Have MLPs and Midstream Actually Reduced Leverage?

Summary

• Reducing leverage to more comfortable levels is important for midstream in terms of increasing financial flexibility and supporting broader investor appeal.
• The average leverage ratio for the current North American midstream universe was 4.6x in 2016 and decreased to 3.7x at the end of 2018. More than 60 percent of the North American midstream universe reduced leverage from 2016 to 2018.
• Getting leverage to a sustainable level is typically a prerequisite for pursuing shareholder-friendly actions such as share buybacks or greater dividend growth.

After becoming overextended during the oil price downturn from 2014-2016, midstream companies have placed greater emphasis on reducing leverage to a more comfortable and sustainable level. Lower leverage provides increased flexibility to withstand challenging market environments and lays the foundation for companies being able to grow their dividend or buy back shares. Today, we examine leverage metrics from 2016 to 2018 for the current North American midstream universe. Whose positioning has improved, who has seen leverage increase, and what are the broad implications of leverage reduction? Keep reading to find out.

Midstream reducing leverage to increase flexibility and broaden investor appeal.
Ahead of the significant drop in oil prices from late 2014 to early 2016, midstream (and energy in general) had become overextended through heavy spending, leading to higher leverage. High leverage constrained financial flexibility for companies, limiting management teams’ options for reacting to the energy downturn when flexibility was most needed. As a result, many MLPs experienced painful distribution cuts. With lessons learned from the oil downturn, management teams have reprioritized financial flexibility and balance sheet strength. Institutional investors (including generalists) are also increasingly focused on leverage, with the topic coming up frequently in panel discussions and company presentations at the MLP and Energy Infrastructure Conference last month (Read More). Ultimately, what matters to investors should also matter to management teams. Furthermore, leverage ratios are an important determinant in credit ratings (Read More), which impacts cost of debt and project returns. It is important to note that ratings agencies and banks may have their own approach to calculating leverage.

Leverage across midstream has generally improved over the past few years.
Most names in the North American midstream universe decreased their leverage from 2016 to 2018. Annual leverage ratios from 2016 to 2018 were calculated using long-term debt divided by adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) for the constituents of the Alerian Midstream Energy Index (AMNA), a broad-based North American midstream index including both MLPs and C-Corporations. See the appendix to this piece for leverage ratios by company for 2016-2018.

As of the end of 2018, 61.8% of AMNA constituents (34 out of 55 names) had reduced leverage from their 2016 levels as shown in the pie chart below. Overall, leverage decreased for the index on both an average and median basis. Average leverage for the AMNA Index was 4.6x in 2016 and decreased to 3.7x at the end of 2018, while median leverage decreased from 4.3x in 2016 to 3.9x in 2018. The color-coded chart below shows the distribution of leverage ratios for individual constituents of the index. The majority of constituents (54.5%) had a leverage ratio below 4.0x as of the end of 2018, and nearly three-fourths of the companies in the AMNA Index had a leverage ratio below 4.5×.