Looking At Fundamental Questions In MLP Investment

by: nstollon

As in many articles on MLPs, a lot of information and assumptions get tossed around in both articles and in the comments. As a relative novice in the MLP field, it seems that there are fundamental questions that need to be asked. I have my humble opinion, but as in many Seeking Alpha articles, the best value will be in the reader comments.

1. Is the MLP structure better for investors than the C corp structure?
It seems difficult to compare at times since standard metrics for C-corps such as PE, earnings and even book values have different or little meaning in the MLP world. While MLP business structures are largely built on tax law, there are other fundamental issues, in an ant (retaining and investing what you earn) vs. grasshopper (always needing new capital and assets) to consider. Even discounting the general partner relationships, investors today seem to value C-corp more than the equivalent MLP (comparing current Linn Energy (LINE) vs. its C-corp (LNCO) valuations as an example), but there is always a break point on what makes best sense for the investor. I am still trying to figure out what is that break point is, (most advice I have seen is a generally dazed "it depends"). This seems increasingly important as more MLPs of all types indicate they are initiating C-corp equivalents. As one point for thought - if the C-corp retains even a fraction of earnings, at some future point it may theoretically own a majority or the entire MLP. At that point, how does that ownership interest impact the ongoing share dilution that is fundamental to the MLP business model?

2. Some MLP discussions gloss over the fact that there are many different types of MLPs. To me, lumping of upstream vs downstream and oil vs. gas vs. coal does not make sense just based on their tax structure. Just looking at upstream vs downstream, these are very different business. Extractors are working with a depleting resource (oil, gas) that is dependent on commodity pricing (even if they are hedging future production). It is worth noting that for gas and coal, pricing currently remains at near historic lows. What happens to general and comparative profitability and returns for gas returns if/when gas increases to more historic levels, either from scarcity field or (a nearer term factor) from export?

Downstream MLPs are more of a fixed asset (pipeline) return, with more well predicted life and returns. Despite arguments, pipeline life times are well understood - while a given mile of pipeline may fail (and be fixed), 100K miles of pipeline can be expected to follow the life time reliability models. Likewise cost for additional build out of pipeline is well understood and essentially unlimited, given the widely available raw materials. The key long term questions for downstream appear to be saturation (when will there be a point of more transport resource than product to be transported, and what does that do to pipeline revenue models?) and residual issues (pipeline end of life cost, are there any value to pipeline if wells get tapped out?).

3. In the current environment, downstream transport and storage seems more limiting factor in MLP business than upstream, but that will change in time as infrastructure increases and at some point will be balanced/surplus to upstream product and demand. The question is when that will happen? This is the essential unknown, depending on:
a. reserves (technical projection and marketing hype seem to blend when both seem to depend on unproven reserve estimates),
b. overall need (what happens to growth drivers when all utilities move to gas…or alternately to nuclear),
c. environmental issues (ranging from water issues to global warming - it does not matter if they are valid, the no-nukes movement of the 1970s proved that popular sentiment trumps technical realities),
d. export feasibility (can the US really become the energy center of the world) in view of both largely unknown reserves in Asia and Africa and corresponding increasing but unclear future needs. There is very significant activity in creating gas export facilities, Chiniere (NYSEMKT:CQP) being a visible, but far from the only player. It is always worth recognizing that current European and Asian energy cost remains 3-4X that of US, but does that translate into a major profit boost from energy export to the entire gas MLP environment?

4. Increasing distributions appear to be implicit to the current MLP model, but the future should always be discounted. Increasing distributions rely on new energy asset acquisitions or more infrastructure build out. Both energy assets and required infrastructure do have inherent limitations. As and when some level of overall upstream asset depletion or downstream saturation occurs, distributions would be expected to level out and eventually decrease. Looking at how MLPs are treated under tax law, should investors consider them, in a way, more of an annuity rather than investment, in that the lifetime returns are above average, but at the end of the day, after the underlying investment may be depleted and of marginal value?

There is no question that historically, the energy MLP has been a vibrant and generally profitable investment area. For the near term, I expect it will remain a compelling investment as it gains visibility and investment interest. The long term viability of the MLP industry to me has different issues. I like to think in terms of very long-term horizons, and this causes some concern in any MLP investment. At some point I expect the current MLP model changes, but evidence is not compelling if it is in a 10 year or a 50 year horizon. This is where some additional insights and analysis would be very useful.

Disclosure: I am long LNCO, BBEP, QRE, CLMT, PVR, NRP, KMI, ETE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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