companies, and they have very different risk profiles and profit opportunities. Hysterical articles suggesting MLPs are dead, across the board cuts in distributions are coming, and many are headed to bankruptcy are oblivious or ignore the differences between MLPs and will be proven wrong, most likely sooner rather than later. The upstream firms engage in drilling. Firms like Linn, EV Energy Partners, Mid- Con Energy Partners and others, drill for oil and gas and their revenues are directly related to the price of these commodities. When oil prices declined from more than $100 per barrel to $45 beginning last Fall, these firms suffered huge revenue declines, while their cost of drilling changed little, which sharply reduced profitability or produced losses. (The full brunt of this revenue decline may show up over a year or two, once any hedges roll off.) Upstream drilling companies with too much debt on their balance sheets account for all the bankruptcies reported. The financially strongest of these upstream companies still suffered large profit declines and every single one we follow has reduced its dividend. Even so, the market expects additional widespread reductions pretty much across the board, and we also expect such cuts. These companies have always been understood to have considerable sensitivity to the price of the commodity and we have always sharply limited our exposure to them for this reason. Not surprisingly, every one of these firms experienced a major decline in their share prices. Of the three companies mentioned above, the year-to-date declines in 2015 through September 30 were 73%, 69%, and 66%, respectively. And since some of these were sizable companies, they are typically held by MLP ETFs, high yield MLP ETFs and MLP mutual funds. Page 1 Charles Lieberman, Ph.D. Chief Investment Officer Management LLC is a individuals, institutions and financial professionals. For information regarding our programs and services please call us at Management, LLC (ACM) is a industry professionals and their clients. Although the information included in this to be reliable, we do not guarantee its accuracy. All constitute the judgment as of the dates indicated and are and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Consult The firm s ADV Part 2A and 2B are available upon

2 White Paper Gathering and Processing MLPs blur some of the distinction between upstream and midstream. These firms, including American Midstream, DCP Midstream, MarkWest, and Midcoast Energy, collect gas from the drilling companies, but they do have some exposure to commodity price risk. So the decline in gas prices has also hurt their bottom lines. They also hedge their gas prices, typically operate under long-term contracts that insulate their bottom line for some period of time, and mostly avoided any reductions in their distributions, so far. In fact, some gathering and processing firms have increased their distributions since the collapse in oil prices. We had minimal exposure to any of these companies, again because they do take some commodity risk. They are not as risky as the upstream companies, but riskier than the pure pipeline midstream and downstream companies that we prefer. The market is understandably worried that distribution cuts may be coming, especially as some of the hedges roll off. Pipeline midstream companies act like highways, connecting oil refineries and gas processing plants with distribution nodes around the country. Like a toll highway, they are paid to transport or store oil and gas, but they don t own the products, so they do not take commodity price risk. Rather, they transport the products under long-term contracts that typically build in annual price escalations that are tied to the Producer Price Index, a measure of inflation at the wholesale level. Their revenues streams are simply not sensitive to the price of oil or gas. These firms include many of the largest firms in the MLP space, such as Energy Transfer Partners, Kinder Morgan, Enbridge Energy Partners, and Williams. I am not aware of a single company in the entire mid-stream sector that has cut its distribution anytime over the past year. Instead, all four of the companies mentioned above have increased their payouts over the past year, sometimes more than once. Profitability has also increased over the past year for each of these companies. And we own all four of these companies in client accounts. Despite the increases in their distributions, their stock prices have been hammered, albeit far less than the price declines seen for the upstream or gathering and processing companies. These four have declined over the first three quarters of the year by 37%, 29%, 38%, and 18%, respectively, with Williams shareholders benefitting from being acquired in a hostile takeover. With increases in their payout and declines in their stock prices, the yields now available on these stocks have increased sharply. Even so, I expect all of them to hike their distributions at least once each over the next year, but multiple hikes are likely. Page 2

3 White Paper Downstream companies are close to the ultimate consumers of energy products, selling energy products directly to users. These firms may be service stations or propane deliverers, including firms like NuStar Energy or CrossAmerica. These companies buy refined products from wholesalers, mark up the wholesale price they pay by a small amount and sell directly to customers, making their money by the volume of their sales. Their business is pretty competitive--think about all the gasoline service stations out there, for example--so the mark ups are small. But with gasoline prices having declined so sharply, consumer purchases of gasoline are setting new all-time record highs every month. NuStar has maintained its dividend over the past year, while CrossAmerica has hiked its payout by a penny every quarter. Again, the dividend hikes have not prevented these stocks from falling sharply in price, NuStar by 22% and CrossAmerica by 43% this year through September 30. Marine MLPs are mostly like midstream pipelines, bringing crude and refined products from one terminal to another across the sea, or from offshore production wells to onshore production facilities, since pipelines can t be run offshore in deep waters. Such companies include Capital Product Partners,, Teekay Offshore Partners, and GasLog Partners to name a few. We own all the aforementioned companies in client accounts and none has reduced its payout, while Capital Product is increasing its distribution and Teekay Offshore Partners just announced a hike. Again, these stocks have all been hammered across the board. A widely circulated report early last week described the MLP model as broken, implied that wholesale distributions cuts were coming on top of those already announced and that the entire MLP corporate structure might be unworkable. This report was also widely criticized because it ignored all the differences between upstream companies and midstream and downstream companies. Its negative conclusions were drawn from the upstream companies, but its implications were applied across the entire sector without distinction. A major publication that highlighted the original report later backtracked somewhat. As another analyst suggested, the MLP model isn t broken or even dented. Rather, it has been misrepresented, misunderstood and abused. So, Are the declines in MLPs warranted? We think the declines seen for the upstream companies, as large as they have been, make a lot of sense. Every single one of these companies has experienced a dramatic decline in profits, cut its distribution very sharply already, and will probably have to implement even deeper cuts in the coming quarters. With oil and gas prices likely to remain low for some time into the future, we expect all these firms to struggle for visible future. There is no cavalry to ride to their rescue. Moreover, we see additional risk in these companies. Most try to hedge their commodity price risk. So, what happens if oil prices do not rebound and the hedges expire? At that point, typically one to two years down the road, the revenues of Page 3

4 White Paper these companies will decline even more. If they are unable to significantly reduce costs, or align their drilling outlays with their cash flows, or if they have a lot of debt on their balance sheet, their solvency could be at risk. We see this sector as troubled for a considerable period of time. No doubt, their prices will get cheap enough at some point to warrant a reconsideration of our negative view on the sector. But right now, that point is sufficiently far beyond our radar screen, we can t even envision when that might happen. In contrast, the declines seen in the midstream and downstream sectors lack foundation and defy logic, since their businesses are largely immune to energy prices. One good question we ve been asked is whether these companies will experience lower volumes for their pipelines, as some fracking activity is scaled back because of lower oil prices. We think not, because final demand for energy products is rising, not falling. Gasoline demand is setting new records each month, as people drive more because it is cheaper. Demand for natural gas is rising rapidly, as utilities displace coal with gas for environmental reasons and chemical companies build more plants to benefit from low energy costs in the U.S. Perhaps a bit less of that gasoline will be sourced from domestic wells. But if that happens, it implies we will be importing more crude oil to refine the increased volume of gasoline being bought. But domestic oil is still cheaper than imported crude, so I doubt there will be much displacement of demand supplied by foreign oil. But either way, MLP pipelines will still be carrying greater volumes, regardless of the source, because demand is rising. Just because downstream and midstream companies are selling oil based products is no reason for their share prices to fall along with the price of drilling companies. Indeed, when the profits of an integrated company, such as Exxon, are taken apart, it quickly becomes clear that its upstream profits have declined quite dramatically, while its midstream and downstream profits have increased. This is why we have tended to avoid the integrated companies. We would much rather own the part of the distribution business that is less vulnerable to fluctuations in the price of the commodity. Is the decline in MLPs sustainable? We think the decline in the share prices of the midstream and downstream companies we own, and many others, are unsustainable because the yields are simply very high compared to any alternative. As time passes, more increases are coming in their quarterly payouts, not cuts. Because these stock prices have fallen in sympathy with the plunge in the price of crude oil, we think this has also reduced their vulnerability to rising interest rates. A 10- year Treasury that yields around 2% today is simply not attractive relative to a company like Energy Transfer Partners, with a market capitalization of $35 billion and diversified operations across large swaths of the country that yields around 9.75%. Moreover, the disparity may rise as the MLP is likely to increase its quarterly distribution over time, while the Treasury coupon remains fixed. As the Fed raises interest rates, Treasury bond yields will rise, reducing the bond price. At the same time, the MLP may be raising its distribution. Without any doubt, the MLP has much greater market price risk, especially in the short-run, as we have seen over the past year. But over the 10-year time horizon of the government bond, the Treasury pays that fixed coupon, while the MLP is likely to hike its distribution quite considerably. So we see the current price of most midstream and downstream MLPs as exceptionally attractive, partly because we see the recent decline in stock prices as having created excessively high yields in a marketplace where decent yields are hard to find. Is recovery possible? Is recovery likely? Midstream, downstream and most of the marine MLPs are, in our judgment, extremely cheap. A recent research report we saw compared current valuations to the lows seen in this space at the bottom of the market in 2009 and noted that current pricing remains Page 4

5 EV-to-EBITDA White Paper above those lows. Since the lows of March 2009 were once-in-a-lifetime lows, we found this comparison borderline useless. It is hard and unreasonable to remain out of the market holding nothing but cash, earning next to nothing on that cash, waiting for a once-in-alifetime depressed valuation before committing capital to the market. On 12/31/2008, two gathering and processing midstream gas MLPs, MarkWest and Targa yielded 32.1% and 26.7% respectively. The gathering and processing business has some sensitivity to the price of gas, not as much as the exploration and production companies, but far more than the pure pipelines and downstream companies. Yet neither reduced its distribution payout in 2009 by even one cent and both rallied by more than 200% off their 12/31 depressed values. Indeed, the entire MLP universe was at multi-generational lows at the end of 2008 into early While not at 2009 lows today, MLPs are extremely cheap. A Wells Fargo report dated 10/1/2015 titled, Rationalizing the Irrational, estimates that the yield on the median MLP is 9.4% today and 807 basis points over the 10-year Treasuries, compared to a 10-year average yield spread of 393 basis points. (A 10-year average includes the high yields of ) When compared to high yield bonds instead of Treasuries, MLPs offer an incremental 293 basis points, compared to their 10-year average discount of 75 basis points. By every measure, MLPs are cheap and, in our judgment, have reached screaming buy levels. As mentioned above, none of the midstream or downstream MLPs has cut its distribution over the past year since oil prices plunged, even as every one of the upstream firms has slashed its payout. And just as a majority of midstream and downstream companies increased payouts over the past year, we expect a sizable majority of these firms to increase payouts yet again in Investors will wake up to those very high yields soon enough. In keeping with our expectations for many distribution hikes by MLPs over the coming year, Teekay Offshore Partners announced on October 2 a 4% increase in its payout for the third quarter from $0.538 per share to $0.56. At yesterday s closing price of $14.52, the prior distribution implied a yield of 14.8%, a seemingly unsustainable yield. Yet the new yield is 15.43%. Not surprisingly, the stock price jumped in response, rising by nearly 4% in an otherwise down market. (The market is not totally stupid.) And to quote the CEO in its press release, Our distributable cash flow is stable and growing, supported by a large and diversified portfolio of fee-based contracts totaling approximately $8.4 billion of forward revenues that are not directly linked to oil prices. In the chart below, we show enterprise value relative to corporate cash flow since Record low levels of valuation relative to cash flows were seen during the market crash of With hindsight, 2008 valuations were an exceptional time to buy. (The same could be said for the entire equity market, of course.) Even so, current valuations are also exceptionally low Alerian MLP Index Historical EV/EBITDA Source: Bloomberg, Management (October 2, 2015) Page 5

6 White Paper So, are the distributions really sustainable? Most MLPs operate with cash flow coverage of their distributions between 1.0 and 1.3 times, with the average around roughly 1.2 times. This gives them plenty of coverage in case something unfavorable happens. But since midstream and downstream MLPs are largely insensitive to the price of the energy products they are transporting or selling, a decline in oil prices isn t the kind of unfavorable event that would impair their ability to maintain their payouts. Rather, the excess cash flow provides flexibility to fund investment programs, overcome seasonality to their business, and manage their business without disruption from the normal ebbs and flows of business. Instead, we expect payout increases in 2016 for most midstream and downstream firms, so we clearly believe the payouts are sustainable. Some of the confusion over the sustainability of the distributions comes from the accounting, and I will use Kinder Morgan (KMI) as an example to explain the point. KMI reported net income or profits (on a GAAP basis) for the first six months of the year of $0.35 per share, but paid out $0.97 per share in dividends. So, how does a company pay out so much more than they earned in profits? The answer is they pay dividends out of cash flow, not profits, and distributable cash flow was $1.07 per share over the same six month period. KMI owns thousands of miles of pipeline and tens of billions of dollars of infrastructure that it can depreciate for tax purposes, which reduces reported profits, but requires no outlay of cash. (The outlay of cash occurred in the past when the pipelines were first laid.) As a result, cash flow is much greater than reported profits. (The same accounting issue is at work with real estate firms that typically report cash flows that greatly exceed reported profits and also pay their dividends out of cash flow, not out of profits.) In fact, KMI has publicly stated it expects to raise its dividend to $2.00 per share in 2015 and all three payments actually made in 2015 were increases over the prior quarter. We anticipate this to continue, at least until 2018, consistent with the company s own public projections, given all of the investment projects it has in different stages of planning and development. If drilling activity is reduced, growth in oil and gas production may slow. But only the first half of this statement has occurred so far. New drilling activity has been cut nearly in half, as measured by the active rig count, but drilling efficiency has increased quite rapidly. As a result, actual oil and gas production has held up quite well, at least so far, despite the reduction in new drilling. Drilling firms are actively trying to reduce costs and become more efficient in their exploration and development efforts, instead of drilling anywhere and everywhere possible. Moreover, since fracking is still a new technology, significant improvements are likely over the next several years. The cost of oil and gas produced from fracking declines as well efficiency improves, which helps lower breakeven costs. I expect production levels of oil and gas to hold up pretty well, partly because the demand for energy products remains robust. What is likely to happen if new energy production slows or declines? MLPs would be likely to respond by moderating their investment plans in new pipelines. If investment spending in new infrastructure and pipelines slows down, growth in cash flow will slow, but the financing needs of the industry will also decline. Growth in free cash flow is not needed to cover existing distributions, which are already well covered. Public financing has been needed to fund the industry s rapid pace of growth. Indeed, growth should be expected to slow somewhat. But at the same time, less of their existing free cash flows would be needed to fund new infrastructure, so more would be available either to pay down debt or to increase their distributions. So a cutback in new investment would only enhance the coverage of existing payouts and would still be likely lead to some additional distribution increases. Page 6

7 White Paper The decline in MLP stock prices may also produce a slower pace of growth, because the lower stock price increases the cost of capital to these firms. In response, MLPs may become more selective about funding expansion of their infrastructure. Some firms will prefer to tap the debt market, which remains an attractive, low cost source of financing, especially to the larger, highly rated midstream MLPs. But they won t want to increase their debt levels too much relative to their equity base, so the debt market does not represent an unlimited source of new capital. As their stock prices recover, MLPs may resume a more balanced mix of financing between debt and equity and growth should pick up. So, what are our most important conclusions? It is our view that there is no impending rebound in oil prices, so we would avoid the upstream companies with revenues tied to the price of oil. If you own these companies, realize your loss so you can share it with Uncle Sam. Midstream and downstream firms are now very cheap, so we regard them as very attractive. Recovery in the prices of these stocks may take some time, since stock prices always seem to fall much faster than they recover. But investors can console themselves with the yields of 6% to 15% or more while they wait. And for those investors who need income, buying now is an exceptional opportunity. Page 7

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