What Happened in September: Six Things Only People Who Followed MLPs During the Financial Crisis Will Remember
Did you know it’s not safe to wear a seat belt? If you’re driving across a frozen lake and the ice cracks, the car will sink, your seat belt will lock, and you’ll drown. Over 40 people die each year in skiing accidents. And yet, I wore my seat belt on the way to the airport this morning, and I’ve already bought my season pass for several mountains this winter. I also haven’t sold my MLP exposure. What am I thinking?
With the invention of BuzzFeed, as people who read things on the internet, we’ve discovered that we love the sensational. We’re not interested in anything nuanced or moderate. In search of that dopamine rush inside the echo chamber of the internet, we forego edited, thoughtful, balanced journalism in times of stress and panic. I’m sorry to say, I don’t have one weird trick that all MLP management teams don’t want you to know. But in that spirit, here are six things that only people who invested in MLPs through the financial crisis will remember.
- No Access to Capital = Reduced Growth (Not the Apocalypse).
MLPs are absolutely dependent on capital markets access to finance the growth we’ve seen during the past decade (over 7% annualized). From May 2008 to May 2010, there was not a single MLP IPO, investment grade MLPs traded down to double-digit equity yields, and senior notes were issued at high single-digit yields by those same investment grade MLPs. And yet, not a single MLP in the Alerian MLP Infrastructure Index (AMZI) cut its distribution during the financial crisis. In fact, several continued to grow, resulting in a weighted average for the index of 2.5% distribution growth in 2009. Sure, it’s a far cry from 7%, but it’s not doomsday.
As far as today is concerned, Enterprise Products Partners (EPD) just announced its 45th consecutive quarterly distribution increase, the last 12 of which have been $0.005 on a split-adjusted basis. In other words, business as usual. And Targa Resources Partners (NGLS) priced $600 million of 6.75% nine-year senior notes at par, proving that even non-investment grade names still have access to reasonable debt financing.
- Some MLPs Can Internally Finance Growth.
EPD has a distribution coverage ratio of 1.3x, and despite a market cap of $50 billion, needs just $1.8 billion of growth capex opportunities financed with retained DCF and debt to maintain its distribution growth rate. Magellan Midstream Partners (MMP) hasn’t raised equity in the public markets since 2010, and yet has more than doubled its quarterly distribution over the last five years. In August, MMP increased guidance, expecting a 1.3x coverage ratio for 2015 and recommitting to 15% distribution growth in 2015 and at least 10% in 2016.
- Distributions Are Not Invincible.
There’s some fear mongering around the internet that MLPs are funding their distributions with debt. This isn’t true—current distributions are funded by cash flow from existing, in-service projects, most of which are underpinned by long-term, fee-based contracts. But MLP distributions aren’t guaranteed, either. Some MLPs operate commodity-sensitive or cyclical businesses and/or pay variable distributions. In the past 12 months, every upstream MLP cut, suspended, or eliminated its distribution.
As a structure, MLPs have a broad and diversified risk profile; just because midstream names are at the lower end of risk, it doesn’t mean that their distributions are risk-free. During the financial crisis, several midstream names also cut their distributions. EnLink Midstream Partners (ENLK) (former name and ticker: Crosstex Energy LP (XTEX)) could not fund all of its growth projects and leverage began to creep up as cash flows declined. Hiland Partners (former ticker: HLND), which went private in 2009 and was bought by Kinder Morgan (KMI) earlier this year), was a gathering and processing (G&P) company with single basin exposure. Atlas Pipeline Partners (former ticker: APL) cut its distribution due to commodity price exposure through its processing business.
MLPs Are Neither Dependent on Nor Independent of the Price of Commodities.
In 2008, crude fell from $145 to $31 in six months. With many processing contracts structured on a percentage of liquids (POL), percentage of proceeds (POP), or keep-whole basis, G&P MLPs were significantly exposed to commodity prices. Today, most processing contracts are fee-for-service, removing that direct exposure. Still, MLPs are more sensitive to the price of crude than to the price of milk, but they are much more sensitive to hydrocarbon production levels.
When the word “energy” is used in American media, it nearly always refers to crude oil, but crude isn’t the only hydrocarbon produced and consumed in the United States. In the Northeast, natural gas takeaway capacity is currently the limiting factor for producers. Until more pipeline capacity is available, there is no economically viable way for producers to bring their product to market. New projects are coming online beginning in late 2015, and analysts expect that production will increase as the bottleneck dissolves. The need for natural gas infrastructure in the Marcellus/Utica has largely been overshadowed by the panic about crude prices, but it is a much more significant driver of future MLP cash flows and growth opportunities.
- Volumetric Risk Is Real.
A toll-road business model is defined by Price x Volume. For interstate liquids pipelines, the Price is federally mandated to increase by PPI + 2.65% every July 1st. Other pipeline contracts have similar rate escalators. There are take-or-pay contracts, minimum volume commitments, fee-based contracts, and acreage dedications. For the latter two, the volume side of the equation has two parts: (a) supply-push, which could meaningfully decrease if commodity prices remain lower for longer; and (b) demand-pull, which given a lower-for-longer environment, could meaningfully increase as manufacturing moves back to the US and more small- and mid-size refineries are built. Gasoline demand has already started to increase. It just depends which crystal ball you prefer.
- MLPs Don’t Trade Based on Yield.
No matter how many analysts love yield-based valuations (and they are useful in a back-of-the-envelope-we’re-drunk-in-a-bar-but-still-energy-nerds kind of way), yield is not actually a valuation metric. On that note, as of month-end, the AMZI was yielding 8.2% and many MLPs have yields in the double-digits now. Then, as now, investors are being paid rather handsomely to wait.
The signal-to-noise ratio for MLPs is changing, and the way we are listening is changing, too. The signal is still the same as ever: MLPs are an investment in the build-out of North American energy infrastructure over the next several decades. The noise just started having better headlines: Emerge Energy Services (EMES), a variable distribution frac sand MLP and 2014 darling among certain analysts and portfolio managers, withdrew distribution guidance in September. While frac sand and upstream MLPs never made up a large percentage of the structure, they tend to get a lot more attention. Even for the blue-chip midstream names, things are not all roses. Both Kelcy Warren and Greg Armstrong (the CEOs of Energy Transfer Partners (ETP) and Plains All American Pipeline (PAA), respectively), have commented honestly and publicly that they are near-term cautious given this environment. They have made and dedicated their fortunes to this industry but warn that things may get worse before they get better. Buckle up (or don’t), because it may be a while before the volatility ends.