In the January 31 edition of Value Investor Insight, VNBTrust's Timothy Mullen explained why he sees opportunity in energy-related MLPs. Key excerpts follow:
Describe the general opportunity you’re seeing in energy-related master limited partnerships.
TM: These are businesses structured as publicly traded partnerships, so they have unusual securities with more complicated tax rules, but also with tax advantages. Similar to REITs, MLPs have to pay out a high percentage of their distributable cash flow and some of that can be deferred for income-tax purposes by investors.
Energy MLPs run the gamut, from small to large, and from virtually no commodity risk to lots of commodity risk. One large MLP we’ve owned for some time is Kinder Morgan Management (NYSE:KMR), which was one of the pioneers in the asset class. The company has a web of facilities throughout North America that transport and store natural gas and oil. Producers typically buy capacity from Kinder pipelines and send it a check every month whether or not they use the capacity, or they rent space in one of Kinder’s storage facilities for a fee. Only about 10% of the entire business is sensitive to the price of the underlying commodities, so it tends to be a predictable and solid profit generator.
The more-established the business and the lower the commodity-price risk, the safer the annual distribution, which in Kinder Morgan’s case has been just over $4 per share. That results in a better than 9% yield at the current share price, and given the contractual and fee-based nature of the business, we think that distribution is at very little risk.
Do you expect the distribution to grow?
TM: The company expanded for years by acquisition, buying pipelines at low multiples and with cheap enough money that the added capacity allowed them to increase distributable cash flow per unit. As purchase prices escalated, Kinder started building out its own pipeline network. Those big capital projects are largely done and the company now has new capacity going on line that will generate incremental revenue and profit. The dynamic of new revenue generation and diminished capital-spending needs should help drive distribution increases going forward.
What kind of upside do you see for the MLP units themselves, now trading around $43.60?
TM: Until recent times, these types of MLPs typically traded at a very narrow spread over 10-year Treasury bonds, say 100-200 basis points. With 10-year Treasuries now yielding 2.5%, the spread has gotten way too wide. Even assuming Treasuries go higher, there’s plenty of room for capital appreciation on the units as the spread narrows.
When you take into account the current yield, the fact that distributions should grow over time and that the spreads are very likely to narrow, it’s not a stretch to assume a 20%-plus return on these units over the next few years.
What’s the difference between these units, with the ticker symbol KMR, and Kinder Morgan Energy, with the symbol KMP?
TM: Each share of KMR is a share of KMP, only it pays distributions in additional shares instead of cash. That simplifies some of the tax reporting – you don’t get a K-1 form, for example – and the tax consequences should be better because all distributions are treated as capital gains when you sell the shares.
At the smaller end of the MLP spectrum is Teekay Offshore Partners (NYSE:TOO). What is the opportunity there?
TM: This is one of Teekay Corp.’s spinoffs, which essentially moves oil from platforms in the North Sea to shore using a fleet of shuttle tankers. You wouldn’t know it from the way the units have traded, but the commodity-price risk in the business is very low. The company contracts with producers for long terms – often for the entire lives of the fields – and for fixed fees. That’s all they do, which is about as straightforward as you can get. The basic thesis is the ability to earn an outsized yield – more than 11% at the current unit price of around $14 – for a safe business that should see distributions grow at a healthy clip over time.
Is there an event providing potential upside here?
TM: Yes. TOO itself doesn’t own the shuttle tankers, but 50% of a partnership that owns the ships. The other half of that partnership is owned by Teekay Corp., which is the general partner. The general partner has said it will downstream over the next couple of years to TOO the other 50% of the partnership that owns the ships. TOO will have to pay for that in some way – and they should ultimately have plenty of capacity to do so – but the end result should be much higher distributable cash flow for TOO.
Beyond that, the company in the regular course of business is starting to bid on deals to expand its contract base to other parts of the world, particularly at the moment in Brazil. The current energy services environment may temper some of their near-term expansion plans, but in a more normal environment they have plenty of opportunity to expand geographically.