For master limited partnerships (MLP), 2013 is both the best and worst of times.
On the plus side are record-low borrowing costs that have endured now for the better part of four years. MLPs are also among the very few sectors that have been able to raise equity in a way that's accretive to profits immediately. And with North American oil production on track to double in a decade, there's no shortage of opportunities to lock in robust long-term cash flows from stable sources. This, in turn, ensures strong distribution growth, which is the fuel for consistent unit price appreciation.
On the negative side is an extremely uncertain U.S. government fiscal policy that could pull the rug out from under the economy in 2013, just when growth seemed to finally be picking up. The potential for turmoil has already pulled down energy prices from early autumn highs. This has cast a pall over drilling activity, even for oil.
To date we haven't seen many major energy midstream projects cancelled. The exception was the late November tabling of ONEOK Partners LP's (OKS) Bakken Express crude oil pipeline due to a lack of producers willing to sign long-term contracts. But a further weakening of prices due to U.S. economic turmoil would no doubt trigger at least some postponement of new deals.
To be sure, that won't impact current cash flows and distributions of strong MLPs. Those are backed by contracts already in place for assets that are currently operating. And the payers are major energy companies, some of the most solid counterparties in the world. But a slowdown in new deals would stall cash flow and distribution growth. And that could cause prices for many MLPs to add to losses we've seen since the Alerian MLP Index hit its 2012 peak in late October.
What's an investor to do in such a volatile environment? The most important thing is to stay focused on the individual MLPs you own. I see several major themes impacting MLPs in 2013.
First, a softer economy and weaker energy prices will keep a premium on financial strength and scale. Larger companies can afford to look ahead in a volatile market while weaker fare can only respond to survive.
Chevron Corp's (CVX) purchase of 50% of the Kitimat project in British Columbia, Canada, is a case in point. Kitimat is a project to construct a natural gas liquefaction facility for the purpose of exporting now land-locked Canadian natural gas, principally to Asia. The project has been stalled up until recently, as partners EOG Resources Inc (EOG), Encana Corp (ECA) and Apache Corp (APA) have been either unwilling or unable to commit funds for a project that very likely won't start producing income until 2018.
Chevron, by contrast, can afford to pay the USD1.3 billion to buy out Encana and EOG and fork out the additional USD10 billion or so to complete the project with the cash it already has in the bank. It can look ahead of the current market weakness to what should be big-time gains ahead. Larger producer companies like to partner with bigger energy midstream MLPs. And when they sell assets to meet regulatory requirements or to better focus operations, their first choice is larger MLPs. The upshot is larger MLPs will see their road to growth smoothed further, while the door slams shut on new entrants or smaller MLPs.
Second, the increased advantage of larger MLPs will make sector mergers increasingly attractive. One that looks likely in the coming months is between Energy Transfer Partners LP (ETP) and Regency Energy Partners LP (RGP). Both share the same general partner, Energy Transfer Equity LP (ETE), and uniting them would increase company-wide efficiency as well as reduce capital costs by simplifying ownership structure. Management has also stated this will be its ultimate objective, though it hasn't specified when an attempt to join forces will be made or what the terms will be.
Regency is likely to be the target and so is likely to get at least some premium for units. But rather than try to decide whether Energy Transfer or Regency will get the better deal, our bet here is that the long term will bring the most benefit, as the combined entity begins raising distributions once again and captures a better valuation.
The third trend I expect is a continuation of low borrowing costs for MLPs. That's largely the result of continued loose monetary policy from the U.S. Federal Reserve. But it's also because a fearful investment public will continue to demand bonds, meaning institutions will be forced to come to the table to buy. After four years of preparing their balance sheets for another 2008, very few MLPs have significant amounts of debt coming due between now and the end of 2014, let alone 2013. With any tightening of credit conditions they can simply hibernate until conditions do improve. And when they do they'll be able to finance expansion cheaply once again.
Finally, I look for continued softness in prices of MLPs that derive significant chunks of profits from margin-based businesses. Natural gas demand is surging in North America and eventually construction of liquefied natural gas (LNG) export facilities will bring prices back to more of a world level. But for now there's such a supply glut that many producers are no longer hunting down reserves. And when prices do rise, as they did over the summer, new supply comes on the market and the glut returns, sending prices sinking once again.
Oil too is coming under pressure, despite being supported to some extent by global prices. But natural gas liquids (NGL) weakened dramatically this year. And with little way to economically hedge what are still relatively thinly traded markets, companies depending on margins for NGLs like ethane and propane suffered greatly.
Mild temperatures so far this winter bode poorly for propane. And while there's still time for a comeback in the mercury, this looks like another potentially difficult year in the making for processors that depend on pricing margins for profit. The biggest MLP winners in 2012 were all on the fee-based side. Not surprisingly, the longer the 2012-style environment pushes into 2013, the more fee-based MLPs will outperform the commodity-pegged fare.
That doesn't mean we don't want to continue owning MLPs dependent on commodity prices. But it does mean that when conservative MLPs get cheap, they should be investors' first priority for purchase.
One of my top MLP plays for 2013 is Enterprise Products Partners LP (EPD), which is trading at attractive levels right now. Enterprise Products subsumed its general partner interest, a move that helped reduce its cost of equity capital. Debt capital too is dirt cheap, in fact ridiculously so with the company's bonds maturing in 2068 now yielding just 4.25% to maturity. That's not likely to last forever. But for now extremely low financing costs give the MLP the ability to keep expanding its fee-based assets at a feverish clip.
Enterprise Products' Seaway pipeline is set to come onstream in early January, helping relieve a longtime bottleneck at the Cushing, Oklahoma, hub that's hurt North American crude oil prices. Meanwhile, the MLP has launched an expansion project for a natural gas liquids system to be added in mid-2013.
Analyst opinion on Enterprise Products is 20 "buys" versus three "holds" and zero "sells."
The MLP is heavily owned by insiders, with the Duncan family being very large owners. The unit price could slide further in coming days should overall market conditions worsen. But at these levels, given the surety of its growth and yield, this MLP is ripe for the taking.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.